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Cannabis Musings - May 31, 2023
Considering Tilray's debt swap to buy some time
Friends! Now that these Cannabis Musings have found a new home at Substack, we’ve got so many new readers that I thought I’d take a quick second to (re)introduce myself.
Hi there and welcome. I’m Marc Hauser of the eponymous Hauser Advisory, advising on cannabis industry strategy and engagement. I’ve been deeply involved in this industry for over five years now, and started Hauser Advisory after 24 years of deal and capital markets law practice. My work includes macro strategy, problem solving, transaction navigation (e.g., M&A, investment, restructuring), and relationship building, and my advisory engagements have run the gamut from long-term transformative projects, to structuring and preparing for a capital raise, to board service.
I’ve been writing these Cannabis Musings semi-weekly for over four years now, and although they’ve evolved across various formats and platforms, they remain at the core an idiosyncratic perspective on cannabis industry policy, politics, and transactions filtered thru the lens of an ex-lawyer and Yiddish enthusiast. If there are particular topics or issues you’d like me to address, please let me know - I’m sure I have an opinion (although it’ll never be legal or investing advice!).
Moving on, I thought I’d dig into last week’s offering by Canadian licensed producer Tilray Brands, Inc. of $150mm of 5.20% convertible notes due 2027, issuing new debt to replace existing notes that are coming due in 2023 and 2024. Bear with me as we get into the weeds, but this issuance is another good example of how cannabis companies are dealing with this uncertain market. (You’re welcome to read the offering prospectus, the publicly-filed document that describes the notes, but these filings, which are mostly drafted by bleary-eyed BigLaw associates, aren’t known for their accessibility).
Let’s start with some background on convertible notes, which are loans that may be converted into equity of the issuer. Investors like them because they sort of get to have it both ways, kind of like brunch. If the company does well, the investor participates in the upside on the equity, while if the company does poorly, the investor has some protection as a creditor. All the while, those investors are clipping coupons (an old-timey reference to physical bond certificates with coupons that could be detached and presented for payment of accrued interest).
Tilray sold these notes in an underwritten offering. While banks “make” loans, issuers “sell” notes or bonds. Same outcome – Tilray borrowed money and has to pay it back – but, as a term of art, notes and bonds are more akin to investments held by investors (and which is why they’re usually treated as securities under US law), while loans are more obligations held by lenders (and which is why they’re usually not considered securities). Ongepotchket? A bisel.
The underwritten offering means investment banks actually purchased the notes from Tilray and then resold them to investors, meaning that the banks took the risk that investors would buy these notes (practically, the underwriters usually have lined up the investors before closing, although that doesn’t always happen (see, e.g., Twitter (yes, that was a bank loan, but still))). The underwriters also have the option to purchase up to $22.5mm of additional notes within 30 days of closing, known as the “overallotment,” “greenshoe” (referring to Green Shoe Manufacturing, the first stock offering with an overallotment option), or, if you’re short on time, “shoe.”
What is Tilray going to do with all of this delicious money? According to the press release, it’s using the proceeds to buy back existing convertible notes that are going to be maturing (coming due) fairly soon. The new notes mature in 2027, so, in short, Tilray is swapping short-term obligations for long-term, gaining breathing room to turn around the business, a workout-ish strategy we’ve talked about before.
Such a deal, right? Well, just like making a wish with a cursed monkey’s paw, there’s a catch - the conversion pricing. These new notes may be converted by the holder into 376.6478 shares of Tilray stock per $1,000 of notes, approximately $2.66 per share, a 12.5% premium over Tilray’s closing stock price the day before the deal was announced (the conversion rate is usually set at a modest premium to the last day’s closing trade). By comparison, for example, Tilray’s 2023 notes (issued in 2018) have a conversion price of $167.41 (that is not a typo) per share, and the 2024 notes (issued in 2019) have a conversion price of $11.20 per share. In other words, the cost of extending the maturity date is significantly reducing the conversion price, trading debt that almost certainly would never have been converted for debt that has a fair chance of being converted. This reflects just how far down cannabis stock values have fallen since the salad days of 2017-19.
The stock market didn’t take kindly to the greater likelihood of dilution from so many shares being issued upon conversion (I’ll let you do the math, but Tilray reported about 617.8mm shares outstanding as of February 28, 2023), regardless of the fact that Tilray was getting years of maturity extension. (Tilray does have the right to redeem the notes (meaning, pay them out at par plus accrued) after June 30, 2025 if the stock price is trading above 130% of the conversion price (about $3.49 per share) for a period of time, giving the company a bit of an opportunity to avoid dilution.)
One other feature of this offering worth noting is that Tilray agreed to lend newly-issued shares of its stock to the underwriters. Stepping back, because these new Tilray notes may be converted into Tilray stock, the notes’ valuation will be somewhat tied to the share price (other things go into convertible note valuation as well, such as interest rates). If the share price were to trade above the $2.66 conversion price, the notes kinda become a stock option, while if the share price trades down, the value of the note may also trade down.
So, to protect the value of the convertible note, an investor may sell the issuer’s stock short, meaning it borrows the stock from someone else and sells that, eventually buying it back (to “cover the short”). A short trade gains value if the stock price drops (you sold it for, say, $10, and then buy it back at, say, $8), making it a potentially effective hedge for any loss in the market value of the convertible note due to the same stock price drop. To place that trade, an investor needs to borrow the stock from someone else and pay them for the privilege of borrowing that stock, which can be very expensive for a thinly-traded, highly-volatile stock (like that of a cannabis company).
In order to make the convertible note offering “more attractive to prospective investors” (per the note offering prospectus), Tilray is making 38.5mm of its shares available to the underwriters to lend out to investors for hedging. This isn’t novel – plenty of companies enter into these arrangements as part of a convertible note offering to make them “more attractive”, effectively meaning that they’ll be able to offer a lower interest rate on the notes. However, it increases the “short interest” on the stock, meaning the number of shares outstanding that have been sold short and not yet bought back, which creates downward pressure on the stock price and increases volatility. Additionally, consider that Tilray is a Canadian company traded on the Nasdaq, an exchange with good liquidity. This type of stock borrowing arrangement would be even more challenging for the stock of a US MSO that’s listed on the Canadian Securities Exchange, where volume is much thinner.
So, what should we make of all of this? On the one hand, it’s a positive that companies are still finding ways to buy more time to ride out the current industry slump. On the other hand, those strategies remain expensive and dilutive (workout is never cheap). I wouldn’t expect that to change any time soon, nor do I expect cannabis companies to stop finding creative ways to abide (the very creativity that Hauser Advisory offers).
Be seeing you!
Hauser Advisory provides advice and strategy on business lifecycle events and cannabis industry navigation, tapping into a deep, national network and twenty-five years of dealmaking and capital markets experience.
© 2023 Marc Hauser and Hauser Advisory. None of the foregoing is legal, investment, or any other sort of advice, and it may not be relied upon in any manner, shape, or form.