Cannabis Musings - October 25, 2024

More on the Dastardly Debt Deadline of Doom

Friends, as a followup to our recent discussion about the looming leviathan of lingering liabilities.  We talked about how there’s a lot of cannabis debt coming due over the next two years, and, in particular:

the fundamental concern raised by FiSai and others in the space that there’s going to be a lot of demand and potentially not enough supply, and even if the supply does arrive, it’s going to be expensive debt.

Well, I’d like to highlight two other perspectives on this topic.  First, Frank Colombo, Managing Director at Viridian Capital, actually did real analysis (rather than yammering about it like these Cannabis Musings) of the issue.  Illustrating the point in a handy chart, he makes the more rational point (without alliteration, sadly) that articles about the maturity wall:

have an alarming tone that we do not feel is representative of economic reality. The cannabis debt capital market is hot, and refinancings are getting done without the need for equity kickers or other expensive features. … Debt refinancings are a curious blend of financial capacity and market psychology. Generally, if the market believes a company is capable of handling its debt load, maturities of debt can be refinanced. 

This is a great point.  Sort of an unintentional riff on “If you build it, they will come,” the lenders will be there if the deal is attractive enough.  For better or for worse, if there’s money to be made, and the asset is priced right, Wall Street somehow finds a way to get the deal done.  This isn’t a guarantee, and I don’t think that Frank is suggesting that at all – rather, I think his point is that, most likely, it’s not going to be as bad as it looks to be right now.

On the other hand, Bloomberg’s Odd Lots newsletter (no link; email only), the adjunct to the excellent, quirky finance podcast, highlighted a recent report by the Federal Reserve Bank of New York titled “Extend-and-Pretend in the U.S. CRE Market” (CRE being commercial (non-residential) real estate).  We mentioned in our prior discussion that the U.S. commercial real estate market is facing a gigantic maturity wall, the kind that actually keeps finance folks up at night. It’s a well-known problem. 

The report makes this sobering point:

banks have “extended and-pretended” their distressed CRE mortgages in the post-pandemic period to delay the recognition of losses. Banks with weaker marked-to-market capital—largely due to losses in their securities portfolio since 2022:Q1—have extended the maturity of their impaired CRE mortgages coming due and pretended that such credit provision was not as distressed to avoid further depleting their capital. The resulting limited number of loan defaults hindered the reallocation of capital, crowding out the origination of both CRE mortgages and loans to firms. The maturity extensions granted by banks also fueled the volume of CRE mortgages set to mature in the near term—a “maturity wall” with the associated risk of large losses materializing in a short period of time.

In other words, since the pandemic and the related spike in interest rates, some banks have chosen to extend loan maturities, rather than defaulting the borrowers and foreclosing on the underlying properties, in order to avoid their regulated financial metrics from being out of whack.  This has apparently resulted in there being less money available in the marketplace overall to refinance other real estate loans coming due (when you extend a loan maturity, you don’t get paid back the principal until later):

extend-and-pretend leads to significant credit misallocation. We show that the maturity extensions granted by weakly capitalized banks to distressed borrowers result in reduced credit origination … extend-and-pretend leads to a contraction of 4.8–5.3% in aggregate CRE mortgage origination.

Now, nearly all of the capital funding loans to U.S. cannabis operators comes from non-bank lenders.  There are some limited exceptions, but, for the most part, U.S. banks can’t generally lend to cannabis operators.  And those non-bank lenders aren’t subject to the same federally-imposed metrics to make sure they remain financially sound (and we don’t end up with another banking crisis like we saw in 2008).  So, ironically, the lack of bank access for cannabis is actually a good thing in this case.

However, this harkens back to the point made by FiSai in its letter to The Cannabist Company (née Columbia Care), that there may just not be enough unallocated capital sloshing around (lovingly referred to by bankers as “dry powder”) in the cannabis capital markets when the time comes to refinance.  It’s the same potential problem as in commercial real estate, but with a different cause (regulatory requirements versus industry-wide distress).  It’s hard to predict whether that’ll be the case, because who knows what the cannabis investment landscape will look like 18 months from now.  But, if we see more “extend-and-pretend” deals (like Ayr, and what’s presumably been proposed by FiSai to The Cannabist Company (née Columbia Care)), the refinancing pool is only going to get shallower.

What’s the likely result?  Well, I doubt that we’ll end up seeing any foreclosures.  Just like the banks lending to commercial real estate, the lenders and bondholders that have made loans to large cannabis operators don’t really want to default those loans and foreclose on the assets.  First off, they’re mostly not in the business of owning and operating cannabis assets – they’re in the business of lending money and financial engineering.  Second, it’s really, really hard to foreclose on cannabis assets because you generally can’t take possession of the licenses and cannabis inventory without state approval, which takes a lot of time (and imagine having to deal with cannabis regulators in multiple states).  Finally, the typical endgame of bankruptcy to sort it all out isn’t available to U.S. cannabis, which makes everything even more difficult.

Instead, I think that it’ll be a combination what Frank Colombo suggests – that the refinancing capital will arrive when the time comes if the loans are priced right (it’s hard to look away from interest rates in the teens with an equity kicker) – and, for the less attractive credits, those very same extend-and-pretend deals that exacerbate the problem.  A vicious cycle.

I don’t want to be alarmist here – I don’t think this poses the same kind of existential threat to the cannabis industry as does so-called “intoxicating hemp”, but it’s something the industry is going to need to reckon with at some point.  So much of the industry was built on blitzscaled growth fueled first by cheap equity, then real estate debt and sale-leasebacks, and, finally, expensive corporate debt, all while top-line and bottom-line fundamentals remained weak, and all without bankruptcy to fix the problem (for better and for worse). 

It’s remarkable to me how long this industry has been able to effectively run on fumes.  Success in this industry doesn’t require winning – it just requires not losing.

Be seeing you.

© 2024 Marc Hauser.  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.  The foregoing represents my own views and not those of Jardín.