A BRIDGE TO SAFE PASSAGE
A lot of the commentary on this week’s announcement that US-listed Tilray acquired an ownership interest in MedMen, a federally-illegal US cannabis company, has centered on the implications for the specific companies involved. I think there may also be some significant implications for the US cannabis sector overall.
Before getting to that, a little background on the transaction1:
Tilray acquired an interest in MedMen’s existing senior secured convertible notes and certain warrants related to the notes which together represent an as-converted 21% ownership interest in MedMen;
These notes and warrants were acquired from an existing third-party investor apparently at a large premium to MedMen’s prevailing enterprise value2;
No transfer of funds occurred between Tilray and MedMen, though MedMen had an active role in the deal by way of agreeing to certain contractual modifications to the notes/warrants; and
Tilray’s investment appears to be purely passive with no contractual influence or control over MedMen.
The deal presentation states “MedMen’s strong presence in the U.S. offers Tilray an opportunity to develop strategic opportunities including commercial arrangements, joint ventures and other significant transactions that offer the potential to expand Tilray’s presence into the U.S. cannabis sector when it is permitted to do so” and “Upon U.S. federal legalization, Tilray would be positioned to develop a potential strategic leadership position” (emphasis mine).3
Note the repeated use of the words “opportunity” and “potential”. There does not appear to be anything contracted in the arrangement that will actually generate operating income for Tilray’s shareholders, now or in the future. Sure, the deal helps build a relationship between the two firms leading up to legalization, but the entry into any eventual commercial agreement will still need to be in the best interests of each firm’s shareholders independently and on terms at least as favorable as could be obtained from third parties. So, this deal, as a non-controlling minority block trade whose commercial benefits seem to amount to hopes and dreams, seems oddly mispriced at a premium to spot.
On the other hand, MedMen gets to enjoy material benefits from the arrangement. Tilray agreed to amend the terms of the notes (which I suspect were driven by a combination of regulatory/listing requirements and a desire to facilitate the success of MedMen and the investment) with the effect of:
Extending the maturity to 2028;
Converting all future interest payments to in-kind rather than cash (coupons will be added to the principal balance of the note payable at maturity); and
“Refocused covenants which were previously a significant administrative burden”, per MedMen CEO Tom Lynch.4
These are individually and collectively significant benefits for MedMen. Cash interest expense that otherwise would have gone to lenders can now be allocated to more productive and (hopefully) accretive uses. CEO Tom Lynch noted that the changes will allow them "to prioritize new market opportunities and existing operations over near-term balance sheet management […] and identify and accelerate further growth opportunities".5 And together with the maturity extension, the company’s risk of default is significantly improved for a lengthy 7 years.
Perhaps unsurprisingly, shares of MedMen closed 20% higher the day following the announcement versus +1% for Tilray.6
So why would this transaction be of any significance to anyone besides the stakeholders of MedMen and Tilray? Well, take a look at the long list of attorneys and bankers who worked on the deal:7
This does not look like a couple of fringe shops gone rogue with an aggressive regulatory arbitrage structure. Irwin Simon, CEO of Tilray, noted on the deal announcement call "there hasn't been a lot of deals done in a long time where the TSX and NASDAQ had to approve and also our banks […] we had to go through lots of regulatory to get this done and because of the structure that we were doing this, it's absolutely been approved”.8
Again, not a case of breaking things and hoping for forgiveness after the fact. Tilray indicated it got pre-approval from its listing venues (including the NASDAQ) and its lenders to proceed with the transaction.
People following the sector closely will know that the convertible/derivative regulatory arbitrage structure is not new. But what is different is that Tilray’s deal follows a similar one announced by Scotts Miracle-Gro just 8 days prior.9 So, now there are more and more US-listed companies (including a major US household brand) that are getting advice from reputable lawyers and bankers while successfully obtaining internal approvals to execute the trades. The perceived risk/reward of US-listed, federally-compliant companies holding effective ownership interests in plant-touching operators may have crossed a tipping point.
Since the structure has few precedents and transactions will be tailored to the specific circumstances of each client, execution will probably require greater client education and assistance on the part of bankers and attorneys. The bankers might command fees of 2% of notional or higher. If a banking team gets $1bn of transactions done in the coming year, deal fees might be around $20mm, with more fees coming from the issuance of any new converts. The partners at the law firms are probably billing $1000+ hourly and $600+ for each of multiple associates. Bespoke documentation and regulatory analysis mean this is also big business for them. The result: the bankers and lawyers have probably already been pitching the structure left and right to potential clients.
So, imagine you are an executive of a non-cannabis firm in the US that wants to acquire plant-touching operators ASAP. Operators want your non-controlling, long-term capital and are eager to work with you to deliver the terms you need. The bankers and lawyers are now telling you it can be done. Your listing venue is telling you it can be done. And precedent transactions have not brought harm to their deal parties. What’s your move?
The specific structure matters when considering the potential impact on share prices. The Tilray format would limit investments to non-controlling, indirect ownership interests. That means the new corporate buyers would probably not bid for shares held by common investors. And as previously noted, it isn’t clear why providers of capital should have to pay a premium to acquire non-controlling blocks when they are the ones in a position of power. Queue the sad trombone for anyone hoping for a quick flip.
Still, there are some very positive potential second-order effects for investors:
1. Those lucky firms that are selected to amend and extend debt or issue new converts on favorable terms may gain a tailwind to operational execution which could drive a higher valuation (as with MedMen);
2. Plant-touching firms might now be able to place new capital (indirectly) into these strategic long-term corporate buckets without weighing on market prices;
3. If the corporate buyers are willing to continue to support targets’ funding needs into the future, the C-suite executives of targets may be able to spend a little less time on retail investor marketing and a little more on execution; and
4. An investor who sells existing converts into one of these deals may choose to reinvest the sale proceeds in other sector investments, bidding their prices up.
So, there could be significant though concentrated effects if more of these deals are executed, just not necessarily a sector-wide rerating like what might follow universally applicable reform such as the elimination of 280E. But at least for those lucky target firms, access to US-listed capital and the improvement to fundamentals that it brings might feel halfway to SAFE Banking.
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Source: https://www.businesswire.com/news/home/20210817005876/en/
Source: presentation dated August 17, 2021 available at https://investors.medmen.com/events-and-presentations/default.aspx
Source: Tilray Business Update Call, August 17, 2021 available at https://ir.tilray.com/events-and-presentations/events
Source: Tilray Business Update Call, August 17, 2021; https://ir.tilray.com/events-and-presentations/events
Sources: https://www.otcmarkets.com/stock/MMNFF/overview and https://finance.yahoo.com/quote/TLRY/history?p=TLRY
Source: https://www.businesswire.com/news/home/20210817005876/en/
Source: Tilray Business Update Call, August 17, 2021; https://ir.tilray.com/events-and-presentations/events
Source: https://www.globenewswire.com/en/news-release/2021/08/10/2277825/33079/en/ScottsMiracle-Gro-Announces-Creation-of-New-Investment-Entity-to-Enable-Investments-in-the-Cannabis-Industry.html