Altitude Partner Roderick Stephan Talks Distressed Debt Investment In Cannabis

The cannabis industry is going rough times — but some experts like Roderick Stephan think this is a time of great opportunity for long-term investors.Stocks from some of the major cannabis corporations like Canopy Growth Corp CGC, Tilray Inc TLRY, Aurora Cannabis Inc ACB, Aphria Inc APHA and Cronos Group Inc CRON are all worth less than half their year-to-date value.

Some companies, like premium dispensary chain MedMen Enterprises Inc MMNFF and media company Leafly were forced to lay off employees in order to stay afloat. In MedMen's case, it fired more than 40% of its staff.

Eaze, the California-based cannabis delivery giant, is known to be low on cash and struggling to keep afloat. Many other smaller and mid-sized companies are being forced to raise emergency capital or get acquired by larger companies to remain active and retain their share of the market until they can turn a profit.

“Right at the time where the markets are closing down and not providing capital to companies is the time when companies needed to vouch. So in come the vulture investors, also known as distressed debt players,” Stephan told Benzinga.

From Crisis Comes Opportunity: Investing In Distressed Debt

Stephan is one of the partners at Altitude Investment Management, an investment firm that holds a vast portfolio ranging across the entire cannabis industry, including cultivation, distribution, technology and media.

“My background and several of my partners’ at Altitude: we are foundational, experienced investors in the distressed debt markets of the United States and around the world,” said Stephan, who co-founded the Distressed Investments Group at Citadel Investment Group and heads Citadel’s distressed research team.

The traditional model for distressed debt consists of buying debt from good companies with a bad capital structure.

“You buy that debt in the secondary market, and then either sell it or convert to equity in a restructuring.”

Why The Cannabis Industry Is Ripe For Distressed Debt Investment

Until recently, few cannabis companies had substantial debt because they were able to raise equity capital on the private side. On the bigger, public side, these companies were able to raise a lot of money. According to Stephan, they started egregiously spending that money to build up and attained ridiculously high valuations. 

“And then all of a sudden, they realize that the revenues aren't coming in as fast as they're supposed to, or if at all.” 

Cannabis companies suddenly had to face the fact that their gross margins were less than expected. They began having trouble covering the very expensive costs of operating in the U.S., which by far exceeds the costs of the Canadian market, where many of these companies were born.

“If you look at Canopy Growth, they're not even projecting cash flow break-even for another four years, and this is the biggest company in the North American universe,” Stephan said.

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How Do Vulture Investors Operate In The Cannabis Industry?

Vulture investors go in as debt heads of equity and cut attractive terms for their investors, Stephan said.

"It could be a cash coupon, a first lien on assets and a conversion into equity at market or slightly above market, but with a ton of warrants.”

These warrants keep distressed debt investors on the safe side. As Stephan explains it, there are two possible outcomes, both of which are favorable.

“If the company doesn't do well, you're covered for your investors in terms of getting your money back, because you are the first lien at maybe 50% loan to value, so there's a huge cushion.”

If the strategy works, vulture investors can covert and have "a ton" of warrants to net an attractive return for investors, he said.

Existing equity holders carry a lot more risk.

“If the worst thing happens, they get zero. And in the best case, if everything works out, there's so much dilution due to warrants that the equity upside is much more severely limited than it previously had been.”

Stephan said vulture funds provide liquidity when the capital market shuts down. He expects this to be the trend in cannabis in 2020 in addition to consolidations, mergers and acquisitions.

Photo by Javier Hasse.