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With little access to fresh cash, Canada’s licensed producers now face a new reality.

GEOFF ROBINS

The warning signs were there all summer, but it wasn’t until the first business day of September that the reckoning arrived for Canadian cannabis companies in need of money.

After markets closed on Sept. 3, Aurora Cannabis Inc., one of Canada’s largest legal marijuana producers, tried to sell its 10.5-per-cent stake in a rival company, The Green Organic Dutchman Holdings Ltd. – better known as TGOD – to public investors.

After two days of marketing, roughly half of the $86.5-million in TGOD shares remained unsold, according to sources familiar with the sale. TGOD had been an investor favourite and the deal was priced at a 14.5-per-cent discount to the market, but buyers still balked.

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At the time, there were already clear signs that the days of easy money for cannabis companies were over. The total amount of money raised by the sector had plunged over the summer. But the TGOD deal sent a message to the entire industry: The taps were almost fully closed.

With little access to fresh cash, Canada’s licensed producers now face a new reality. They have spent years focused on financings to fund their expansions, paying little mind to positive cash flow. Without new capital, they will have to scrap construction projects and scale back growth plans. Or worse.

“The vast majority of the companies are going to go bankrupt,” said Igor Gimelshtein, the former chief financial officer of MedReleaf Corp., which was sold to Aurora Cannabis Inc. in 2018 for $3.2-billion. He is a partner at Toronto-based Zola Global Investments, which invests globally in the cannabis industry.

In September, independent investment bank Mackie Research Capital Corp. calculated that nine companies had less than six months worth of cash available to fund operations. The figure jumps to 21 companies after adding capital expenditures. A few weeks later, TGOD shelved plans to finish a 1.3-million-square-foot greenhouse facility in Quebec, and it is seeking bridge financing just to keep the lights on at a smaller operation in Ontario.

In this environment the share prices of many cannabis stocks have been eviscerated, and executives face painful options: fire sales, shotgun mergers, radical downsizing or bankruptcies. Even the largest producers are selling off assets and taking on expensive financing to ride out the bear market.

In the past two weeks, Canopy Growth Corp. and Aphria Inc. have both sold stakes in Australian cannabis companies. Late last month, Hexo Corp., Quebec’s largest cannabis grower, announced it is shuttering one of its greenhouses and laying off 200 staff.

expectations vs. reality

Cannabis producers raised billions of dollars

between 2014 and 2018 by promising mas

sive greenhouses and industrial scale output.

Most have failed to meet expectations. Now

that access to capital has dried up, compa-

nies are slashing production estimates,

reporting lower than expected sales and

shelving construction plans.

THE GREEN ORGANIC DUTCHMAN

Original

Revised

Estimate for

2020 production

Estimate for 2020

licensed square footage

in Canada

156,000 kg

1,257,245

20,000 - 22,000 kg

~170,000

HEXO CORP.

Estimate

Actual

Fourth quarter

revenues

Volume shipped

to SQDC

in year 1*

20,000 kg

$26-million

$15.4-million

~10,000 kg

*Société québécoise du cannabis

APHRIA INC.

Expected

Most recent

quarter

Quarterly production

for 2019

63,750 kg

10,581 kg

brennan higginbotham and JOHN SOPINSKI/

THE GLOBE AND MAIL, SOURCE: company

disclosures; refinitiv; bloomberg

expectations vs. reality

Cannabis producers raised billions of dollars between

2014 and 2018 by promising massive greenhouses and

industrial scale output. Most have failed to meet expecta-

tions. Now that access to capital has dried up, companies

are slashing production estimates, reporting lower than

expected sales and shelving construction plans.

THE GREEN ORGANIC DUTCHMAN

Original

Revised

Estimate for

2020 production

Estimate for 2020

licensed square footage

in Canada

156,000 kg

1,257,245

20,000 - 22,000 kg

~170,000

HEXO CORP.

Estimate

Actual

Fourth quarter

revenues

Volume shipped

to SQDC

in year 1*

20,000 kg

$26-million

$15.4-million

~10,000 kg

*Société québécoise du cannabis

APHRIA INC.

Expected

Most recent

quarter

Quarterly production

for 2019

63,750 kg

10,581 kg

brennan higginbotham and JOHN SOPINSKI/THE GLOBE

AND MAIL, SOURCE: company disclosures; refinitiv;

bloomberg

expectations vs. reality

Cannabis producers raised billions of dollars between 2014 and 2018 by promising massive

greenhouses and industrial scale output. Most have failed to meet expectations. Now that

access to capital has dried up, companies are slashing production estimates, reporting lower

than expected sales and shelving construction plans.

THE GREEN ORGANIC DUTCHMAN

Original

Revised

Estimate for

2020 production

Estimate for 2020

licensed square footage

in Canada

156,000 kg

1,257,245

20,000 - 22,000 kg

~170,000

APHRIA INC.

HEXO CORP.

Expected

Most recent

quarter

Estimate

Actual

Quarterly production

for 2019

Fourth quarter

revenues

Volume shipped

to SQDC

in year 1*

20,000 kg

$26-million

63,750 kg

10,581 kg

$15.4-million

~10,000 kg

*Société québécoise du cannabis

brennan higginbotham and JOHN SOPINSKI/THE GLOBE AND MAIL,

SOURCE: company disclosures; refinitiv; bloomberg

Amid the rout, cannabis executives are taking it on the chin, and some, including ex-Canopy chief executive Bruce Linton, have been ousted.

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Bay Street, however, has largely evaded blame – even though the industry was built on the terms it set. The cannabis bubble was fuelled by stock promoters, hedge fund managers, investment banks and law firms that have helped raise close to $8-billion from public investors since 2017, and have clipped hundreds of millions of dollars in fees in the process.

With the money pouring in, cannabis executives made outlandish predictions and inked expensive deals with few repercussions. Of the industry’s many problems, “the biggest one is the lack of intellectual integrity," Mr. Gimelshtein said.

For all the money they made, the industry’s original financial backers have now largely moved on to more promising U.S.-based companies, or are out of the sector altogether. Retail investors are still heavily invested, holding 80 per cent or more of many cannabis companies’ shares.

As with so many bubbles, much of the smart money got out early, leaving behind retail investors who clutch shares with dwindling values – with little hope of recouping big losses.

Laying the foundation

When the federal Liberals came to power in 2015 with the promise of legalizing and regulating recreational cannabis, they touched off a stock market frenzy. To many investors, it was a once-in-a-lifetime opportunity to become the new-age alcohol barons, and licensed producers soon began trading on the TSX Venture Exchange and the Canadian Securities Exchange.

Amid the hype, no one seemed to care how realistic business plans were; actual legalization was still some distant event. It was the perfect environment for stock promoters, many of whom had been starved of oxygen after the junior miners and junior energy companies they touted in the early 2000s, and again after the Great Recession, collapsed after commodity price downturns.

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These promoters prowled the country looking for early-stage cannabis companies to take public, typically by merging them with a dormant mining shell company still trading on the TSX-V or CSE.

It was a tried-and-true formula. Much like in mining booms, promoters would sell a publicly traded shell to a private cannabis company, then take cheap shares in the new public entity. As a condition of the merger, the cannabis company would also pay for stock promotion, using third-party “investor relations” firms to produce online posts and videos directed at unsophisticated retail investors.

Cannabis companies would routinely pay tens, even hundreds, of thousands of dollars for a few months of promotion. One company, Wayland Group Corp., formerly called MariCann Group Inc., paid investor relations firms more than $4.5-million in 2018 – half in cash, half in shares.

One investor relations specialist, who spoke on the condition of anonymity, estimated that at least half the cannabis companies that went public on the CSE were never built to survive long-term as real businesses. They were vehicles that promoters could use to make quick money, and then bail.

Compared with prior booms, promoters didn’t have to work all that hard, either. Many baby boomers and millennials are passionate about cannabis. Millennials were also often new to investing, so they had never experienced a downturn. All they saw was upside potential.

In other words, they were fresh meat.

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“It’s been really distressing to watch, because I’ve seen a lot of bad corporate behaviours [and] gross disrespect for shareholder money,” said Jeannette VanderMarel, who co-founded TGOD but sold a controlling stake in the company to a group of investors in 2017, when it was still a small, private greenhouse operation. “A lot of it has been shameless self-promotion without any viable products to sell.”

Yet, as cannabis stocks soared, detractors found themselves screaming into the wind. To the surprise of everyone, U.S. beverage giant Constellation Brands Inc. bought a 10-per-cent stake in Canopy in October, 2017, for $245-million, and pot stock prices soared after. Here was real money from an established company justifying all the hype.

Building the bubble – on Bay Street’s terms

The cannabis boom was an investment banker’s dream. With so much retail investor demand, it was easy to underwrite share sales – and to dictate the terms of the game.

Because licensed producers weren’t generating much revenue or cash flow, the mantra when selling deals was “funded capacity.” The formula: Take the value of cash on a producer’s balance sheet and multiply it by the amount of land it owned and the amount of cannabis per square foot it hoped to grow. Little attention was paid to the quality of marijuana or the challenges of building a viable business.

“Companies were just rushing for scale,” said Aaron Salz, principal with Stoic Advisory Inc., a cannabis capital markets advisory firm. "That wasn’t optimized for success with consumers. It was more optimized for success in the capital markets.”

It became a speculative circle. The more money a producer raised, the more it was worth – which helped it raise even more money. Aphria Inc., one of the first out of the gate, raised $305-million from four share sales in 2017.

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Mergers and acquisitions were also rampant. In early 2018, Aphria agreed to purchase Nuuvera Inc. for $826-million, even though Nuuvera had gone public only four weeks earlier.

For the first several years, the Big Six Canadian banks were too timid to touch cannabis for fear of running afoul of U.S. federal laws. That left the sector wide open to smaller independent investment banks such as Canaccord Genuity, Eight Capital Corp., GMP Securities Inc. and Clarus Securities.

At Canaccord, cannabis dominated its Healthcare and Life Sciences division, and this unit brought in $267-million in investment banking revenue in fiscal 2018 and 2019 combined.

Little known to outsiders, the key to much of this fundraising was a small group of Toronto hedge funds – notably MMCAP International, Anson Funds and K2 & Associates. They figured out how to cycle money through deal after deal, with relatively little risk.

When a brokerage had a large cannabis offering to sell, the hedge funds would buy in. In one example, when Hexo raised $150-million in January, 2019, MMCAP scooped up $75-million, according to a buyer’s list obtained by The Globe and Mail.

However, the funds often were not buying shares to hold them. They were using sophisticated financial tricks to get out quickly at a profit.

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One tactic involved short-selling, a strategy used to bet on a falling stock price. Financings are usually issued at a discount to market prices in order to attract buyers. But hedge funds anticipating a new cannabis deal could short the issuer’s shares before the deal launched. They then covered their positions by purchasing large portions of the financing. In effect, the hedge funds could instantly earn the discount percentage.

These transactions were frequently aided by cannabis company insiders, who would help the hedge funds short their company’s stock by lending shares they owned. All three funds either declined to comment for this story or did not return a request for comment.

"The guys who were doing most of the bought deals weren’t bringing in real buyers,” said Anthony George, head trader at independent investment bank Infor Financial Group. "Most of the orders on these deals were guys that were short … They were providing liquidity, but they were turning over the same paper.”

The financial wizardry, while legal, created the impression that producers were attracting long-term institutional investors. In reality, the smart money was often out the door before a financing even closed.

The inevitable bust

Canada’s cannabis fever started breaking in mid-2018, under the weight of warnings about ridiculous valuations, bad deals and aggressive stock promotion. Yet, the sector caught a second wind after Constellation invested $5-billion more in Canopy that August.

HMMJ, an exchange-traded fund that tracks publicly-traded cannabis companies, jumped 79 per cent in two months. And then recreational legalization came off as announced on Oct. 17.

But the market downfall that followed was almost as swift. Mere months after legalization, product shortages were rampant and legal retail stores were still scarce. Canopy reported a $323-million quarterly loss in June, and two weeks later Mr. Linton, the one-time face of the Canadian industry, was fired.

Soon afterward, CannTrust Holdings Inc. was found to have grown thousands of kilograms of cannabis in unlicensed parts of a greenhouse in Ontario, leading Health Canada to suspend the company’s licences. With all the commotion, demand for new financings dried up and stock prices collapsed.

The current debacle, though, runs deeper than simple investor fatigue. The woes are structural.

Throughout 2018, a stampede of cannabis deals chased a limited pool of money – a trend that was exacerbated by a new wave of U.S.-based companies that went public in Canada. Smart money shifted south, where legal cannabis markets in several states are thriving and federal recreational legalization is looking increasingly likely.

“It became pretty obvious to us that there just wasn’t the institutional capital that could support these [Canadian] deals,” said Mr. George, the trader at Infor. The same was true for daily trading. “When a stock would correct 10 per cent all of sudden, there was just no one there to stop it.”

On top of that, a lot of money remained trapped in private companies. Many of them raised startup capital in 2017 and 2018, with the hopes of going public. That would allow early investors to exit at a profit. Now, however, Canadian IPOs are off the table.

Worse, assets held by those private companies have lost value. Not long ago, a standard Health Canada cultivation licence had a market value between $50-million and $100-million, Mr. George says. But Health Canada keeps issuing more licences – 245 growing or processing licenses so far – and each one is now worth less than $10-million.

Starved of cash, one option for the sector is to consolidate. However, mergers are hard to pull off when balance sheets are littered with landmines.

For one, many companies have loads of warrants outstanding. Warrants are similar to stock options, allowing holders to buy shares at a preset price in the future, and they are often offered to cannabis investors as a sweetener when raising money. At the moment, many of these warrants are worthless because market share prices have plummeted. But if share prices rebound, the warrants could severely dilute the ownership of existing shareholders.

Convertible debt also hangs over much of the industry. As it became harder to sell straight equity, many producers turned to convertible debentures. This debt often allows the issuer to convert the securities to shares if the stock price rises, removing a liability from their balance sheet.

However, if the share price remains below the conversion price, the debentures have to be paid back in full.

Aurora, for example, issued $230-million in convertible debentures that come due in March, and the company can force conversion at $17 per share. Aurora’s stock closed at $4.69 on Friday.

In its recent analysis, Mackie, the investment bank, noted that eight cannabis producers have convertible debt that matures in the next 12 months.

Companies may have to go back and reprice and renegotiate the conversion prices … creating a more significant dilution event than people maybe anticipated,” said Mr. Salz of Stoic Advisory.

Salvaging what’s left

Cannabis producers are scrambling to adjust to the new reality. In July, Flowr Corp., a mid-sized B.C. grower, cancelled plans to raise $125-million and later settled for $43.5-million instead.

In late October, Vancouver-based Zenabis Global Inc. announced a $20.8-million rights offering that priced the shares 73 per cent below their market price. The company said this was the “least dilutive” way it could access capital, “given current market conditions.”

Amid the shakeout, the investment banks that profited the most during the bull market are largely silent. Canaccord Genuity, Eight Capital and Clarus Securities all declined to comment for this story. However, GMP Securities CEO Harris Fricker responded.

“I don’t think you can characterize the investment banks that were active here as a homogeneous group,” he wrote in an e-mail. “The key players brought very different approaches to the underwriting market and this is very well known on the Street.”

Independent investment banks also can’t be singled out anymore. After staying on the sidelines early on, many large banks entered the cannabis sector in the past year. CannTrust’s last financing before running into trouble with Health Canada was underwritten by foreign banks and Royal Bank of Canada.

Despite the shakeout, Mr. Fricker is still optimistic. “We continue to believe that this will ultimately be a huge international market anchored, inevitably, by the United States," he wrote. And like any consumer product, he added, a few key players will dominate.

Some smaller companies could also emerge leaner and stronger. That’s what TGOD CEO Brian Athaide is hoping for.

“We would still make these choices [to postpone construction plans] because of market conditions,” Mr. Athaide said, "even if we had sufficient cash to do the larger construction. From a business standpoint it makes sense: Why invest more capital before it’s needed?”

But to win investors back, cannabis companies will need a new mindset: less cowboy mentality, more professionalism. Too many boards and executive offices were stacked with friends of the founders.

“Finding great talent is the next important phase for this sector,” said Les Gombik, an executive recruiter. Yet hiring that talent isn’t so easy any more.

“A lot of people entered the industry because it was exciting, and there was huge upside potential,” Mr. Gombik said. Now, executives are confidentially calling his firm and asking for ways out. “It’s not as much fun any more,” he said.

The radical new reality may surprise retail investors who got burned. But the truth is, Canada has seen this all before. We are a country rife with commodity cycles.

If previous busts are any indication, there will be blood for many small cannabis producers. The TSX-V housed a lot of the junior mining companies that soared after the Great Recession and the index peaked in Feburary, 2011, but has since lost 78 per cent of its value. Once the growth financing disappeared, companies weren’t valued on their potential; they were assessed on what they actually produced.

It is still too early to definitively say that cannabis is in the same spiral. This market has been volatile and there may be another upswing.

All producers aren’t identical, either. A handful of companies with strong balance sheets and economies of scale "are ultimately going to be very successful,” Mr. Gimelshtein said.

“But before that happens, a bunch of these companies are going to hit the wall.”

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