There’s a quote widely attributed to Warren Buffet…..the ‘Oracle from Omaha’. He was reputed to say: “When the tide goes out, you’ll see who’s been swimming naked”. It’s often referred to when talking about folks holding short positions when stocks go up (or perhaps those on margin when they go down).

Me, I liken that person ‘swimming naked’ to companies without fundamentals underpinning their business. A situation when a share prices are high relative to the assets that comprise the equity. When that happens, the tide is high. And should it go out – the company will be the one who’s ‘naked’, and the investor ends up holding a very large bag of rocks.

It’s a tough situation to be in as an investor if you’ve bought higher than intrinsic asset value, and little prospect of much changing in the foreseeable future. TheCannalysts – and likely yourself – have watched this from a ringside seat over the past several years as companies during the ‘first wave’ of interest in legal cannabis have been all over the place in terms of share prices. And many bags have been filled.

Right now, we’re in the middle of a second wave (the ‘Blue Wave’ in the United States) due to the prospect of federal legalization. GoBlue’s recent thoughts about this are here.

Those share price rises though impact more than the value in your portfolio. They often impact assets acquired prior to a share price run.

‘Contingent consideration’ is a phrase that describes additional earn outs paid for acquisitions should ‘things work out’. In a best case scenario (for the investor, and the company), a fixed price top up is paid for performing assets. But this is legal cannabis, and ‘normal’ earn outs are not as ‘normal’ as in other sectors. Often here, they are paid in shares of the acquiring company.

It means that optionality was embedded within an acquisition: and it adds a variable to the capital structure of the acquirer itself.

In the case of Curaleaf ($CURA), their blockbuster ‘Select’ acquisition came with an issuance of a potential 52MM additional shares, as well as cash. We’ll only find out if that brand generated the requisite level of sales to generate that ‘bonus’ in fiscal 2020’s final financials. Between the estimate of total incremental cost of $300MM for Select (based upon a $CURA share price of $7.21 CAD), that total cost could swell to north of $700MM given December 31st’s close of $15.24. Hey – it’s non cash right? Or at least the incremental cash component was only $300MM. The asset’s performing. Quiet down.

No. That incremental billion comes right out of existing shareholder’s investment. We’ve recently talked about how Terrascend had to go to debt markets to finance a ‘previous’ acquisition they had suggested to pay cash with, taking up balance sheet real estate….and inducing $15MM in incremental interest cost per year over 4 years. Beneath a ‘demand’ loan no less.

Ayr Strategies has issued sone 2MM in ‘exchangeable shares’ while acquiring, at a price of ~=$16 (or $32MM). Should they remain outstanding (we’ll find out at year end), that value today lands north of $80MM given current share price (relatively modest, yes. But the optionality picked up was mainly in related party transactions).

Jushi Holdings is a great example of being a ‘victim’ of their share price success, with their contingent liabilities now being around ~=$210MM at recent close of share price – now north of $10 CAD. This is the impact that the 44MM in ‘derivative warrants’ brings. They’ve just announced another raise. If required to satiate liabilities – it’s better than debt, but still dilutive. Moreso, what are the foregone opportunities in asset addition versus continuing to buy assets?

The standard Investor Relations line around this is that ‘it means the deal performed as expected’.

That doesn’t speak to the incremental cost of capital it can bake into the balance sheet. Nor does it say whether the initial deal was actually a ‘good’ one at the time……for anyone but the vendor.

Above all, should share prices retreat from these ‘good ‘ol days’ of now, acquisitions installed that access current share price optimism will demand a higher RoR on the underlying assets in the future. Forever. Management used the company’s (your) equity to acquire them – and levered optionality to induce a purchase.

I’ve been looking up SPAC’s (Special Purpose Acquisition Vehicles) lately, and will be producing a primer on them shortly. There’s 4 in the US cannabis pipeline right now that are expected to exceed more than $1B each. SPAC’s are vehicles to lever founder investment, and their initial design will write the respective cost of capital in stone.

More to come.

The preceding is the opinion of the author, and is in no way intended to be a recommendation to buy or sell any security or derivative. The author holds no position in any of the companies mentioned.