Large U.S. funds are exploring lending to Canadian cannabis companies as a way to gain expertise in the burgeoning market ahead of potential U.S. legalization, according to an investment banker who’s been holding weekly calls with the firms.

Funds with US$100 billion or more in assets under management are considering issuing loans to mid-tier marijuana producers, said Alfred Avanessy, managing director at Toronto-based brokerage Cormark Securities Inc., which offers cannabis investment banking, advisory and research. At least three other people at other financial services firms have been approached by the funds regarding cannabis lending. All declined to name the potential investors as the talks are preliminary.

The funds are “realizing it will become fully legal at some point in the U.S. and when it does, they need to be ready to invest,” Avanessy said in an interview at Bloomberg’s Toronto office. “As part of their learning curve, they’re going to spend the next couple years with Canadian players, using Canada as a testing ground.”

Firms with assets of more than US$100 billion that do direct lending include Carlyle Group LP, KKR & Co. Inc., and Oaktree Capital Group LLC. KKR declined to comment while the others didn’t return telephone and email requests for comment.

First Lien

Pot companies have yet to issue a straight bond but are increasingly offering convertible debt, including about $1.3 billion from the three largest firms since last June. The cannabis industry is exploding in North America with spending on legal marijuana expected to reach about US$28 billion by 2022, according to Arcview Market Research and BDS Analytics.

The investors don’t have the appetite to speculate in pot stocks which are notoriously volatile and often richly valued. Instead, they are comfortable with providing credit based on the firms’ enterprise values, Avanessy said.

The idea is to provide first-lien loans, which are first to be repaid when a company fails, ranging from US$25 million to US$150 million, according to Avanessy. While that’s less than what these firms typically lend, it’s enough to test the new market.

“They just need to get their feet wet somehow and they need to put up something to tell the world they’re looking at cannabis,” he said, adding that one of these deals could materialize as early as the second quarter.

Safer Bet

While a majority of U.S. states have legalized marijuana for either medical or recreational use, the drug remains banned at the federal level, keeping big investors away from the sector. However, it’s looking increasingly likely that some form of federal legalization will occur. Attorney General nominee William Barr said on Jan. 15 he’ll respect state marijuana laws and urged Congress to make a country-wide decision on the drug’s legality, while New York and New Jersey have both said they’ll make legalization a priority for 2019.

In the meantime, several U.S. cannabis companies with valuations north of US$1 billion have listed their shares in Canada, taking advantage of growing investor appetite for exposure to the market. But Canadian cannabis producers are still seen by many big investors as a safer bet until U.S. laws change, opening up a wider range of financing options to the Canadian firms.

Convertible Debt

Most cannabis companies have relied on equity to raise funds as traditional bankers shied away from the space. Access to debt “allows us to move towards a more traditional balance sheet,” said Greg Engel, chief executive officer of mid-tier Canadian producer Organigram Holdings Inc., which has CUS$96 million in unsecured convertible debentures.

Several of the largest pot companies have offered convertible debt. Canopy Growth Corp. issued $500 million of 4.25 per cent convertible senior notes in June, Tilray Inc. sold US$450 million of 5 per cent notes in October and Aurora Cannabis Inc. closed an offering of US$345 million Thursday at an interest rate of 5.5 per cent. The deal was upsized from US$250 million, according to one person familiar.

That followed a traditional $200 million debt facility with Bank of Montreal that closed in September. Other big lenders, including Canadian Imperial Bank of Commerce, have slowly been getting into pot lending, as well as offering other banking services.

“For those of us that know we’re going to have significant positive cash flow on a go-forward basis, debt is a preferred option and obviously it creates less dilution for our shareholders,” Cam Battley, chief corporate officer at Aurora, said in a phone interview.