At the end of May, marijuana company Cannabis Wheaton Income Corp. raised $115 million in a bought deal co-led by the Bank of Montreal’s investment banking arm.

The deal, the third involving BMO in the past six months, appeared to confirm a narrative developing in Canada’s cannabis industry: that mainstream financial support, for the most part sidelined by legal and reputational concerns, was finally pouring into the sector.

But for those who have watched the emergence of the industry, a peek inside the deal book would have revealed a familiar name.

More than half of the securities offered — $61.7-million worth of shares and share purchase warrants — were bought by a single hedge fund, MMCap International Inc.

MMCap is a Cayman Island-domiciled “opportunistic multi-strategy fund” that bills itself as being focused on mergers, short selling, convertible arbitrage and other “special situations.”

Over the past four years, MMCap has been the leading player in what numerous industry insiders say has been the biggest untold story of the cannabis sector’s emergence: How a handful of hedge funds have used a sophisticated financial playbook to essentially recycle capital through multiple companies and deals, funding wide swathes of the sector in the process.

Hedge funds have provided much-needed cash to companies with little to no revenue, but the extent of their activity and the often short-term nature of many of their investments raise important questions about the sector and the protection of retail investors as legalization nears.

“The retail investor likely would be concerned if they understood how it worked on the inside of the tent,” said Paul Rosen, former chief executive of PharmaCan Capital Corp., which became Cronos Group Inc., and a prominent investor in the space. “Retail investors tend to pay for the party that the insiders are enjoying.”

Investing in a young and volatile industry is never risk-free, but conversations with more than a dozen people — fund managers, investors, traders and cannabis company executives — and an examination of both public and private documents suggest that the hedge funds have employed an array of strategies that allow them to limit their own risk while securing significant returns.

The techniques include using bought deals to close short positions — something that is permitted in Canada providing a fund is not tipped to the pending deal, but that faces restrictions in the U.S. — and borrowing shares from company insiders during private placements, a tactic that can give an investor liquidity to hedge out their position before the traditional lock-up period ends.

“There’s almost going to be nothing that they don’t have some way to hedge on,” said Canopy Growth Corp.’s chief executive Bruce Linton, who has been dealing with MMCap since 2014, when it participated in early financing for Canopy’s predecessor, Tweed Marijuana Inc.

Canopy’s own $200-million financing in January, also co-led by BMO, saw two-thirds of the securities being bought by three hedge funds, with $100 million going to MMCap.

The speed at which Canada’s legal cannabis industry has emerged, and the excitement surrounding it, has often made it difficult for retail investors to figure out what’s happening behind the scenes of the companies they’re buying into.

Canopy Growth Corp. CEO Bruce Linton.

In less than four years, dozens of companies have raised billions of dollars, positioning the best among them to dominate the upcoming legal recreational market at home and the medical marijuana market abroad.

With this, valuations have exploded, particularly in the past 12 months. Canopy, the world’s largest public cannabis company, now has a market cap of around $8 billion, and the five largest public Canadian cannabis companies have a collective market cap of around $20 billion.

Remarkably, it’s largely been achieved without institutional money.

Hedge funds such as MMCap, and others known to be active in the space, have played a major role in that growth.

Public records show that MMCap alone has pumped at least $600 million into more than a dozen cannabis companies over the past three years, helping fund big names such as Aurora Cannabis Inc. and Aphria Inc., mid-sized companies including The Supreme Cannabis Company Inc. and Hydropothecary Corp., and smaller players, among them Invictus MD Strategy Corp. and Hiku Brands Company Ltd.

And that’s only what shows up in public filings.

MMCap has participated in most Canopy financings since 2014, Linton said. But its name does not appear to surface in Canopy’s public documents, suggesting the fund’s total impact could be much larger than $600 million.

“Those funds, for the most part, make up anywhere from 50 to 90 per cent of any deal. And early on they were like 90 to 100 per cent of those deals, the same five or six funds popping up on every single list,” said one industry insider, who spoke on condition of anonymity. Numerous other industry insiders echoed this assessment.

MMCap’s extensive funding comes despite the fact that its Canadian arm — which is managed by Toronto-based Spartan Fund Management Inc. and run day-to-day by Hillel Meltz and Matthew MacIsaac under the name MM Asset Management — reported a net asset value of less than $500 million at the end of 2017.

When asked about its strategies, MMCap wouldn’t comment, with Meltz writing that “we don’t discuss investment strategies or holdings publicly.” A lawyer representing the firm, Jason Chertin of McMillan LLP, added that MMCap “operates its business in compliance with applicable securities laws and regulatory requirements.”

Elements of the playbook used by hedge funds such as MMCap, however, can be reconstructed from public filings and conversations with people with knowledge of their tactics.

On a basic level, it is understood that retail investor excitement over the cannabis industry has been crucial to the hedge funds’ success.

For the past several years, retail investors have been eager to snap up almost any cannabis-related security, providing a cushion of demand that doesn’t exist in other Canadian small-cap spaces such as junior mining or oil and gas exploration.

In some instances, that has allowed funds to cash out of their positions almost immediately following bought deal financings, leaving them to profit from “sweeteners” such as share purchase warrants, but with little skin left in the game in terms of the companies involved.

Another strategy involves using bought deals to close pre-existing short positions, in the hopes of taking advantage of the usually discounted price of shares being offered.

This type of transaction is impossible to see in public filings, but was described by numerous people with knowledge of cannabis financing.

“We have a net short bias to the (cannabis) space,” explained one investment manager who spoke on the condition of anonymity. “So deals that come along opportunistically can generate a little alpha for a short period of time. It’s not that we short stocks in front of deals — we’re always short stocks and we can cover and re-put it back out.”

The investment manager likened the strategy to game theory.

“If you put on a graph when all the LPs (licensed producers) raise, it will be cluster, cluster, cluster. So if you see three raise, you know these other five have to raise. And so people will say, ‘Okay, I might as well be long this one and short this one.’”

Retail investors have been eager to snap up almost any cannabis-related security, providing a cushion of demand that doesn’t exist in other Canadian small-cap spaces.

This kind of trade is legal in Canada as long as it doesn’t involve insider tipping. It’s not, however, always legal in the United States, where the Securities and Exchange Commission prevents firms that sell short in the days ahead of an equity financing from participating in the deal, due to concerns over potential price manipulation.

Then there are the deals that appear to be structured to reduce a hedge fund’s investment risk, with things such as share lending agreements with company insiders.

One such deal, involving MMCap and Cannabis Wheaton — which changed its named to Auxly Cannabis Group Inc. on June 8 — can be seen clearly in public filings.

In November 2017, Cannabis Wheaton raised $35 million through the sale of convertible debentures, $28 million of which came from MMCap.

Convertible debentures are a type of interest-paying bond that can be converted into shares at a set price. Typically they stop paying interest if and when they are converted into shares.

Cannabis Wheaton, however, indicated in a press release in September — the only publicly available description of the debentures — that buyers of the company’s eight-per-cent debentures could convert them “at any time,” and they would still receive “a cash payment equal to the additional interest amount … (it) would have received if it had held the Debentures from the date of conversion to the maturity date.”

MMCap appears to have wasted no time. Public filings indicate that it converted the November debentures sometime between Nov. 10 and Dec. 10 into 23,333,333 shares at a conversion price of $1.20, even though Cannabis Wheaton shares did not close above $1.20 at any point during that time frame.

According to the terms, the conversion would have triggered an immediate payout of five years worth of interest payments — or more than $11 million — less than six weeks after the deal was closed.

In connection to its series of financings, MMCap also entered into share lending agreements with insiders of Cannabis Wheaton.

According to public disclosures on SEDI (the System for Electronic Disclosure by insiders) and regulatory filings, MMCap had at various times nearly 40 million shares on borrow from insiders at the company.

Of those borrowed shares, 23,333,333 were marked to be returned on March 2, 2018, according to an alternative monthly report filed by Cannabis Wheaton and signed by MMCap’s Meltz. That date coincides with the end of the four-month lock-up period for the November securities.

MMCap did not address a question about the purpose of the share lending agreements, but convertible arbitrage strategies often involve establishing an offsetting short equity position.

Given that MMCap had already triggered the share conversion, it could have essentially hedged its entire 23-million-plus share holdings before the four-month lock-up had expired, and would have still held roughly 23 million share purchase warrants that were part of the original deal.

“If we did the term debt we’re paying that interest anyway,” said Cannabis Wheaton chief executive Chuck Rifici, acknowledging that a one-time interest payment was made to MMCap.

“You typically prefer not to do convertible debt,” he said. “But when a company needs capital at a certain time, then you have to look at what’s available to you, and I think the reason MMCap has been successful with a number of companies … is that they come in with a large lead order.”

The relationship between MMCap and Cannabis Wheaton has continued.

Cannabis Wheaton CEO Chuck Rifici in 2017.

In January, public filings show MMCap agreed to take another $67.9-million worth of Cannabis Wheaton convertible debentures. By April, the fund had sold all the warrants, shares and debentures it had acquired in its two previous deals, in June and November of last year.

Then there’s the financing in May that was co-led by BMO. According to a regulatory filing, MMCap acquired 56.1 million shares, but disposed of 17.5 million within a week.

“They recycle cash into new deals,” Rifici said. “At a micro level, you could see how they’re short here, long here, but at a macro level, as far as our relationship with MMCap, I see them as a long investor and supporter of Cannabis Wheaton.”

Share lending agreements involving MMCap also appear in filings from Aurora (9.7 million shares lent out in 2016), Hydropothecary (2.5 million in 2017) and Invictus (1.5 million in 2017).

Whatever combination of long and short strategies MMCap has used, it has made massive returns on the cannabis trade. In 2016, the Canadian arm of the fund posted an annual return of 45.32 per cent, according to a company report.

In 2017, the annual return rose to 61.42 per cent, with the company posting a 25.15 per cent return in December alone.

The deals have been a boon for investment banks such as Canaccord Genuity Corp. and GMP Securities Ltd., as well as smaller boutique firms like Eight Capital Corp. or Clarus Securities Inc., which, until recently, had a free hand to bank the sector while the Big Five banks stayed away.

Canaccord, for example, generated record earnings in the last three months of 2017, with significant revenue coming from the Canadian cannabis trade. For example, Canaccord made $3.7 million in fees on Aurora’s $115 million raise in November, of which MMCap took $104 million.

“When you have slam dunk, fee-generating opportunities, where you can raise money for a cannabis company and you only need a relationship with a handful of hedge funds that will take the deal, it’s a pretty great recurring revenue opportunity, just doing deal after deal after deal,” an industry insider said.

None of the investment banks mentioned responded to requests for comment.

If the cannabis trade has been a cash cow for fund managers and investment banks, it’s less clear what it means for retail investors.

Dozens of cannabis companies have been catapulted onto Canadian public exchanges, typically through reverse takeovers of energy or mining shell companies, many with little more than a licence to cultivate cannabis from Health Canada (an increasingly common asset).

“One of the problems the sector has currently is that there are far fewer businesses than there are companies,” said Linton, whose company, Canopy, is one of the few cannabis players that have been able to start attracting investments from mainstream names such as BlackRock Inc.

“If you’ve got these (hedge fund) guys on a trade, the underlying company doesn’t have to be a great company, it has to be a good trade,” Linton said.

Medical marijuana mother plants are photographed at Canopy Growth’s Tweed location in Smiths Falls, Ont.

Retail investors, however, don’t typically see these machinations.

They see companies raising hundreds of millions of dollars in a sector with undeniable momentum, even if valuations are astronomical. Driven by a combination of excitement and fear of missing out, they’ve been enthusiastic buyers of cannabis company shares, no matter how steep the hill to profitability some of the companies might face.

“We saw it in the ’90s here in the U.S. with the dot-com bubble, we’ve seen it with blips recently in crypto, where there’s just so much demand. You can’t blame the companies which are taking advantage of the situation to raise capital,” said Karan Wadhera, a former Goldman Sachs investment banker and the managing partner of U.S. cannabis investment firm Casa Verde Capital.

“Hopefully, they’re doing it for the right reasons to shore up their balance sheet and make smart acquisitions. (But) compared to what I’m investing in and what we’re doing on the private side, no, (Canadian valuations) don’t look reasonable at all.”

There’s no doubt the hedge funds have helped back powerhouses, which could be around decades from now doing deals with pharmaceutical companies and competing with major alcohol sellers. Likewise they’ve floated smaller players able to carve out profitable niches at different points in the value chain.

But in the process of making money for their investors, they’ve kicked up a lot of froth.

“It’s the history of all bubbles and crashes: it’s always that retail guy getting in at the end, and they’re buying the worst companies,” said the investment manager who asked to remain anonymous.

“They’re not buying Canopy … They’re buying the garbage at $1 thinking it’s going to $50. And it’s crazy, but nobody listens, and history repeats itself continuously.”

Financial Post

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