Description

The four levels of the SSIC investment thesis:

Level 1: Buy $1 for $0.65 (happy and protected investor)

Level 2: $1, bought for $0.65, spits off $0.10 a year in distributions (happy coupon clipper investor)

Level 3: Market pays $1 for $1, even though bought for $0.65 (even happier investor)

Level 4: Market, thirsty for yield, bids a 10% yield down to 8% yield; $1, bought for $0.65, trades for $1.25 (ecstatic investor)

Silver Spike Investment Corp. (“SSIC”): Situation and Company Overview

SSIC is a Business Development Company (“BDC”) which recently IPO’d on the NASDAQ in February 2022 trading with negative enterprise value. SSIC is one of a handful of NASDAQ-listed investment vehicles targeting deploying structured capital into the cannabis industry looking to generate mid-teens returns. Like other debt focused BDCs, SSIC’s investment mandate is to generate yield but to do so with a bit more flexibility than a REIT which must distribute its earnings to avoid corporate-level taxation. BDC’s typically trade on P/NAV and % yield metrics and analysis, and I would expect this psychology for SSIC as well. SSIC is an externally-managed BDC which means that SSIC itself really has no team other than its Board, and it is managed by an affiliate called Silver Spike Capital, LLC (“SSC”), which is where the investment team sits and gets paid.

SSC was so eager to set up a public vehicle of this nature that SSC invested ~$63MM of cash in the ~$85MM IPO and owns ~72% of the shares outstanding and is contractually locked up until August 2022. That majority shareholder’s $63MM investment is now trading for only $41MM just two months later. Like a publicly-traded PE firm or hedge fund, SSC derives a fairly high 1.75% annual management fee on gross assets with some other reimbursements (e.g. incentive to scale and obtain leverage but drain on low AUM situations like this) as well as a 20% incentive fee on pre-incentive fee income over a 1.75% quarterly / 7% annualized hurdle, with a catchup. Not bad work if you can get it, and this sets an incentive to generate NAV growth of at least 7% or more. These fees are typically payable irrespective of the trading level of the BDC, which you can liken to an LP vehicle, where SSC is a GP. SSIC’s Board could theoretically fire SSC and try to liquidate, but it would owe high fees to SSC to do so, and I think that scenario is fairly unlikely so we can set aside this Ben Graham net-net visual.

With a handful of peers including structured lenders and investors AFCG (AFC Gamma) and REFI (Chicago Atlantic Real Estate Finance, Inc.), with a cousin peer set in the publicy-traded cannabis REITs such as IIPR, NLCP and possibly PW, SSIC listed on the NASDAQ just in time for a broader market pull down, Russia/Ukraine, and Fed tightening. Also, for those not watching the cannabis industry closely, the global cannabis sector has also been decimated. MSOS, a reasonable proxy for public US cannabis companies, is down ~70% since its most recent peak in Feb. 2021. Other cannabis vehicles like SSIC attempted to hit the window to go public, but a number failed to get there and those which had the ability to are presumably on hold given market conditions. SSIC is managed by a team led by Scott Gordon which has experience in the cannabis space (operators, 2x SPAC promoters and investors) as well as traditional capital markets (https://www.silverspikecap.com/team).

Unlike other BDCs, based on what information is out there publicly, there are no existing loans to evaluate, criticize or praise since SSIC has just gone public. For all we know SSIC is comprised essentially 100% of cash, equivalent to ~$13.70 a share. Let me say that again—this is a NASDAQ-listed entity which is almost pure cash trading at a negative enterprise value, creating a great margin of safety.

Base Case

In this ‘throw the bathtub out’ moment, as investors struggle to gauge risk and determine whether this sell-off is tip of the iceberg or just another blip, a mini COVID panic which will subside, I believe SSIC is an asymmetric opportunity. Buying today allows you to buy into what may be a 100% cash vehicle at the bargain price of 65 cents on the dollar. With NAV around ~$13.70, SSIC trades around $9.00 at the time of this writing, just 65.6% of NAV. With reversion to a 1.0x P/NAV over a year, buying SSIC today would yield a 1.5x MOIC and a 53% IRR.

Upside Case

With the drawdown in the broader market with even more pain in the cannabis industry, I am excited if not outright jealous about SSIC’s positioning. Unlike other BDCs or funds, SSIC has raised fresh capital at exactly the right moment. While a BDC scaling certainly helps distribute overhead costs and improve net delivered yields and NAV growth, how many of us would like to go back to events of sudden market turndowns and have fresh capital to deploy at the top of the capital stack in a vehicle which could get ~50% leverage eventually? For those unfamiliar with cannabis, there are maybe 10-20 vehicles or funds which have AUM levels in the $50MM+ range. Even the formerly cash-rich public cannabis companies (Canadian or US) are all struggling with valuations and capital markets access, so they’re not in the lending game, and BofA and Blackstone are certainly nowhere close to coming into the space

With ~$85MM in cash, I’m sure most here at VIC would scratch their head about why a micro-cap of this nature is so interesting but if you’re steeped in the cannabis space, this is an incredibly enviable position. A year ago, senior loans in the cannabis space were being done in the 6-12% IRR context, often with light covenants and vanilla cash interest payments. Today, that environment feels radically different. I would anticipate lenders such as SSIC would probably not even look at a deal less than a 10% IRR; they are probably stretching target returns today to high teens. For context, with capital raised and deployed mostly from 2019 through 2021, AFCG boasts a ~19% YTM on its 15-loan portfolio (~12% of which is cash interest) and REFI markets a ~17% YTM on its 23-loan portfolio (~14% cash+PIK yields). Net of expenses and any capital held back to grow NAV, let’s assume SSIC generates a ~10% yield on net assets of ~$85MM. As soon as that yield is generated (let’s assume it takes until end of Q3 to deploy which is a reasonable guide from around the IPO), you’d be generating a 15% current yield on today’s price. Ok, pretty good for senior cap stack risk. Held for 1 year and reverting to 1.0x P/NAV, your MOIC would improve to 1.64x and your IRR would improve to 66%.

If you looked back over the last year, the peers didn’t always trade at NAV either. In fact, in better times, a P/NAV of 1.25x is quite possible. This would put you at a MOIC of 2.02x and an IRR of 105%. When Piper Sandler wrote their equity research initiation report, they noted peers were trading at an average of 2.2x P/NAV (though I personally find that to be far too rosy to underwrite).

I don’t think further refinement of the upside case is necessary here, but another angle for upside is back-leverage. Like other BDCs which must operate in the confines of the 1940 Act, SSIC discusses a target 0.5x leverage ratio (e.g. $0.50 of debt for every $1.00 of equity). Typically, this leverage comes in as lower cost capital, allowing the BDC to recycle that capital in higher returning opportunities, thereby improving the ROE and dividend yield. This is one such reason why you could see P/NAVs exceed 1.0x academically because the buyer universe may simply price the BDC equity to a target yield, say 8%. Given this is the cannabis industry, which operates in contravention to US federal law, I was personally skeptical about FDIC-insured institutions offering such back leverage but on May 2, 2022, AFCG proved me wrong by getting $60MM-$100MM of such leverage (https://finance.yahoo.com/news/afc-gamma-enters-60-million-123000949.html). Naturally, leverage is a double-edged sword but for those concerned about an $80MM portfolio being sub-scale and NAV eroding from costs to run the platform, 50% back-leverage would allow ~$120MM of assets to cover essentially the same level of overhead.

Downside Case

Since SSIC is already so heavily below cash NAV, it does stretch the imagination to think of a fundamental reason why it should trade this low for prolonged periods of time. Even paying the costs to fire SSC and liquidating should keep that from being a long-term outcome. Nevertheless, BDCs have traded at wider discounts as high as 60% once in the last decade (vs. the 35% discount today). If you need a ‘Downside Case’ box to fill out in your investment process, I suppose you could use that but I think it skews the Base/Upside/Downside presentation more than warranted.

More pragmatically, SSIC could go write a bunch of silly paper in terrible companies, justifying an erosion in NAV. If you are concerned about this, I think your best comfort will come in meeting the team and reviewing their track record.

BDCs: Current Trading Context

According to CEF Advisors, a data source for BDCs and other similar investment vehicles, as of 5/2/22, the average BDC trades at a 7.7% discount to NAV with average yields in the 8.3% area, with equity-oriented BDCs gapped out to a 37.3% discount to NAV and debt-focused BDCs at a 5.0% discount to NAV. Presumably the discount for equity BDCs is due to a belief that NAV isn’t marked properly, NAV will decline, a large liquidity discount is merited, or other reasons. I would also note that the average debt BDC has a market cap of ~$1.3Bn, significantly in excess of SSIC’s market cap of <$60MM.

Nevertheless, at a 35% discount to NAV, SSIC is clearly trading in line with the equity-oriented BDCs without good reason. However, SSIC is focused on the debt opportunity in the cannabis space and as of the IPO in February, just 3 months ago, held 100% cash. I also believe, based on the yields of the two most comparable cannabis lending/investment peers to SSIC, AFCG at ~14% and REFI at ~9%, SSIC should be able to generate yields even greater than the BDC average and therefore should actually merit a minor premium to NAV. This premium is due to both the scarcity value of capital in cannabis, scarcity of NASDAQ-listed vehicles to deploy capital into cannabis (less relevant when trading at a steep discount to NAV though), and the 200-500bps of excess return which feels present in the cannabis space relative to other industries given the regulatory quirks of the sector.

The data’s an eyesore, so I’ll try to include as an attachment, but even better, you can see the real-time data here as it gets updated after this write-up: https://cefdata.com/bdc/  Foreshadowing a minor catalyst (discussed below) for a moment, you will note that SSIC is not yet on this data pull.

BDCs: Historical Trading Context

For the dinosaurs amongst us, we can also look to historical P/NAV levels of the BDC market in general. Going back to 2012, there were two periods where P/NAVs declined to wider levels. In early 2016, we saw discounts of ~20% and in March 2020 when COVID broke out, the sector gapped out to ~60% discounts before returning to slight premiums by mid-2021 (likely along with most everything else). Otherwise, the sector generally trades near a P/NAV of ~1x Given the BDC composite I looked at from CEF data shows the sector at a ~8% discount, we are on the cheaper side of history but certainly not at some bombed out low. However, most of these declines come with periods where faith in NAV or the trajectory of NAV is properly or improperly questioned. In the case of SSIC, we are talking about cash trading at a discount, not a loan portfolio deployed during good times and being marked in bad times. In fact, quite the opposite—SSIC will be able to deploy during high capital cost periods and should be favorably re-rated during the next time Mr. Market gets happier.

Source: CEF Advisors’ Debt-Focused Business Development Company (BDC) Index as of May 2022

Cannabis Lending Vehicles: Current Trading Context

AFCG and REFI are not technically BDCs, thus they do not show up in databases like the CEF Advisors data shown above. Nevertheless, AFCG and REFI are the most pertinent comps and their business models are very similar, but AFCG and REFI used a REIT structure to climb the great wall which is an organization which touches US cannabis in some manner trading on the NASDAQ/NYSE. Using AFCG’s published book value from 12/31/21 of $16.61 and excluding any earnings since 12/31/21, AFCG trades at 0.97x P/NAV. My math on REFI suggests book value of $15.07 (a little below their 10k’s stated $15.13), which suggests a P/NAV of 1.11x.  So, the two cannabis peers, which admittedly have deployed portfolios and yield track records, are still trading at 0.97x – 1.11x P/NAV, a large premium to SSIC’s P/NAV of 0.65x where NAV is just cash. I have some perspective around the value of 'book' at AFCG and REFI which I won't share here. Let me just say that I don't think cash should be worth 35% less than the face value of AFCG and REFI's loans, and arguably this cash being freshly deployed during an industry downturn will be better paper (economically, structurally, covenant-wise, etc.).

Illustrative SSIC Loan Portfolio Construction:

For anyone new to BDCs or new to cannabis BDCs, it’s probably helpful to get a sense for what an SSIC investor would like to see SSIC mature into. This will help you better understand the diversification risks, maturity profiles, sizes, economic features, and yields.

Here is AFCG’s latest portfolio overview from their Q4 2021 earning presentation dated March 10, 2022:

Here is REFI’s portfolio drawn from their latest 10K:

Disclosures:

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Catalysts to Improvement in P/NAV / Why does this exist? :

As SSIC is relatively young, its presence in various databases is still forthcoming. Stifel (Hold; $14 price target) and Piper Sandler (Overweight; $17 price target) did initiate coverage on the name so that catalyst is already out there, but there are a few places like the CEF databases as well as Yahoo!Finance or Bloomberg which don’t yet have any yield data or dividend track record to post. I suspect that will help a little and should come out gradually in the coming months or quarters. Nevertheless, I think the biggest catalysts will be SSIC deploying its capital, generating yield, building its track record, maybe issuing equity (at prices > 1.0x NAV) and eventually obtaining back-leverage.

Beyond that and standard market catalysts, US federal legalization likely could swing P/NAV in a positive fashion. While there are pros & cons to the long-term fundamentals (pros being SSIC accessing cheaper capital; cons being increased competition in providing capital to the industry), there is no doubt that retail and institutional investor interest waxes and wanes around rumors in DC about Schumer’s new cannabis legalization agenda or a Republican-led solution.

As I think through why this discount exists, I half-fear that SSIC wrote some god awful loan to the worst operator in the space and only the ~1,000-2,000 shares that trade a day know about it and not me. While that is possible, I think the situation here is pretty transparent. The float is very thin with 72% of SSIC owned by SSC. That leaves only ~$15MM of float up for grabs. Volumes are low, averaging around 10,000 shares a day, so you’ll have to be patient if you want in or out.