Equity lending revenues on a high
28 May 2019
IHS Markit’s Sam Pierson explains why the cannabis sector is driving Canada’s equity lending revenue
Image: Shutterstock
The growth in the Canadian cannabis sector has been impressive in the year following the June 2018 legalisation of recreational use. The total market capitalisation of Cannabis firms with primary listings in Canada has more than doubled over that time from just under $20 billion to over $40 billion. The expansion was not on a straight line, with the emerging sector realising far greater volatility than the overall market. Investors in the space were compensated for the additional risk in year one, with the average monthly total return on ETFs tracking the sector, HMMJ and MJ, being just over 3 percent with a standard deviation of 20 percent.
For comparison, the EWC ETF, which tracks large and mid-cap Canadian equities, had an average monthly return of 0.4 percent with a standard deviation of 5.7 percent. In other words, investors in the Cannabis sector were able to generate approximately eight times the return with three and a half times the volatility.
The volatility has also attracted short sellers. The total loan balances in the sector increased from $1.3 billion on the eve of legalisation to $2.9 billion at present. The short side has had some success, for example, Aphria has declined 24 percent since legalisation amid concerns voiced by activist short sellers around acquisition values. The largest short positions in dollar terms, Canopy Growth and Aurora Cannabis, have returned 18 percent and 42 percent since legalisation. Those returns haven’t dampened the demand from the short side and short positions in both firms are just below the post-legalisation peak. Merger and acquisition (M&A) activity has also been a driver of demand, with the most significant example in revenue terms being Aurora Cannabis acquisition of MedReleaf, which closed in July last year.
Merger and acquisition activity has also been a driver of demand, with the most significant example in revenue terms being Aurora Cannabis acquisition of MedReleaf, which closed in July 2018. The increase in fees for Aurora loans generated just over 10 percent of 2018 revenue for Canadian Cannabis equities. On 18 April Canopy Growth announced plans to acquire US firm Acreage Holdings for $3.4 billion. The primarily stock-based deal involves a unique contingency regarding the legalisation of Cannabis in the US at a federal level. There has been a marginal decline in the borrowing of Canopy shares since the announcement and the price of Acreage remains well below the offer price, suggesting a lack of confidence in the deal getting done.
A consideration of the returns to long and short investors in the Cannabis space must include the borrow fees paid by short sellers, which have been substantial. For example, the average borrow cost for Aphria over the last year was 13 percent, more than half of the short seller profit from the price decline. Overall year-to-date Canadian cannabis equity lending revenues are $95 million, or 47 percent of all Canadian equity lending revenues. Last year, the total was $140 million, or 29 percent of Canadian equity revenues. That revenue growth has offset declining revenues for non-Cannabis Canadian equities, which would have been down 14 percent for 2018 relative to 2017 excluding the impact of Cannabis; including Cannabis total revenues were up 8 percent. The nascent industry only generated 9 percent of 2017 revenues.
The number of shares in lending programmes in the Canadian cannabis sector has more than doubled post-legalisation, a measure of increased institutional investment in the space. The increased supply of shares in securities lending, along with the significant share issuance by the firms in the sector, has caused a general downtrend in weighted average fees over the last 2.5 years as the sector has matured. At present, the weighted average fee in the sector is 11 percent, down from 40 percent in early 2017. It is worth noting that Canopy and Aurora still make up 80 percent of balances, so they are the primary determinant of weighted sector fees.
Nearly a year into legalisation the stakes have been raised in the sense of increased market cap and increased short positioning. Taking into account the share price return along with securities lending fees it would seem the long side has gotten the better of the shorts so far; however, short sellers have shown no desire to give up on the trade. Regardless of which side of the trade, the borrow fees should be taken into account when considering an investment in the space.
For comparison, the EWC ETF, which tracks large and mid-cap Canadian equities, had an average monthly return of 0.4 percent with a standard deviation of 5.7 percent. In other words, investors in the Cannabis sector were able to generate approximately eight times the return with three and a half times the volatility.
The volatility has also attracted short sellers. The total loan balances in the sector increased from $1.3 billion on the eve of legalisation to $2.9 billion at present. The short side has had some success, for example, Aphria has declined 24 percent since legalisation amid concerns voiced by activist short sellers around acquisition values. The largest short positions in dollar terms, Canopy Growth and Aurora Cannabis, have returned 18 percent and 42 percent since legalisation. Those returns haven’t dampened the demand from the short side and short positions in both firms are just below the post-legalisation peak. Merger and acquisition (M&A) activity has also been a driver of demand, with the most significant example in revenue terms being Aurora Cannabis acquisition of MedReleaf, which closed in July last year.
Merger and acquisition activity has also been a driver of demand, with the most significant example in revenue terms being Aurora Cannabis acquisition of MedReleaf, which closed in July 2018. The increase in fees for Aurora loans generated just over 10 percent of 2018 revenue for Canadian Cannabis equities. On 18 April Canopy Growth announced plans to acquire US firm Acreage Holdings for $3.4 billion. The primarily stock-based deal involves a unique contingency regarding the legalisation of Cannabis in the US at a federal level. There has been a marginal decline in the borrowing of Canopy shares since the announcement and the price of Acreage remains well below the offer price, suggesting a lack of confidence in the deal getting done.
A consideration of the returns to long and short investors in the Cannabis space must include the borrow fees paid by short sellers, which have been substantial. For example, the average borrow cost for Aphria over the last year was 13 percent, more than half of the short seller profit from the price decline. Overall year-to-date Canadian cannabis equity lending revenues are $95 million, or 47 percent of all Canadian equity lending revenues. Last year, the total was $140 million, or 29 percent of Canadian equity revenues. That revenue growth has offset declining revenues for non-Cannabis Canadian equities, which would have been down 14 percent for 2018 relative to 2017 excluding the impact of Cannabis; including Cannabis total revenues were up 8 percent. The nascent industry only generated 9 percent of 2017 revenues.
The number of shares in lending programmes in the Canadian cannabis sector has more than doubled post-legalisation, a measure of increased institutional investment in the space. The increased supply of shares in securities lending, along with the significant share issuance by the firms in the sector, has caused a general downtrend in weighted average fees over the last 2.5 years as the sector has matured. At present, the weighted average fee in the sector is 11 percent, down from 40 percent in early 2017. It is worth noting that Canopy and Aurora still make up 80 percent of balances, so they are the primary determinant of weighted sector fees.
Nearly a year into legalisation the stakes have been raised in the sense of increased market cap and increased short positioning. Taking into account the share price return along with securities lending fees it would seem the long side has gotten the better of the shorts so far; however, short sellers have shown no desire to give up on the trade. Regardless of which side of the trade, the borrow fees should be taken into account when considering an investment in the space.
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