In 2018, global legal cannabis sales were between $18-20 billion. The booming cannabis industry offers significant opportunities for investors and private fund managers, but is also fraught with risks and legal knots. As we progress into the second half of 2019, cannabis industry investors and analysts should be aware of some of the key issues and where to look for opportunities.

SCOPE OF INVESTMENT OPPORTUNITIES

Cannabis investments can take two forms: plant-touching or ancillary. Plant-touching companies often prove more innovative and, as a result, are more efficient in allowing for arbitrage opportunities. However, these companies are disfavored by many investors because their operations directly violate the Controlled Substances Act. Unique acquisition structures are being developed to manage this risk. Most notably, Canadian-based Canopy Growth Corp recently agreed to pay $3.4 billion for the right to acquire New-York based Acreage Holdings upon a change in federal law making Acreage’s operations legal.

Conversely, ancillary companies may be preferable as they are scalable, require less capital, and have less exposure to legal implications. Nevertheless, ancillary companies must also be mindful of the legal implications of doing business in the space. For example, ancillary companies may encounter issues with their insurance coverage if a claim arises in the course of servicing a plant-touching customer.

Due to their scalability, technology-based companies offer unique prospects for investors. Real estate also provides opportunities due to the rent premiums arising from the risk of federal forfeiture. Landlords with cannabis-compliant properties can often generate double (or more) the rent that would be paid by a non-cannabis client for another use.

In the capital markets, there is a preference for equity investments rather than debt. Investors seek to underwrite large returns and there are currently few debt instruments corresponding with the equity underwriting.

ANALYZING INVESTMENT OPPORTUNITIES

In evaluating financial metrics, investors should pay particular attention to free cash flow and capital expenditure requirements, as these can be more easily verifiable and are crucial for the viability of the company. To properly evaluate a cannabis company, investors should carefully consider various non-financial factors such as board composition, corporate governance, and the composition of the management team.

Another crucial factor is alignment with the investor’s vision and values. Companies should be evaluated on how they fit into the investor ecosystems, whether there are shared visions for success, and whether the company’s future plans align with the investor.

When evaluating a company, it is also crucial to look for red flags which may be more subtle and difficult to detect. Two of the biggest red flags are management selling their shares and acting irrationally. Such behavior is currently a regular occurrence and should be monitored closely.

PREDICTIONS

Companies will be able to differentiate themselves by developing a strong brand and relate to the consumer. As a result, more capital should be deployed into brands, particularly to develop consumer experiences and loyalty. Social equity programs will be critical, as governments are using licensing as a means to create job opportunities for individuals previously incarcerated for non-violent cannabis-related offenses.

While the industry continues to grow, we may see a looming distress cycle fueled by companies that receive funding, incur significant capital expenditures, and are unable to support their infrastructure. This could provide opportunities to investors who are looking to buy distressed assets and stabilize such businesses, and will lead to significant levels of distressed debt in the cannabis capital markets.

With multiple states having passed cannabis legislation in 2018, including Missouri and Michigan, and new states expected to enact medical and recreational cannabis programs in the coming year, there appears to be an increase in public acceptance for cannabis. This extends to medical cannabis, where consumers do not yet understand the benefits of the various products. This growing acceptance will likely result in a massive new consumer base.

Overseas, many opportunities exist for cannabis industry investors. These opportunities offer international growth for brands, particularly in Europe, where 14 countries currently permit medical cannabis. That number could increase this year and it is likely at least one European country will legalize recreational cannabis. The United Kingdom in particular could serve as a barometer for the rest of Europe and Africa, as other countries look to its approach for guidance. For the remainder of 2019, as cannabis’ stigma declines, we can expect better management teams to emerge in these international regions and cannabis programs to develop throughout India, Africa and Asia.

Barry Weisz is a corporate strategist and outside general counsel to small– to mid-sized companies. He is the managing partner of Thompson Coburn’s Los Angeles office and one of the founders of the Firm’s Cannabis practice.

Michael Rosenblum represents and advises public and private companies, private equity firms and hedge funds in a variety of transactions and industries. He is an active member of Thompson Coburn’s Cannabis practice.

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