Ever since states began legalizing the recreational use of marijuana, the growth trajectory of legal cannabis has skyrocketed. As of Nov. 8, there are 28 states that have legalized marijuana for medicinal purposes, and seven that have legalized it for recreational use. With adult use now legal in California, it is predicted to be a $4.5 billion market as the medical use currently yields about $2.5 billion, according to data and analytics firm New Frontier Data in conjunction with ArcView Market Research (see “Game changer,” below).
Here, we will breakdown the structure of this ever expanding industry, discussing risks of investing in cannabis, institutional investment interest, investment trends and predictive analytics of growth patterns. Who is investing in the industry and how will that likely affect its growth and viability? Cannabis’ unique legal status presents specific obstacles to its growth and stability. What do investors need to be concerned with?
According to New Frontier and ArcView, the legal cannabis market was $5.9 Billion in 2105 and is projected to be $7.1 billion for 2016. That is barely 10% of the actual cash crop estimates as calculated by Panther Capital’s 2015 analysis, which extrapolated a gap study done by the state of Colorado and combined it with the actual recorded sales to estimate the black market retention of cannabis production. That study estimates the cash crop at about $58 billion.
Marijuana is the fastest-growing industry in the United States, according to New Frontier, far outpacing almost every industry except electronic vehicles (see “Growth curve,” below). In its analysis, the adult-use market grew 232% last year and they project a compound annual growth rate of 29% from 2014 through 2020 when medical use is included. The total market is predicted to top $20 billion by 2020.
Asenticing as all this is, there are still a number of traditional and non-traditional factors that have had an effect on public markets as well as infusion of institutional capital. Both of these leading indicators of market maturation remain premature, putting the ability to invest beyond the reach of most retail investors.
Risk and regulatory factors
Cannabis is not like any other industry or asset class. Sure, it is an agricultural crop and falls significantly into the Consumer Product Goods sector, but the fact that it is illegal and seen, by some, as immoral creates unique risks. The industry is divided into two distinct divisions: those that “touch the plant” and those that don’t. The latter generally being referred to as ancillary carries a much lower perceived risk. The definition of touching the plant means that any part of your operation derives revenue directly from the sale, distribution or physical contact with the psychoactive component in cannabis, which is tetrahydrocannabinol (THC). It would also include the beneficial ownership of a license issued by a state or municipal government.
The biggest risk by far is reputational risk. At least that is what the market is indicating. Corporate and institutional leaders are apprehensive to be associated with pot. Adding $20 million or $30 million in deposits or assets under management for an institution that has many billions, and whose stakeholders might see it as offensive, creates high down-side risk. They are afraid of a mass exodus.
Banking would have to be the next largest risk factor. Large banking institutions have been known to lock out other industries such as predatory lending (pay-day lending and so forth). These are not illegal industries; the decision is based partially on reputational risk and the fact that it attracts suspect activity (making it more likely to have bad actors), which carries compliance and audit risk; and that is costly.
Some state charter banks and regional banks don’t care about reputational risk, but still won’t touch it because they are either genuinely afraid of the Federal laws or simply cannot afford to deal with the compliance costs to maintain the accounts. Sundie Seefried of the Partner Colorado Credit Union has stated that 10 of her 40 employees are full-time-dedicated to servicing cannabis accounts, which total a mere 5% of the deposits. The reason for these hurdles is that every bank, state or federal, has access to the Federal Wire System via the Federal Reserve and they have refused to grant access to the wires for a cannabis financial institution. The Fourth Corner Credit Union of Colorado has been suing the Federal Reserve of Kansas City to grant them a master account since 2014 and had an appeal set for Nov. 16. Existing banks that rely on the Cole Memo (a sort of no-action relief from the Department of Justice regarding Federal cannabis laws) are subject to compliance audits, and the cannabis accounts trigger so many compliance audits that you need a full-time person to manage them, as Seefried pointed out. Banks end up with an auditor at their institution full-time.
If you can’t get a cannabis bank charter it is going to be difficult to get individual banks to devote the resources needed to achieve economies of scale.
The last major issue is management risk. Qualified people coming into the industry, while beginning to increase, are still very scarce. Finding a competent management team with previous cannabis industry experience via either IPO or acquisition is near impossible. Until the reputational risk begins to lessen, this will remain prevalent in the industry. Cannabis appears to be where same-sex marriage stood about five years ago.
Other notable risks include regulatory and legislative risk, but until the above are resolved they will not matter much. Legislative risk will take care of itself as it did on Nov. 8, and however cumbersome, will happen. Regulatory risk is an unknown but early adopters should be able to sell out to big cannabis (agriculture, tobacco, pharma or liquor) when they decide to swoop in and lobby the regulators. They will want to one-up one another and buy into the space.
The lack of institutional capital affects both the public and private markets. Without institutions willing to invest in cannabis making a real public market is difficult. There are only a handful of stocks that are affiliated with cannabis that don’t trade over the counter. GW Pharmaceuticals (GWPH) is the largest and best known. It has some real traction and even rumors of a takeover bid, but GW is far ahead of the rest of the field. The stock has tripled since March 2016. The North American Marijuana Index (MJIC) has analyzed the listed stocks in the space and has identified 23 for its North American Index with 13 U.S. and 10 Canadian companies out of a universe of more than 200 stocks listed. The previous index listed more than 150 stocks from the space but MJIC created tougher listing standards in publishing its new indexes this September, which combine trading volume, price and market cap metrics. The index will be updated quarterly and based on the 90-day average.
Recent activity on the Australian Securities Exchange (ASX) reveals newer players in the public market. MMJ Phytotech (MMJ) and Creso Pharma (CPH) were oversubscribed according to sources and neither has any revenue. The ASX has decent liquidity, but more importantly it is legal in Australia in a manner that permits institutional investors to enter.
MJIC Inc., a California based diversified operating company in the ancillary services sector of the industry, has entered into underwriting agreements to initiate an IPO on the ASX and expects to go public in early 2017. It would be substantially more attractive than the other issuers as the consolidated annual revenues should exceed $3 million in 2016. Still, this is a far cry from a mainstream IPO. “There is an appetite for this in Australia we don’t have here in the U.S.,” says MJIC President Randy Shipley.
Shannon Soqui, partner at cannabis focused boutique investment firm Ackrell Capital, says the Nasdaq or NYSE would allow an S1 under the right set of circumstances, but MJIC’s Shipley says that they won’t be ready for another two to three years. Mass Roots (MSRT), which did an IPO via an S1 in 2015, was denied its application to uplist to the Nasdaq in May of 2016 due to affiliation with the cannabis industry. Most of the traded stocks on the OTC exchanges were reverse mergers and lack any substance at all. It is hard to attract talent without institutional capital.
There is some activity, however. Microsoft (MSFT) recently dipped its toe into the space with a software deal. Scott’s Miracle Grow (SMG) has invested about $300 million of a committed $500 million into the space, primarily through hydroponics and agroponics. Merrill Lynch published an industry report in 2015 that was mostly validation to insiders and focused largely on testing as the most viable sector. But that marks a substantial entry point. Duff & Phelps was shopping a private placement but nothing has materialized to date. Cowen and Company has made an attempt to enter the space with a report, but the video they put out is less than groundbreaking. The aforementioned Ackrell capital published a pretty solid industry research report in February of 2016 and plans an update in 2017.
The only fund of any size in the industry is Tuatara Capital, which raised $96 million but has only done two deals to date: One being Willies Reserve, Willie Nelson’s branded line of products. Ackrell Capital and Med Men claim to be raising $100 million funds, but neither has confirmed how much they have raised. Others including High times have tried but failed.
On the Private Equity side, Privateer is probably the best known for both its success in getting an investment from Peter Theil’s Founders Fund (rumored about $5 million) and in securing the rights to Bob Marley’s brand Marley Naturals. They raised $75 million in their B round that Founders fund helped to lead at a valuation of $475 million. In late October, they announced an additional $40 million in funding for its series C of a planned $100 million, making them the largest in the industry by far.
In early October, Alan Gold co-founder of Alexandria Realty and Biomed Realty Trust filed an S1 for the first cannabis REIT. It intends to raise $175 million, according to the filing. Duchess Capital (Doug Leighton) has been very active in deals, most notably the aforementioned Mass Roots but they have not taken any outside capital. Viridian Capital Advisors has been active as an investment bank but has struggled to find a long-term business model. The industry hasn’t caught up with Viridian yet but founder, Scott Greiper appears committed to becoming a leader in the space.
A little downstream you can find some players who have been active but don’t qualify as institutional. Many stem from the ArcView network, which was founded by Troy Dayton and Steve DeAngelo. ArcView has brought together many of the early adopters on both the investor and issuer side. They are by far the largest angel groups in the cannabis space and one of the larger angel investor groups in the country with more than 400 members, claiming more than $80 million in funding.
Of note from ArcView is Poseidon asset management who has been an influential player in the early stage equity space. MJIC has converted to an operating company but prior to that it raised $2 million and has invested in more than 10 companies that remain part of its portfolio. TL Partners has raised and invested $2.5 million in 12 deals and is looking to raise a $10-million fund. Phyto Capital raised $2.5 million and has invested in nine early-stage deals so far.
Others include Salveo Capital, which failed to win a license in Illinois but has reinvented itself as an equity fund and is raising $10 million; Hypur Ventures/Anslinger Capital (the two merged in September); Tress Capital and Casa Verde Capital, which is Snoop Dogg’s fund, and has made investments in companies like delivery service Eaze, which just received $13 million in funding in early November.
Analytics and trends
With a good three years of real and trackable data coming from groups such as New Frontier Data, BDS Analytics and most recently Headset we are finally able to begin measuring some things. The cannabis industry is an industry of immigrants. Most came from somewhere else. There are three waves of immigration:
- Cannabis 1.0 is those who have been doing it for several years and existed largely in the shadows.
- Cannabis 2.0 is the ArcView crowd. More professional investors and business operators but there is still an activist culture that is prevalent.
- Cannabis 3.0 is the proliferation of the institutions and operators who have begun to emerge. The infrastructure of this industry is still being developed.
There is no Gartner or Forrester playing in the space, so the first movers in the analytics and data space have the most significant measurable data.
New Frontier Data was the first. It is run by CEO Giadha Aguliar DeCarcer, a hard-driving entrepreneur who forgot to read the chapter on the glass ceiling for women in her studies and has just completed a series A round where the valuation is confidential but substantial. For data firms the struggle is to find data to analyze, not the analysis itself. The investor survey just published by New Frontier on investment trends is comprised of 100% ArcView members. It has a bias since all the ArcView Members are accredited investors but the data is still significant and the report is excellent for anyone who wants to understand trends in the industry among those who are currently investing (see “Investment trends,” below).
For Public stock information, MJIC tracks the historical data of stocks once they became cannabis companies. The majority of cannabis stocks are reverse mergers, so all other data is flawed. New Frontier uses Viridian’s data, which is still pretty undisciplined, however, first movers are often criticized and like Cowen, Viridian is helping to legitimize the space.
According to The New Frontier/AcrView Survey, 68% of investors are willing to touch the plant where only 28% say they will invest but only in ancillary products.
However, 64% state that their top investment category is ancillary products, so clearly this is still considered a safer bet. The survey shows that 48% are interested in edibles, the alternative form of ingestion for those who do not care to smoke making it the favorite for those willing to touch the plant.
Not surprisingly, because the survey focused on private placements, most investors stated that their biggest challenge was due diligence. What was interesting, however, is that 71% of investors from this group list stocks and bonds as their investment background and only 35% say they have experience in angel and VC investments. Curious for a group that is 100% angel investors and rarely gives stage time to public companies. It clearly points to an appetite for a more mature public market in cannabis.
MJIC operates three divisions with nine different businesses all aimed at providing ancillary services to the industry that comprise infrastructure, professional services, media and trade shows, distribution and development of intellectual property. In a survey of MJIC investment conference attendees, 65% of the respondents were not accredited investors.
Of the respondents who answered, 92% indicated interest in public stock investments while 70% indicated an interest in private placements. This data points to the fact that investing into the industry has limited appeal since legitimate public stocks remain scarce. More than 50% of the MJIC respondents were over 50, while 70% were over 40, indicating an older demographic.
At the end of the day what you have in the cannabis marketplace from an investment perspective is an incredible opportunity if you can be patient and connect with people who understand the industry. Don’t go it alone. It simply does not act like other industries. It is moving very slowly despite the appearance of rapid growth. It is fragmented because you cannot ship over state lines or use simple resources like banks. Profit margins on the product side are massive but unique tax codes can eat into profits. Cash is a nice thought, but people are literally sitting on millions of dollars of cash in safes or buried in the ground who simply cannot find anything to spend it on. Nobody in 21st century business takes large amounts of cash.
The industry has all the trappings of mature forerunners: agriculture, alcohol, pharma, tobacco; but cannabis lacks the permission to mature. Once it does we are likely to see another epic bubble for investors. Mature industries will rush in and buy up as many small pieces as they can and try to assemble them into a cannabis superstructure. Until then, however, strategic investments will be difficult without access to industry insiders who also have the skills necessary to do due diligence on early stage investing, a combination that is sorely absent in the space.