How to seize M&A opportunities in marijuana’s gray market
The conventional wisdom on Wall Street is that it’s impossible to time the market. Venture capitalists, however, know all too well that when investing in either startup companies or nascent industries, timing is everything. Nowhere is this more true, today, than in the emerging cannabis market.
To investors in the still developing cannabis industry, many believe the market is just now approaching its own inflection point, as it transitions from a black to gray market, characterized by a more attractive risk profile and outsized growth potential. The sticking point is that as a Schedule I drug illegal under federal law, cannabis still presents imposing obstacles for traditional investors, ranging from capital markets that remain inaccessible to uncertainty over bankruptcy proceedings. Yet, ironically, it’s these very same obstacles that make the opportunity so appealing to investors willing to operate in an indefinite gray area to create an ecosystem for a market expected to reach $75 billion in size by 2030.
For most, the question isn’t whether the federal government legalizes cannabis, it’s how much longer investors will be able to capitalize on this undefined future to influence and profit from how the ecosystem ultimately takes shape. If the M&A market can serve as a leading indicator, the runway for investors is already becoming shorter as strategic buyers represent both a threat and opportunity. In fact, major players within Big Alcohol, Big Tobacco and Big Pharma have each made inroads in the space, which proves out the investment thesis, but will surely beckon added competition.
Capturing the Momentum
In many ways, 2018 has already proven to be monumental year as the number of states that have approved and legalized at least some form of cannabis continues to reach critical mass. In addition to the nine states and Washington, DC, that have approved or introduced recreational usage, 37 other states allow for medicinal or low-THC applications. Not to be overlooked, particularly among investors, Canada legalized recreational marijuana on Oct. 17, marking the first G7 nation and the second country in the world to enact full legalization. This move will disrupt a group of consumer product categories collectively worth up to $500 billion, including pharma, wellness & beauty, nutraceutical, food, alcohol, and tobacco. Legalization not only is a disruptor to CPGs, as the sale of marijuana transitions from a black market to a fully regulated and taxed market, it also opens up brand new demographics of consumers with different consumption preferences.
Still, the ongoing political debate in the U.S. can invoke bouts of agita. The Justice Department’s rescission of the Cole memo in the first week of January, for instance, floated the possibility that federal prosecutors could target existing operators in compliance with state laws. Since then, however, President Trump pledged he would support a legislative solution offering certainty for jurisdictions that have legalized recreational use. Senate Minority Leader Chuck Schumer, in May, also co-sponsored legislation that would decriminalize cannabis at the federal level. Even John Boehner, the former Speaker of the House, made an about face when he joined the board of cultivation and dispensary operator Acreage Holdings, saying on Twitter that his thinking around cannabis “has evolved.” He went on to note that “de-scheduling” the drug would facilitate further research and potentially provide an alternative to opioids for chronic pain.
In many ways Boehner’s change of heart reflects the evolving perception among the larger population, particularly as awareness around marijuana’s medical applications grows. In fact, seniors represent one of the fastest growing consumer demographics. According to the 2018 BDS Analytics study of “Public Attitudes and Actions Toward Cannabis in the U.S.,” more than half of adults over the age of 50 living in states with medical or recreational pot have either consumed cannabis over the past six months or would consider doing so in the future. And eight out of every 10 adults over the age of 50 believe there should “some form of legal marijuana.” Canada’s legalization will spur increased focus and investment in medical R & D, which will further our understanding of the many health benefits associated with individual cannabinoids produced by the plant. In addition, legalization opens up the entire banking system and capital markets infrastructure, providing a free flow of credit that was once scarce, providing CapEx fuel to an already turbo-charged industry.
The Growing Investment Case
Even as all the pieces are in place for the cannabis industry to take off – save for one major “federal” component – timing will indeed matter for investors. In fact, it already has, particularly among smaller entrepreneurs and investors that “touch the plant,” such as farms, dispensaries and other suppliers.
Consider the early impact of state legalization on the cost of recreational cannabis. When marijuana was first approved for recreational use in Washington in 2014, it sold for as much $35 a gram. Today, as larger-scale operators have moved into the market, the price has fallen by nearly 70%. This has tipped the scales in favor of the largest growers with the most resources.
This market bifurcation was a topic of discussion during the May earnings call of ScottsMiracle-Gro, whose Hawthorne Gardening subsidiary has been actively building out its hydroponics business. After a disappointing quarter, in which the company announced restructuring charges, CEO Jim Hagedorn cited California’s struggle to transition from a loosely regulated market for medical marijuana to a larger, “but strictly regulated,” recreational market. “The combination of the slow approval process and the excess inventory is likely to result in fewer players once everything shakes out,” Hagedorn told analysts. He added, “The survivors are likely to be only those with deep enough pockets to get through this tough but temporary disruption.”
This, of course, brings to mind the maxim among VCs that “too early is often indistinguishable from being wrong.” But it also speaks to where the opportunity often resides. For most VCs, the point of entry is typically in backing the ancillary services that will help build out the ecosystem. This was the approach of Tiger Global, the New York-based firm that previously scored homeruns investing in Facebook and LinkedIn. In April, it invested in a Series A round to back Green Bits, a developer of compliance software.
Other VC investments, however, have targeted everything from biotech companies specializing in tissue-culture propagation to “pot tech” startups that offer technology-enabled applications around business services unique to cannabis operators. Of course, opportunities also exist in helping more traditional operators scale their operations. In fact, Salveo Capital, in July, took part in a Series A round, backing Flow Kana, a sustainable sungrown cannabis provider that produces small-batch, boutique strains of cannabis out of California’s Mendocino County and Southern Humboldt regions.
The rush to build out the ecosystem has been accelerated as large corporate investors move into the market. In late 2017, beer and spirits giant Constellation Brands acquired a nearly 10% stake in Canopy Growth Corp., a TSX-listed producer of medicinal and recreational pot, and recently invested another $4 billion bringing its equity stake up to 38%, while Novartis’ Sandoz International unit, in March, inked a collaboration deal with Tilray, a federally licensed producer of medical cannabis in Canada. Even ScottsMiracle-Gro, which has encountered some early turbulence, remains unswayed. The company acquired Sunlight Supply in April for $450 million. Market watchers also took note of Alliance One International’s string of recent deals for Island Garden Inc., Goldleaf Pharm Inc. and a minority stake in Criticality, giving the tobacco company instant exposure to the medical cannabis production market in Canada (Island and Goldleaf) and hemp cultivation in the U.S. (Criticality). The corporate interest only underscores the opportunity for venture capital investors to develop and scale innovative businesses to serve this growing market. It also speaks to why timing is so important. If venture capital can absorb some of the risks of operating in a gray market, investors can position themselves for a tailwind that could drive the space for years to come, whether the market opportunity resides in Canada and select U.S. states or, eventually, all of North America.