Cannabis Investing in 2020 – 10 Things Investors Should Know

Pete Karabas Article - Cannabis Investing in 2020 - GCI Content Hub
Pete Karabas Article - GCI Content Hub

Cannabis Investing in 2020 – 10 Things Investors Should Know

The year 2020 has thrown several curve balls at us to say the least – the world as we know it is changing permanently, which has created opportunities for those who can adapt quickly and stay ahead of the curve. On all fronts, many of the obstacles we face today are unprecedented and because of this, overcoming these obstacles will require creative, outside-the-box thinking.

One emerging market that is no stranger to outside-the-box thinking is the legal cannabis industry, largely due to the fact that the legal cannabis industry is itself unprecedented – never in history have we seen such unique market dynamics taking place. If we take the US as an example, the largest and most obvious market dynamic in cannabis is the very fact that many states have legalized cannabis in some form; however, under federal law, cannabis is still classified as a Schedule I controlled substance — something with ‘no accepted medical use’ and a high possibility of abuse and physical or psychological dependence.

This means that currently the US government believes cannabis is as dangerous as heroin, which many would argue is an absurd notion today. Even though the US government classifies cannabis as a highly dangerous drug, entrepreneurs are currently running large cannabis businesses within US borders and are paying both state and federal taxes on their profits. Simultaneously, in states where cannabis is not legal, those working in the illicit market are being arrested and potentially incarcerated if caught. Quite a contradictory situation to say the least.

A Philosophical Shift: Illegal to Essential

Earlier this year we saw something interesting take place in the cannabis political landscape as state and federal governments were forced to determine which businesses were ‘essential’ to everyday life. In February 2020, the debate around cannabis in many states remained a question of if or if not the plant should be legal. One month later, dispensaries in US states with legal medical and/or recreational cannabis were declared essential businesses alongside grocery stores, postal services, banks, and pharmacies. This was in large part due to the classification of cannabis as an essential medicine for many citizens; however, recreational dispensaries also remained open since cannabis is believed to help with sleep, stress reduction, anxiety reduction, and boredom.

Nicole Elliott, California Gov. Gavin Newsom’s senior advisor on cannabis stated that California wanted to continue to offer medical marijuana users access to their prescriptions and recreational users an alternative to the black market. “Recognizing that patients need access to this medicine, as well as acknowledging the importance that consumers continue to be able to access legal cannabis made safer by our regulated marketplace, the governor has deemed the cannabis industry essential,” Elliott said in a statement in April.

The declaration by the vast majority of state governors across the US that cannabis is essential to daily life is a milestone philosophically speaking; however, this declaration was also critical in keeping the cannabis economy alive, since many cannabis companies are early stage and do not have the balance sheets to support heavily suppressed operations for 3-6 months. Just like any other emerging industry, many early stage cannabis businesses are tightly managing their cash and are constantly raising new funds – two things that become much more difficult if revenue growth slows.

Now that some time has passed and the initial shock of the pandemic is behind us, both investment managers and entrepreneurs are back on the road raising capital, except this time something is different – they are not actually on the road. Fundraising is a business that is rooted in frequent travel, many conference room meetings and presentations, dinners, drinks, and handshakes – how will this change in a post-pandemic world?

Raising Capital in a Post-Pandemic World

Raising capital is notoriously challenging even when times are good; however, those raising capital today are playing the game on a new level of difficulty. The economic environment is both volatile and uncertain, and simultaneously critical in-person meetings and due diligence sessions must be done remotely.

From the perspective of an investment manager, many limited partners are choosing to put their new investment goals on hold for a few months since they need to focus their efforts on their existing assets. Conversations have turned from discussions around cannabis valuations, investment strategy, or specific deals to “let’s reconnect in 3 months,” or “we’re putting out fires and are pausing new investment activity at this time.” According to survey data published in April 2020 by the Institutional Limited Partners Association:

  • 6% of respondents said they are slowing their private equity commitments generally,
  • 7% are pausing all new commitments,
  • 23% said they were unsure about the impact on commitments and are evaluating the situation, and
  • 26% reported that they do not expect any changes.

Even though some investors are fearful, history tells us there is no better time to deploy capital than now; and if 2008 has taught us one lesson, it is about the importance of deploying capital consistently through market cycles. Whit Matthews, senior investment director of private equity at globally asset manager Aberdeen Standard Investments stated, “funds raised right now will get deployed over the next four to five years. So, in many ways, investors and GPs sitting on dry powder today may be those GPs best positioned to take advantage of the current opportunity set as it presents itself,” in an article written by Kathryn Mulligan, Editor-in-Chief of Middle Market Growth earlier this year.

There are many shifting sands today – the global pandemic has changed how people conduct business and has created a volatile global economy. At the same time, the US is in the middle of another divided election year that rivals what we saw in 2016. There is a lot to figure out, particularly for those in an emerging, politically charged industry such as cannabis, and the natural question is: what does the global cannabis industry look like going forward?

10 Things to Know About the Legal Cannabis Market in 2020

  1. Do not confuse perception with reality – the legal cannabis industry is still one of the fastest growing industries in the world. Reality: Legal cannabis spending worldwide grew by 45.7% to $14.9bn in 2019 and is estimated to grow to ~$20bn in 2020, according to BDSA. Perception: Public cannabis stocks fell by 58% from the April 22 high in New Cannabis Ventures Global Cannabis Stock Index.
  2. Many of the companies who raised capital in 2018 and 2019 did so at enormous valuations that could only be justified in a red-hot cannabis capital markets environment – some might call the time period between 2018 and 2019 “Cannabis 1.0” or “The Green Rush.” Those who raised at too high of a valuation or were unlucky from a timing perspective may run into roadblocks if they struggle to hit revenue targets in 2020. Slow or negative revenue growth combined with tighter capital markets will certainly lead to some down-rounds and re-wirings of capital stacks.
  3. In the near future, the cannabis industry may be even more constrained for capital than it was prior to the pandemic, since many investors are focused on their existing assets rather than entering new, emerging spaces. For investors who are already involved in cannabis or who have dry powder dedicated to cannabis, the ability to dictate terms and valuations has improved since capital is scarcer and in higher demand.
  4. We will likely see accelerated growth in certain subsectors of the cannabis economy, similar to how we saw Amazon, Apple and Zoom soar even as the rest of the economy sank. Many existing tailwinds inside of cannabis will pick up speed – delivery services and direct to consumer marketing are a couple easy examples.
  5. Growth expectations and valuations will be recalibrated as investors refocus on fundamental financial metrics and put an emphasis on profitability rather than top line growth.
  6. Darwinian market forces will likely shake out some of the weaker cannabis companies, making room for new entrepreneurs and innovation, and simultaneously changing the competitive landscape.
  7. In the US, we anticipate an increase in the rate at which states legalize both medical and recreational cannabis in an effort to balance the massive amount of taxpayer dollars spent in the form of financial relief during the pandemic. “I expect a record number of states to legalize marijuana in 2021, in part due to the financial pressures, along with the racial injustice imperative to reduce unnecessary police-civilian interactions,” said Karen O’Keefe, director of state policies for the Marijuana Policy Project, the lobbying organization behind many state cannabis policies in place today.
  8. Vice industries have remained an effective shield from market downturns. Compared to other asset classes, we have already seen data to support the recession resiliency of cannabis. As of June 2020, spending on adult-use cannabis in markets that are not tourist-driven has increased year over year, as have sales in nearly every domestic cannabis market according to the Marijuana Business Factbook.
  9. Talented executives will continue to move into the cannabis space as the industry grows more competitive and sophisticated. Leafly’s fourth annual jobs report found the cannabis industry was the fastest growing industry in America, adding 30,700 jobs in 2019 with additional sales and jobs growth expected in 2020.
  10. It seems neither Trump nor Biden has a strong stance on marijuana policy reform. In July this year, Violet Cavendish of the Marijuana Policy Project told GreenState she believes the advancement of consequential cannabis reforms in the next four years will depend not on the president himself, but rather on who the candidates choose to hire on their staff. To date, Trump has been consistent in supporting the rights of states to make their own decisions regarding legalization of cannabis; however Biden, although he has crafted some aggressive anti-drug laws in his past, can be expected to surround himself with staff more likely to advocate for cannabis reform. Biden has also promised to “decriminalize the use of cannabis and automatically expunge all prior cannabis use convictions” if elected.

Summary

While the landscape of the legal cannabis market is shifting once again, there is no denying the sector remains attractive for investors especially in a world where several other asset classes are struggling. Many have already started calling the post-pandemic phase of the cannabis market “Cannabis 2.0” and are comparing it to the post-dot-com bubble tech era which does not seem far off.

In addition, some investors who were not ready to dip their toes in the water in 2019 have expressed a renewed interest in the space given valuations have reset across the board. Regardless of where you stand, one thing that we can all agree on is that the pathway to global legalization is becoming clearer with each day that passes and we can certainly expect to see some interesting developments in the cannabis market’s near future.

by Pete Karabas, Founding Partner at KEY Investment Partners

Check out other articles on the GCI Content Hub by clicking here.

To learn more about investment and finance in the cannabis industry, check out the GCI Virtual Summit.