The state of play in North American cannabis investment

Torys Quarterly: Canadian sector report

The North American cannabis markets continue to mature against the backdrop of challenges unique to this sector. Through the second and third quarters of 2019, we’ve seen difficult financing conditions in the cannabis capital markets. However, this tightening of the capital markets is occurring against the backdrop of a continually improving legal landscape for the cannabis industry in Canada, the U.S. and abroad. These and other key developments in the cannabis space are discussed below.

Legal and regulatory developments

In Canada, the Cannabis Act is now in effect and published edibles regulations are also in force (October 2019). Provincial rollout of retailing has been bumpy, especially in some provinces such as Ontario, but is slowly settling into place. In the U.S., Congress gave overwhelming bipartisan approval to the SAFE Act, legislation intended to protect financial institutions from liability related to money laundering and proceeds of crime when servicing the state-legal, federally illegal U.S. cannabis industry. The legislation faces an uncertain reception in the Senate, although some commentators have expressed optimism. More and more states, such as Illinois, have legalized recreational cannabis and others, such as Pennsylvania and New Jersey, may be in the process of doing so. Meanwhile, pressure continues to be put on the FDA (and, conversely, by the FDA back on Congress) to develop an approach to CBD that will permit and regulate edible Cannabidiol (CBD). Although speculative, it’s even possible that more sweeping legal developments could occur south of the Canadian border, with all current Democratic nominee contenders supporting full federal legalization (except Joe Biden, who supports decriminalization), and strong support in some wings of the Republican party for a form of legalization—perhaps a “states’ rights” approach.

Financing and deal activity

With an improving legal landscape for the sector, we expect to see more normalization in cannabis financing markets. These trends are very important for industry participants, as many players, especially licensed producers, continue to have significant financing needs in order to execute their business plans, and the sector’s volatile capital markets landscape is no longer favourable for financing.

The initial exuberance and hyperactive financing environment of the cannabis industry has until recently relied heavily on the support of retail investors. As we move through 2019, we have seen a marked cooling off in this market—likely attributable to many factors including non-compliance with applicable laws, resulting in the suspension (and, in one case, revocation) of licenses issued by Health Canada; licensed producers not meeting sales projections; and high-profile crises, such as at CannTrust’s alleged use of fake walls to conceal from Health Canada unlicensed cultivation at its cultivation facility. As markets normalize and institutional investors become more significantly involved, we expect to see improved compliance, fewer crises and a more rational market.

In M&A and other strategic transactions, we expect to see interest not just in the companies themselves but also in their assets, including through sales and leasebacks of cultivation facilities to REITs. Investment firms (public or private) have to date mostly sat on the sidelines of the cannabis industry, making up less than 6% of all M&A purchasers in the market, but as valuations start to normalize and as the scope of legalization widens, this is expected to change. Now that the cannabis commercial market is real, investment decisions are becoming less driven by projections and speculation and more driven by traditional financing metrics. Among the well-capitalized investors, a number of strategics in the alcohol, tobacco, consumer packaged goods and pharmaceutical industries are increasingly active. Debt finance is also playing a bigger role as it becomes more readily available to maturing companies with effective discipline regarding capital allocation and burn rates. We continue to expect consolidation, especially among the cultivators, with others going out of business altogether.

All in all, the path of cannabis financing and M&A markets has been similar to the path of other new and emerging markets (such as the dot com market of the 1990’s, among others) where initial exuberance is eventually confronted by reality, and finally, normalization. Companies that are able to differentiate themselves through finely timed execution, branding, intellectual property, technology and alliances, tax-advantaged structures and/or size will be the survivors, and anchor the cannabis industry going forward.

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