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CHASING THE TIGER

February 1, 2019

 

Deals are coming fast and easy.  The action suggests panic buying like a tiger on the run. Whether the deals are worth it, only time will tell.

The announcement of Altria Inc.’s $1.8-billion investment to acquire 45 percent of Cronos Group, as well as listing activity on the Canadian Securities Exchange (CSE) and consolidation transactions just since August, underscore the watershed impact of Constellation’s 2018 announcement of its $4-billion investment in Canopy Growth Corp. It also lends credence to the view that 2019 may be a seminal year for the cannabis industry. Notably, while both the Constellation and Altria transactions were for minority stakes, their longer-term intentions and, more importantly, expectations regarding the potential of the cannabis markets are reflected by the fact that each provided a pathway to control. The Constellation and Altria investments almost certainly presage additional strategic investment activity.
Marketplace expectations and support are also reflected in the rising tide of large consolidation acquisition transactions (representative examples being announcements in October of iAnthus’ $835-million deal for MPX and Medmen’s $682-million deal for PharmaCann) and the CSE’s November report on financings (20 new listings in November involving capital raises of more than $1 billion and a pipeline of 55 issuers in queue).
These high-dollar transactions, as well as other developments (e.g., increasingly favorable public opinion, U.S. and global geographic growth, and progress on the medical front) and an ever-broadening array of products and applications, are rapidly changing the landscape. They are indicative and predictive of the industry’s short- and longer-term trajectory, and their cumulative impact may have already tipped the balance scales concerning the elephant in the room—U.S. law. Even short of federal legalization in the U.S., absent unanticipated adverse developments, 2019 could be the year in which that happens and the industry’s future scale, shape and scope are dramatically clarified.
As an aside, the somewhat excited state of the public cannabis markets seems eerily reminiscent of the lead-up to the dot-com bubble. While it is likely that the public markets will continue to be volatile, and may experience a correction, perhaps a significant one, if newly listed companies post disappointing results as we move into 2019, there are important distinctions between the dot-com and cannabis industries which will likely at least mitigate the depth and length of such a correction.
In addition to their apparent impacts on acquisition and investment activity and valuations, including paving the way for, perhaps driving, additional strategic investments, cumulatively these developments also have subtexts from which other potentially essential inferences may be drawn:
- There has been clear and likely decisive tilt in the playing field, making much more likely changes in U.S. law sooner rather than later. If substantive changes are made, they are almost certain to alleviate the U.S. banking and tax impediments which currently impose significant constraints that are inhibiting the industry’s operations, profitability and growth.
- There is an emerging and persuasive perspective that the markets for cannabis and cannabis products may be more significant, perhaps much more extensive than current, credible projections reflect;
- The Agricultural Improvement Act of 2018 (the Farm Bill) may provide a side door pathway and point of entry into the U.S. markets for cannabis businesses in which strategic investments, like those made in Canopy and Cronos, are enabled by the absence of operations that violate U.S. law. Relatedly, the DEA’s approval of imports from Canadian cannabis companies for U.S. medical testing will boost this trend;
- The virtually total absence of the ridicule with which the market met speculation about the possible investment interest of Coca-Cola that swirled around at the time of the Constellation transaction, but didn’t happen, may be as or more significant than any of the more tangible developments demonstrating how quickly and far into the mainstream the industry has moved in a few short years; and presenting the enticing prospect that Coca-Cola may represent an additional genre of strategic partner, consumer product businesses, suggesting potentially vastly expanded product and marketing opportunities from those contemplated by partnerships or exits involving the usual suspects: the pharma, alcohol and tobacco industries
Finally, the perspectives and observations reflected in this article should not be considered investment advice. The well-founded admonition against taking investment advice from anyone who has to work for a living should be kept firmly in mind.

Has there been a decisive tilt in the U.S. legal playing field?

 

While the Constellation and Altria investments were enabled by the fact that Canopy and Cronos do not engage in operations in the U.S. that are illegal under U.S. law, without changes in U.S. law or a much larger global market than presently projected, it is a challenge to make these, other anticipated strategic investments and the enterprise valuations of listed companies pencil out.

This factor, combined with other developments, has caused a final tilt on the playing field on which U.S. marijuana law is being and will be addressed. This tilt will significantly influence and almost certainly determine the outcome, and either shorten the time frames or at least remove some of the uncertainties which currently adversely impact the industry.
New, powerful, highly sophisticated and motivated players are being introduced into the arena as a by-product of the Constellation and Altria transactions, the additional strategic and financial investments now even more likely to follow, and the population of the C suites of listed companies with seasoned, establishment rooted executives with impressive biographies, accomplishments, and political and business savvy and contacts. These strategic investors, and those likely to follow, the C Suite executives, and their respective legal, financial and other advisers (and yes, lobbyists) bring levels of access, influence, and stature (read: leverage) into the process that was previously not present within and mostly unavailable to the industry. They are wise in the ways of the world, used to and skilled at playing the “game.” They are intimately familiar with and have access to the levers of power that need to be pulled, and they know how to pull them.
The prevailing theory was that establishment player—lawyers, investment and commercial bankers, and institutional investors—were deterred from participating and lending their talents, contacts and other resources to the cannabis industry by both its illegality under U.S. law and the potential reputational risk believed by many to be involved. A look at some of the players in the Constellation and Altria deals makes it apparent that concerns over reputational issues have been clearly consigned to and are rapidly disappearing in the rearview mirror, at least among a representative sample of the elite within their respective professions and businesses: (the author is a lawyer, so lawyers first) Wachtel, Lipton; Sullivan & Cromwell; Hunton Andrews; investment and commercial bankers: Goldman Sachs; Bank of America; JPMorgan Chase; Lazard Ltd; Perella Weinberg.
In parallel with the economic imperative for the industry of access to the U.S. markets, with the reputational issues apparently no longer an impediment to participation, U.S. law remains the only barrier to their ability to fully participate in and derive the financial benefits of the increasingly substantial professional and commercial opportunities being presented by the cannabis industry. Thus, in addition to the businesses directly participating that want and need U.S. law to change, so to do their powerful supporting cohorts that, like them, are firmly ensconced in the establishment and the halls of power:
- Primary U.S. law and accounting firms that have to continue to be deterred by U.S. law have watched as professional fees have continued to increase for those few U.S. firms that have been willing to provide services to the industry, and for Canadian firms that have benefited from the lack of access to U.S. exchanges;
- Financial firms registered with the U.S. Securities and Exchange Commission (SEC) and the Financial Institutions Regulatory Authority (FINRA) that have passed on tens of millions of dollars in fees they are confident they would have earned had they not been deterred by uncertainties under U.S. law from participating in underwriting syndicates, a number of which, perhaps many, are actively studying possible alternatives that will permit them to do so; and
- Commercial bankers, deterred by uncertainties under US law from accepting and lending other borrowers billions in deposits, making profitable loans to an industry with a growing appetite for financing which can be reasonably secured by assets such as equipment, real estate, and providing treasury and other profitable fee-based services.
Concerning the commercial banking and registered financial firms, there do not appear to be any published regulations that clearly preclude their participation in the industry, but concern over the enforcement uncertainties created by the absence of any published guidance from their regulators has thus far been a deterrent.
A small number of banks have openly entered the business, relying upon guidance published in 2014 by the Financial Crimes Enforcement Network (FinCEN) arm of the U.S. Treasury Department. Arguably, in the absence of preclusive policy statements or regulations, SEC- and FINRA-registered firms might do likewise. If U.S. law doesn’t soon, and the profitable opportunities continue to grow, the incentives increase and become more compelling for these firms to move proactively, either by chinning the risk in reliance upon compliance with the FinCEN guidance or perhaps making formal ruling requests or doing so by indirection by finding a way to file amendments to existing registrations.

Tiger Out of the Shadows
Public acceptance will continue to grow, and the industry will increasingly move toward full legitimacy. This would likely occur organically, even without focused public relations campaigns (which would not be surprising), as more cannabis companies achieve critical mass and more visibility. Organic acceptance is also likely to snowball as more iconic strategic investors from an ever-broadening universe of businesses, markets and products (like Coca-Cola) express interest and make commitments, and the medical segment of the industry builds on the facilitation of medical testing by the DEA and an apparently growing receptivity of the FDA to cannabis-based drugs.
Although Coca-Cola subsequently announced that it was not pursuing the rumored investment, the fact that the rumor was regarded as credible speaks volumes about how far and fast things have moved when just a few years ago, other than the true believers and visionaries, many would have regarded such a suggestion as ludicrous. Not anymore. In addition to the implications of investment and acquisition transactions on the arc of U.S. law, mainly because of recent statements from sources which must be taken seriously, these valuations and investments may also reflect an underlying but growing gut conviction that the U.S. and global markets may prove to be much larger than currently projected. Recent information provided by ArcView and other reliable sources projects legal 2022 U.S. and total global (including the U.S.) revenues of about $23 billion and $33 billion, respectively, expecting that the global legal market will reach $57 billion by 2027. However, ArcView also reported that 2016 estimated illegal U.S. sales totaled about $46 billion, and reports of a global illicit range of sales as high as $200 billion. Credible sources are beginning to agree. In October CNBC interviews, the CEOs of Tilray and Canopy suggested much larger global numbers; Tilray’s Brendan Kenney’s number was $150 billion, and Canopy’s Bruce Linton’s was $500 billion.
Coca-Cola, while in the beverage industry, is, in reality, a consumer products company. The prospect that consumer products and marketing behemoths will join the tobacco, alcoholic beverage and pharma industries as strategic investors, and apply their creative energies to expand products and demand may well support this proposition and is likely to be intriguing to investors.

The Farm Bill
Although the actual impacts that the Farm Bill may have on the U.S. cannabis industry will be difficult to assess until there is an opportunity to see how it plays out, one potential consequence of its passage may increase the urgency with which U.S. cannabis companies and their investors approach the need to address U.S. cannabis laws.
The extent to which passage of the bill may provide a pathway for companies like Canopy and Cronos, that don’t have U.S. cannabis operations, to establish U.S. beachheads and platforms remains to be seen. Directly, or perhaps in joint ventures with their presumably growing array of strategic partners, participating in the rollout of the rapidly emerging and probably complementary hemp industry would ultimately facilitate the extension of their cannabis operations into the U.S.
In addition to branding opportunities implicit in the DEA-approved participation of Canadian companies in US medical testing, and those otherwise presented in conjunction with marketing hemp products, accessing markets through hemp operations would enable critical foundational activities, such as the identification and acquisition of locations and the establishment of political/community relations so essential to the industry, that will ease the glide path when full access becomes possible.

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