Trends Watch: Cannabis Outlook

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.  

This week, Elana talks with David Kutcher, Co-Managing Partner and Chief Investment Officer, Torian Capital Advisors.

What is your outlook for cannabis?

We believe the industry is still in its infancy and will continue to experience significant growth over the next 24-48 months; driven by new medical and recreational states, continued consolidation by the best-funded and managed groups and the emergence of “national” brands.  We also expect the STATES Act, or variation thereof, will pass before Q3 of 2020, which will increase access to capital by those with proven business models.  When the STATES act, or variation thereof, is approved, we may see cannabis companies migrate from the Canadian Securities Exchange (CSE) where they have previously been raising capital to the U.S. exchanges like the NASDAQ or the New York Stock Exchange (NYSE).  In addition, there is private equity and more traditional growth capital sitting on the sidelines in the U.S.; once passed we expect those firms, and hedge funds interested in the space but restricted from investing, figuring out how to engage the U.S. cannabis markets.  We also expect interest from the institutional allocators to increase considerably as they seek exposure to the industry.   

What areas do you believe are the most attractive and why?

We believe in the thesis behind vertical operations and having a diversified footprint across several states.  While we would expect companies we invest in to be leaders in nearly all states in which they compete, we’re also focused on the broader portfolio and realize that certain groups have a dominant presence in certain states – Harvest in Arizona and Pennsylvania, Green Thumb Industries in Illinois and Nevada, Cresco Labs in Illinois, Trulieve in Florida, etc. We also find infrastructure (e.g., logistics, distribution), software and lab testing interesting; however, we have yet to see a software company which can support substantial debt.  Moving into 2020, we will see more intellectual property (IP) deals take place centered around very specific technology and product applications that will be a draw for traditional industries to take a closer look at the cannabis sector.  It’s probably too early place a bet on a brand winner; however, there are a few brands building loyalty by producing quality products which deliver on an experience, and we’re looking for a few to start leading the pack within the next 24 months.

What is the biggest challenge when it comes to investing in cannabis companies?

The industry is rapidly evolving, but given the issues surrounding federal law, for many true institutional investors, or those without significant cannabis investment experience, it remains out of reach.  As a firm, we can take positions across the capital structure; however, the underwriting criteria is different.  When you look at credit-driven investments, understanding the business fundamentals is important in determining the overall credit risk and return profile: profitability and cash burn, total leverage, near-term capital expenditure and M&A cash expenditures, quality and execution capabilities of the management team, along with collateral coverage inclusive of license values, equity valuation and the ability to effectively hedge the equity risk.  When you look at equity investments, many make logical sense.  The core fundamentals and rational for the businesses are undeniable, like investing in a vertical operator with aspirations of becoming a multi-state operator.  The real risk revolves around the management team, the standard operating procedures (SOPs) and the executional team.   Executional risk may be the biggest unforeseen difference in what makes or breaks long term success.  Also, an incredibly strong understanding of regulations on a state by state basis, and compliance, by management remains paramount.  A certain level of risk here is acceptable, but there is no guarantee that any given structure is acceptable and an analysis of the impact on the business is critical in underwriting any investment in the sector whether its debt or equity.