What are the challenges unique to cannabis investments?

Posted by Andrew Borowiec on Dec 12, 2018 10:59:00 AM


Investments in cannabis companies and cannabis funds are growing in popularity with US investors and this has in turn led to an increased demand for due diligence in the space. IMDDA recently spoke to Alan Brochstein, CFA and owner of 420 Investors, an expert with 5 years due diligence experience on cannabis funds and a further 30 years of investment management experience, much of that for institutional investors.

In his webinar, he looked at some of the challenges unique to investing in this space that you can use to inform your due diligence approach.

Challenge 1: Stigma

There’s no getting away from it. Cannabis still carries a huge amount of stigma, mainly hangovers from previous decades worth of illicit trade. It may be that for your organization, this alone means that you’d not be prepared to invest, based purely on the potential reputational issues that it might present were it to become known that you’d put money into the market.

We expect this stigma to gradually recede in the wake of every new legalization, as it allows for the crop to become more than a one dimensional leisure drug as characterized by its role within black market trade. The more medications and other traditionally legitimate uses are found for it, the paler the grey area will become.

Challenge 2: Federal Illegality

Another huge challenge is the ongoing federal illegality of cannabis. Not only does this contribute significantly to the ongoing stigma that surrounds the industry, it provides the context for and cause of a lot of other challenges:

Market fragmentation

As legalization is only State-by-State, this presents challenges for firms looking to scale. Brands and IP can travel state to state but not product. This means a firm setting up in California can’t ship to Oregon.

Limited depository banking

There’s a common misconception that banks can’t accept funds from the cannabis trade. This actually untrue, for all that a lot of the major banking institutions refuse to touch funds generated this way. Credit Unions regularly step in to this gap, charging higher fees and allowing these companies to form a large part of their business.

For a due diligence professional, the use of a non-traditional banking partner can require closer scrutiny as the risk here is higher on many fronts (smaller player, greater exposure, less resources for due diligence) and things like anti-money laundering and accounting issues will probably need more investigation as you can’t assume the bank has taken care of it.

Limited investment banking

This challenge has lessened in recent years with a couple of tier 1 companies coming to play in a space previously only occupied by tier 2 businesses. That said, it is still an issue because the involvement of investment banking in the market is still not widespread enough to mean that there are many sources of reliable information and due diligence on the companies in the space, whether licensed producers or ancillary services.

For investors, this really means you’re still on your own and that you’ll have to do all the due diligence yourself as there won’t be enough reliable partners in the space to have trodden the path before you.

Onerous taxes

The cannabis industry is subject to legislation 280E, a law originally invented to tax cocaine dealers but that applied to all Schedule 1 and 2 drugs, including cannabis. The crux of the law is that you are taxed on every part of the sale apart from the cost of the product itself. So, anyone involved in the cannabis trade is not allowed to deduct any operating expenses at all, apart from the cost of the physical product. This means that it is possible for tax to be greater than income. There are obviously workarounds, but there are also the accompanying risks that loopholes might be closed by the authorities at any time.

Heavy regulation & compliance

In many ways this is a positive as well as a challenge. The greater the regulation and requirement for compliance, the easier it will be for the industry to build itself a clean and legitimate image,separate from the shady black market.

That said, heavy handed applications of regulations and zero tolerance attitudes to compliance issues mean that otherwise sound looking investment opportunities can be folded up completely, almost overnight based on a single infraction.

Challenge 3: Limited market knowledge

Brochstein describes this as a world of “outlaws and rookies”. The genuine experts in the domain are very likely to have previous ties to the illicit market. This presents a huge potential risk for the investor, both in terms of reputational damage and the expected reliability of these individuals. In turn, fear of this leads firms to employ people with no domain experience, which brings its own risks.

Challenge 4: Limited investor knowledge

In addition to the industry itself being populated by very inexperienced people on the whole, the financial space is also lacking in experience here. The absence of the major players means that there’s not the usual levels of research and reports available to help investors evaluate the opportunities available to them.

With that in mind, we recommend you listen to the full webinar from Alan Brochstein in order to best prepare yourself as best you can to do due diligence on a cannabis related fund. You can access the recording here:

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Tags: Due Diligence, Cannabis Funds, Cannabis Investing

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