When New York became the latest state to legalize medical marijuana, in early July, those hoping to indulge weren’t the only ones paying close attention. The news was also cheered by the growing contingent of eager investors.
“Where there are real [cannabis-related] business opportunities happening in the backyard of the financial capital of the world, that really changes things,” says Troy Dayton, CEO of ArcView Group, whose angel investor network consists of 300 accredited investors who gather each quarter to hear in-person pitches from entrepreneurs in the cannabis industry. ArcView’s investor network membership, open since 2011, has more than doubled since January and continues to climb.
The news out of New York was an important milestone in the development of a legal cannabis industry but not necessarily a defining moment. Today 23 U.S. states and Washington, D.C., permit the use of medical marijuana, and two have legalized its recreational consumption. This November both Alaska and Oregon will ask voters to decide whether recreational use should be legal in those states, and Florida will do the same for medical marijuana. In 2016 as many as seven states will have legalization measures on their ballots.
As a result, the size of the legal marijuana market is snowballing. ArcView Market Research says the market will be $2.6 billion by the end of 2014, up from $1.5 billion at the end of last year. By 2018, the analysts expect, the market will balloon to $10.2 billion.
These numbers invite comparisons to other industries that followed similar trajectories of exponential growth: the Internet, biotech, personal computers. But Brendan Kennedy, CEO of Privateer Holdings — a Seattle-based private equity firm founded in 2010 to focus on investing in cannabis companies — says investors miss the point if they think that what’s happening with marijuana is categorically similar to these other sectors. “This isn’t a new industry, and this isn’t about creating demand for a new product,” Kennedy says. His firm estimates that in the U.S., the total size of the marijuana market — legal and otherwise — is between $40 billion and $50 billion a year. He believes that range has been relatively steady for years, and will likely remain so. “This is about taking something from the black market and migrating some of it through the gray market to a white market — a fully transparent, legal market. That comparison is really hard to find. You have to look back to the end of alcohol prohibition to find something similar.”
As a result, the risks attendant to the emerging legal cannabis market are not those generally associated with emerging industries. Less important are technology risk, execution risk and questions about the degree of consumer demand. More important than for most other industries, however, is factoring in the extent of regulatory risk.
Even in states in which the substance is completely legal for adult use, cannabis investors face a complicating factor: The plant is still considered a Schedule I drug by the U.S. Department of Justice, which puts it in the company of heroin, LSD and Ecstasy. Recent years have seen Internal Revenue Service and Drug Enforcement Administration crackdowns on cannabis operations in states in which the substance is officially legal. In 2012 a spate of such federal enforcement actions caused the legal market to contract slightly, according to ArcView’s figures. Kennedy says Privateer has stayed away from investments in U.S. companies that “touch the plant,” i.e., growers and processors, to stay on the right side of federal law. Over the past year or so, a series of memos and guidelines from the Department of Justice have indicated that investors and business owners can safely defer to their state laws, but many remain skittish. Most recently, in mid-July, the House of Representatives passed a resolution to prevent federal regulators from penalizing banks that do business with legal marijuana businesses. The bill will next move to the Senate. But banks especially are hesitant to participate.
“Banks are still reluctant to get involved; there is still no guarantee that the federal government won’t take action,” says Barry Peek, co-chair of New York law firm Meyer, Suozzi, English & Klein’s labor law group. “I think after the election cycle there will be more clarity on specifically allowing banks and financial institution to do business.”
Peek’s law firm is in the midst of establishing a cannabis practice group, which will consist of himself and three or four other lawyers. Because lawyers are prohibited from counseling their clients to commit federal crimes, the firm can’t yet officially list its new specialization.
The public markets present another significant risk for investors and — some fear — for the budding industry itself. A year ago the Financial Industry Regulatory Authority issued a public warning to investors regarding marijuana stocks, given the influx of so many new, not-quite-legitimate names. This May the Securities and Exchange Commission published a similar warning and issued temporary trading suspensions for five companies claiming to be a part of the cannabis industry.
“The list of public companies in this space, both in the U.S. and Canada, is full of charlatans and shenanigans,” says Kennedy. “The risk is that a lot of them are going to end really poorly, and some Main Street investors are going to lose a lot of capital. That’s something that really concerns me: The potential that a few bad players in the penny stock segment of the industry have the potential to give the whole industry a black eye.”
For its part, Dutchess Capital Management, a Boston-based hedge fund firm founded in 1996 that has been investing in cannabis for about a year, is finding names it likes in the public market — but because of risk considerations, “none of the companies [we invest in] can touch the plant,” says Dutchess co-founder Michael Novielli. The firm plans to invest in a Boulder, Colorado–headquartered company called MassRoots, which provides a private social network for the cannabis community, when it begins publicly trading in about eight weeks, and it has invested in American Cannabis Co., a Denver-based marijuana consulting and goods-and-services provider.
As hedge fund firms like Dutchess and other investors take an interest in the developing marijuana market, capital saturation is making for another investor challenge.
“There is a disconnect right now between the amount of money that would like to play in this space and the opportunities they’re seeing that meet the standards for which they would normally invest that kind of money,” says ArcView’s Dayton, who speaks for both the public and private sides of the industry. “Investor interest is increasing faster than businesses can develop to meet investor demand.” He adds that this is causing many investors to “shift their criteria a little bit” to get into a market with limited room — and limited licenses to disburse. As a result, he says, valuations are going up.
But many investors, like Dutchess’s Novielli, feel the difficulties of the business are worth their cost. “I think there are risks here, but it certainly warrants, from our perspective, educated investments,” he says. “We believe there’s a tremendous upside here.”
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