Events over the last nine months have created an opportunity for investors new to the cannabis space. The recent restriction of capital, coupled with the halting of the economy due to the COVID-19 crisis, has resulted in the creation of distressed cannabis assets in need of funding.

Given the steep discount in company valuations, now could be one of the best times in history to invest in the cannabis space.

However, investors should take a cautious approach as they deploy capital into the cannabis space. For investors who do not have prior experience with distressed assets, it might be safer to pursue this opportunity through a fund structure with other like-minded investors.

Cannabis and Distressed Assets

The distinguishing factor of a distressed asset is that unless the company does something aggressive to kickstart the business, it won’t survive. This is where the term “distressed” comes in to play. It means the company does not have much capital at its disposal and sales are typically languishing. The business is not working efficiently, and capital is just one portion of the issue.

In cannabis, distressed assets are often different than those in other industries. A cannabis company may have a strong management team with a great product and market fit, and revenue may be at an all-time high. But it may be distressed in this situation because it now doesn’t have enough access to capital, whereas the company previously enjoyed prolonged access to financing in a capital-intensive industry. How cannabis companies are taxed can also exacerbate their distressed status, depending on how many different tax levels are stacked on top of a company.

Like any industry, there are also cannabis companies with bad or misaligned management teams and inefficient capital structures. Although these scenarios exist within the cannabis industry, these factors don’t need to be present for an asset to be considered distressed. In fact, a distressed asset having positive revenue and a growth story typically only happens in cannabis.

What is the opportunity?

Consumption behavior has not changed due to COVID-19. Although devastating to the economy, it is not an apocalyptic situation, and it is not going to last forever. Cannabis markets that were once thriving will surely thrive again.

But in 2019, the cannabis industry began to experience a tightening of capital, resulting in layoffs, shuttering of facilities and massive shakeups in the C-suites. With the slowdown of the economy due to COVID-19, many cannabis companies are in dire need of a cash infusion. This is reflected in deeply discounted company valuations, some shrinking 90% compared to their valuations in the previous year. The stock prices of publicly traded cannabis companies are near all-time lows, and groups in need of capital are much more willing to accept financing structures that just 12 months ago would not have been part of the conversation. But this intersection of scarce capital, COVID-19 and the continued demand for cannabis has created a potentially lucrative buying opportunity for investors interested in the cannabis space.

One of the more attractive opportunities involves the merger of several distressed assets into an entity that is more valuable than the sum of its parts. For example, if a company that has a great set of dispensaries in some great locations is doing incredible amounts of sell-through but still needs more capital to survive, plugging a distressed cultivator into the picture could help to lower the overall cost of capital. And If the distressed cultivation asset is fully functioning and can be acquired at a discounted price, merging the cultivator with the dispensary chain could potentially decrease the new organization’s overall cost of goods. In this situation, the distressed assets would have a higher valuation than a true fire sale, since, ideally, there would be revenue, an increase in growth and positive margins if they continued to scale.

Astute investors will want to eye later-stage deals where the assets are generating $20 million or more in revenue. According to Codie Sanchez, managing director of Entourage Effect Capital, a private equity firm specializing in the cannabis industry, large conglomerates that will be coming into the space as legalization progresses are likely going to buy out companies doing more than $50 million in revenue.

“Less than that is a great business, but not likely to be bought by the big guys,” she says. “The platforms that will get bought will be vertically integrated players with proper licensing, retail presence and brands behind them.”

Approaching the opportunity

Individuals new to the cannabis industry should invest alongside professionals that are experienced in this arena. This can be done through a fund-like structure, or a special purpose vehicle (SPV), with investors and advisors that have done it before. SPVs are a funding structure that pools individual investors together into a single entity. Since the most attractive distressed deals are late stage and fairly large, insiders and current investors are likely going to have the first run at these companies.

Investors should not rely solely on business brokers or the “word on the street” to identify distressed assets, because these probably won’t be the best investment opportunities. More likely, they will be the businesses that don’t have a chance for a real turnaround. It’s advisable to invest alongside other distressed investors through a fund family where individuals can safely access the benefits of a distressed situation.

“If individuals choose to pursue a different investment approach, it’s important to make sure they have a history in distress,” Sanchez says. “It’s a unique animal.”