(From the staff of Marijuana Business Magazine.)
The cannabis industry was experiencing a major shift in merger and acquisition activity before COVID-19 derailed consolidation strategies. Coronavirus exacerbated concerns about plummeting company valuations and ongoing regulatory hurdles, disheartening already tight-fisted investors wary of funding marijuana shops.
Gone are the days when big public cannabis firms snapped up rivals to boost their market footprint. Instead, bargain hunters keen to scoop up valuable properties at a discount are gleaning opportunities from the proliferation of financially distressed companies.
“It’s an incredible time to be an investor,” Morgan Paxhia, managing director of San Francisco-based Poseidon Asset Management, told Marijuana Business Daily in March. “It means we’re getting very attractive, rational valuations. We’re able to build another portfolio that can generate some really strong return profiles.”
To be sure, the impact of coronavirus has dampened the excitement for some players in the space. The increasing number of consumers losing their jobs, competition from the illicit market and supply-chain disruptions make the current cannabis sector in California impractical to investors, said Rob Hunt, founder and managing member at California-based Linnaea Holdings.
“For this reason, we will be watching from the sidelines for the foreseeable future. We do not believe funding new transactions, at a time of global uncertainty such as we have never seen before, would make us responsible stewards of other people’s capital,” Hunt said.
M&A activity, already down from previous years, could be limited this year mainly to companies still in a position to search for distressed or struggling businesses with the greatest revenue and expansion opportunities and the fewest red flags.
“We’ll likely see mergers of mediocre equals and perhaps some strategic distressed acquisitions by the very limited number of healthy operators with sufficient cash on their balance sheet,” said Jeff Schultz, partner and general counsel at New York-based investment firm Navy Capital.
Switching strategies
Deal making in this new, tougher financial landscape requires companies to develop acquisition strategies and a clear understanding of how a potential deal will be beneficial, experts agreed.
Scott Greiper, president and founder of New York City-based cannabis investing firm Viridian Capital Advisors, noted that much of the M&A activity that occurred in the marijuana space during recent years were “land grabs,” where companies looked to boost their portfolios with the acquisition of licensed operators in multiple states and, sometimes, countries.
“It was just a land grab to establish as big a portfolio of assets globally as possible—even if those assets were not revenue-producing or losing a ton of money or hadn’t even become operational. The market was supporting that acquisition activity even at a non-accretive, non-strategic level,” Greiper said. “That’s over. The market is not supporting that anymore.”
Instead, many companies are being more strategic in their acquisition approaches by thinking through what types of deals could boost revenue, increase market share in a state or region, improve efficiency or offer some other benefit to their portfolios. Some companies looking at distressed business are willing to pick up the assets—equipment, property, licenses, etc.—and leave the underlying entity to avoid legal or financial burdens.
“We just want to be opportunistic and buy things way, way under market that are wildly accretive as opposed to just accretive,” said Jason Wild, chair of TerrAscend. The Ontario, Canada-based firm’s portfolio includes cannabis companies in the United States, Canada and Europe.
TerrAscend is open to buying assets off a struggling company but has no interest in taking on a heavily debt-burdened business, Wild said.
“Generally, it’s a deal killer if a business needs to spend a lot of money to get to cash-flow positive. I’d rather pay a little more and buy an asset that is going to be cash-flow positive in the near term and doesn’t need a lot of capital to get there,” he said.
Last year, TerrAscend acquired California-based retailer The Apothecarium in a deal worth more than $118 million. Wild said the company is looking to nab other dispensaries on the West Coast to build out The Apothecarium’s footprint.
On the East Coast, however, TerrAscend is looking for fully integrated cannabis businesses. In August, the company announced a deal to acquire Ilera Healthcare, one of five vertically integrated cannabis cultivator, processor and dispensary operators in Pennsylvania.
Distressed sales
Financial pressures could essentially force less successful or struggling cannabis businesses to seek a buyer to avoid going under.
“I think that there’ll be many more distressed types of M&A opportunities popping up. There are so many companies out there starved for cash that some of these companies may have no other option other than to sell themselves at a remotely decent valuation,” Schultz said.
In some cases, companies that should be healthy are struggling with external factors that are creating short- or midterm cash problems and shortfalls. For instance, earlier this year, Los Angeles-based multistate marijuana operator MedMen Enterprises struggled to pay its vendors.
“There are plenty of companies that are owed money by MedMen. And some of these companies … may be fine businesses, but if they can’t get paid by someone else in the supply chain, they’re going to have a tough time,” Schultz said.
The global spread of the coronavirus also has disrupted business operations for companies in the cannabis industry. Organic Alternatives, a retailer in Fort Collins, Colorado, closed up shop temporarily on March 16 in response to the pandemic. And several local governments in the San Francisco Bay Area allowed cannabis sales to be made only via delivery or through online orders and curbside pickups in March.
Businesses already tight on cash might be in real trouble if they are unable to adapt to new rules, maintain a healthy workforce or cover expenses while shuttered.
“You might have good companies that are just sort of stuck when huge chunks of their bills don’t get paid,” James Parker, founder of Trava Capital, told Marijuana Business Daily. Trava is a California-based firm that invests in distressed companies.
“It’s one thing if you’re a marquee name and can still wrench open the capital markets to keep yourself alive; it’s quite another when you’re at the bottom of the chain, which is where I think some of the most interesting opportunities are,” said Parker, who was a former chief financial officer at MedMen.
Buyers might be able to identify a struggling business through researching layoffs, gaps in payments or other red flags. Another option is to hire a broker or lawyer with M&A experience to identify acquisition opportunities. But most experts said recent deals involved buyers and sellers getting connected organically through their networks.
Those looking to nab a company struggling with cash flow or other financial problems need the mindset that they’ll go in and clean up the business through a cash infusion, slashing expenses or both.
The due-diligence process is different and more nuanced with a distressed deal and presents a different flavor of execution risk—namely the ability to successfully turn around the struggling company, Schultz said. On the other hand, acquiring an EBITDA-positive, vertically integrated operator in a “mature” state such as Colorado comes with a lot less execution risk. The purchase price will be lower for a distressed investment, but the potential return on the investment is higher.
Due diligence
The shift in M&A activity encourages investors to undergo proper due diligence and evaluate the strengths and weaknesses of individual companies, instead of just piling into the cannabis industry because it’s considered sexy or because everyone else is doing it, said C. Adam Foster, founder at the Denver-based law firm Foster & Jones.
“Obviously, part of it is looking at financials, but I’d say the starting point is to look at state law and any restrictions put on change of ownership or investment by public companies. And then also look at local law, because sometimes there can be local restrictions on changes of ownership in addition to the state law,” Foster said.
Buyers can talk with state licensing officials and look at licensing authorities’ websites to get a handle on how to acquire a cannabis licensee’s operations. A lawyer also can help firms make sense of state and local regulatory environments.
“It is a buyer’s market, especially versus a year or two ago, but that doesn’t mean that sellers need to be totally desperate or do some kind of a fire sale. It does mean that sellers need to really be able to tell a story about their company,” Foster said.
Acquirers should be looking for companies that can tell a story about having really solid financial and corporate records and governing documents “so that a buyer can see there’s been sound financial management, the finances of the company are in good shape and the business has been managed in a professional way that respects corporate formalities,” he said.
Sellers also should be able to highlight whether they own their real estate or have locked in favorable lease terms. And if part of the deal is keeping the management team, sellers should be able to detail their team’s expertise and how they’ll work with the buyer’s staff.
“It’s caused some short-term pain within the industry, but this type of rigor and focus on the fundamentals may be positive for the industry in the long run,” Foster said. “It’s going to tend to reward good operators who have been running their businesses carefully.”
