How coronavirus will affect the private cannabis market

Today we find ourselves in a nerve-racking environment as COVID-19 spreads across the globe. The pandemic has sent the global economy into a recessionary-like environment as investors remain uncertain as to how things will play out. I’m sure all of you have read quite a lot about the virus; however, we wanted to share specific insight on effect of COVID-19 on the private cannabis market and how the recent events could uncover opportunities for savvy investors.

How we expect the virus to affect the private cannabis markets

Public market volatility is off the charts today and many investors are seeking liquidity. It is our job as private markets investment managers to keep cool heads in the face of uncertainty, analyze situations objectively and make decisions that are in the best interests of our clients over the long-term. Below are five key points summarizing how we believe the spread of COVID-19 and subsequent economic slowdown will affect the private cannabis markets.

No. 1: Private cannabis companies who have raised capital recently and have cash on their balance sheets should be in good position to weather the storm. On the other hand, private cannabis companies who are in the process of fundraising, or had plans to do so in 2020, will likely struggle to raise capital. Some of these companies will run out of cash and become distressed, making them acquisition targets for their competition or for opportunistic investors (further enabling investors to drive exceptional terms). We urge cannabis executives to prepare for a rocky couple quarters by identifying what costs are non-essential to their core business and can be pushed down the road until visibility is clearer.  

No. 2: As investors face uncertainty associated with the spread of COVID-19, they are less likely to invest in early stage cannabis companies. We believe investment managers with dry powder will ultimately benefit from such an environment since capital dedicated to cannabis investments will become scarcer. This will enable investors with dedicated pools of cannabis capital to drive more favorable terms and valuations since their capital is in higher demand.

No. 3: Vice industries will remain an effective shield from market downturns. Compared to other asset classes, we expect the cannabis industry to be relatively recession resilient (especially considering the pent-up demand in the black market, which is estimated at nearly 10-times the legal market). Since the COVID-19 outbreak, we have seen an uptick in cannabis sales, particularly delivery sales, as people use cannabis to cope with mounting anxiety around the pandemic and create stockpiles of product out of fear that dispensaries will run out.
While cannabis has never been legal during a U.S. recession, we can look at alcohol as an example to understand how vice industries perform in recessionary environments – research has shown that although consumers tend to spend less in total dollars on alcohol and other vices during a recession, the quantity tends to increase as people buy more of less-expensive products. According to financial information company Sageworks, alcoholic beverage sales grew by 10% in the U.S. in the trailing 12-month period between June 1, 2010, and May 31, 2011. This period, following the steepest recession in seven decades, featured an average unemployment rate of 9.3%.

No. 4: An economic slowdown will make cannabis legalization at the federal and state level more attractive as budgets become tighter due to decreasing tax revenues. There is an argument to be made that federal and state legislatures that were previously ‘on the fence’ regarding cannabis legalization may now proactively push for it as a means to make up for the decrease in tax revenues caused by the slowing economy.

No. 5: Most economists predict the U.S. will start to rebound later in the year, though they are split over how soon and how fast. Some economists see a rapid recovery starting as early as summer with help from government stimulus. Given the strength of the cannabis consumer, we expect the cannabis companies who can weather the storm today to continue their rapid growth trajectories once the pandemic is under control.

The bottom line is that cash is king today – cannabis companies who have strong balance sheets will weather the storm and investment managers with dry powder will be in a position to deploy capital in opportunities that wouldn’t have otherwise existed if a surging bull market were to have continued.  The cannabis consumer remains strong – global legal cannabis spending grew 46% year over year from 2018 to 2019 and while, in light of recent events, we don’t expect the same year-over-year growth from 2019 to 2020, we certainly still expect cannabis consumer spending to grow significantly.

How ‘winning’ companies to act in a downturn

A study by Bain & Company analyzed the financial performance of more than 5,000 companies over a ten year period including the global financial crisis, and found that ‘winners’ grew at a 17% compound annual growth rate (CAGR) during the downturn, compared with 0% among the losers. What’s more, the winners locked in gains to grow at an average compound annual growth rate (CAGR) of 13% in the years after the downturn, while the losers stalled at 1%.

How did ‘winning’ companies in Bain’s study act shortly after and during a downturn?

• They did not heavily cut costs or reduce research and development – subsequently they did not lose top talent.
• They did not stray outside their core business to “find a way out” of a recession.
• They viewed cost management as a way to refuel the growth engine for the next stage in the business cycle.
• Management tightly managed cash, working capital and capital expenditures as a means to create “fuel” to invest throughout the cycle.
• Management divested non-core assets in order to further invest in their core business.
• They focused their sales efforts on top priorities and maintained marketing spend while their competitors cut back.

Amid chaos, there is also opportunity

History has shown us that in any market disruption, panic-induced decision making rarely benefits investors, and that huge wealth is truly created after market downturns. While many investors will be too fearful of the current economic conditions to invest, we believe that those who have the confidence to deploy capital in cannabis investments today will benefit tremendously over the long term.

Below are the reasons we believe cannabis investors should look at the current state of the financial markets opportunistically, especially when compared to other industries.

• Cannabis is the fastest growing industry in America.
• The cannabis industry is likely to show more resilience to a recessionary environment than other industries since cannabis is a vice, and vice industries perform relatively well through market cycles.
• The cannabis industry was constrained for capital before COVID-19 and will be even more constrained for capital in a recessionary environment, enabling investors to drive better terms and valuations.
• We may see an increase in the rate that states legalize medical and recreational cannabis to make up for lost tax revenues.
• Mature U.S. companies will likely become even more reluctant to expand into the cannabis space in a recessionary environment as they will be forced to focus on their core business, reducing competition for early-stage cannabis companies.

Pete Karabas is a founding partner of KEY Investment Partners, a Denver-based investment manager focused on providing growth capital to early stage companies in the cannabis space. He is responsible for sourcing investment opportunities, structuring strategic partnerships and raising capital for the firm. He currently sits on the board of BDS Analytics, a market research and data analytics firm for the global cannabis industry.