Thoughts from a Cannabis Investor

EA:
John, let us know a little bit about the investment strategy of FocusGrowth Asset Management. How did you first get into the cannabis space?
JL:Yeah, sure. So as I said, I've been a professional investor since 1998, doing banking and private equity at Goldman Sachs, then moving into the long-short equity business, first at Tiger Management, then at Viking Global Investors. I worked with some amazing people at Goldman, Tiger and Viking, and I was well-trained and decided to leave Viking and launch Hoplite capital in 2003. And after 16 years, I wound down Hoplite in 2019. The long-short equity market had gotten really competitive and our fund had grown up to $4 billion, but had gone from 4 billion to about 800 million over the preceding five years. I thought the right thing to do would be to return capital to investors and just look for something else to do with my capital and my time.

And I have a college friend, someone I've known for a little over 30 years, who was a litigator. And in 2016, he and a partner from the cannabis industry started a New York-based cannabis-focused law firm. So while I was winding down Hoplite, I had my 17,000 feet of office space over on 7th Avenue, and the law firm had grown from two people in 2016 to 12 people in 2019, and they needed new office space. So I said, "Why don't you guys move in, be my tenants and teach me about cannabis?" So they moved in, in September of 2019, and our office quickly became a hotbed of cannabis activity. And I don't mean cannabis consumption, but cannabis companies coming through looking for legal and regulatory advice, structuring advice, and of course capital.

And I was really intrigued. I left the most liquid, transparent, competitive markets in the world, and cannabis was at the other end of the spectrum, very opaque, very fragmented, this Byzantine legal and regulatory structure. And I wanted to get involved. So that's what first piqued my interest in cannabis and got me started on a business plan for FocusGrowth. But since this was a new frontier industry, I wanted to partner with real cannabis operators who could help us navigate the risks and avoid the landmines that plagued several operators and investors in the industry. So I started interviewing cannabis operators. And in late 2019, I met my partners, Pete Bio and Jonathon Goldrath. And Pete and John had worked at well-known institutional credit asset management firms before winning licenses and launching a successful business in the cannabis space. So they were experienced institutional credit underwriters with hands-on cannabis operating experience. And I thought this was a perfect match, so we began working together on launching FocusGrowth.
EA:Most of your investments are secured debt. What makes secured debt more attractive than equity investments in this industry?
JL:So it's interesting, our first two funds are really focused on debt. And what drove us to debt is at that time, me and my partners, we are the largest investors at FocusGrowth, and we said, "This is where we see the greatest opportunity for alpha, for risk-adjusted returns." Well, over the last three years, as equity prices both in the private and public markets have come back to what I'd say are more reasonable levels, subsequent bonds might focus on equity. But at the time, over the last three years, we thought you could get equity-like returns without taking the equity risk by being a lender.
EA:And how long do you typically hold your investments?
JL:Our loans are three- to five-year loans. And the typical structure of a loan might be a five-year or four-year duration. There's call protection. But if companies can refinance or want to refinance us or get acquired, there's a scope for them to repay the loan in year two or three, before the loan matures. But we plan on holding things for the duration.
EA:What advice can you give to a potential borrower?
JL:The first thing is, while debt is cheaper than equity, the first thing you want to do is make sure you have a very good capital plan and a budget so you can assess how much money you truly need, because as an operator, you don't want to be in a position where you're two-thirds of the way there and you're out of money. So the most important thing is have a great plan. And we work with our borrowers to cement the plan and really build into contingencies and make sure that they have the appropriate funding to get from point A to B. That's the first thing.

And along with that would be making sure that your operating plan over the next three or four years can support the debt. And I say these two things because we've seen numerous examples over the last three years of companies that are almost at the finish line, but need more capital. And then debt and equity is super hard to raise at that time. We've also seen companies that are operating where their budgets were aggressive, perhaps in Massachusetts or Michigan, continuing to believe that pricing would be at $3,000 a pound in the wholesale market, and now they're really upside down and can't support the debt. So the most important thing is just be prepared.
EA:This industry, things move so fast in this industry. How has your market evolved in the past 12 months?
JL:It's interesting. Things move fast except on the regulatory side or legal side, where they move at glacier show pace,. But I agree ... things, it's a dynamic market over the last couple of years, the things I'd say the cost of capital has definitely gone up. You've seen equity prices come down. So as I mentioned earlier, equity might start to look attractive, but that's really increased the cost of financing. Interest rates are up in the broader world. And I think spreads in the cannabis market have stayed pretty consistent, but cost of funds is up a lot.

And then we've seen in some of the markets a lot of competition and excess supply. So I think in markets ... primarily California is a market, a planet all unto its own. But in other states, in Michigan and in Massachusetts, you've even seen it a little bit in Maryland in preparation for a move from medical to rec. Also in Pennsylvania, you've started to see the dynamics shifting. First, the wholesale price has come down precipitously. And second, larger companies who have access to capital and can build scale and are vertically integrated have started to move to box out independent grow processors. So that's something I think would've been really hard to forecast two years ago.
EA:What do you look for when you're making investment? Is it the management team, the product, the customers, or probably all the above?
JL:Yeah, it's all of the above. But the most important thing to us first is the state. We like being in limited licensed markets, where instead of focusing on the collateral, we're going to focus on the cash flow that's going to bolster the value of that collateral. So in Illinois, Ohio, Missouri, Maryland, where they're finite licenses, we can really get our arms around the future licensing around. So I'd say the first thing is the state, and just making sure that the state can support the cannabis companies that are licensed, that should be in operations, and then those companies can support our debt. That's the first thing.

The second thing would be management. And we don't do any greenfield or any startup financing. So we like to see a management team that has two things. One is success in their lives prior to cannabis. So a lot of our CEOs and management teams have had success in retail, food distribution, waste management, commercial real estate, but they're adults who are savvy and have built businesses and created some personal wealth. That's the first thing. And then the second thing, specifically in cannabis, since we're not looking at startups, we want to assess their growth. We want to see that this company is really frugal, is able to hit budgets, and is producing a high-quality product consistently.
EA:There used to be a stigma associated with working in the industry, that old stoner image. Does that stigma still exist?
JL:I would agree that three years ago when I left my business and started running a business plan for FocusGrowth in cannabis, yeah, my wife would say, "What kind of people are in this business?" I'd say there's like three big buckets. There's the stoners or the people who are committed to the plant and that lifestyle. And no judgment, but that used to be a much bigger part of the audience and people who are involved in cannabis. There's the get rich quick, "I'm going to chase a dot-com, I'm going to do the Canadian junior mining, kind of flipping companies. I'm going to get a license and then be able to flip it." Those people are gone now, for the most part, because the market just isn't there to support winning a license and flipping it for 20 times your investment.

And then there's that small segment of people that we want to do business with, which is the professionals who have had success in prior lives. So I would say that segment is getting bigger, and the other two segments are getting smaller. So does the stigma still exist? When you start to see big law firms willing to work in cannabis, big accounting firms, other service providers, I would say that the stigma has been reduced quite a bit.
EA:When you talked about the level of professionalism in the industry, is that getting better these days?
JL:It's getting better, but Eric, I'm sure you know as well as I do, it's still ... This is a scrappy industry. And I applaud a lot of the operators, because you need to be scrappy and you need to be frugal. And regardless of how much money you have in the bank, the frugal bootstrapping mentality, that's what's going to persevere. That's what's going to position you for tough markets like we had over the last 12 months. So there's still a lack of professionalism. I mean, our companies complain about it. It's pervasive in the industry. But I would say that it is becoming more institutional and less frontier. But if I had to put a number on it in terms of what inning, I'd still say we're in the second or third inning.
EA:And this industry seems to be going through a transition. Every time I look at my inbox, I see another large MSO laying off 10% or 20% of its workforce or exiting a market. How do companies survive during these trying times?
JL:The truth is a lot of companies aren't going to survive. And when you see a Curaleaf exiting markets ... Curaleaf generates tremendous free cash flow. And when they make a decision to walk away from the sunk costs and leave the California market, and I look at the number of legal and illegal operators in a market like California, the truth is a lot of the companies shouldn't survive. And the companies that have the right assets now, and especially if they're not in financial distress, they should be looking to optimize that portfolio. So if you're a company that's dominating a market like Oregon and you won some dispensaries in Illinois or Ohio, you should be looking to monetize those. If you're not vertical in Ohio or Illinois, you should be looking to get vertical and sell non-core assets. So I think the people who aren't operating on their heels, who aren't in financial distress and who might be asset rich, should really be looking to trade and optimize their operating portfolio.
EA:For those that survive, do you see this as a real opportunity for them?
JL:I do, especially over the long term. I mean, as we said earlier, I think things at the legal level move at a very, very slow pace. But this is a massive market. We know that the illegal market will continue to shrink at the expense of regulated legal operators. And over time, as you start to get federal legalization, I think there's a tremendous opportunity, thinking pharmaceuticals, nutraceuticals, nutrition. I think this is going to be a huge market. But that is not a five- or 10-year view, that's a 20-year view. And between here and there, we have to have a lot of consolidation. We need to have changes at the federal level, and there needs to be a lot of change in the industry. So it's very dynamic.
EA:You spoke before a little bit about some of the states that you like to do business in. What states do you see as possible good states, and what states do you want nothing to do with?
JL:Yeah, look, California, the biggest market on the planet, it's also the biggest illegal market on the planet. And when I think about assessing a market, the regulator needs the willingness and the ability to police that market and reduce the illicit market. And in California, you really don't have the political will. And even if you had the willingness, the ability to shut down the illegal market is somewhat constrained because of the large border with Mexico, the ocean border, the Emerald Triangle, where you can grow some of the best outdoor product. So it's really difficult. So I'd love to get involved in California, it's just not time yet.

Other markets, the ones that are a limited license, where the price of cannabis is still in the 2,000s or 3,000s, are really great markets. And we have a lot of exposure to Illinois, Maryland, Ohio, Missouri. We got a little tailwind coming our way with the ballot initiatives in November, where both Maryland and Missouri approved recreational sales. The Missouri rec market kicked off in early February. The Maryland market will probably kick off no sooner than July 1, but my guess is in Q4 of this year, early next year. That doesn't mean to say the other markets aren't attractive.

If I look at the most mature markets like Colorado or Oregon, those markets are really fragmented, and there's a different investment thesis. The investment thesis in Illinois, it might be back a company who has a tier one license who's going from 10,000 square feet of canopy to 30, to 50, to 80, to 100. That's great. And then who's going from two or four dispensaries to the limit of 10? That's an interesting growth thesis. In Colorado and Oregon, where Colorado, you have 700 or so dispensaries, Oregon, 600, you have this massively fragmented market. And some companies that have the right SOPs, the vertical integration, grants and business savvy, are able to consolidate that market and go from 10 dispensaries to 20, 30, or 40. And we're seeing that play out in Colorado and Oregon. I expect that'll play out in Michigan and Massachusetts sometime in '25 and '26.

So as you said earlier, it's a very dynamic market. And the place in the chain to extract economic rents is also dynamic. You wanted to be one of the 50 dispensaries in Illinois back in '20, '21, '22. Now that there's more dispensaries coming online and you might have 200 dispensaries by the beginning of 2024, I think the opportunity to extract the economic rents has shifted upstream to the cultivation. So yeah, it's really exciting, and things change pretty quickly.
EA:How involved is FocusGrowth with its invested companies? Besides capital, what else do you provide?
JL:Yeah, I think this is our greatest asset. My two underwriting partners at FocusGrowth are cannabis operators. They had a career in institutional credit, working at big firms like Lazard and Fortress. In 2018, they won a grow processor license in Pennsylvania in the first round. They were the second operation up and running. Cresco beat them by a couple of weeks. And they built a 60,000-foot commercial grow processor. They then won a processor in Ohio and built that out; a dispensary in Pennsylvania in the second round. They sold those assets, but they're cannabis insiders and operators and have successfully engaged in winning licenses, investing equity, raising equity, lending, raising debt, buying companies and selling companies.

So we bring this arsenal of cannabis experience to our companies. We are not the cheapest capital. We might be really flexible because we understand the businesses, but we have onerous, ongoing requirements for our companies, with monthly reporting. And the pitch to our companies is we're going to bring all our tools, talents and money. We're going to make you institutional. We're going to maximize the value of your enterprise. And that takes shape in many ways, from bringing a botanist or a grower in to consult, reviewing mechanical, electrical and plumbing plans, engaging with the general contractor. My partners have experience in doing this, and they've done it successfully. And that's what we bring as a value-add to our companies to help them succeed.
EA:Where is the future of this industry? Is it flower, or is it other products like pre-rolls and beverages?
JL:I'm really excited about beverages. We talk about this a lot, not just at work, but with friends and family. Americans like to drink. Americans also like to pop pills, right? So when we think about where this is going, we're operating from a low base in terms of innovation in this industry. And I think beverages are going to be a massive market, as well as other things along the lines of the pharmaceuticals.
EA:And is branding part of our future? And if it is, how important is that to the industry?
JL:So branding, I think like any other consumer products or consumer package good, branding is really important. I think the mistake people make is focusing on brands ... right now, because of the lack of interstate commerce, the lack of ability of flower shelf space, brands are a lot less important than one would have estimated. So when I first started looking at cannabis, I thought, "Hey, you want to be in brands. You want to be a branded CPG company." And then you start to see a brand from one state, say, Colorado, want to get into Illinois, and no one in Illinois will sell them flower or give them shelf space, regardless of their brand. You've seen very few brands be able to transcend. And if you have two dispensaries, one next door to the other, very few branded dispensaries can demonstrate the value of the brand by increased revenue relative to peers. So I think we're still early in that game.
EA:I guess without interstate commerce, it's really hard to have a national brand of any kind.
JL:It is, but the brands I'd be most interested in are coming from California. I don't see a brand from Illinois or Michigan or Massachusetts moving West with the same ease that I see brands from California, where cannabis culture is much more pervasive, moving East. But I think it's early. I think it's early to be making the brand bets.
EA:Well, although this market's been around for a few years, it's still really in its infancy. What needs to happen to help this market mature?
JL:You need rationalization. So it's so hard to generalize. So when we say "this market," I think there's a different answer in almost every state. You need the illicit market to go away. In order for that to happen, you need ample supply of cultivation and retail dispensary outlets so people won't have to ... If you're giving someone a choice of someone's going to deliver something to your door, or you can go downstairs out of your elevator bank right around the corner and buy something illegally, or pay 2X the cost and drive 25 minutes, the illegal market's going to win every day. But I believe that people want to comply. They want breadth of product. Safety is always a concern. They want to buy things safely. They want to understand that the product is tested. But all that comes with convenience and a price.
EA:John, my last question. Do you see federal legalization anywhere on the horizon?
JL:I'm a bit of a skeptic. As we said earlier, I was a short seller for 22 years, so I'm a bit of a cynic. And I originally had thought that it's not going to happen anytime soon because the folks that matter most, i.e. the federal government, doesn't want things to change. They don't want things to change. Right now, they have windfall taxes, and they don't have to lift a finger on compliance, right, because they leave it to the states.

I still believe that that's going to mean that we're a long time away from federal legalization. But we'll see what happens when Congress is back in session this year. But I'm still a skeptic. So whatever time period, I usually take the over on federal legalization. Yeah, I would like to see it rescheduled to maybe a schedule three, which would really make a difference at 280 in the after-tax cash flow. That might happen sometime sooner, but I still think this is going to be a long, cumbersome process, and it's going to be a decade before we have a market that looks like alcohol and tobacco. States will seek to offend the commerce clause. I think governors of Midwestern states are not too keen on importing all their cannabis from California and Arizona and Colorado, so it's going to be really messy.
EA:Thanks, John. And thanks for listening to CannaCast, as part of the EisnerAmper podcast series. Visit www.EisnerAmper.com/cannabis for more information on podcasts. Also, please visit www.focusgrowth.com for more information about FocusGrowth Asset Management, LP., and John. And join us for our next CannaCast podcast, where we'll discuss other budding issues.

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