The Boston Globe published an article at the end of June suggesting private equity firms could be ready to start buying up distressed cannabis stocks.
Before I get into my gallery of three names, let’s consider why this argument makes a lot of sense.
According to RBC Capital Markets, the private equity industry’s dry powder – the dollar amount of funds committed by investors but yet to be invested – has grown from $615 billion in 2010 to $1.43 trillion at the end of 2019.
On the one hand, private equity firms want to get uncommitted capital invested so the clock can start ticking on their returns. However, the fact that we are in the middle of a pandemic means many of their own portfolio companies will struggle.
So, it’s not realistic to suggest that all $1.43 trillion is available to be invested in struggling cannabis companies. That said, a slice of it probably is going to be invested there.
Cannabis stocks have lost approximately 63% of their value over the past 18 months. So, a billion-dollar market cap at the beginning of 2019 is worth $375 million today.
“If you’re looking to invest, I’m not sure there’s a better time,” said Entourage Effect Capital managing director Codie Sanchez. “We’re working right now on three really large distressed deals that pre-Covid and the cannabis pullback we would not have been able to do.”
Sanchez estimates that very little private equity capital has been invested in the cannabis industry at this point, leaving a tremendous amount available for future use. She puts the figure of institutional cash on the sidelines as high as $4.7 trillion.
Once U.S. legalization takes place, the floodgates will open. So, in many respects, now is the time for private equity to jump on cannabis.
Here are three cannabis stocks I think could be private equity targets.
Cannabis Stocks for Private Equity: Apria (APHA)
It varies by industry, but private equity investors tend to use debt to finance their acquisition of companies.
In the 2010s, private equity deals proliferated like weeds. According to Bloomberg contributor Joe Nocera, 1,927 private equity deals were completed in 2009 in the U.S., worth an estimated $142 billion. In 2018, that number was 5,180 and worth more than five times the amount nine years earlier.
“The main thing private equity has done this decade is to pile debt onto companies — imposing repayment costs while pulling out fees and dividends that have no bearing on what the private equity firm has actually done. Famously, Toys R Us went bankrupt because it was buried in private equity debt,” Nocera wrote in December 2019.
What does this have to do with Aphria?
Well, the classic private equity acquisition is one in which the target company is struggling to gain traction in an industry that is either proliferating or outdated and in need of a makeover. The buyer puts up 40% in cash, borrows the remaining 60% and repays its equity investment in the form of dividends.
So, a company like Aphria which has a lot of net cash (163.8 million Canadian dollars) as of May 8, becomes very attractive to a buyer because it can use this cash to obtain the debt needed to finance the purchase.
Equally important, it helps if the company is growing, and can keep growing.
In Aphria’s third quarter, it grew net cannabis revenue by 65% to $CA55.6 million. On the bottom line, its adjusted EBITDA from its cannabis operations increased by 78% to $CA6 million, the company’s fourth consecutive quarter of positive adjusted EBITDA. It also had net income of two cents a share, a 167% increase over the third quarter of 2019.
Aphria is headed in the right direction.
Private equity firms would love to get a hold of it. It’s relatively well-run under the guidance of veteran chief executive officer Irwin Simon, who for a long time was best known as the founder of Hain Celestial Group (NASDAQ:HAIN).
Aphria currently has an enterprise value of $1.13 billion. A prospective buyer would likely have to pay a slight premium (not huge) to buy it.
Innovative Industrial Properties (IIPR)
The cannabis industry continues to puzzle investors of all stripes. Everyone and their dog knows that cannabis stocks are a unique growth opportunity that one day will reap significant rewards. The only question is when.
Innovative Industrial Properties is a real estate investment trust that’s been benefiting from this growth without having to grow a single gram of weed. That’s because it owns industrial properties in the U.S. that lease to state-licensed medical marijuana producers.
The company went public in December 2016, selling 3.4 million shares to the public at $20 a share. It used some of the proceeds to buy its first industrial property for $30 million in Montgomery, New York. It acquired the property from PharmaCann in a sale-leaseback transaction that saw the medical marijuana producer turn around and lease the facility for 15 years.
Thus was born a business model that’s gone on to acquire 55 properties in 15 states, including six in the first quarter alone. As the company states on its website, medical-use cannabis programs exist in 33 states and the District of Columbia. This leaves a lot of fertile ground for the REIT to acquire more properties in the future.
I’ll be the first to admit that I don’t know enough about how a private equity firm would structure this transaction. Still, I do know that Innovative Industrial Properties’ business model is a winner.
Merida Merger Corp. I (MCMJ)
One of the big trends in the past couple of years on Wall Street has been the proliferation of special purpose acquisition companies, also known as SPACs. I wrote about 10 of them in March. Billionaire investor Bill Ackman recently filed regulatory papers to raise $3 billion from investors in the largest SPAC to date.
Needless to say, as assets have gotten more expensive, the SPAC’s become a popular vehicle because it’s become more about the jockey (Ackman), than the horse (acquisition).
While this trend remains hot, the Merida Merger SPAC remains an exciting option.
It’s sponsored by Merida Capital Partners III LP, the third investment fund from Merida Capital Partners, a private equity firm that’s been making cannabis investments since 2013. Things got going for Merida when it hired Daisy Mellet in 2017. Its assets under management have grown exponentially ever since.
The SPAC raised $120 million in early November. It has 24 months to consummate an initial business combination. Although it doesn’t have to acquire in the cannabis industry, that’s Merida Merger’s intention.
With more than a decade of experience in the cannabis industry, Merida is a perfect jockey to bet on. And who knows, maybe it will buy Aphria?
Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia. At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.