Legal marijuana is becoming more prevalent in the US, with 33 states now legalising it for medical uses, as well as 10 states and Washington DC allowing its recreational use by adults over 21.
As more states are legalising some form of cannabis use, public acceptance is also increasing. According to an October 2018 Gallup poll, two-thirds of Americans support legalisation.
More hedge funds are now getting into the space. Omega Advisor’s Leon Cooperman has a personal investment in cannabis, and Tiger Global’s Chase Coleman is also allocated to the sector.
Rick Frimmer, a managing director and cannabis and hemp practice leader at EisnerAmper says he is seeing a lot more hedge fund investments in the drug, but not from very large funds. “It’s mostly smaller funds who have developed solely for the purpose of investing in cannabis,” he says.
Ron Geffner, a partner at Sadis & Goldberg agrees there is more interest from hedge funds looking to invest in this space and it “is picking up steam.” “We’re working with several funds right now looking to invest in cannabis,” he says.
For any investor in cannabis, there is an ever-changing labyrinth of requirements to stay compliant with various state laws and federal regulations. Any violation could lead not only to fines and enforcement actions but also to jail time.
First, existing hedge fund managers must review their governing documents, such as the private placement memorandum and the limited partnership agreement, to ensure they are able to invest in marijuana.
According to Frimmer, many fund documents prohibit illegal activities, which would include cannabis because it is still illegal at federal level.
“Because cannabis is still federally illegal, in writing our legal documents – our PPM and LPA – there is a laundry list of legal disclosures around our business activities,” explains Morgan Paxhia, founding partner and chief investor at cannabis hedge fund Poseidon Asset Management.
“But whether you’re only investing a portion of your portfolio in cannabis or dedicating your whole portfolio to it, the risk disclosures need to be there.”
These disclosures should warn investors that while the fund will not be harvesting, distributing or selling cannabis, by investing in companies that do or that supply products to growers of marijuana, funds could be deemed to be participating in marijuana cultivation, which is illegal under federal law, and exposes the firm to potential criminal liability.
Elliot Frank, a partner at Sadis & Goldberg notes that if a fund’s governing documents do not allow for cannabis investing, they would need to be updated. “You would also need to update the risk factors in your PPMs to address the risks in this space.”
Managers can also go back to investors for approval to make investment and charter changes, Frimmer says.
Investors are another area of concern for managers, as some will not allow for cannabis investments.
Frank explains that foundations, endowments and pension funds may have restrictions against investments that do not comply with applicable law.
“The issue here is that while cannabis may be legal in the states in which these companies may be based, cannabis still remains a schedule 1 drug and is illegal under federal law so certain investors are precluding from these investments.”
Robert Hunt, co-founder of cannabis consulting firm Shingle Hill, agrees that certain pension plans or endowments may have an absolute prohibition in their charters against doing or taking part in anything that breaks the law. “[You] have to make sure that every single investor in your fund is ok with what you’re planning on investing in,” he says.
Poseidon’s Paxhia adds: “Cannabis is still considered, and wrongfully so, a vice. It typically falls into the ‘vice clause’ category for funds so they are not permitted to be investing in things like guns, tobacco, alcohol and, in many cases, cannabis.”
Most marijuana funds tend to be registered at the state level and not with the SEC, largely because most have less than $150m of AuM. Frimmer notes that SEC registration could be a “stumbling block” for registered funds with reporting requirements because the federal government does not yet support a legal cannabis industry.
“And, because of the SEC regulations and their own trading restrictions, private funds started out looking for ‘soft’ cannabis businesses, meaning business that don’t touch the flower, like software, compliance, consulting and banking alternatives,” notes Frimmer.
Service provider considerations
Managers also need to speak with service providers to ensure they will work with cannabis investments.
According to Paxhia: “Service providers can shy away. Major audit firms are still very wary. Getting standard fund coverage insurance used to be very difficult, although it is getting better. You’re also starting to see more law firms working in the space but if you have service provider relationships already, you want to check with them to see if they’ll work with cannabis investments before you just jump in.”
Frimmer adds that most of the large accounting firms will not audit cannabis companies. “So long as it is federally illegal, there are professionals, including lawyers and accountants, that have concerns over whether or not they can assist companies that are technically in violation of the law.”
Many banks are also reluctant to handle cannabis investments due to the Bank Secrecy Act, which requires banks to report the activity of their clients in the cannabis industry to the US Treasury.
As Hunt explains: “For banks, the possibility of having to file these SARS reports every day exceeds the value they are getting out of these accounts, so they decide not to take the business.”
The requirement makes larger institutional banks less likely to do business with companies in the space, although smaller regional banks in states that have legalised marijuana use tend to be more willing.
With a number of states legalising cannabis usage in one form or another, there is now a split in the legality of cannabis in the US.
While there is a belief in the industry that it is only a matter of time before the drug is federally legal as well, Hunt thinks it unlikely within the next two years.
However, at the federal level there has been some thawing in attitudes.
First, the Farm Bill which passed late last year, removed hemp from the list of controlled substances, making it permissible for US farmers to grow it for industrialised use.
Earlier this month, Congress introduced the Secure and Fair Enforcement (SAFE) Banking Act which would create protections for depository institutions that provide financial services to cannabis-related legitimate businesses and services providers for these businesses.
Last year, Congress proposed the Strengthening the Tenth Amendment Through Entrusting States (STATES) Act, which would amend the federal Controlled Substances Act to exempt state-legal cannabis activities from its provisions and allow banks to work with legal cannabis businesses.
The SAFE Banking Act was approved on 27 March by the House Financial Services Committee, sending it to the full House of Representatives for a vote.
The STATES Act was introduced in the Senate and Congress. The Senate bill was referred to the Senate Judiciary Committee and the House bill was referred to the House Judiciary Committee and the House Energy and Commerce Committee. No decisions or proposals have yet come forth.
Despite cannabis’ illegality at the federal level, the Rohrabacher–Blumenauer amendment prohibits the US justice department from spending funds to interfere with the implementation of state medical marijuana laws.
Hunt explains that the amendment is specific to medical marijuana and does not change the legal status of cannabis. It expired during the shutdown, but has been reauthorised, as it must be each year.
However, one of the most relied upon legislations or statements regarding cannabis at the federal level is the Cole Memorandum, introduced by Obama administration attorney general James Cole.
The memo says where states have “strong and effective regulatory and enforcement systems to control the cultivation, distribution, sale, and production of marijuana … enforcement of state law by state and local law enforcement and regulatory bodies should remain the primary means of addressing marijuana-related activity.”
There has been some uncertainty around the Cole memo in the past year and a half or so, as former US attorney general Jeff Sessions essentially repealed it by announcing to all US attorney generals that the Cole memo doesn’t hold any weight at all.
However, during his confirmation hearings, new attorney general William Barr said he would not to “go after” marijuana companies that comply with state laws, essentially keeping the Cole memo in play.
However, Frimmer advises managers and others in the cannabis industry that the Cole memo is only guidance, not law, and that illegal activities including sales to minors, diversion to other states, involvement with organised crime, and cultivation on public lands will be prosecuted.
“So, do your homework and really get comfortable with the companies in which your investing,” Frimmer urges.
“Make sure they have all of the appropriate licenses and are operating according to the law. Just because the Cole memo deprioritises state-legal cannabis operations doesn’t give anyone blanket protection to break the law.”
Paxhia agrees: “Know who you’re investing in. There is still a bit of a negative view towards cannabis so if you’re investing in this area, do your due diligence and only work with and invest in firms that are operating lawfully.”