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The Deal Magazine

The Deal logoIn 2012, it took Seattle-based private equity firm Privateer Holdings Inc. 18 months to raise just $7 million for investment in the medical marijuana sector. This January, Privateer raised $15 million in just three weeks. Any day now, it will embark on a $50 million target raise.

“Things have changed,” said Brendan Kennedy, Privateer’s CEO.

In 2012, the medical marijuana industry was hampered by regulatory uncertainty, clashing federal and state laws and reluctant investors.

The uncertainty hasn’t entirely gone away as the distribution and sale of marijuana are still illegal under federal law.

However, 22 states and the District of Columbia have laws in place making medical marijuana legal within their own jurisdictions, and legislation is pending in New York, Florida, Ohio and Pennsylvania. Colorado and Washington have made recreational use permissible. And the U.S. House of Representatives passed a measure May 29 that would instruct the Drug Enforcement Agency to halt its targeting of medical marijuana businesses in states where such clinics or businesses are legal.

“Our investors have already made their minds up about investing in the sector,” Kennedy said. “This is the easiest it has ever been for us to land investors.”

Two years ago, Privateer was a pioneer in medical pot finance. Today, it is not alone.

It and the other funds that are prospering with medical marijuana are largely focusing on private companies, as publicly traded companies in the sector have been used as vehicles for stock promoters and have drawn negative attention from securities regulators.

High Times, the well-know marijuana lifestyle magazine, says it’s putting a $100 million equity vehicle together called the HT Growth Fund. It will make investments of $2 million to $5 million each in marijuana-related businesses over the next two years.

Emerald Ocean Capital Fund, an entity related to pot conglomerate Ghost Group, says it wants to target pot related software and technologies for investments. Dutchess Capital Management, a Boston-based hedge fund manager, is making equity investments in medical marijuana start-ups.

Ontario, British Columbia, merchant bank PharmaCan Capital is striving to position itself as the go-to medical marijuana financier in Canada.

KindBanking is a West Hollywood, Calif.-based firm offering debt, convertible debt and equity financing for legal cannabis businesses.

And ArcView Group, a San Francisco firm, is doing venture-style financing of medical pot companies.

For start-up investors, medical marijuana may, in some ways, be less risky than other fields.

“In this sector, demand is firmly established,” said Douglas Leighton, co-founder at Dutchess. “There is already a market there for it.”

Quantifying the value of that market is problematic, however. Marijuana is listed as a Schedule I drug under the federal Controlled Substances Act. The designation, which is the same one that has been given to heroin and LSD, means that under federal law, marijuana is not considered to have any accepted medical use and high potential for abuse. The Schedule I designation makes measurement of consumption difficult.

Rough estimates by economists, advocates and law enforcement value the market for marijuana at anywhere from $10 billion to $120 billion a year, but those numbers includes recreational use nationally.

ArcView estimates the value of U.S. medical marijuana at $2.5 billion this year, but forecasts that it could be worth $9 billion in two years. Estimates for the Canadian market run at $120 million for 2014, according to industry players, but national health agency Health Canada estimates that in a decade, the market will blossom to C$1.2 billion ($1.11 billion) in sales.

Despite that projected growth, investors’ hopes are tempered by the risks.

“There is a lot of money on the sidelines wondering what the government will look like in 2016, because that election could change everything,” said David Dinenberg, CEO of KindBanking. “The feds have said as long as you are in compliance with the laws in your state, we will just be watching. But what happens in 2016?”

Investors are also influenced by the performance of the handful of medical pot companies that are now trading publicly in the U.S.

“There aren’t that many of them, but they are showing all of $50,000 in revenues, with inflated market caps,” Dinenberg said. “I get calls from investment banks about going public too, and I say no thanks. I’ll wait until we can have a market cap that means something.”

Last August, the Financial Industry Regulatory Authority issued a public statement warning investors of the risks of investing in medical marijuana stocks. The Securities and Exchange Commission followed in May of this year with its own public warning.

The SEC has also halted trading in the shares of at least nine marijuana-related companies since March.

“Private companies in this sector are now looking at being able to go public as a real option,” said Troy Dayton, CEO of ArcView Group. “And with the hype coming off the penny stocks, I do think it is beginning to put pressure on the valuations of private companies and investors are going to start seeing that.”

A number of private equity players pointed to the shifting of public opinion regarding both medical and recreational use of marijuana as contributing to investors’ comfort. Recent polling by the National Organization for the Reform of Marijuana Laws shows that 80% of Americans favor the medical use of marijuana while 75% supports no jail time for recreational users and 58% approve of legalizing pot.

“There has been a shift in thinking. The majority now believe that marijuana will become legal,” said Kennedy of Privateer. “Investors are now not only more comfortable but they are doing more of their own due diligence and they are coming to us having already made their minds up about investing.”

The handful of funds investing in privately held marijuana companies are doing so with different approaches. So far, Privateer has invested in Arbormain, Leafly, Lafitte Ventures Ltd. and Tilray. Arbormain provides specialized warehouse space in Washington state for growing pot. Leafly bills itself as the Yelp.com of the medical marijuana world, disseminating information on different strains of pot and dispensaries. Lafitte is a certified, Canadian-based grower of medical cannabis, as is Tilray.

The investment in the Canadian companies is a departure for Seattle-based Privateer. The company had a baseline rule that it would not invest in any company that was involved directly in the medical pot trade, so companies that grew or sold were off the table. In the trade, such companies are said to be “touching the sun.”

However, with the advent of a nationalized program in Canada for providing medical marijuana, Kennedy said his firm’s approach changed.

“Unlike the United States, there are no federal-state regulation conflicts,” he said. “The Canadian model is incredibly complex, and requires a great deal of time and expertise, but there is less risk.”

Privateer sees its investments as five-to-seven-year holdings, with investors contributing anywhere from $100,000 up $5 million.

“Some investors are now talking about $5 million to $10 million.” said Kennedy. “We have even had people talk about investing $25 million. It’s beginning to be real money.”

Leighton from Dutchess says his fund is taking its investment approach on a case-by-case basis.

“We are seeing a lot of business plans: eight, maybe 10 a day,” he said. “And since the demand is already there, some of the start-ups have pretty compelling stories.”

Dutchess is doing deals with structures ranging from funds of partners to club deals, where they partner with other investors or funds. Leighton said Dutchess would invest “someplace in the eight figures” in the medical cannabis sector in 2014. Like Privateer, Dutchess has committed to an upcoming investment in Canada. The firm’s best-known investment may be MassRoots Inc., a public company offering a social app for the cannabis community.

KindBanking is making equity investments as well as offering debt and convertible debt, according to Dinenberg.

“We want to be the GE Capital for the industry,” he said. “The trouble for the industry is that going to banks for traditional financing isn’t going to work, which means for infrastructure and capital expenditures, it’s all cash, and that has to change.”

Dinenberg says KindBanking has raised $25 million from high-net-worth investors but has yet to make an investment. He sees a six-year investment horizon with a 10-year life for the fund.

“We think an IR north of 30% is realistic, especially when you consider risk,” Dinenberg said.

“Our conversations begin with, ‘Are you in compliance with your state laws? If so, let’s keep talking. If not, we can’t go any further,'” Dinenberg said.

ArcView is something of a hybrid in that it is organized as a platform to bring accredited investors and pot companies together. While Dayton likens ArcView to an angel investor organization, he also hesitates at that description.

“Too many Angels talk a lot about investing, but they don’t end up investing,” he said. “But in the last 12 months, ArcView has seen $10 million invested in 14 different companies.”

While Dayton said that he is seeing more sophisticated investors coming into the sector, there is also a breed of investors that are not as bottom-line oriented.

“You see people who are investing because they want to change the world, or they know someone who really benefited from medical marijuana and they want to make a difference,” he said. “It’s like green energy. People cared about wind or solar, but until investors began seeing that there was a profit to be made in change, it was just people talking.”

One trend emerging from the private equity niche is geographically focusing.

“We are seeing people who are Denver-centric or maybe Colorado-focused,” said Kennedy.

“Each state ends up being a micro-climate of its own,” said Dayton. “They have their own regulations and that is a key. This is not a demand-driven industry. It is a regulatory-driven industry.”

No place is that more evident than in Canada.

It has gone from the government growing and distributing the medical marijuana to a model where certified companies grow the pot and ship the product through the mail to certified patients.

“The regulations are very complex, and the regulator is very serious,” said Kennedy of the program overseen by Health Canada.

“We have had Health Canada show up unannounced twice for inspections that lasted three days where they want to count every plant in the building.”

Paul Rosen, CEO of PharmaCan, said medical cannabis regulation is strict.

“I would call it extremely onerous,” he said. “That said, we are happy to comply with the regulations.”

While 800 companies have applied to become certified growers, just a dozen carry that designation now, and Privateer counts two of those companies in its portfolio, as does PharmaCan Capital, with Whistler Medical Marijuana Co. and Peace Naturals Project Inc.

Rosen said he believes that, while Canada’s regulatory model includes strenuous oversight, it has made Canada more attractive to investors.

“We know what to expect, and we are not subject to the whim of the federal government,” he said. “We finished our third round in May and raised $9 million, and that included institutional investors and we were oversubscribed.”

Read more: Private equity firing up medical marijuana sector – The Deal Pipeline

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