Distressed Asset Investors (Finally) Descend on California Cannabis

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california distressed cannabis debt

In my ten years of advising and guiding cannabis companies from a corporate, transactional, and M&A perspective, and especially since 2012 (when Washington and Colorado legalized), every cannabis market in which I’ve worked has experienced a period of extensive business failures, consolidations, and market stress. And it’s that time now for California cannabis (and that was already happening before COVID-19 struck, which is actually a kind of economic shot in the arm for cannabis businesses, all of which have been deemed essential and are allowed to continue to operate). It’s been nearly two years of licensing, and in a strong local control market like California, it’s no surprise that many cannabis companies (of all sizes) are either going under or headed that way (and will still likely be so post-COVID-19 when the level of sales goes down again). What that means is that enterprising investors experienced with distressed assets have significant opportunities before them.

Many things are causing this uniform failure across California’s cannabis marketplace. The first is local control. To get a California cannabis license, your cannabis business must first secure local authorization to proceed. There are 482 cities in California and 58 counties. Every single one of them (if they even permit commercial cannabis activity) has a different regulatory regime in play. From permitting to local licensing to comprehensive development agreements, would-be cannabis licensees experience a myriad barriers to entry and higher costs and taxes than they would face with state regulators. For example, the City of West Hollywood had an insanely competitive and expensive licensing process, and the City of Los Angeles has a complicated three-phase gauntlet of licensing with a social equity component. Worse though is that the majority of California cities and counties still ban commercial cannabis activity altogether.

Second is compliance costs, which almost no cannabis company correctly predicts because of constantly changing regulations and market volatility. To get through state licensing costs a chunk of change and you also must demonstrate a right to real property for the license type you seek. This means you need a deed or a lease in place before you even receive a license. Once you finally get licensed (which can take weeks and even months because of government red tape), you must ensure all your product is made in accordance with regulations, packaged and labeled properly, tested accordingly, and then popped into the distribution chain in line with the rules, ensuring everything is tracked and traced. There are a lot of rules and ambiguities, ensuring you will need to retain and pay for an experienced cannabis attorney or cannabis consultant to protect you against rule violations. Few California cannabis companies plan for the exorbitant costs of compliance.

Third is the illegal market and an overall lack of effective enforcement. The illegal cannabis market in California is large and rampant and it will take years to tame it, much less eliminated. It isn’t easy a for law-abiding, licensed cannabis business that must bear the heavy burden of constant compliance and state and local taxation to compete with an unlicensed, unregulated, un-taxed competitor that can sell its cannabis product at lower prices.

Fourth is bad timing. Many cannabis companies, including legacy operators, rushed into the cannabis industry without sufficient (or sometimes any) planning, simply believing their cannabis would sell itself. Wrong. Though cannabis in California is still mostly a cottage industry, it is very competitive, especially with no licensing caps and when local governments have nearly unbridled power to ban commercial cannabis activities outright. On the one hand, California has little pocket markets from city to city with some spots having literally hundreds of cannabis licensees of all kinds and where cut-throat competition reigns. And on the other hand, California also has some places with only a handful of licensees in densely urban populated areas where the money is relatively easy.

Fifth is just California’s overall market volatility. It’s no secret that many retailers and distributors are shorting their wholesale customers because they either cannot move as much product as they anticipated or because they just don’t have the money because every dollar they receive they must reinvest back into their business just to keep it alive.

All of the above, combined with cannabis businesses being unable to seek relief in federal bankruptcy courts has put many California cannabis companies on the path to complete failure. State court receivership is an option, but usually a not very desirable one. Not surprisingly, hardly a week goes by without one of my law firm’s California cannabis lawyers getting a phone call or an email asking whether we know of any white knight that could bail them out.

Since the beginning of the new year, I’ve been working on a number of matters involving distressed asset investors (including funds backed by institutional money) seeking to buy into or lend to failing cannabis businesses desperate for cash. Somewhat unusual for distressed asset investors, many are looking to take a controlling interest (or at least secure controlling authority through debt instruments) in the cannabis business they want to turn around or restructure.

Most of these distressed asset investors are looking to buy the debt of the failing cannabis company or to extend it credit in return for a large chunk of profits when the once failing cannabis company rights itself. Most of these distressed cannabis asset investors are prioritizing debt over equity because of the priority on pay outs in the event of a dissolution. However, because bankruptcy is not an option for cannabis businesses, I am also seeing failing cannabis companies enter into all sorts of pledge agreements with distressed asset investors, giving those investors a priority position in the cannabis company’s equity in the event of a default.

Distressed asset investing — particularly in the California cannabis industry — is rife with risk. In addition to the various issues mentioned above, investing in a California cannabis businesses is very complicated and it requires the investor make all sorts of disclosures to state regulators, and often to federal enforcement agencies as well. Though some cannabis businesses are opposed to “vulture investing” in the cannabis industries, I would urge everyone to keep an open mind as there are many California cannabis businesses with few realistic options for continued survival without a serious infusion of capital. That will continue to be true unless and until the State of California starts fixing things.

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