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  • Gary S. Kaminsky

Cannabis – A Regulatory Arbitrage Worth Pursuing


On September 13, 2018, Gary Kaminsky of MainLine Investment Partners, LLC., will speak at Kahner Global's Cannabis Private Investment Summit in New York City. This event gathers industry leaders and investors for a day of collaboration and networking.

Gary S. Kaminsky, a former SEC enforcement attorney and co-founder of two alternative fund management companies has over 30 years of experience developing and implementing regulatory enterprise risk management systems for

registered firms. Mr. Kaminsky is currently the chief regulatory officer for the cannabis business of MainLine Investment Partners, LLC.

Cannabis mandates a different perspective on regulatory arbitrage

I have spent the better part of my 30 plus year career advising against the “losing” trade of regulatory arbitrage. I have repeatedly warned managers against pursuing alpha in regulatory questionable activities. I have articulated arguments

that the negative expectancy of violative behavior far outweighed the probability of alpha generation. Either you can teach an “old dog” new tricks or more accurately, this old dog has identified cannabis as an asset class where regulatory arbitrage

effectively executed may well be one of the most compelling strategies the investment world has seen in generations.

Cannabis is a unique asset class

Cannabis investing is a unique asset class, unlike any other strategy that has been pursued by legitimate investment professionals. The legal dichotomy created by federal prohibition makes cannabis investing very challenging and wrought

with complications and aesthetic hair. Nonetheless, 30 states (and DC) have legalized cannabis for medical use and 9 for adult use and the FDA has approved a drug for mainstream distribution whose primary medicinal benefit is driven by

cannabis. In a new survey conducted by Harris Poll, 85% of respondents said they believed marijuana should be legalized for medicinal use, and 57% backed legal recreational use. According to Arcview Market Research and its research

partner BDS Analytics, over the next 10 years, global spending on legal cannabis is expected to hit $57 billion. According to Arcview Market Research and its research partner BDS Analytics, over the next 10 years, global spending on legal

cannabis is expected to hit $57 billion. The US cannabis market is currently estimated at $5-6bn and is projected by Cowen to grow to $75bn by 2030. Simply put, the cannabis train has left the station and astute investors are well advised to

get on board. A ticket, however, is hard to obtain and requires diligent scrutiny of the right train to ride.

As a compliance geek and one who gravitates to regulatory intensive businesses, cannabis offers the ultimate in stimulation and challenge. Name another “legitimate” investment that carries the risk of US Department of Justice prosecution or where a company is not allowed to deduct valid business expenses from its US taxable income. Add to that the challenge of finding a bank to deposit cash or pay vendors. State and local law compliance present additional hurdles as each state and locality have different mandates. In short, cannabis presents a huge opportunity for the investor who can navigate the legal dichotomies, enlist expert resources and professionally manage the investment program. The barrier to entry

is large, the risks significant, yet the upside potentially substantial.

Cannabis demands investor attention

Conventional arbitrage strategies like convertible arbitrage, merger arbitrage, activist investing or PIPES all carry certain risks and require navigation of unique legal issues. However, none of these should be conducted as regulatory

arbitrage exercises in which legal risk is tolerated for the sake of alpha generation. Cannabis, on the other hand, requires investors to accept unavoidable illegality due to federal prohibition. The uniqueness of this continues to keep large industry

players out of the space and institutional investors from allocating to the strategy. This, in and of itself, creates an arbitrage opportunity for those willing, and more importantly, able to execute an appropriate investment program. Given that over

half of the states in the US have legalized cannabis in some way, the majority of the populace support cannabis and federal agencies are acknowledging the efficacy of the plant, not exploring investing in such an asset class seems short sighted. More importantly, the ability to invest in an asset class that has limited institutional involvement is compelling and demands attention.

Executing an effective cannabis investment strategy

Investing in cannabis is complex, labor intensive and requires unique skill sets and expertise. It also requires a deliberative approach and flexible perspective as many of the issues are unique to the asset class. The overall legal dichotomy

and detailed state regulatory mandate a careful, focused approach and specific expertise. While assessing the efficacy of a management team and the business plan of a cannabis company is critical, the company’s willingness to develop,

implement and maintain regulatory enterprise risk management (“Regulatory ERM”)1 infrastructure should be a prerequisite to any investment.

Due diligence challenges

Unlike other industries, cannabis is a zero-tolerance proposition. Compliance transgressions can compromise the entire organization resulting in suspension or loss of licenses and even criminal prosecution. Cannabis company “compliance” is not simply a “check the box” exercise of adhering to specific regulations. Rather it is wholly enmeshed in the overall operational, financial and risk systems. Cannabis compliance mandates a commitment to Regulatory ERM. Prior to investing in any cannabis related company, investors need to assess the efficacy of the entity’s willingness and ability to develop, implement and maintain Regulatory ERM. The due diligence review of prospective investments is substantially more challenging as a comprehensive review of all licenses, regulatory communications and overall regulatory infrastructure must be satisfactorily completed.

To effectively complete this review, investors will need to employ regulatory “experts”, who due to the newness of the space can be hard to find. As a result, having internal regulatory expertise and the ability to challenge invests and conduct post-investment oversight is critical. Compliance Observer Rights agreements built in to the purchase agreement are recommended. In this regard, potentially the biggest challenge that investing in cannabis presents is the need for lexibility in assessing due diligence results. Unique to the asset class, invariably there are certain areas of cannabis that investors will not be able to get definitive comfort on prior to making the investment decision. Accepting that you are investing in a federally illegal enterprise is paramount. Additionally, license tracking can be difficult, as in some states the “licensee” may not actually be the functional operator of the cannabis business. Further, many cannabis companies have young and inexperienced management that could benefit from additional assistance and oversight.

Investment platform prerequisites

Clearly, cannabis investing is not for the faint of heart nor for the unsophisticated investor. To effectively gain exposure to this compelling asset class, interested persons need to identify the right platform. This platform should be a firm that has experience managing money and investing in private companies. SEC registration can be a positive as it connotes a level of assets under management and requires a certain amount of regulatory internal infrastructure.

Notably, there are a dearth of RIAs in the space as $150mm under management is required to register and capital raising has been a challenge. Experienced personnel are essential. The platform must have professionals with experience in

investing, providing operational support to private companies and uniquely, regulatory compliance. Cannabis investing should be a partnership between the platform and the company. Investors should seek to be strategic and hands-on with

their investees. Cannabis requires such a partnership and must include transparency with regular reporting.

Conclusion

Cannabis investing in the US is a complex strategy requiring particular expertise and regulatory tolerance. While the plant remains illegal on a federal level, a majority of the states have embraced cannabis for its potential medical

efficacy. The winds of change are strongly blowing this controversial substance towards legitimacy making investment in its future potentially very bright. Sophisticated high-net worth individuals, family offices and institutional investors

need not shy away from the regulatory challenges cannabis presents but rather need to identify the appropriate investment platform to partner with to navigate this compelling regulatory arbitrage.

The Cannabis Private Investment Summit brings together the best and brightest cannabis entrepreneurs and ultra high net worth investors & family offices. It is the premiere summit for institutional investors, family offices, and ultra high net worth investors. For additional information, please visit www.cannabrunch.net or email us at info@kahnerglobal.com.


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