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Marijuana mayhem: Cannabis consolidation expected as financing, tax rules stress out sector

Five years ago, the cannabis industry was on a high. Hopes that federal legislation would open up the weed industry led to investors piling in. But regulations have not eased and much of that early hope has gone up in smoke, leaving many growers and peddlers of the psychoactive drug – legal on a state level, but illegal in federal eyes – nearly prostrate. 

Mergers and acquisitions targeting North American-based cannabis companies reflect the euphoria of 2018 and 2019 and the subsequent slow exhale. M&A hit a dollar high of USD 13.7bn in 2018, followed by a record 222 transactions the year after, according to Dealogic data. Since then the number of deals have declined year after year, dropping to 53 in 2022, the lowest since 2016. 

The legal marijuana industry – worth USD 27bn in 2021 – faces a moment of reckoning. In a rising rate environment, marijuana companies – already stymied by punishing tax rules and onerous state regulations – face difficulties landing financing and with it the ability to become profitable and self-sustaining.

“We’re going to see a lot of consolidation,” says Aaron Miles, chief investment officer of Verano Holdings [VRNO.CN], owner of 14 cultivation facilities and operator of more than 120 dispensaries. “There’s a dynamic that’s very disfunctional,” he said at Roth Capital’s recent conference in Dana Point, California.

Taxes and death

Although legal in 19 states for recreational use and 39 states for medical use, cannabis is still classified as a Schedule 1 drug. Because it is federally illegal, cannabis companies are prohibited from deducting expenses thanks to Section 280E of the tax code, introduced at the height of the “war on drugs” in 1982. That law means cannabis businesses pay tax on gross revenue, giving them an effective tax rate of 60%, says Scott Fortune, analyst at Roth Capital Partners.

Companies have challenged the tax law, although the courts have sided with the IRS.

In states where it is legal, there are onerous regulations, which are costly, and some cities don’t allow cannabis stores, eliminating access to consumers. That pushes users to shop online or buy from illegal suppliers, not legal dispensaries. Only 30% of the market is legal; the other 70% is illicit, estimates Roth’s Fortune.

Another major difficulty is financing. Proposed legislation to allow banks to do business with cannabis companies operating in states with legalized marijuana – known as the SAFE Banking Act – foundered in the Senate in December 2022. Some expect a renewed attempt in Congress this year.

Cannabis companies can still get financing from alternative lenders, however, but at a higher cost than regular businesses. Verano last October refinanced a USD 350m credit facility at a rate of 12.75% with Chicago Atlantic.

Distressed benefit

Because debt is expensive and difficult to get for cannabis companies, and 280E forces many to operate at a loss, there are “a lot of distressed companies,” said Marc Claybon, a principal in Crowe’s tax group, during the Roth event.

The larger multi-state cannabis operators – known as MSOs – are coming and strategically buying grow facilities that have been shut down, often at cents on the dollar, Claybon added.

Some of the biggest MSOs, notes Fortune, are Curaleaf Holdings [CSE:CURA], Verano, TruLieve Cannabis [CSE:TRUL], Green Thumb Industries [CSE:GTII], Cresco Labs [CSE:CL], Ayr Wellness [CSE:AYR-A], Ascend Wellness Holdings [CSE:AAWH-U], and Jushi Holdings [CSE:JUSH]. Tilray Brands [NASDAQ:TLRY] and TerrAscend [CSE:TER] are others. Almost all have seen their shares crater from highs reached two years ago. 

Many have been among the busiest or biggest acquirors in the last four years, including Curaleaf, Trulieve, Tilray and Cresco, according to Dealogic data.

They have the scale and access to capital to benefit from the sector’s volatility, Fortune said. “We’re going to see elimination or consolidation.”