Cannabis Rethink Sparks Private Equity Interest – Latham & Watkins

The once shunned cannabis sector now offers attractive PE opportunities in many jurisdictions.

30 Cannabis Business Ideas for Entr...
30 Cannabis Business Ideas for Entrepreneurs

By Stuart Alford QCTom D. EvansEveline Van KeymeulenElizabeth RichardsDavid J. Walkerand Catherine Campbell

Cannabis Rethink Sparks Private Equity Interest - Latham & Watkins 4

In years gone by, the prospect of significant PE investment in the cannabis industry would have been unthinkable for many. However, regulatory and legal developments have created opportunities for medical cannabis businesses and legalised new non-medical cannabis applications in many jurisdictions. According to Pitchbook, buyout firms invested US$3.54 billion into the cannabis sector in 2021 across 223 transactions, showing significant appetite for deals. PE firms now have scope to embrace growing medical and consumer interest in certain jurisdictions, while in others, such as the US, evolving legal restrictions continue to challenge investors.

Medical Use Uptake

In Europe, medical cannabis is essentially regulated at the national level. In 2017, Germany legalised medical cannabis, followed by the UK a year later. Several other countries are now considering whether to follow suit, including France, Ireland, and Denmark, all of which have initiated pilot projects to explore legalisation. The acquisition of Neuraxpharm — one of the first European pharmaceutical companies to include medical cannabis products in its portfolio — demonstrates increasing sponsor and investor appetite for companies pursuing authorised medical applications of otherwise restricted products, including cannabis.

Booming “Wellness” Business

Despite the use of hemp having been authorised in Europe for decades, until recently, the use of hemp-derived CBD in cosmetics and food was prohibited in the EU, as CBD was considered a narcotic as a cannabis extract. Notably, plenty of products were available, and enforcement was infrequent. In November 2020, the European Court of Justice took a significant step toward softening the EU position, ruling in favour of French retailer Kanavape that CBD was not a narcotic and could, subject to the applicable regulations, be marketed across Europe.

The ruling paves the way for the development, sale, and distribution of CBD products in Europe and enables many companies, especially those in the cosmetics and food and beverage sectors, to invest in CBD-based products. Use in food products still requires novel food authorisation, so investors are eagerly awaiting the first European Food Safety Authority opinions on CBD, expected in early 2022.

US Experience

US federal law considers certain forms of cannabis to be a controlled substance, with no currently accepted medical use and a high potential for abuse — making its distribution illegal even though some states have legalised medical or, in some cases, recreational uses. Consequently, investors have largely shied away from businesses involved in the sale or distribution of certain forms of cannabis or related products, due to federal enforcement risks.

A recent amendment to federal law effectively removed hemp (which under US law may include CBD) from the definition of a controlled substance, but hemp remains subject to regulation and restrictions. For example, CBD is currently prohibited from being marketed in food and dietary supplements, even though products containing CBD are widely marketed and enforcement has been inconsistent. Federal legislation has been proposed to loosen these legal restrictions.

Money Laundering and Other Risks

While direct fund restrictions on cannabis-related investments are less common, investor concerns (moral as well as legal) can arise, and local laws applicable to investors and their portfolio companies will require careful diligence. In particular, the possession and supply of cannabis for recreational purposes remains a criminal offence in the UK (and in many other jurisdictions), with the effect that financial proceeds, even where legally generated, may be deemed criminal property. For example, PE investors deriving profits from drug-related products, which may be lawful overseas, could face money laundering risks in the UK and elsewhere. Firms should consider risk management around this issue, and the potential for ring-fencing any profits.

Exit Opportunities and Active Growth

Following FCA clarification of the rules surrounding access to London Stock Exchange listings in late 2020 and additional clarification in July 2021, several medical cannabis companies have already listed, underlining a pathway to Exit as cannabis investment moves into the mainstream.

As with any new sector, legal cannabis comes with grey areas and pitfalls, but it may offer high-growth opportunities for PE depending on the jurisdiction.

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