Launching a Cannabis Hedge Fund: Headache or Opportunity?

Currently, the medical use of cannabis is legal in 37 US States and Washington D.C. The recreational use of cannabis has now been legalized in 18 states and once again, Washington D.C. While the use and possession of cannabis is still illegal under federal law, the Rohrabacher-Farr amendment prohibits federal prosecution of individuals complying with state cannabis laws. This move towards full legalization by the states and increasing public acceptance have created an investment opportunity for the alternative funds industry.

While opportunity exists, everyone knows there is no such thing as a “free lunch,” and there are potential headaches that fund managers who are contemplating investment in cannabis should take into consideration.

For example, as long as marijuana continues to be considered a Schedule 1 controlled substance under federal law, many financial institutions will avoid doing business with firms involved in the cannabis industry. Likewise, many audit firms will avoid taking on clients whose focus is on investments in cannabis-related companies. It is important to have a strong understanding of the company’s approach to capital raising, compliance program and vendor relations before making an investment.

Anti-Money Laundering (AML) issues are also unique in the cannabis industry. Because of the preponderance of cash transactions inherent in many cannabis businesses, any hedge fund investing in the space needs to be especially mindful of their responsibilities under federal AML and terrorist financing rules and regulations. Any entity doing business with a legal cannabis-related enterprise must make regular assessments and document any risks involved.

The existence of an appropriate risk-based compliance program to prevent illegal activity is paramount. Entities financing cannabis businesses should perform due diligence to make sure this is the case. Any complete compliance program should include the appointment of an AML Compliance Officer.

And let’s not forget about taxes. Federal tax code section 280E prevents marijuana businesses from taking traditional business deductions on their federal income tax returns due to federal classification of cannabis as a controlled substance. However, hedge and PE funds, which are usually structured as partnerships can exclude up to 100% of capital gains on the sale of qualified small business stock. To be eligible, the shares must have been held for more than five years and directly acquired by original issuance from a U.S. domestic C corporation. While most gains reported by PE firms are long-term in nature, due to the typical duration of a private investment, wouldn’t a 100% exclusion look better than a preferential rate to investors?

Savvy investors understand that where there are risks, there is usually opportunity. The cannabis industry is a prime example, especially if one considers Europe, where medical marijuana has been legal in many countries for years. Oskare Capital, a Paris based PE fund hopes to raise 150mm Euro to do deals in the medical marijuana sector. The firm is targeting emerging biotech companies that are developing cannabis-based treatments for ailments such as depression, cancer and neurological disorders. They believe the market for cannabis based medicinal treatments can be as much as 400 billion USD in the next several years.

An opportunity like that should attract many hedge fund entrepreneurs, existing firms as well as those that are just a gleam in their mother’s eyes today. Given the size of the opportunity, will the U.S. remain behind Europe much longer in the quest for the gold?

Grassi’s Fund Administration and Cannabis Advisory teams have extensive experience helping investors make the right moves in the cannabis industry. Contact John Zoraian, Fund Administration Principal, or John Pellitteri, Cannabis Practice Leader, to learn more.

John Zoraian John Zoraian is a Principal in Grassi’s Financial Services practice, where he provides expert fund administration, compliance and advisory services to hedge and private equity funds, funds of funds, master-feeders, investment advisors, broker-dealers, family offices, fintech entities and more. John draws from more than 35 years of experience in the hedge fund business. Prior to joining Grassi, he established S&Z Fund Services, a division... Read full bio

Categories: Fund Administration