Top considerations in starting a cannabis-focused alternative investment fund

The rise of a new industry will always drive innovation in the financial services sector, but few industries have presented the kinds of challenges that have come along with the geographically selective legalization of cannabis. The industry continues to advance: Nearly 40 states allow medical use, nearly 20 allow recreational adult use, and federal legalization bills continue to be presented, although they likely face an uphill battle. As governments across the world take steps toward legalization, investors are backing the industry that is helping to propel things forward. But this varying legality – and cannabis’s status as a Schedule I controlled substance – leaves operators, investors, and other industry stakeholders significant repercussions to navigate while operating in this sector, from the patchwork of applicable state laws and taxation to reduced access to banking and professional services. 

Fund managers looking to create investment vehicles focused in this sector face a variety of specialized considerations that break down into three categories: operational, tax, and regulatory. If you’re thinking of starting a fund to invest in the cannabis industry, it’s a good idea to familiarize yourself with each one so you can plan ahead more effectively. 

FUND STRUCTURE AND DOMICILE

Some of the first considerations that come into play when starting a cannabis-focused fund are ones that have implications in all three categories. The structure and domicile of the fund will have a significant impact on the day-to-day operations, the taxes it will have to pay, and the regulations with which it must comply. Typically, closed-end structures are more effective for making non-public investments, mainly because of lack of liquidity and complexity of valuation.

The fund domicile has similar cross-functional repercussions. Every jurisdiction, whether it’s a state within the U.S. or a foreign country, will have some limitations when it comes to cannabis investments. The key is to understand those limitations and determine which jurisdiction will most effectively align with your fund’s objectives to minimize the operational, tax, and regulatory drag on the fund. 

Closely related to fund domicile is the residence of your investors, as your fund’s investment decisions could have different consequences for U.S. v. non-U.S. investors. 

Learn more about top fund structure types and considerations in Chapter 2 of our Emerging Managers Resource Guide.

OPERATIONAL CONSIDERATIONS

Many of the operational considerations that cannabis funds face stem from the legal limbo in which cannabis presently resides. Given the current position of the federal government and many states on its illegality, businesses that operate in this sector (and, by extension, funds that invest in them) may face a challenging scarcity of support resources. 

The SAFE Banking Act has passed the U.S. House six times, most recently in February 2022. It remains to be seen if this will progress further. As a result, a growing number of banks and credit unions have been finding alternative solutions to working with cannabis businesses, such as technology-based tools or specialized intermediaries. Still, the strict regulations and risks involved inhibit many institutions from doing so, and those that do may impose minimum balance requirements and high fees on their cannabis customers. Thus, the industry remains underbanked. (Read more about the current state of banking for cannabis.)

It can be difficult to find professional services support – lawyers, accountants, administrators, etc. – who are qualified to help with the compliance and regulatory requirements in both financial services and the cannabis industry. Insurance may also be limited, and the risks involved may require specialized provisions, especially in the director and officer area. Many U.S.-based funds need to pay particular attention to a professional resource’s knowledge of cannabis rules in Canada as well as in the U.S., as funds frequently cross this border in search of investors and investment opportunities. It’s important to make sure your fund has access to resources that are familiar with providing support to both plant-touching and non-plant-touching businesses prior to launching. 

Focused professional services support is particularly important at the outset, as so many of the decisions you make in setting up the fund will lay the groundwork for its overall success. The evolving nature of the cannabis industry demands that a fund’s investment strategy allow its managers considerable flexibility. The unique risks of cannabis investments also drive some very specific disclosure requirements that can affect investment solicitations as well as financial statements. Internal controls need to be particularly robust given the level of scrutiny that some regulators direct toward cannabis investments. 

As your fund grows and explores new investment opportunities, it will need to have access to resources that have a level of sophistication when performing due diligence procedures in the cannabis sector. Evaluation of risk and valuation of underlying portfolio investments are particularly challenging given that so many of the ventures seeking equity support are untested start-ups. (Have a cannabis business you’re looking to sell? Read about 3 trending tax issues in sell-side due diligence. Or, if you’re looking to invest, use this as a heads-up of areas to watch.) 

TAX CONSIDERATIONS

The most significant tax consideration for cannabis fund managers is Internal Revenue Code (IRC) Section 280E, the federal rule that prohibits the deduction of ordinary and necessary business expenses from the gross income of plant-touching cannabis businesses. Your fund needs to be structured so that it doesn’t inadvertently become subject to this rule, and you need to consider this obstacle whenever you’re calculating the after-tax return of potential investments. 

The federal rules also demand more meticulous recordkeeping from businesses in the cannabis sector. As noted above, the sector is often subjected to a higher level of scrutiny. The federal prohibition against ordinary and necessary business expenses needs to be properly disclosed to investors, and compliance with the rule needs to be documented extensively.

State tax consequences can get even more complicated, as many states start their business income tax calculation with federal adjusted gross income. Some of the states that have legalized cannabis have restructured their state tax codes to allow businesses in the sector to deduct expenses for state income tax calculations, but others haven’t gotten there yet. Plus, it’s not just the state level cannabis businesses need to watch for: In many states, local taxing jurisdictions also have registration and collection rules. (Read about more top state and local tax considerations for cannabis businesses.) 

REGULATORY CONSIDERATIONS

In addition to the regulations already noted, states may have specialized restrictions on cannabis businesses that should be evaluated. Even in states where adult-use cannabis is legal, it is still highly regulated and closely monitored. Restrictions on advertising and licensing might apply to your fund as well as the businesses that you might evaluate for investment. Registration as an investment advisor at the federal and state levels can be affected by a fund’s involvement in the industry. 

Restrictions on percentages of cannabinoids in products can vary from state to state, meaning that products legal in one state might be illegal elsewhere. Also, after being removed from Schedule I classification in 2018, hemp is no longer subject to Section 280E, so managers will need to pay attention to whether they are dealing with hemp or marijuana products and the distinctions between their treatments. Investment disclosures may be different for businesses promoting products from hemp-derived CBD vs. marijuana-derived CBD. 

PROCEED, BUT DO SO WITH CAUTION

Despite federal prohibition, the U.S. cannabis industry has experienced dramatic growth in recent years, and signs are trending for continued growth in 2022 and beyond. As the industry matures, it will likely attract more structured forms of investment: At the very early stages of development, investment mostly came from family offices, high-net-worth individuals, or others seeking direct investment in the operating companies themselves, but moving forward we expect that an increasing number of investors will be interested in going through professional managers. 

Still, working in the cannabis sector holds numerous challenges, and just like with any other investment, the potential for higher rewards must be balanced against higher risks. The key to managing those risks is understanding them up front and making choices for your fund that follow your investment strategy.