Cannabis M&A will likely be volatile in the near term as the industry grapples with a capital crunch and ongoing regulatory hurdles that led to companies backing out of more deals in 2019 than any of the previous five years, experts said.

"The turbulence will continue," John Kagia, chief knowledge officer at cannabis analytics company New Frontier Data, said in an interview. "But amidst it, there's going to be a lot of opportunity, and for those who make it out of this next period of turbulence they should be in a very strong position to compete in the market as it continues to mature."

In 2019, cannabis-linked companies backed out of 95 deals valued at a combined $2.46 billion, up from 48 terminated cannabis deals valued at $946.7 million in 2018, according to an analysis by S&P Global Market Intelligence.

Companies announced or completed 368 cannabis deals for a combined $6.61 billion in 2019, down from 375 completed or announced deals valued at $7.49 billion in 2018.

Heightened regulatory scrutiny of cannabis deals, collapsed valuations and competition from the illicit market fueled many of the deal cancellations, experts said. Another factor was the outbreak of a lung illness tied to illicit THC vaping products with vitamin E acetate oil that killed 60 people in the U.S. While the outbreak and associated negative headlines have tapered off, other challenges for the cannabis industry remain.

Larger companies with more cash could be in a better position for acquisitions, while companies with less healthy balance sheets could face bigger risks, according to experts.

Conditions changed

The logic behind many of the previous cannabis deals no longer applies because the cannabis industry has changed, experts say. Cannabis valuations have fallen, the opening of legal markets in Canada and California has not gone as smoothly as expected and antitrust reviews in 2019 delayed the closing of some deals.

"The industry's development fell short of the aggressive guidance outlined by many management teams," Stifel analyst W. Andrew Carter said in a January report. "Many companies with capital needs face a difficult financing environment with damaged credibility and capital structures burdened with actions taken during peak industry excitement."

Experts say the future of the SAFE Banking Act, which would let banks serve cannabis companies, is now unclear after a key U.S. senator came out in opposition to the legislation. The U.S. House of Representatives passed the bill in September 2019 and passed it to the Senate, where it sits in a committee.

In California, the state's Cannabis Advisory Committee expects $3.1 billion in licensed cannabis sales in 2020, but another $8.7 billion is expected to be spent in the illicit market. A similar dynamic is playing out in Canada, where few of the biggest publicly traded cannabis companies are turning a profit.

"I think the mind-frame has shifted quite dramatically," Karan Wadhera, managing partner at Casa Verde Capital, said in an interview. "I think consolidation will happen out of a need for survival as opposed to ... these kinds of megamergers to dominate a nascent industry."

The biggest deal to fall apart last year was Green Growth Brands Inc. failed hostile takeover of Aphria Inc., a transaction valued at $1.05 billion, according to Market Intelligence. Neither company responded to a request for comment.

In October 2019, MedMen Enterprises Inc. terminated its $682 million merger agreement with PharmaCann LLC in part because federal and state regulatory hurdles delayed the closing timeline, according to a MedMen press release. The deal had the second-highest transaction value among canceled cannabis deals in 2019, according to Market Intelligence.

"We are all sadder but far wiser now as we look forward into 2020 with regard to our M&A activity," Jeremy Unruh, PharmaCann director of public and regulatory affairs, said in an interview. "I think that we are going to be more cautious, but we're still going to be opportunistic when it comes to the right M&A opportunity."

Asked about MedMen's M&A strategy, a spokesperson directed Market Intelligence to some of the company's recent press releases. Co-founder and former CEO Adam Bierman stepped down effective Feb. 1. MedMen on Jan. 14 announced a $78 million senior secured term loan and in December 2019 detailed plans to sell some of its noncore assets for expected gross proceeds of $74 million.

Consolidation expected

Some U.S. multistate operators could break up their operations to get a better handle on the complex regulatory environment and the fast growth from 2019, Morgan Paxhia, co-founder of cannabis investment firm Poseidon Asset Management LLC, said in an interview. There is potential for a couple of big failures in 2020, Paxhia said, adding, "We call this the Darwin phase."

Companies with enterprise values of less than $100 million have the potential to go out of business or become acquisition targets, Paxhia said. Another factor that could drive consolidation is bigger companies hunting for smaller acquisitions in key markets where they do not have a lot of exposure, Paxhia added.

As more deal terminations and even some outright failures are expected, they will likely come amid a continued push to consolidate, experts say. The canceled deals from 2019 likely mean there are cannabis businesses still in need of some way to grow, Rob Lambert, an investment strategist at Strategic Wealth Partners, said in an interview.

"Deal activities still will be pretty robust," Lambert said. "They might not be quality M&As, but it's something they need to do."

Canopy Growth Corp. and Cronos Group Inc. have enough cash on hand to invest in ways they could benefit from fallout in the cannabis industry and raise costs for others to operate, Stifel's Carter said. Tilray Inc. has the resources and the access to capital to continue investing toward the larger global opportunity, Carter said. Meanwhile, Aurora Cannabis Enterprises Inc., whose CEO just retired, faces cash demands on its business likely to exhaust resources and require a big ask of capital markets, Carter said.

"Canopy Growth has executed dozens of acquisitions to establish solid infrastructure and IP that has enabled us to bring our products to market," Jordan Sinclair, vice president of communications and media for Canopy Growth, said in an emailed statement to Market Intelligence. "In terms of business strategy, Canopy Growth appreciates that our balance sheet gives us the option to acquire as it makes sense and in the current market opportunities may present themselves more frequently."

Aurora Cannabis declined to comment as the company was observing a quiet period related to its earnings update scheduled in the first half of February, a spokesperson said.