Bengal Capital - Q1 Letter

Our Q1 letter, albiet a bit delayed

The following is a copy of our Q1 letter, which went out a bit later this year. Feel free to ping us with thoughts/responses, and share to your heart’s content.

As an aside, we estimate that our Fund’s performance (unauditted) continues to be positive through Q2.

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Dear Investor,

The Bengal Catalyst Fund, LP’s (the “Fund”) performance (preliminary, net of fees, and unaudited) is presented below alongside MSOS, a US cannabis-focused ETF. We do not consider MSOS a benchmark, but we do believe it is the closest equity market proxy for the U.S. cannabis industry, so we view it as a reasonable indicator of investor sentiment for the sector. 

Assuming an investor had been a part of the Fund since day 1 and therefore participated in the Fund’s side pocket investments (returns of which are not reported in the table above per general fund performance reporting requirements), their return would have been modestly better than the since inception return noted above.

Your individual investor statements are now being distributed directly from our fund administrator, NAV Consulting (please let us know if you did not receive them). Also, a reminder that your results may vary from those above depending on time of investment. 

As is our usual practice, we are sharing some thoughts regarding the cannabis investment environment as well. Please feel free to share this letter should you wish to - making our 2022 fund letter public led to significant positive engagement which we hope continues in the future.

Even though we are generally skeptical of larger MSO equity valuations, some of the debt yields we are seeing in the marketplace right now could be an opportunity for more debt-focused investors. For example, as of this writing, Trulieve’s bonds were trading at 19-20% yields, which strike us as potentially compelling. While our fund and focus remains on equity investing, we are happy to connect and chat with investors who are interested in our views on current opportunities in debt.

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Bengal Commentary - Q1 2023 

When the first draft of this letter was being written, it had a note regarding a recent bright spot in sentiment induced by an upcoming hearing on the SAFE Act in the Senate - any such bright spot has dissipated as of the final draft. In addition to lack of political movement, many of the larger cannabis companies have missed estimated financial performance and revised down future estimates. IIP, the NYSE-traded cannabis REIT, has also started to report some worrying trends in unpaid rent by some of its tenants. However, the fund’s absolute performance was positive in Q1 2023, led by the performance of Grown Rogue (CSE:GRIN, OTC:GRUSF), the Fund’s largest holding and the one we will be highlighting in this letter. In contrast to larger MSOs, Grown Rogue is a powerful example of how we believe true value will be built in the long term for shareholders.

Grown Rogue, at its core, is a craft cultivator of cannabis which can create a high quality pound for (our estimates) $400-500/lb in direct costs in its operations in Oregon and Michigan. Then, they have overhead of about $200/lb in the form of an accounting department, public filing costs, officer salaries, etc. They do this day-in, day-out in a brutally competitive market (Oregon) and a fairly competitive market (Michigan), and still manage to generate cash. Let’s say the average price Grown Rogue sells cannabis for in Oregon and Michigan is a combined $900/lb, so its “know-how” of how to grow a high quality craft cannabis pound is “worth” $200-300 in its current markets. Grown Rogue’s cost structure is solid so there is not much room for improvement there and, while pricing has returned a bit from its trough in Oregon and Michigan, Grown Rogue’s clearest way to generate profits from its “know how” is to take its abilities to a market with higher prices.

One of the best ways to port that knowledge into new states is to pair with an existing operator, like the deal which Grown Rogue recently inked with Goodness Growth Holdings. In simplest terms, the deal is this: Goodness made a reasonable forecast of what it expected to do solo and Grown Rogue now comes in to help Goodness improve its process/procedures (i.e. its operational DNA and core weed hustle) and is, in turn, entitled to a portion of the profits generated above the solo forecast. So, when Goodness wins, so does Grown Rogue. Grown Rogue now has access and the ability to profit from burgeoning markets like Maryland and Minnesota without the need for expending any capex and only moderate opex costs. We believe this arrangement will be beneficial to both companies. Note that we hold both in the Fund, and that Bengal partner Josh Rosen is the interim CEO of Goodness. 

Another potential way of porting this knowledge is taking advantage of industry distress as operators abandon underperforming facilities which Grown Rogue can step into on a discounted basis and operate better (as was exactly the case when they purchased Acreage’s Oregon indoor facility) - we continue to believe that these opportunities will be forthcoming as we continue to see increasing distress on the horizon for many players, including larger operators, in the industry (discussed more below).

The end result is that Grown Rogue is able to make a tidy profit in its home states, and now has access to two new states where it has significant profit potential, and stands to benefit from others’ distress or lack of operational know-how. Through it all, it continues to build brand equity with customers across its markets by simply delivering a high quality, high value product - an asymmetric blue sky of upside that is not currently appreciated in the wider cannabis markets which tends to view “brand” as equivalent to “pretty box.” In many ways, Grown Rogue is the antithesis of larger MSO operators.

The underlying pattern that we suspect is being played out repeatedly in many large MSOs is this: (1) enter a new market using relatively expensive sale leaseback financing to build a facility; (2) lack of cannabis building expertise leads to the facility being improperly or expensively built (i.e., spending $30mm on a facility with the performance of a well-built $5-10mm facility), and; (3) the facility is overstaffed and underperforms because of lack of operational expertise. This may seem far-fetched to some readers, but tigers don’t change their stripes - many large MSOs started as financial conglomerates buying up limited license pieces of paper and have minimal, if any, inherent ability to actually use those pieces of paper to make money, particularly as competition arrives. 

For a few years, these sins were covered up by high cannabis prices in limited license markets, but those prices are now starting to come down. As prices come down, large MSOs look for a new state to enter which still has high pricing (read: New Jersey) in order to keep profitability up. In turn, large MSOs start to shutter or divest of cash burning operations if they can (e.g. Curaleaf’s recent moves to shutter its California, Oregon and Colorado operations), and often blame the market itself rather than their lackluster performance in it. If a company’s value is based on its future profitability, with future meaning beyond the couple of years when you can sell cannabis for $3000+ in New Jersey, then the values of many large MSOs look highly suspect.

While many of these large companies may continue to exist in one form or another, and some of them may even be successful (GTI seems to distinguish itself from the herd of other large MSOs, although we hold no position in the fund), what is difficult to truly see is many of these large MSOs creating value for shareholders. What we see instead is a continued cycle of distress, overhead cost cutting, reorganizations, dilutive capital raises, and ultimately unprofitable expansion meant to shore up near term results or investor excitement - hardly a sequence conducive to creating long term shareholder value. This despite what remains an attractive growth backdrop of an illicit market transitioning to the regulated market.

Ultimately, we believe many companies in the sector, notably many of the larger MSOs, will repeatedly be reduced to temporary attempts to take advantage of high cannabis prices and will peter out as soon as those high prices go away for a sufficiently long time. Grown Rogue is resilient to lower prices and is built to create long lasting value. The latter is the approach we continue to invest in, and we look forward to apprising you of progress along the way.

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Disclaimer

The information contained in this letter is provided for informational purposes only, is not complete, and does not contain certain material information about our Fund, including important disclosures relating to the risks, fees, expenses, liquidity restrictions and other terms of investing, and is subject to change without notice. This letter is not a recommendation to buy or sell any securities.

The information contained herein does not take into account the particular investment objective or financial or other circumstances of any individual investor.  An investment in our fund is suitable only for qualified investors that fully understand the risks of such an investment after reviewing the relevant private placement memorandum (“PPM”). Bengal Impact Partners, LLC (“Bengal Capital” or “we”)  is not acting as an investment adviser or otherwise making any recommendation as to an investor’s decision to invest in our funds.

Perhaps most importantly, Bengal Capital has no obligation to update any information provided here  in the future, including if any positions discussed are sold or purchased, or if different positions are purchased.

This document does not constitute an offer of investment advisory services by Bengal Capital, nor an offering of limited partnership interests of our Fund; any such offering will be made solely pursuant to the Fund’s PPM.  An investment in our Fund will be subject to a variety of risks  (which are described in the Fund’s definitive PPM), and there can be no assurance that the Fund’s investment objective will be met or that the fund will achieve results comparable to those described in this letter, or that the  fund will make any profit or will be able to avoid incurring losses. As with any investment vehicle, past performance cannot assure any level of future results.

We make no representations or guarantees with respect to the accuracy or completeness of third party data used or mentioned in this letter. We provide services, such as strategic consulting services, to certain entities mentioned in this letter and may in the future provide such services to more in the future, or to companies not mentioned in this letter. While we may sometimes advise on issues regarding corporate communications, we do not believe any of the services which we provide are “stock promotion” - we have not been and will not be compensated for the mention or discussion of any of the companies discussed herein. We disclose such arrangements to investors in the Fund and will continue to do so.