Bengal Capital - Q2 2023 Letter

Our much more timely Q2 2023 Catalyst Fund performance letter

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 be modestly better than the since inception figure above.

Your individual investor statements are now available directly on our fund administrator’s portal, please let us know if you need help accessing them. Also, a reminder that your results may vary from those above depending on time of investment. 

Please also note, consistent with previous reminders, that our fund has grown increasingly illiquid and more concentrated. This combination inherently leads to more short term volatility in returns, both positive and negative. So, while we’re pleased with our recent performance (we are human after all, and seeing green on our screens is a bit more pleasing than seeing red), we also recognize that our focus is on long-term value creation and the underlying execution of our portfolio companies.

As is our usual practice, we are sharing some thoughts regarding the cannabis investment environment below as well.

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Bengal Commentary - Q2 2023 

Steve Wozniak: You can't write code... you're not an engineer... you're not a designer... you can't put a hammer to a nail. I built the circuit board. The graphical interface was stolen from Xerox Parc. Jeff Raskin was the leader of the Mac team before you threw him off his own project! Someone else designed the box! So how come ten times in a day, I read Steve Jobs is a genius? What do you do?

Steve Jobs: I play the orchestra, and you're a good musician. You sit right there and you're the best in your row.

From the film Steve Jobs (2015), and almost certainly a completely made up interaction between Jobs and Wozniak that, nonetheless, captures something about Jobs’ genius as a manager

What is Good Management?

Many (long) books have been written about what constitutes good management, but most people that have looked at the question deeply seem to agree on core principles. First and foremost, good management is about decision making, often in the context of resource allocation, most notably capital allocation - understanding that you are deploying shareholder capital and looking to generate the best return on that capital over the long term. Good capital allocation, in turn, requires a very in-depth understanding of your own business and what its real returns are likely to be for various projects, what your core competencies are (and, conversely, where your biggest holes are), and to what extent you should plug your holes and/or lean into your core competencies. Mastering good management requires synthesizing a lot of information and often just having good sensibility about inferring what will likely happen in the real world. Good capital allocation also often involves being appropriately opportunistic. In most respects, good decision making starts and ends with understanding what will (or probabilistically should) create shareholder value in the long term: high returns on capital. 

The key aspects of good management do not change when applied to the cannabis industry. The situation is different from other industries, but the basic mechanics of good decision making are the same. If anything, given the uncertainty of cannabis, good management is that much more valuable. 

Many investors seem to have forgotten this, if one is to go by Twitter* as an indicator. Some seem to suggest that what constitutes good management in cannabis is the stock price action over a few weeks, or large amounts of time spent by a CEO on Capitol Hill lobbying for the SAFE Act, or how good a CEO is at promoting the company in any venue that will accept him/her. In our opinion, once management nails the first part of their job (capital allocation), there are modest communication needs related to making sure employees and investors understand the direction of the company. But without nailing the first part of the job, management’s “promotion” is just lipstick on a pig - trying to play short-term capital markets games without an eye on the long term.

Many cannabis investors are eagerly awaiting the passage of a version of the SAFE Act that will allow US MSOs to uplist to national exchanges like NASDAQ and NYSE. It seems to be an unspoken axiom now that any uplisting will bring with it sustained expansion in multiples as institutional capital floods the space. But with institutional capital also comes institutional scrutiny, and a key part of that scrutiny is determining whether a company has good management. This kind of institutional lookback is much more in-depth than US MSOs have generally been subjected to. Institutions will want to know what management has a history of doing (and paying themselves), how they articulated those plans to investors/employees, the results of those actions, and perhaps most importantly, how they iterated on those plans as the landscape changed.

What might this kind of scrutiny reveal? In large MSOs’ case, a seemingly newly found religion of discussing cash flow metrics vs. recently only using obfuscated adjusted EBITDA with a wide variety of add backs. And, critically, add to that a very suspect history of value destroying mergers and acquisitions. Just counting goodwill impairments and asset write downs (and not merger/restructuring charges, etc.), the four largest US MSOs have already written off nearly a billion dollars in value. Sometimes accounting rules can be a bit conservative and force writedowns when true economic value over the long term is not particularly impaired - that is not the case here. By and large, many of the acquisitions and assets that are being written down and off were not just value destroying but predictably so - good management would have easily steered away from these icebergs (we privately keep a list of the most egregious, with some of the related party transactions being particularly irksome). 

Given all of this, it is difficult to see many large MSO management teams getting a “good management premium” in the marketplace post institutional-level diligence - far from multiples re-rating upwards, we think there is a material chance of management concerns forcing downwards re-ratings upon an uplisting, at least over time (it’s hard to imagine that a little bit of retail hype and broader speculation doesn’t initially creep into many of these stocks). After all, more liquidity also makes it easier to execute short positions. 

General, and later President, Dwight D. Eisenhower is famous in personal productivity circles for creating the Eisenhower Matrix: 

Cannabis investors seem to spend too much time in Quadrant 3 - urgent but not important. Resource allocation is important, but often not urgent. We hope in the future that shareholders start applying as much scrutiny to current managements’ capital allocation as many do to SAFE Act passage rumors.

Real World Examples

We spend a significant amount of time and energy thinking about capital allocation at our portfolio companies and sharing our views as collaboratively as possible with their management teams. Over time, these have become some of the best conversations we have because we are able to combine Bengal’s analysis and industry intel (which tends to come from the top down) with our portfolio companies’ (which tends to come from bottom up) and ultimately all come away with more informed views. A few examples on why these conversations are important:

Early on in our relationship with Grown Rogue, its Michigan facility was still being expanded out of cash flow. We saw, and continue to see, Grown Rogue’s facility in Michigan as an excellent performer that would generate great returns even as prices continued to compress but, critically, we did not see a strong return in incremental capital being used to continue the build out. We argued that the right move in this situation was waiting - a better use of capital was highly likely to appear as players in other markets continued to experience distress and lack of capital made new market opportunities more realistic. Obie Strickler and his team engaged with us and ultimately decided not to continue expanding Michigan. We believe this decision put Grown Rogue in a much more flexible position, which then helped it to be able to commit readily to a strategic partnership with Goodness Growth (another Bengal fund holding, and of which Bengal partner Josh Rosen is interim CEO). We believe we will continue to see the benefits of the decision not to allocate incremental capital to Michigan for years to come, particularly as Grown Rogue has recently significantly augmented its balance sheet (we estimate around ~$9mm in pro forma cash on the balance sheet from convertible debt which carried very reasonable terms, likely better than many supposed Tier 1 MSOs could attain) as well as improved its earnings.

Another example is Body and Mind’s (BaM) recent definitive agreement to sell its Ohio dispensary license for $8.25mm in cash and up to $2.5mm in additional consideration if existing dispensary licenses are granted a second license within a few years (link). We’ve written before about BaM’s disparate assets, which make the company particularly prone to undervaluing in current cannabis markets. Our counsel on capital allocation has generally been to focus on the company’s highest near/medium term return projects in its two Illinois and one New Jersey retail assets. Ohio was a well-performing store, but its value to a strategic vertical buyer was going to be superior to its value as a standalone asset in the near and medium term. Taking the cash now, paying off the senior debt, and having incremental capital with which to develop a second Illinois store and its New Jersey store is the right move in our minds for creating long term shareholder value. 

We believe our focus on good decision making, especially capital allocation, will help our portfolio companies achieve superior returns. We tend to think of trusting a management team to compound good decisions with much of the same reverence we hold for compounding financial returns. And importantly, in almost all cases, other companies’ success is not rivalrous with the success of our portfolio companies, so we continue to encourage other cannabis investors to do the same with the companies that they hold; we believe the industry continues to have a meaningful talent (including leadership) gap.

*Note: Between the first draft and publishing of this letter, Elon Musk has provided a powerful counter example to the good management of Steve Jobs by renaming Twitter to “X.” We refuse to acknowledge the name change.

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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.