Bengal Capital - Q3 2024 Letter

A Steph Curry on Every Corner

Dear Investor,

The Bengal Catalyst Fund, LP’s (the “Fund”) performance (preliminary estimates, net of fees, and unaudited) is presented below alongside that of MSOS, a US cannabis-focused ETF. We do not consider MSOS a benchmark but rather a reasonable indicator of US cannabis investor sentiment.

*Note that the above figures net out our current estimate of incentive allocation for the period. The final numbers may be slightly different from what we estimate, but hopefully not materially so. 

The Fund was approximately flat in the third quarter.

A few reminders: 

• Your results may vary from those above depending on time of investment

• The above figures do not include the results of any side pockets

• We expect our returns to be volatile given the illiquidity and concentration of the Fund’s portfolio. Regarding the last point, we fully expect that there will be periods in which we underperform the broader cannabis equity market as we seek to generate sustainably better longer-term returns.

Your individual account statements should be available soon at the Panoptic investor portal. Please reach out to us if you need help accessing them.

As is our usual practice, we are sharing some thoughts regarding the cannabis investment environment below as well. Please feel free to share with others.

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Bengal Commentary - Q3 2024

A Steph Curry on Every Corner 

Portfolio Review

The Fund continues to hold the publicly traded equity of Grown Rogue, Vireo (formerly Goodness Growth) and Body and Mind (BaM). In private positions, the Fund continues to hold BaM convertible debt and now BaM term debt (discussed more below), and has recently added an investment in the preferred equity of a cannabis-focused reinsurance business. The XS Financial go-private transaction noted in last quarter’s letter closed towards the end of Q3 and the cash for the fund’s shares was received in early Q4.

Individual commentary on portfolio holdings is below.

Vireo

After the end of Q3, Bengal partner Josh Rosen left as Vireo CEO and departed from the board. In our view (our bias should be apparent), Josh demonstrably improved Vireo’s trajectory, most notably leaving the company with a more flexible balance sheet and a significantly improved operational foundation, positioning Vireo to capitalize on the ample opportunities in front of it - most notably the anticipated launch of adult-use sales in their home market of Minnesota in 2025.

Grown Rogue

Last quarter, we converted the vast majority of our stock into non-traded multiple voting shares so that the company could keep its FPI status for another year (read: keep compliance costs lower by not having to comply with the full gamut of US securities laws). We patted ourselves on the back for being such committed long term investors. This quarter, at the company’s request, we converted back to “normal” stock since the company is simplifying its capital structure in anticipation of being a typical SEC reporting company next year - but we still are patting ourselves on the back as long term investors! 

As New Jersey was transitioning into its adult use market, the cannabis industry was experiencing a dearth of capital availability - even worse than the situation today. We believe this led to less capacity being built to serve a burgeoning adult use market than would typically be the case, which in turn has created an environment where wholesale pricing should stay robust for longer than usual, producing a longer period of surplus profits. We believe this will be a tailwind to Grown Rogue’s New Jersey flower sales starting towards the end of this year, and look forward to seeing how the company does there.

Body and Mind 

As recently announced, the fund has extended a loan of approximately $2.3 million to BaM. The primary use of proceeds is to enable the continued buildout of BaM’s unfinished Illinois and New Jersey dispensaries. Building out the dispensaries as quickly as possible helps retain their value as strategic assets - BaM can either push forward with operating the assets as quickly as possible to take market share, or it will be in a better position to attain reasonable valuations in sales. Either way, we feel that the asset base is worth more than Bengal’s combined debt investments in BaM, and think that the fund is being properly compensated for the risk incurred.

The term loan carries 18% annual interest, paid monthly in cash, as well as a 5% original issue discount, sits senior secured on top of BaM’s capital stack, and matures in 24 months. As part of issuing the term loan, BaM’s convertible debentures (in which the fund holds a position) were also modified - the interest rate was increased to 15% (50% cash and 50% paid-in-kind), as well as the convertible debentures now becoming secured in second position behind the term loan. Additionally, any key asset sales or extraordinary proceeds received by BaM must, per the terms of the term loan and convertible debentures, be used to pay off first the term loan and then the convertible debentures.

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On Politics

We try to avoid long discussions of political predictions, but some short thoughts on things that seem to be top of mind for investors.

We have seen commentary recently that suggests that a final rule regarding Schedule 3 will occur before inauguration or shortly thereafter. We find this timeline unrealistic - investors should anticipate that the full process takes longer than that. 

On Florida’s Amendment 3, it seems that the polling is going the industry’s (read: Trulieve’s) way. Trulieve has invested more than $70 million into A3’s passage. If it succeeds, they can take a well deserved victory lap. If it fails, investors will want answers and to have their expectations set on how the company will look moving forward. So, we are surprised that Trulieve would choose to schedule its Q3 earnings call on the morning of election day before any results could come in, rather than the day after. This is not something we would expect to see in more mature industries, but it certainly seems at this point like Trulieve’s investment will be well worth it so maybe the plan is to have an early earnings call and then another victory lap call the next day?

A Steph Curry on Every Corner

It’s widely regarded that Steph Curry is among the greatest shooters the game of basketball has ever seen. Down by 2 points, with 1 second left in the game -  there is almost no one else you’d rather have taking the potential game winning three point shot. In fact, since he entered the league, Curry has vastly outperformed the league wide 3 PT shooting %. 

There is a treasure trove of data both past and present indicating that Steph Curry is an exceptionally great shooter when compared to his NBA cohorts. 

The more interesting question is why can’t others shoot like Steph Curry? Is it just more practice? Greater Skill? Some innate ability? A combination of all? There is no perfect answer - but the proof of his value and contribution to his team are reflected in his contract and multiple NBA titles. 

We liken the “Steph Curry vs the rest of the NBA” analogy to the narrative being spun when comparing cannabis operators (especially MSOs). When one MSO consistently leads the pack in a state or region in terms of margin profile or profits it is given a tiny amount of credit (think GTI in general or TRUL in Florida). When others with similar geographic footprints consistently underperform - they are thought to have “upside” or “room for improvement.” To us, that’s the same line of reasoning as saying Russell Westbrook will eventually be as good of a 3 point shooter as Steph Curry only because he has underperformed for so long that he’s due to “catch up.” Nothing could be further from the truth.  

At this point, the better company has had consistently superior numbers for years on end. What makes anyone think that an underperforming MSO is suddenly going to turn around operations and come in line with its consistently best-in-class competitors?  Just as the magic that makes Steph Curry is a multitude of factors - the things that make a premier operator so much better than its competition are also hard to pinpoint and not something easily replicable across companies, and as we’ve highlighted, often across different markets for the same company (example - TRUL hasn’t been able to recreate the magic they have had in Florida in any other state they operate within).

The premier companies deserve premium multiples as their operations and ability to outperform should compound over time. If you don’t believe so - our team members are available for your next pick up game for far less than an NBA player. Just because we’re never shot like Steph Curry doesn’t mean we can’t reach that level…consider us “high upside” players. 

Operational Rigor

We have often focused on operational rigor as one of the key competitive advantages that is underappreciated by many cannabis investors. When it comes to forecasting a company’s future success, we believe that operational rigor both enhances upside by allowing a company to extract more profits during high prices and mitigates downside by allowing companies to make decent profits even in mature markets. 

In assessing operational rigor, we try to look for companies which have demonstrated operational rigor and business success in mature (read: competitive and low-priced) markets which have an active ecosystem of competitors. The paradigm example, which we have written about many times before, is Grown Rogue. In looking at their results, we saw that they could make a small profit even in one of the most competitive states in the country. We believed that the kind of operational rigor that Grown Rogue showed would create substantial profits when taken to new markets. Michigan was the first demonstration, and we believe that Grown Rogue’s upcoming entry into New Jersey will continue its impressive trajectory.

Grown Rogue’s operational rigor is made up of many factors both big and small, but they are all contained roughly in the area of indoor craft cultivation. Broadly, this is an operational competence that we believe “travels” well when mapped against an achievable number of new opportunities- it is not difficult to see how an edge in craft indoor cultivation in a competitive market translates into a new, less competitive, one. Critically, it is also easy to see what did not contribute to Grown Rogue’s edge: state regulatory structure. The high amount of licenses in Oregon provide no meaningful barrier to entry - a company survives or dies on its operations. The lack of regulatory factors contributing to Grown Rogue’s success make it, paradoxically given the often myopic focus on “limited license markets,” easier to underwrite its continued success. 

Grown Rogue is sometimes compared to other small cannabis operators that have been able to demonstrate consistent cash flows in their home markets, but these comparisons miss the critical differentiator of Grown Rogue: when you break down the reason for their success to operational competence, you can build a much more “firm” trajectory of future success in taking that operational competence to other markets. Many of the other small operators Grown Rogue is compared to had a different road to achieving their relative success, and that road often involved at least some competitive advantage from regulations like limited retail licensing.

Multiples 

Where at least some of a company’s success is due to regulatory structure in its home market, it is more difficult to unpack how much “luck” and how much “skill” was involved in the company’s success. Therefore, it becomes more difficult to forecast how successful a company will be in its future growth. Where this matters most acutely as investors is in valuation - colloquially what “multiple” is appropriate for cannabis companies. Simply, and all other things being equal, a company that has relatively more of its success attributable to “skill” deserves a higher multiple than a company that has had more likely “luck.” 

To be clear: the ability to successfully identify and enter markets with favorable regulation is its own “skill,” but just not one that we think has the same kind of “traveling” ability or staying power as operational rigor - given how quickly even “good” regulatory markets can mature, we don’t see this skill as a sustainable advantage for growth.

In our mind, Grown Rogue deserves a much higher relative valuation than a stable vertical operator in a state with relatively limited retail licenses that has produced consistent cash flows for years, because it is so much more difficult to draw a convincing trajectory for growth of the latter company. If cash flows are not set to grow meaningfully in the future, a high multiple is not justified - regardless, unfortunately, of the success the company has had in the past and the admittedly under-appreciated accomplishment of generating consistent free cash flows in cannabis. 

Again, to be clear: we are not saying these latter companies are bad companies. We often even admire their accomplishments and appreciate them more than some industry peers. But we cannot justify assigning a growth multiple to such companies because we do not see significant potential for future cash flow growth, and so we often find them to be roughly fairly valued at current prices.

The other side of the coin is why we are so skeptical of “systematic undervaluation” arguments for most other large cannabis companies - while we acknowledge they will likely make super profits for a few years as they get a bounce from a new state going to adult use, eventually their results will tend to drift down to a level where reliable profits are in significant doubt. In finance speak, we are skeptical that the “terminal value” of many of the large cannabis operators is positive - the adult use bumps are temporary reprieves from bankruptcy more than they are proof of the need for significant multiple expansion. How many folks are talking about what Florida is going to look like in 2027, yet a DCF cares intimately? 

Operational Rigor Wins Early And Often

We most often discuss scrappy operations as important in the mature stage of cannabis markets, but here we want to highlight how much of a difference operational rigor makes in the salad days of early markets as well. 

Skymint, a Michigan operator which is currently being parted out in receivership after failing, grew cannabis at $1,000 per pound in costs, according to a recent article (we are assuming this includes attributed overhead, even though it likely refers just to COGS). Skymint owes more than $120 million to its lender, and also had IIPR properties in which north of $50 million was invested. Yet, its $1,000/lb cost is significantly higher than our conservative estimate of Grown Rogue’s (4 Wall EBITDA costs including attribution of in-state overhead but not general corporate overhead such as public company reporting obligations, etc.) of $600-700/lb. 

At the end of the maturation cycle, the cost difference (despite the multiple orders of magnitude of invested capital difference!) is the difference between death and survival. But transplant these same numbers to early in a market like New Jersey and operational rigor still makes an enormous difference: that $300/lb+ in cost difference falls straight to the bottom line. At Grown Rogue’s NJ target production of 1,000 pounds of whole flower per month, that’s easily $4 million per year in extra cash flow from the start - a huge difference in capital returns. And, exactly the kind of economics that drive a deservedly high multiple.

How Hard Is It?

Much harder than most investors seem to think is the answer. Skymint, Parallel, and others serve as a cautionary tale. Revolutionary Clinics, a Massachusetts private operator with substantial capital invested in addition to sale leaseback investments of over $42 million provided by New Lake Capital Partners, is another recent example. As business seemingly got more difficult, Revolutionary renegotiated its leases and entered into a forbearance agreement with NLCP in November 2023 to lower their lease expense and presumably allow the business to work out of the hole. 

But, just seven months later, Revolutionary was unable to fully pay its new, lower, lease obligations - NLCP disclosed in its Q2 2024 financial statements that Revolutionary had “failed to pay 50% of its June and July 2024 contractual rent.” This is a difficult business, and investors will be surprised to see how difficult it is for many larger “Tier 1” operators when the buoy of high prices is removed. There’s likely a reason so few MSOs share details on their performance in Massachusetts, despite operating in the commonwealth. 

What Will Save Us?

Many investors point to the seemingly impending elimination of 280E through rescheduling to Schedule 3 as a potent upswing for cannabis companies. Leaving aside that many large cannabis companies are already not paying “280E taxes” and therefore actual, reported, cash flows will not be boosted by 280E elimination, investors seem to be vastly over estimating the robustness of how long the increased net margins of 280E elimination will stick around.

Elimination of 280E is, functionally, just a tax rate change. So, while it would be a bigger tax cut, the elimination of 280E looks a lot like the 2018 Tax Cut and Jobs Act corporate tax cut from 35% to 21%. What happened to net profit margins of fairly competitive industries after that tax cut? As the chart below shows, there was no significant, durable step up in profits after 2018’s change (this graph cuts off before COVID starts to introduce significant noise into the results):

In our minds there is no reason to think that the effect of 280E removal will be anything but modest on actual cash flows in the medium to long term. At a minimum, conservative underwriting demands this view.

Whether 280E removal “unlocks” some kind of magical trading event or change in perceptions by “institutional capital” is something we continue to be skeptical of. If future cash flows are not more than modestly affected, any long term “multiple expansion” would not be based on fundamentals. Good traders may make some money, but the Dunning-Kruger effect seems to be strong in the trading community.

Who Will Save Us?

As the tide turned in cannabis capital markets a few years ago, some companies decided to return to the standard corporate American playbook as a way of turning things around: the executive search. And that executive search produced exactly the standard result many would expect: an “outsider” CEO from a more “professional” industry with stellar credentials. The lessons of Green Growth Brands, which crashed and burned under the leadership of Victoria Secret’s highly touted ex-COO, seemed to have been lost to time before apparently being re-learned by both Ayr and Ascend when they recently axed their poorly performing outsider CEOs.

After a disastrous tenure of outsider leadership, Nike seems to have learned its lesson as well. Here is the resume of Nike’s new CEO:

The odds of an outsider CEO righting a sinking cannabis ship are small. Investors should realize that the best executive talent in this industry is actually undervalued and act accordingly.

This is not to say that investors should blindly trust insider CEOs who have a long tenure in the industry, especially when that tenure does not have a clear record of business/operational success attached to it. Take, for example, the recent “retirement” by Curaleaf’s CEO and his replacement by the firm’s long time, and deeply involved, chairman. Here, a long-time chairman stepping into the CEO role is not so much a return to a company’s operating “roots” that should be celebrated, but instead something that should give investors pause as to the quality of those roots to begin with.

Conclusion

We continue to try to look at the cannabis industry with a long-term rational lens. This means we often look at things almost no one else will touch (a private cannabis reinsurance company? really?). Rather than continue to troll for different theses on how to make money in cannabis, we are happy to lean into the simple insights that we think have produced our success so far. We continue to be excited especially by the prospect of investing in under appreciated, demonstrated operating talent honed in mature markets.

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Should you wish to respond to this letter or discuss anything within it, please reach out to Bengal partner Jerry Derevyanny at jerry@bengalcap.com. We are always happy to thoughtfully engage with those that agree and disagree with us.

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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.