Canopy pays $300-million to secure right to buy Acreage Holdings

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Canopy Growth Corp. said it will pay US$300-million to secure the right to buy U.S. cannabis producer Acreage Holdings Inc. should federal marijuana laws change in the United States.

Canada’s largest cannabis grower will pay US$2.55 for each Acreage share up front in cash. That gives it the right to acquire the New York-based company for shares that were valued on Thursday morning at US$3.4-billion, a 42-per-cent takeover premium.

The highly unusual deal, which does not expire for 7½ years, links the companies’ fates. A full acquisition would be automatically triggered upon certain changes to U.S. federal law. Cannabis is still a Schedule I illegal drug in the United States. However, more than half the states have legalized the drug, for either medical or recreational use, at a state level. The U.S. Congress is considering legislative changes that would either legalize the drug, or offer protection to states that have legalized it.

Canadian licensed cannabis producers have spent the past several years raising billions of dollars on the assumption that they will become global market leaders and will need the money for international expansion. However, some have been unable to participate in the largest and most sophisticated cannabis market in the world largely because of stock-exchange rules.

Canopy cannot own assets in the U.S. cannabis market as a result of Toronto Stock Exchange and New York Stock Exchange listing rules prohibiting engagement in federally illegal industries. Thursday’s deal offers a way to stay onside those rules, while still securing a bigger U.S. foothold.

If an acquisition of Acreage follows, it would mark one of the first significant cross-border acquisitions in the legal cannabis industry and could change the face of merger activity in the rapidly growing sector.

“We really liked what Acreage had built and bought," said Bruce Linton, chairman and co-chief executive of Canopy Growth, noting that the companies began discussing a deal in January. “We can lend them licensed access to our knowledge, know-how, brands and trademarks, so they can deploy that to advantage.”

As part of the deal, Acreage will get U.S. licensing rights for Canopy’s brands, including Tweed and Tokyo Smoke.

“Cannabis is still federally illegal in the U.S., but the lack of regulation has allowed products to evolve much more rapidly than in Canada. We continue to believe differentiated branded products are key to long-term success, and this appears to be a much more significant opportunity in the U.S. than in Canada,” Michael Lavery, senior research analyst with U.S. investment bank Piper Jaffray, said in a note to clients about the Canopy announcement.

Because of banking restrictions, U.S. companies have had to come to Canada to raise money, with many U.S. multistate operators (MSOs) – including Acreage – listing on the Canadian Securities Exchange.

Acreage, one of the largest MSOs, has licenses to operate cultivation facilities and dispensaries in 20 states. The company is still early stage: It reported $10.5-million in revenue in the fourth quarter of 2018 and posted a $217.6-million net loss. But it has managed to attract high-profile directors, including former prime minister Brian Mulroney and former speaker of the U.S. House of Representatives John Boehner.

“Part of the reason we like Acreage is that the board members they’ve attracted mean that, by default, they’re careful about how they conduct themselves,” Mr. Linton said.

Canopy, whose largest shareholder is U.S. beverage alcohol giant Constellations Brands Inc., has been probing the U.S. opportunity for more than a year. Through the use of conditional warrants, which give it the right to buy stock later, Canopy has already made investments in U.S.-focused businesses such as TerrAscend Corp. and Slang Worldwide Inc.

It also began investing in U.S. hemp assets after the passage of U.S. hemp-reform legislation in December, which removed hemp-derived cannabidiol from the Controlled Substances Act.

Canopy intends to spend upward of $2-billion expanding its U.S. hemp assets over the next two years, Mr. Linton said. Upon federal cannabis legalization, these assets can quickly transition to servicing the cannabis industry, he added.

The Acreage deal comes amid a push in the U.S. Congress for broader cannabis reform. Legislation that would increase access to banking services for cannabis companies was introduced in the House last week. Also before Congress is a bill called the STATES Act, which would prevent federal cannabis prohibition from applying in states that have legalized the drug.

“With the reintroduction of the bi-partisan STATES Act two weeks ago, conversations around the potential for M&A between the U.S. and Canadian operators has unsurprisingly increased meaningfully,” Vivien Azer, an analyst with U.S. investment bank Cowen Inc., said in a note to clients.

Acreage CEO Kevin Murphy said he expects the STATES Act to become a major political issue in the next two years.

“It’s going to play a massive role leading up to the 2020 election. … It’s going to be a fight between the Democrats and the Republicans as to who gets credit for legalizing cannabis,” Mr. Murphy said.

Ahead of legislative change, conditional deals such as the one between Canopy and Acreage could become more common, said Jonathan Sherman, co-lead of Cassels Brock & Blackwell LLP’s cannabis group and one of the legal architects of the deal.

“The Canadian TSX-listed [cannabis] companies will look to replicate this structure, no doubt,” Mr. Sherman said. “And this is kind of a road map for anybody. Whether that’s alcohol, tobacco, CPG, pharma, it’s an opportunity to get access to a market that everyone kind of saw as restricted."

Canopy won’t exercise control over Acreage before the acquisition. The deal, however, was designed with certain “guardrails and guideposts,” Mr. Sherman said. Acreage will have to consult with Canopy on certain decisions, and has agreed to a cap of 58 million on the number of shares it can issue in M&A transactions.

To enable the deal, Constellation Brands agreed to change the structure of the warrants it owns in Canopy, in order to maintain its option to acquire a majority of the company.

Shareholders of both Canopy and Acreage still need to approve the deal, and votes are expected in June. Canopy shares rose 4.4 per cent on Thursday, while Acreage shares declined 0.6 per cent. Constellation Brands rose 3.8 per cent.