Affluent clients seeking uncorrelated returns can now consider an investment that’s so alternative it was once a symbol of the counterculture: cannabis. After citizens of Colorado and Washington voted in 2012 to make legal the personal, non-medical use and possession of limited amounts of marijuana by adults, investor interest in this nascent industry spiked. “Since the election in November, we haven’t made an outbound investment call. Investors have been calling us,” says Michael Blue, chief financial officer of Seattle-based Privateer Holdings, reportedly the first private equity firm to invest in the legal cannabis sector.

Although federal law prohibits cultivating hemp and growing, selling, possessing or using marijuana, this seems to be having little effect on investor enthusiasm. And cannabis investors aren’t just aging hippies driving rusted Volkswagen buses plastered with peace signs. “We’ve been raising money from high-net-worth individuals, single-family offices and multifamily offices,” says Blue, who has an MBA from Yale. “Our investors are from all over the country and all over the world. They’re from red states and blue states. We have ranchers in Kansas, physicians in California, Wall Street executives in New York and farmers in the Midwest.”

Both marijuana and hemp are varieties of the plant species Cannabis sativa, but the two are genetically different and further distinguished by their uses and chemical profiles. Marijuana is grown primarily as a recreational or medicinal drug. Hemp has been cultivated for thousands of years to produce a wide variety of industrial and consumer goods and is being touted today as a green alternative to many products.

As of this writing, 18 states and the District of Columbia have legalized medical marijuana, with Colorado and Washington the first to legalize recreational use. Nine states have legalized growing hemp. A number of bills in the U.S. Congress that enjoy rare bipartisan support would, if passed, liberalize marijuana laws. A bill co-sponsored by Senate Minority Leader Mitch McConnell (R., Ky.) would end the federal government’s ban on domestic cultivation of hemp.

Cash Crops
Legal medicinal marijuana sales in the U.S. are projected to hit $1.5 billion this year, according to Medical Marijuana Business Daily, an industry publication that reports on legislative and financial developments. In 2014, the first marijuana retail stores are expected to open in Colorado and Washington, which could generate about $1 billion in revenue during the first full year the facilities are in operation. The combined national medical and recreational markets are expected to generate state-legal marijuana sales of $3 billion in 2014 and $6 billion by 2018.

The Hemp Industries Association says the current market for hemp products in the U.S. is about $500 million. Many hemp products are available for sale in the U.S., but beacuse of the federal prohibition on growing hemp, the seeds, oil and fibers used to make them are all imported. If hemp is legalized, the domestic market could ultimately be 10 times the size of the market for marijuana, but it’s expected to be slower to take off since hemp hasn’t been grown on a commercial scale in the U.S. for over 60 years.

In the short term, investors are focusing on the marijuana market because it’s larger right now and the infrastructure is in place in many states. Industry insiders are betting the market will continue to expand no matter what happens legislatively on the federal level. In 2016, the citizens of several states, including California, are expected to vote on whether to allow recreational marijuana use.

Business-friendly Colorado legalized medical marijuana in 2000 and has one of the fastest-growing markets in the nation. Colorado also has one of the most well-established schemes for regulating and taxing the plant. The state is now developing recreational marijuana regulations that are expected to be a model for other states, patterned after regulations on alcohol, tobacco and prescription drugs. For example, in Colorado there are no sales to those under 21 years of age, no smoking in public and no sales without childproof packaging on containers.

Joint Ventures
There are essentially two ways to make money on marijuana: grow and sell the plants or the products made from them, or participate in ancillary businesses that do not directly handle the plants.

The potential profit from growing and selling marijuana can be significant. The quality of marijuana, and thus its price, is largely determined by its tetrahydrocannabinol (THC) content. THC is the psychoactive chemical found in the resin produced by the plant’s flowering buds that creates a feeling of euphoria in users. Lower quality leaves, although consumable, are typically discarded in commercial operations.

A single mature marijuana plant can produce about 4 ounces of high-quality buds that can retail for about $200 per ounce. While plants mature naturally twice a year outdoors, they can be induced to bud about once every 10 weeks in an indoor operation that regulates light exposure. A facility with 100 plants could produce revenues of $400,000 annually. Not including labor costs, a typical investment of $10,000 to $20,000 for lights, wiring, irrigation systems, fertilizer and other growing tools could easily be recovered with the first successful harvest.

Notwithstanding the profit potential, many investors avoid any association with growing and selling marijuana because it’s risky. Regardless of what the voters in any state say, as far as the federal government is concerned, marijuana is illegal. Those who grow or sell the plant are risking raids by federal agents, prison time and civil asset forfeiture. A 1982 law bans business tax deductions related to trafficking in controlled substances, so those who grow and sell marijuana must pay federal taxes on gross sales. It’s also hard for growers and sellers to open business checking accounts and merchant credit card accounts because banks and credit card processing companies worry about the U.S. government charging them with money laundering.

Given these risks, many avoid direct contact with marijuana and invest only in the myriad ancillary business segments that support the industry, such as horticultural equipment, potency and purity testing devices, consumption devices, inventory management software and business management solutions.
Advisors should note that the definition of “ancillary” is sketchy. Federal law prohibits drug paraphernalia and bans items that are primarily intended or designed for growing or consuming marijuana. As a practical matter, many sellers of ancillary items simply market them for other uses—for example, as hydroponic equipment aimed at flower or vegetable growers. Industry experts say companies in ancillary industries, even consulting firms that offer advice on growing marijuana, are rarely targeted by law enforcement. Nevertheless, it would be wise to seek legal advice before making any marijuana-related investments, whether direct or ancillary.

Got Pot?
There are several ways to invest in marijuana, such as joining an angel investor group or investing in a venture capital fund, private equity firm or public company.

San Francisco-based ArcView Angel Investor Network was formed in 2010 to link investors with companies operating in ancillary areas of the cannabis industry. Troy Dayton, co-founder and CEO of ArcView, says it’s the only cannabis-oriented angel investor group in the country. “Investors tend to want to invest in businesses they know with a track record of delivering returns in a particular area. That doesn’t exist for this industry. So what do you do if you want to get in? Well, you need to develop relationships with people who do know the industry,” he says.

ArcView’s about 65 members run the gamut from executives who made their money in traditional industries like real estate to self-made tech entrepreneurs. The group has some high-profile members, including heirs to family fortunes, such as Joby Pritzker, whose family owns the Hyatt hotel chain. A few members are wealth managers who participate on behalf of clients. Some are entrepreneurs in the marijuana industry. ArcView president and co-founder Steve DeAngelo is CEO of Harborside Health Center, the largest medical marijuana dispensary in the world, with locations in Oakland and San Jose, Calif. DeAngelo was the star of the Discovery Channel’s 2011 reality TV series Weed Wars.

ArcView members gather at least once per quarter to evaluate investment opportunities. “Our meetings are just like the popular TV show Shark Tank. The companies pitch and the investors pepper them with questions,” says Dayton. There is one difference, though. The after-pitch parties go on until midnight and some are enjoying more than just cocktails. “It’s so interesting to see the level of engagement, the kinds of conversations that happen and the relationship-building that occurs. I think a lot of it has to do with the benefits of this plant. It gets people talking.”

Four start-ups announced funding commitments of more than $1 million at a recent ArcView forum, including Uptoke, a California-based company that makes portable handheld vaporizers. Colorado-based Canna Security America was also funded. The company provides security products geared toward the marijuana industry, including alarm and closed-circuit TV systems and safes. At present, only ancillary businesses are considered at the pitch meetings, but Dayton says ArcView plans to allow state-legal cannabis entrepreneurs.

Another way to invest is through a venture capital firm. Newport Beach, Calif.-based Ghost Group just announced that it plans to raise between $10 million and $25 million by the end of the year for a fund called Emerald Ocean Capital. The fund will target ancillary marijuana start-ups.

Investors can also get in on the action through a private equity firm, like Privateer Holdings, which invests only in ancillary businesses. As of this writing, the firm is finalizing its $7 million Series A round of funding, which it plans to use to acquire additional marijuana-related businesses to complement its existing portfolio. Privateer’s clients typically invest in increments of $200,000.

The firm acquired its first portfolio company in 2011: is an online Seattle-based start-up that advertises as “the world’s largest cannabis strain resource.” It’s been described as a blend of Yelp and Consumer Reports. The site has over 80,000 reviews of more than 500 strains of marijuana, categorized by medical benefits and side effects. The reviews are helpful for patients who seek relief from problems such as nausea caused by chemotherapy, but who want to avoid side effects such as sleepiness.

Leafly has iPhone and Android apps for mobile access to the site, which draws about 2.5 million visits per month. CFO Blue says sales are increasing 10% to 15% a month. He expects the site to generate $1 million per month in revenue within the next 12 months.

About 75% of the medical marijuana dispensaries in the U.S. are registered on Leafly. Blue says Privateer plans to expand Leafly’s revenues by turning it into a portal for news and information, as well as a venue for sales of other products and services.

“All of the acquisitions that we’re making are going to ultimately fit together in a cohesive way,” he says. One possible exit strategy is an IPO, but Blue thinks it’s more likely Privateer’s portfolio companies will ultimately be acquired by a Fortune 500 company in the alcohol, pharmacy, retail or agricultural industry.

So far, there aren’t many private equity firms in this space and they tend to keep a low profile. According to a May 2013 news report from Medical Marijuana Business Daily, an unnamed private equity firm launched a $250 million fund to offer cash advances to marijuana-related businesses through a third party, Guardian Data Systems, a provider of financial services to high-risk merchants. Interest rates charged to borrowers will be between 14.9% and 28%.

Another private company has recently surfaced in the media: Diego Pellicer in Seattle, which was founded by ArcView member Jamen Shively, a former Microsoft executive. The firm is calling itself “the first retail brand in the United States focused exclusively on legal, premium marijuana for pleasure and creative pursuits.” The company is reportedly raising $10 million in start-up capital to build a $100 million chain of stores, first in Colorado and Washington, then in other states, should marijuana be legalized elsewhere. They’re billing themselves as the “Davidoff of marijuana”—a reference to the high-end tobacco brand.

As for public companies, there are already at least 20 that sell products and services directly to the medical marijuana industry. A number of small-cap stocks could gain from an expanding market. Winners might include Medbox Inc. (MDBX.PK), a $404 million market cap company that sells its patented dispensing and storage systems for medicine and merchandise to licensed medical marijuana dispensaries. The West Hollywood, Calif.-based company’s first quarter 2013 revenues increased 20% year over year. Medbox’s stock was trading below $3 per share last October, but rocketed to $215 a share in November after the ballot initiatives passed in Colorado and Washington. As of this writing, the stock is trading at about $27 per share.

At least one pharmaceutical company is already selling medical marijuana. British drug manufacturer GW Pharmaceuticals (GWP), which trades on the London Stock Exchange’s Alternative Investment Market, recently licensed its Sativex liquefied marijuana to drug giant Novartis, which is marketing Sativex in Europe, Asia, Africa and the Middle East. Sativex is currently sold to help relieve symptoms of multiple sclerosis. In the U.S., major pharmaceutical companies are reportedly seeking Food and Drug Administration approval to market cannabis-derived drugs for use in treating a variety of chronic conditions, including pain.

Green Revolution

While some are calling cannabis an alternative investment, many say it’s also an impact investment—one that can provide financial as well as social and environmental returns.

Dayton says cannabis investors want to make a difference. “Activism has brought cannabis policy 90 yards down the field. But it’s going to be business that takes it the other 10, because business is the most powerful platform for political change,” he says. “So if you want to see cannabis legal in this country, one of the best ways to do that is to make sure that it’s a well-capitalized, professional, responsible and politically engaged industry.”

Many of ArcView’s members serve on the board of the Marijuana Policy Project or are major donors to political and public education efforts about cannabis reform. “They see this as part and parcel to their other activism and their philanthropy,” Dayton says.

A number of Privateer’s investors share this view. “Ultimately, it comes down to high-net-worth individuals and families who are looking to make a significant financial return and a social return, in terms of ending cannabis prohibition and the harms that it causes,” says Blue.

Reforming marijuana policy has some vocal and high-profile backers. Billionaire Peter Lewis, chairman of Progressive Insurance, is a longtime marijuana advocate. He reportedly donated several million dollars to groups that backed Colorado’s and Washington’s marijuana legalization efforts. In October 2011, he wrote an article in Forbes calling the nation’s marijuana laws “outdated, ineffective and stupid.”

Former Mexican President Vicente Fox appeared at a news conference for Diego Pellicer, saying he backs nationwide legal marijuana markets in the U.S. to combat the deadly drug violence that has ravaged Mexico for decades. “Every dollar spent in the legal cannabis industry is a dollar that’s not going to criminals,” says Dayton.

Legalizing marijuana also means it can be regulated and taxed by revenue-hungry state and local governments. Hemp proponents say legalization could usher in a green industrial revolution that has the potential to boost the economy, create jobs and improve the environment.

As for the mythical bus full of hippies, Dayton thinks they may be on to something. “The hippies keep being right. They were right about personal computing, renewable energy and organic foods. They’re right again about cannabis. Good ideas bubble up from the counterculture. That’s how laws change. That’s how business changes. And it’s happening again right now,” he says.