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Navy Capital’s one-room office in midtown Manhattan could probably fit in the coat closets of many of its competitors. But the hedge fund’s digs belie the firm’s success in betting on something few of its peers will touch: cannabis.

Since the Navy Capital Green Fund launched in May 2017 the company said it’s increased assets under management to almost US$100 million from US$10 million and returned more than 100 per cent net of fees last year.

As for 2018, “we’re having a good year so far,” Sean Stiefel, Navy Capital’s 30-year-old founder said in an interview at the company’s office on Lexington Avenue, where the only adornment is a white board labelled “prospects.”

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As Canada moves toward legalization of recreational marijuana on Oct. 17 and the U.S. shows signs of growing leniency, hedge funds such as Navy are leading the advance of institutional money into a sector that’s so far been dominated by retail investors.

Uruguay, Really?

Currently, institutions account for only a fraction of shares held in many pot companies: big firms hold 6.5 per cent of Aphria Inc. and just 5.2 per cent of Aurora Cannabis Inc., both members of the Canada’s S&P/TSX Composite Index, according to data compiled by Bloomberg. By comparison, 76 per cent of portfolio stalwart Rogers Communications Inc. is held by institutions.

For the few cannabis companies that are cross-listed on U.S. exchanges, institutional ownership is higher. About 18 per cent of Canopy Growth Corp., which trades on the New York Stock Exchange, is held by institutions, while Cronos Group Inc., listed on the Nasdaq, is at 22 per cent.

Navy Capital’s foray into cannabis investing started in 2016 when it got a call from a Canadian broker urging them to look at ICC Labs Inc., chosen by Uruguay to produce recreational marijuana after it passed a law legalizing the drug in 2013.

Chief Investment Officer John Kaden, 44, said they almost didn’t take the call. “I mean, cannabis in Uruguay?”

But the growth projections couldn’t be ignored and Navy bought in at a C$40 million valuation before Vancouver-based ICC listed on Canada’s TSX Venture Exchange through a reverse takeover. Four months later when it had reached a market value of C$160 million, they sold. It’s worth about C$206 million now.

“After that we were like, ‘How do we learn as much as we can?”’ said Stiefel. “I went to Israel, Australia, Europe, Canada and we really tried to spend the latter half of 2016 understanding the landscape.”

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Roller coaster Ride

Today, about half of Navy’s portfolio is invested in Canadian companies that it considers “properly valued,” including CannTrust Holdings Inc., Hydropothecary Corp. and Organigram Holdings Inc. The remainder is split between the U.S. and Europe, Israel and Australia. The fund invests in both public and private companies and sees the best investment opportunities shifting from Canada to the U.S., Europe and Latin America.

“We’re staying at the bleeding edge in the newer markets that are just legalizing,” Kaden said.

Canadian pot stocks have had a wild ride in the past year with the BI Canada Cannabis Competitive Peers Index surging about 250 per cent from October to December as the road to legalization became clearer in Canada, before dropping by about 36 per cent this year. The index is up about 109 per cent since it began in January 2015.

Still Leery

While hedge funds like Navy are embracing the pot space, pension and mutual funds are still reluctant, said Chris Barry, a Seattle-based lawyer at Dorsey & Whitney LLP who works with cannabis firms. That’s not because they don’t see a compelling investment opportunity.

“I know personally of a number of occasions where a company has walked into a major mutual fund, an everyday name that you would know, and said, ‘How about it?”’ Barry said in a phone interview. “And people around the table have said, ‘Oh, our fund couldn’t possibly consider doing that,’ and then they pulled out their checkbooks and invested personally.”

Many U.S. funds don’t want to run afoul of investors and regulators in a country where marijuana is illegal at the federal level. That’s less of an issue for specialty hedge funds and family offices that fly under the radar. “It’s much easier for them to decide to assume the legal risk that Jeff Sessions is going to show up at the door someday than it is for a publicly listed mutual fund or a union pension fund,” Barry said, referring to the U.S. attorney general.

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Family Office

Pension giants the California Public Employees’ Retirement System and the Canada Pension Plan Investment Board said they have steered clear of the sector, while The Vanguard Group Inc. said it only invests in the stocks through its indexed products. BlackRock Inc. declined to comment.

Some cannabis firms are taking matters into their own hands, hiring people with capital markets experience to help lure institutional investors to their stocks. Last month, Khiron Life Sciences Corp. appointed Chris Naprawa, formerly a partner at Sprott Capital Partners and head of equity sales at Macquarie Canada, as its president with the goal of boosting the Vancouver-based company’s visibility to institutions. Naprawa said he hasn’t seen much appetite from large Canadian investors, but U.S. family offices and hedge funds are starting to buy into the space.

Gaining Legitimacy

Investors say the industry has received three stamps of legitimacy in the past 12 months: Tiger Global Management, the US$22 billion investment firm, bought a stake in San Jose, California-based cannabis software startup Green Bits Inc.; alcohol giant Constellation Brands Inc. bought a 9.9 per cent stake in Canopy Growth; and GW Pharmaceuticals Plc received approval from the U.S. Food and Drug Administration for a cannabis-based epilepsy treatment, the first marijuana-derived medicine to get the green light in the U.S.

“Those types of breakthroughs are breaking down stigmas,” said Charles Taerk, chief executive officer of Toronto-based Faircourt Asset Management Inc., which runs the pot-focused UIT Alternative Health Fund. UIT, with about C$20 million in assets, caters primarily to retail investors.

Like Prohibition

San Francisco-based Poseidon Asset Management LLC, one of the longest-running hedge funds in the cannabis space, said it’s seeing tentative interest from bigger institutions but they may not take the plunge until U.S. federal laws change.

“They’re all interested in getting educated but they don’t feel necessarily compelled to jump in yet,” said Morgan Paxhia, who co-founded and co-manages Poseidon with his sister Emily. “We’re just trying to build those relationships for when they do.”

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Poseidon launched in January 2014 and has assets under management of more than $60 million. The fund has invested primarily in private companies for high-net-worth individuals and family offices, but plans to gradually increase its public exposure to as much as half its assets.

Another factor keeping the biggest investors away from the space is that most cannabis companies are still relatively small, said Kaden at Navy Capital.

“The reality is the Blackstones of the world can’t make this a core part of their business because it’s not going to move the needle for them,” he said. “They have to be able to deploy US$1 billion to move the needle and right now it’s hard to deploy a couple hundred million.”

It may only be a matter of time. There are at least 91 publicly traded companies in Canada with a combined market value of more than C$30 billion, according to data compiled by Bloomberg. The largest of those, Canopy, has a market value of C$7.8 billion.

“I find this space so exciting, it’s like getting involved in liquor right before prohibition’s about to be eliminated,” said Navy Capital’s chief financial officer, Kevin Gahwyler.