Where did natural foods investments go?

Natural foods pioneer and veteran investor Steve Hughes suspects that for about five years leading up to the end of 2021, more capital was funneled into the industry than during the previous 50 years.

"It was unchecked," he says.

But the environment today—slightly more than a year after the end of an epic parade of fundraising and new natural foods brands—serves as the boom's opposite: a bust. Investors have turned off the spigots. The next few years could be brutal.

"This is the toughest time, really beginning with COVID, that I've ever seen. It's jarring," says Hughes, who first became involved with the industry in 1978 and now is a co-founder and managing partner with Sunrise Strategic Partners, a natural foods investment and management firm in Boulder, Colorado. "I've spent the past six months with the Boulder natural foods community. Every conversation is the same. They've been at it for 10 years. They have between $10 million and $15 million in revenue. They ask how do I fund this? And I don't have answers."

What investors want varies

What Hughes refers to as a "perfect storm" upended the industry's investment landscape. COVID disrupted everything; supply chain complications punished brands; then labor shortages and inflation followed. Along the way, investors from other areas, such as tech, began dumping money into natural foods. Ditto for multinational traditional food conglomerates hunting for routes toward millennial and Gen X consumers. In both cases, those investors understood little about the quirky natural foods industry. Throughout 2022, too, the stock market has been sinking, prompting investors to seek especially safe bets.

Related:Securing capital in 2022: How to survive and maybe even thrive

While founders and brands for years could point toward growth and revenue as rationales for fresh capital, Hughes says the only companies that now receive solid investments are either profitable or have clear paths toward profitability. Also, they have extremely polished and savvy leadership teams—people who understand all the complexities surrounding building brands in natural foods.

"Every boom has an end. Free money is free money," Hughes says. "I think there will be a hangover effect. All of this money came into the space from 2015 to 2022, before the bubble burst. There will be a lot of capital lost."

Natural foods' new world has affected Alex Bayer, the founder and CEO of coconut beverage Genius Juice in the Los Angeles, California, area. Investors are much more choosy and careful now, he says. Rather than hunting for new prospects, they are doubling down on existing portfolio companies. Instead of focusing on revenue, they seek well-run companies with sustainable margins.  

"It has impacted us with higher costs, and having to cut back dramatically to make sure we lower net losses and continue to find a pathway to profitability amidst the market conditions," Bayer says. "We have been able to weather the storm. However, capital has become much tighter and we are much more judicious about where capital is going. It needs to go toward items that bring immense value to our company."

The natural foods market today, he says, is a story of haves and have nots, in terms of capital. Most companies don't have it and need to make enormous adjustments to their budgets. At the same time, they have to find ways to increase margins even as costs for everything remain historically high. Manufacturers also need to find creative ways to boost sales while consumers are holding back.

Bayer's straightforward but tough-to-achieve advice? They must build "better margins, cut their operational expenses and find a realistic pathway to profitability."

CPGs need to know their customers

Where Hughes is a large investor, looking for companies with $20 million in revenue or more, Ben Fenton with BFG Partners in Boulder looks for smaller bands with annual revenues of a few million.

He believes that "probably too much money" was brought into natural foods prior to the bust.  

"Valuations got disconnected from fundamentals, especially with CPGs," Fenton says. Another factor that contributed toward the natural foods boom was direct-to-consumer plays, he says. Until the past few years, products needed strong partnerships with distributors and retailers to have a shot. But the explosion of online shopping, especially in the wake of COVID, promoted investments in brands that lacked strong distribution networks.

"It's acutely more painful for earlier stage brands, exacerbated by supply chain challenges we have seen that predated the war in Ukraine," he says. "The whole chain is under stress and [that] inevitably leads to longer lead times, which ties up cash."

Looking ahead, Fenton says brands will need to exercise much more discipline about where they are selling their products. Many brands were a "mile wide and an inch deep" in terms of their distribution, he says.

"Brands need to focus on their core markets and geography, and understand why people are buying the product," he says. "What works in terms of marketing? Do people re-buy the product? All of this leads to more efficiencies. We are willing to trade growth for healthier revenue and higher repeat-purchase behavior."

Fenton is optimistic about 2023. Good opportunities still exist in the market. BFG Partners has capital to deploy and is actively searching for investments, he says.

Hughes says that good news in coming years is that "commodity prices will come down and there will be a lot of money to be made."

"Pricing will be sticky. Prices go up in food and beverage, but they don't come down," he says. "Costs will increasingly become normalized. In a couple of years, the wind will be at the backs of the brands that survive."