Search Fund

What is a search fund?

Search funds (SFs) are great tools for budding entrepreneurs with an eye for spotting strong product/service offerings or business models. These funds have performed extraordinarily and can be a great vehicle for making strong investments.

Started in 1984, these investment funds have gained significant popularity over the decades. This may be on account of increased interest in entrepreneurship or because the numbers coming in for search funds are extremely favorable for investors.

This presents itself as a great opportunity to be entrepreneurial for the fund's management team. This is because the fund managers have the ability to start with a business they have already identified and vetted and believe they can manage successfully.

Why start this type of fund and not a PE fund, or just invest in the stock market? What are the unique benefits of this investment vehicle? How does it work, and how does one get started? We will address all this and more throughout the article.

Understanding A search fund

They are investment vehicles that offer potential entrepreneurs a quick way to start managing a target business, with purposeful ownership, for a fair price. The funds are typically pooled by hopeful managers and occasionally by outside investors (LPs and/or GPs).

According to some sources, this investment class is growing in popularity significantly, over 400% during the past 5 years, which works out to about 32% growth per year.

Essentially the same as a management buy-in, the fund managers interested in participating in managing an acquirer have the option to do so. Another term applicable to search funds is entrepreneurship through acquisition.

However, search funds may have a management team with limited experience in some structures. In this case, mentorship might be obtained from investors in the fund, management team members kept on after acquisition, and (for a fee) consultants.

These funds mostly target companies of $5 - $30 million of enterprise value.  Therefore they effectively target the lower-mid market of businesses and may dip below this class.

It may be associated with private equity investment. Where private equity funds seek to invest in and operate businesses, a search fund fundamentally does the same, but typically with only 1 company.

Unlike private equity funds, SFs allow the management team to narrow their focus more and/or run smaller teams by only having to worry about 1 or a few companies instead of a portfolio of companies.

Why start a search fund?

Investors have many options: private equity, stocks, real estate, etc. As for entrepreneurs, they could find their businesses and build what they want from the ground up. So why start one, or why might anyone invest in one?

For one, there is a potential to limit risk and “take out the middleman” simultaneously. Many entrepreneurs have recently used the SF boom to buy out baby boomers. 

Taking advantage of a cash-flowing business while providing capital for retirement seems like a fair trade. The fund manager can identify and acquire a successful business in this scenario.

If the venture is self-funded, then the new CEO/Owner (the fund manager) can fully benefit from the acquisition by managing the business.

This also removes the element of having to trust someone else with the management of the business as opposed to starting a new venture where there may be a significantly higher risk of failure caused by the failure of key fundraising rounds, poor market fit, or any other unforeseen obstacle to the business's success.

We have touched on this already, but let's provide a realistic example of how SFs can help entrepreneurs reach the c-suite. 

There are many stories of MBA grads who, despite their extensive education, do not have significant management experience. As a result, it could be years or even decades till they climb the ladder to the top of any corporation.

However, it's becoming commonplace for MBAs, especially at larger Universities/Colleges with the funds to sponsor/invest in such ventures, to start SFs hoping to take the short route to CEO.

With this form of entrepreneurship through acquisition, management of the fund can buy out an owner, appoint themselves as management, and start putting their education to work immediately.

Many users (especially ivy grads) have told their success stories of using this model, making successful acquisitions, becoming managers, and earning a handsome return for themselves and their investors.

From the investor's perspective

With low bond yields and the ever-increasing desire from investors to diversify outside of the stock market, where do they invest their money while not sacrificing gains?

Here is a peek into what returns for investors in various asset classes might have been over a decade (2010-2019). By comparison, SFs seem to have been outperformers.

According to a Stanford study, the IRR (internal rate of return) for SFs has been ~33% (pre-tax) on average. That far exceeds the annualized rate one might expect from investing in an all-stock portfolio and even more so for other asset classes/fund types.

The same Stanford study also states investors may have seen about 5.5x returns on their invested capital. That same return is unseen in many other diversified portfolios of different asset classes.

Compared to private equity, venture capital, and buyout funds, SFs often outperform their counterparts by 10-15%.

For investors simply looking to increase their cash flows, SFs may structure their equity offerings as preferreds, in which many offerings have a 5-8% yield (relatively similar to the average stock market performance) but with added security.

Due to the flexibility required by investors in this class, many favorable conditions have become the norm for funds to offer:

• Such preferreds, as mentioned above, may come with a 1x liquidation preference.
• The units which investors buy may come with pro-rata follow-on rights.
• Equity may come with step-up conversions.

But these are all the benefits of owning units. So what are some fundamentals that make this asset class attractive?

We mentioned that you are diversified outside the stock market and can receive consistent cash flows, but are there any other benefits, such as the growth of the business?

Investing in the right business might mean picking a fund and business that wants to adopt or continue an acquisition strategy for growth.

This method might limit outgoing distributions to investors. Still, it is not uncommon for fund managers to focus on this strategy, especially if their fund showed significant strength in identifying and acquiring target business(es) before.

Investors seeking to steady their portfolio's volatility recently may have noticed that average bond rates (even some corporate) still fail to outpace the current inflationary environment. So what are investors looking for in cash flows and stable portfolio values?

Buying equity structured as a preferred from an SF might be a valid option. As we showed in the link above, the alternatives have either vastly underperformed the market or even lost value and failed to lower volatility in select cases.

If we are talking about diversity, how does investing in SF, which only acquires one company, offer diversity? The good news for investors is that smaller funds may only seek around 50k to start investing with the fund in the searching stage.

This is significantly lower than other private equity, venture capital, or similar fund types. With the lower cost, investors can create and diversify their portfolio of SFs.

Another reason this investment may increase the interest of seasoned investors is the relationship that can be established with the management of the firm. 

Especially if investors are involved at the searching stage, these funds typically only bring on 10-20 investors, making it easier to get face time with management. In addition, the fund manager may come to you for mentorship if you are a seasoned manager.

In this case, the investor has a significantly stronger influence on business management.

This last point does not tie directly to the investors or the fund's management but to the seller/owner.

How is a search fund made?

Once an entrepreneur decides to start an SF, how do they start fundraising? Once they start fundraising, how do they go from there to the eventual exit to harvest the value created from their work?

As a quick refresher, SFs are investment vehicles. They are pooled capital provided to allow a would-be entrepreneur to acquire a business.

The amount of SFs has approximately quadrupled between 2001 and 2016. With this mass of growth, one might ask, “how did SF start?”

We can break the creation of a search fund down into 5 different stages:

1. Forming 
2. Searching (funding round 1)
3. Acquisition (funding round 2)
4. Operations and scaling
5. Exits and Transitions

So, what does each stage entail?

The funds raised from the first round are utilized in the search to pay the administrative and operational costs of searching for a business. Funds typically see a 75% success rate in identifying an ideal candidate for acquisition.

Once there is significant reason to believe an acquisition will occur, the fundraising round for the acquisition will occur. Typically they search for a post-profit business generating free cash flows. Funds typically see 67% success in acquisition once a seller has been identified.

SFs have about a +50% overall success rate in making it to the operating and scaling stage. Additional funding may be conducted at this stage, depending on the fund's structure and the business being acquired.

Lastly, the exit or transition is the opportunity for the investors and/or manager to sell their equity in the business, harvest the increase in value, or transition from being a private to a public business.

Forming the search fund

Forming is fairly straightforward, but the fund, its goals, and its purpose are identified, and the first fundraising round starts shortly after. Once the above has been started, the private placement memorandum can be drawn up.

It is important to identify and outline the following:

• Search fund strategy
• Acquisition strategy
• Acquisition criteria
• And sample industry

Once that is complete, you may start scouting for potential investors. Of course, the ideal candidate has management experience or is a seasoned investor (potentially both).

Typically when raising capital in this stage, $400-500k is the average raise, and the fund is searching for 6-10 investors to get started. So 50k is on the lower end for an average capital raise.

The funds are typically structured as an LLC in this stage, and the most important part of the fund's success is finding investors whose goals align with the fund.

Searching

Searching is a very exciting part of the process. All the networking and possibilities are ahead of the fund. There is so much opportunity for the fund managers and the fund itself.

First things first, the fund the industry will search for must be solidified. This provides a few benefits. The entrepreneur (and employees) can focus on gaining knowledge in one specific space. 

SFs love to hire 1st or 2nd-year undergraduates in the U.S. to do much of the sourcing and diligence work.

It’s important to note that much of the work you’ll be doing may seem tedious as they look to acquire only one company instead of traditional PE companies (i.e., a “portfolio” of companies).

However, it’s a great place to start your finance journey if you are interested in competitive fields like IB or PE!

The fund managers can gain knowledge and connections in their preferred industry even if no deal is reached. When networking, attending trade shows, and negotiating, the entrepreneur should take the opportunity to learn as much as possible.

Some factors to consider:

• Is the industry growing?
• How big is the industry?
• How much do the larger corporations control the industry?
• How capital-intensive is the industry?

Once the industry has been decided upon, the criteria for an ideal candidate come.

The goal is to find a company with a manageable operations structure that the fund manager can handle, which has historical growth, earning positive EBITDA, with low CapEx, in a growing industry.

Many entrepreneurs and fund managers working in acquisitions (not just SFs) consider recurring revenue a big plus in businesses as it offers safety in future revenue. 

These factors may change depending on the industry of choice, but in a broad sense, these may be some positive factors to consider.

Another advantage of search funds compared to other funds is their mobility. Since management is one or a few people working on one deal at a time, they can pour their focus and resources into seizing the best opportunities without losing out elsewhere.

This especially comes into play when meeting with the c-suite and/or owner of an acquisition target. The c-suite’s schedule may change rapidly, and being agile allows the fund manager to get much more face time than someone staffed on several deals.

At the end of the day, the goal for SF is to find a company that will yield stronger returns than the amount that is invested.

Acquisition

Despite the goal of the fund, which is to acquire a private business using pooled capital, acquiring a business may still be considered a failure, and here’s why.

It should go without saying that acquiring a bad business is not a good thing. But what makes an acquisition good or bad?

In the case of SFs, poor acquisitions might come from acquiring a business that the manager cannot manage. This may come from the entrepreneur’s ability or the business’s complex operations.

Sometimes the perfect acquiree is not available, but this is where private equity type funds can make a big difference. With management and industry knowledge paired with an outside perspective, an imperfect company can have value added by the fund managers.

Perhaps you acquire a business experiencing slow growth or having trouble gaining operational profitability. In this case, an outside perspective might be able to remedy these issues and quickly add value to the business.

In finding the right candidate, this is the perfect opportunity to consult the fund's expert investors and use their insights to help ensure the success of the acquisition and business once acquired.

It’s incredibly important to note that SFs, once acquired, give full ownership to the entrepreneur, thus giving him/her full operational rights to be CEO of the company.

This stage is where the second round of financing will occur, which is utilized to acquire the business. Again, current investors have the right of first refusal (pro-rata right), which means they can invest additional capital to avoid diluting their ownership.

At this stage, additional financing may be needed from outside investors and debt. The debt financing conditions and the amount will largely depend on the characteristics of the acquirer. 

Then the process is quite similar to the private equity acquisition timeline.

Firstly, the entrepreneur should take time to settle into the management position. As many fund managers are unseasoned, they may need time to practice some basic day-to-day management, meet their team, and understand what is unique about their business.

New management might take 1-2 years to settle in before making significant changes to the business. 

Suppose something needs to be addressed immediately. In that case, management should deal with it, and that's why having seasoned managers as investors can add value to the fund since they can offer quality advice.

But change is not always necessary right out of the gate. Adding value over time is how strong returns are generated for the investors. Taking a stagnant business and sparking growth or helping a growing business accelerate its growth is the end goal for most SFs.

This stage may take 5 or more years to complete, but the entrepreneur should seek to accomplish 3 main goals during this stage:

1. The new management should learn about the industry and the business itself.
2. Management should seek coaching and mentorship from investors to grow personally and benefit the business further.
3. If the above is done correctly, and the right management choices are made, value is added to the business before entrepreneurs and investors take their exit.

Once investors are ready to exit, how do they do so, how do they get their capital back plus any value that was brought to the business?

Operations & Scaling

Remember, as we briefly mentioned above, while nobody likes to give up ownership of their company, upon getting acquired by a SF, the entrepreneur will typically assume the title of CEO for the business acquired.

While there are several ways to “scale”/grow the business, the most common ways are as follows:

• Increase in net sales (i.e., net sales = revenue - returns - allowance - discounts)
• Margin expansion (i.e., gross margin = gross profit/revenue, EBIT margin = operating income/revenue, pre-tax margin = pre-tax income/revenue, & profit margin = net income/revenue)
• Roll-up M&A
• Product diversification 
• Geography expansion
• Investments (technology & management)

We want to emphasize the last bullet point on “investments” quickly.

With the ever-growing technological increase, many SFs are looking to invest in new/emerging tech to expedite processes, such as supply chain issues affecting customers.

As you already guessed, SFs ensure customer satisfaction remains of the highest standard when directly addressing issues in the supply chain with technology improvements! 

However, above all else, improving management teams is the best option for any SF.

Why is management the “game changer”?  The answer is quite simple – these operators typically have more experience in the said industry in which the SF invests.

And just to further paint the picture, management teams can elect to improve operations by firing under-performing employees and any unnecessary expenses, such as capital expenditures (or CapEx for short).

Why would management teams do this?  Remember, if any significant amount of debt was used in the acquisition, companies will want to “pay down” said debt with cash flows… and the best way to increase cash flows is to reduce/eliminate any unnecessary costs!

That said, you’re now ready to understand how and when SF may exit the business.

Exiting the business

Every entrepreneur should consider how or when they might exit the business. While there is plenty of time and certainly no need to rush the process, the greatest benefit will be eventually from selling some or all of the business.

There are a few different ways to exit the business, each with a unique benefit and cost to the fund manager/CEO.

First, there is the IPO. This is when you have decided and meet the requirements to become listed on a public exchange (the stock market). With this option, you as the CEO, may not get replaced immediately, if at all. 

Management and investors will also have the opportunity to sell their equity in the business if they wish to do so. The business may also have an easier time raising equity as it can issue new shares on the public market.

Unfortunately, there are some drawbacks to this option. The business will have to start preparing financial documents quarterly for audit and then make these statements available to the public. The business also becomes an easier target for a hostile takeover.

Private equity acquisition also becomes an option. The issue here is that some of the c-suite may be removed immediately. It is not uncommon for these firms to appoint their management. However, it is less common that they immediately target the CEO position.

There are also more strategically focused acquisitions where the business might be sold to a competitor, supplier, or customer, as well as management without an equity stake who may also wish to purchase equity in the company.

These can go in various directions, but for the sake of simplicity, they are somewhat similar to private equity transactions.

The main takeaway is that fund managers can now share the upside of their hard work alongside the investors. In almost all cases, the fund manager will have invested some of their capital into the venture, so they will also share the upside.

This is not the only payout for management. Vesting can take place after a certain period from managing the business (or exiting) after successfully being acquired and perhaps if certain KPIs are met along the journey.

Types of search funds

There are three main types of SFs. The differences are based on the acquisition of funding. It comes down to the lender being targeted and how the fund manager wants to interact with them.

1. Traditional fund structure

This fund is like the one primarily described in the article. There is a group of investors who the fund manager brings together.

These investors will often share some characteristics, including geographical location, to make it easier for “boots on the ground” investigation when searching for and consulting on the acquirer's choice.

All investors share the benefit, and the proportion is based on equity invested in the fund, not the level of active management taken in mentoring the fund manager.

2. Self-funded

This structure is probably the most simple in the beginning, as the fund manager entirely funds the search process. It is not until acquisition that outside funding is needed and searched for.

The benefit here is that entrepreneurs can set out searching while holding little to no obligation to investors. Once a target business is identified, selecting the appropriate investors with the right management experience becomes easier.

On the downside, the entrepreneur must have the available funds to sustain themselves and the fund throughout the search process and into the beginning of the acquisition process. Some entrepreneurs may also find it difficult to negotiate without current investors in the fund.

Another downside is that many who start this fund may find it difficult to get by and, therefore, will take on small-business administration loans.

3. Single sponsor or fund-less sponsor funds

Depending on the fund manager's management style, they have a single investor, which may be good or bad.

Because the single sponsor fund requires such large capital, the investor may be a significantly wealthy individual, a private equity fund, or somewhat of a “fund of funds” specializing in SF investment.

These businesses have a lot of experience in the SF space and management in general. However, finding a fund specializing in a specific industry may be hard.

Because of their initial investment size and the fact that they are the only sponsor, they can exercise significant influence over the business and fund. 

However, because of their expertise and experience in this line of business, they will mostly offer the best advice appropriate for the business or fund. Therefore, they would be a valuable asset to the entrepreneur.

Researched and authored by Joshua Tobias | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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