Search Funds Explained: Overview and Insights
Many people, when first introduced to Search Funds, feel that they have misunderstood the concept. Generally, one common question emerges; why would investors (other than family and friends) back a first time CEO in their late twenties/early thirties with no operational experience? The answer is quite simple; financial return. Annualised returns amongst Search Funds, since the mid-nineties, have stood persistently around 30%. As always, the financial return is matched by the the financial risk, which lies somewhere between that of a venture capital and private equity investment.
The analogy of a jockey, horse and horse trainer is often used to explain the traditional Search Fund model. This entails the acquisition of a company by a single person or two people (the “Searcher(s)”) who aim to become entrepreneurs by taking over the running of an existing company. The Searcher is the jockey and the company is the horse with the Search Fund investor being the trainer using the above-mentioned analogy.
History of Search Funds
Investing in Search Funds is part of the wider asset class of “Entrepreneurship through Acquisition” (ETA). This is a relatively new asset class/investment strategy. The concept was pioneered by Professor Irving Grousbeck, a professor at Harvard Business School, who originated the concept in 1984 while lecturing at the university. While the Search Fund eco-system in North America remains the most developed, it has grown significantly in both Spain and the UK the past decade. New geographies that have gained in popularity also include Colombia and Mexico.
What is a Search Fund?
A Search Fund consists of a pool of capital raised to support the efforts of the Searcher in locating and acquiring a privately held company for the purpose of operating, expanding and eventually exiting the company in the medium to long term (6 – 10 years). There are a number of different ways a Searcher can fulfil their dream of becoming an entrepreneur through acquisition, these include:
- Traditional Search Funds
- Self-funded Search Funds
- Sponsored Search Funds
- Accelerator Search Funds
While the objective of the above remains acquiring a company, some of these structures involve skipping a step in the traditional Search Fund model, such as fundraising (see below).
What is the Search Fund model?
The traditional Search Fund model tends to follow the following five steps:
Fundraising – This is the initial search capital raised from a group of aligned investors. Principals often include a large network of friends and family, business associates, angel investors, business owners and institutional Search Fund investors.
Search for an acquisition – This generally takes place over a one to two year period during which the Searcher generates leads to identify a good company in a great industry at a reasonable price.
Acquire a target company – Once a target has been identified and the LOI has been signed, the Searcher will seek to perform due diligence, likely with the help of legal and accounting professionals. Typically an investor who invested during the search phase, will see the funds they initially invested be transferred to equity in the newly acquired company at 1.5x the money they invested pre the target being acquired.
Operating – This is by far the longest step, The first 6 – 18 months is generally spent learning the business and gaining management experience before any radical changes are made to improve future growth.
Exit – Most Search Funds are established with a long-term plan in sight. The exit opportunities for investors can occur in a number of ways, such as trade sales or another form of buyout, similar for equity holders in other privately held companies.
Who are the Searchers?
The Search Fund community often describes the typical Searcher as an MBA graduate with a background in consulting or investment banking. The median age of a Search Fund entrepreneur typically varies from 30 to 32 years old, while in less mature markets, it is more common to find Searchers with a minimum of ten years in fulltime employment. Of the many advantages of pursuing a career as a Searcher, the financial remuneration through the ability to use one’s entrepreneur’s relief is widely quoted.
Both in Ireland and the UK for example, the ability to use entrepreneur’s relief means a Searcher can typically net €900k after tax provided they make a capital gain of €1m plus (note in a traditional Search Fund the Searcher will typically have a 25% stake). Working as a salaried employee paying income taxes, the individual would typically need to earn circa €1.8m to end up with €900k net after income taxes. This is a significant amount to earn as a salaried employee over a 6 – 10 year period in addition to one’s salary. Below shows the increase in the number of Searchers in recent years.
Who are the Investors?
Investors in Search Funds typically consist of high net worths and people from the Search Fund community. Furthermore, some investors may be institutional, whose sole purpose is to invest in Search Funds. Examples of Search Fund investors include Jan Simon and Kristoff Puelinckx’s Vonzeo Capital and Gautam Basu and Mikko Järvinen’s True North Search. Upon researching investors in this space, one will note the strong crossover between lecturers and investors, which is not something that is typically seen across the wider finance community.
What kind of business are they interested in?
Searchers will typically either take an industry agnostic approach or a sector specific approach, depending on the size of the market that they have decided to undertake their search in. In a small market such as Ireland, it is likely that a Searcher will take a sector agnostic approach to maximise the probability of a positive outcome. On the other hand, in a large market, such as the USA, Searchers are likely to take a more sector specific approach as they get deeper into their search. Popular sectors include TMT, business services and healthcare. It should be noted that despite spanning a range of industries, these businesses are typically asset light with strong recurring revenues.
Current trends in this space
Despite the recent tech layoffs occurring worldwide, some have suggested that the number of searchers will continue to surge. Well-known business schools in North America such as NYC Stern and Cornell have waived GMAT requirements for their MBA programmes starting August ‘23 to take advantage of the pool of talent that has been affected by the layoffs. This is in keeping with the suggestion among many market commentators, that many of the talented staff recently laid off by tech giants will be ‘push’ entrepreneurs, who will nurture and develop new and existing businesses through start-ups and entrepreneurship through acquisition (ETA).
Pros and Cons of Search Funds
The advantages of the Search Fund model include downside risk protection, because investment failures are usually identified at the early stages of acquisition, during the due diligence process. Additionally, 73% of entrepreneurs (per the most recent Stanford University study) who find and buy a business successfully scale and exit that investment, whereas in venture capital the success rate tends to be significantly lower.
Disadvantages of Search Funds include demanding a high investment of a manager’s time and energy. Furthermore, capital is not enough from the investors side, investors’ feedback and guidance on target companies are necessary given the relatively limited experience of the younger Search Fund entrepreneurs.
For more further reading in this space, feel free to checkout some of the below:
Search Funds & Entrepreneurial Acquisitions: The Roadmap for Buying a Business and Leading it to the Next Level (Jan Simon)