Search funds are one of the least well-publicised and least well-understood asset classes in the world today. As we mentioned in this post, almost all search fund activity has historically been in the US, but in recent years more search funds have appeared in Europe, and in the UK in particular.
For entrepreneurs who have built a sizeable private business over many years, search funds can be an attractive route to exit. These funds exist to actively search for and acquire exactly the type of small private company that these entrepreneurs are looking to sell. Importantly, search funds back investments over a typically longer period than other private equity vehicles. While some business owners are concerned about selling to private equity groups for fear that they will “slash and burn” their business in order to generate quick profits, this concern is lessened with search funds because of their different approach and longer investment horizon. Search funds typically own the business for longer and are interested primarily in revenue growth rather than simply staff-cutting.
These funds exist to actively search for and acquire exactly the type of small private company that these entrepreneurs are looking to sell
So what are search funds, and what are they looking for? According to the Stanford Graduate School of Business, a leader in education around search funds in the US, a search fund is “an investment vehicle through which investors financially support an entrepreneur’s efforts to locate, acquire, manage, and grow a privately held company”. In other words, these funds will provide equity for the purchase of a business by a young entrepreneur or pair of entrepreneurs (typically MBA graduates), who will use their management expertise to grow the company and eventually sell it, providing a return on the investment. Interestingly, search funds will also finance the entrepreneur’s expenses during the search for the right business, which can take up to two years.
Search funds typically target businesses with revenues of $10m to $30m (£7.5m to £15m) with very strong and stable (>15%) EBIT margins. Some funds’ criteria will be for slightly smaller companies than this: Richard S. Ruback and Royce Yudkoff from Harvard Business School advise searchers to look for businesses with pre-tax profits of $750k to $2m (£500k to £1.5m). Their book, An HBR Guide to Buying A Small Business, is an instruction manual for entrepreneurs who want to go down this path. Some search funds, such as Captiva Partners in the UK, have slightly broader target criteria, incorporating companies with revenues from £500k upwards.
Search funds are looking for opportunities to help stable companies to grow significantly under new management, and as such, they look for signs that the existing management have not capitalised on every available opportunity. Often the target will be a company where the owner is looking to retire and does not have a succession plan for handing the business down to his children. Having built the business from scratch, the owner is already very successful, but has grown the company to the point where his own knowledge and skills are no longer sufficient to enable substantial further growth.
Typically search funds are looking for companies with sustainable recurring revenues (not loss-making ones or startups), although rapid growth is often not considered favourable as it usually brings associated risk. Ruback and Yudkoff favour companies that are growing slowly, but with a sustainable competitive advantage in their industry – they describe these companies as “enduringly profitable” because of the stable position they have achieved and the reliability of future earnings. For there to be potential for substantial growth under new management, the industry should ideally be fragmented (not heavily consolidated), and it does not have to be glamorous or high tech: often quite the opposite. Searchers look for businesses with a strong position in an industry with “straightforward operations”, as Standford GSB puts it, since the new management will likely not have technical expertise in the field. Importantly, the target company’s success should not be very closely tied to the owner, but instead based on a solid second-tier management team.
Searchers look for businesses with a strong position in an industry with “straightforward operations”, as Standford GSB puts it, since the new management will likely not have technical expertise in the field
Valuations of these companies vary slightly by industry and size, but the smaller ones within this range will be purchased for 3-5x net pre-tax earnings, the larger ones occasionally stretching to a slightly higher multiple. While other equity vehicles (or strategic buyers) may be willing to pay a higher price, search funds position themselves as a “friendlier” solution, since their objectives will usually not require sudden dramatic staff cutting. Search funds will be looking to exit eventually, but their investment horizon will often be longer than 5 years.
Inherent in the search fund model is the belief that a relatively young MBA, who usually will not have any industry-specific expertise in the acquired company, will be able to grow the revenues of the company more effectively than the previous owners, simply through superior management skill and enthusiasm. The fact that this model places so much faith in the principle that professional management alone can transform the business, and especially the belief that industry experience is not required (since the fund backs the entrepreneur, before the target company is even found), may partly explain why search funds are still relatively rare beasts. It is not entirely intuitive that this model would work. In addition, funding the search for the target company as well as funding its acquisition is highly unusual for investors outside of this specific ecosystem. But the search fund model has proven very successful since its inception in 1984, and it is here to stay.
For investors these vehicles provide a more reliable return than other classes such as venture capital. While maximum returns are lower than the home-runs possible with VC, the risk of failure is also far lower. As one search fund investor puts it, while 80% of VC funds are expected to fail, 80% of search funds are expected to provide a positive return. Stanford’s 2016 study of 258 search funds showed an aggregate pre-tax internal rate of return of 36.7%, and an aggregate pre-tax return on invested capital of 8.4x. These numbers compare favourably with venture capital, which aims for 30% IRR but achieves, on average, only about 10%. Returns in both classes vary considerably from year to year of course, but the numbers suggest that search funds are an attractive option for the limited partners (LPs) who invest in these funds.
While the vast majority of search funds are still in the US, the model is spreading to Europe and elsewhere. In a 2015 study by the IESE Business School in Barcelona, 45 non-US search funds were identified, of which 9 were based in continental Europe and 12 were in the United Kingdom.
For the entrepreneur, the search fund model provides a unique opportunity to take over the management of a much larger company than he or she would otherwise have the means for. Acquisitions are typically funded with roughly 70% debt and 30% equity, the latter provided by the search fund. The entrepreneur earns equity over time by achieving growth targets: if things go as planned young manager can own as much as 25% of the company within five years.
For the entrepreneur, the search fund model provides a unique opportunity to take over the management of a much larger company than he or she would otherwise have the means for
Stanford’s primer on search funds explains the entrepreneur’s earnings in detail. During the search phase, the young manager or pair of managers (who are the “principals” of the search fund) receives a salary in the range of $80-120,000 per year each in the US, while searching for the target. Once a target is found, principals will typically receive a 15-30% equity stake in the company, in three equal tranches:
- Tranche 1: Received when the company is found and successfully acquired
- Tranche 2: Vests over time (approx. 4-5 years), as long as the principal remains employed by the company
- Tranche 3: Vests when performance benchmarks (such as internal rate of return targets) are met
While managing the company the principal receives a salary of course, in accordance with standard executive pay in the industry of the target company.
A solo principal may end up with 20-25% equity in this way, whereas it is rare for a pair to be granted more than 30% combined, so partnering with another entrepreneur does come at an equity cost. The authors note that it is common for the investors to receive a preference of some kind over the search fund entrepreneur, ensuring that their investment is repaid, usually with a return, before the principal receives anything. So only in the event of the successful growth and sale of the business will the principal benefit from his or her equity stake.
If things go as planned young manager can own as much as 25% of the company within five years
The search fund asset class is a fascinating one, providing an unusual but much-needed solution for all three parties in an M&A transaction: investors, entrepreneurs and the sellers of large private companies. Hopefully we will see more activity from these vehicles in Europe and across the world in future.