Investing in Search
What is a Search Fund?
A Search Fund is a variant of Private Equity (PE) based around a single person buying a single business to be its CEO. Imagine that instead of a big fund building a portfolio, an individual who feels entrepreneurial but has no ideas for a new business follows the PE model. The individual has a few options:
- She can grind in a family-owned business and maybe help run it, but probably not be given true ‘ownership’
- She can work in a big business until promoted, hopefully leading a division if not the entire business, itself
- Or, she can buy a business
How does a Search Fund differ from Private Equity?
If the Search Fund finds the same lemonade stand, maybe they offer $90 instead of $100, but indicate that your friend can keep the entire sum and retire. This person will follow the same Leverage Buy Out (LBO) model as a PE Fund. They will source a business, value and negotiate on the price of the business, obtain a loan to cover most of the cost, and acquire it. At this point begins the differences from PE: the Search Fund replaces the seller to become the day-to-day operator of the business. A Searcher does not build a portfolio, instead she finds and purchases a business to run itself. Though investors construct portfolios of Searchers, Searchers simply focus on growing one business.
Breaking down a Search Fund Deal
Here’s how it works for a traditional deal: a young, recent MBA from a top school decides they want to start a Search Fund and be a Searcher. They go around to Ultra High Net Worth (UHNW) individuals to fundraise ‘units’ in their Search Fund. These individuals will each provide the Search Fund with $25k to $50k for a 24 month ‘Search’ period. This money would finance the Searcher’s salary and all costs for the fund for two years (the time needed to find and negotiate with the lemonade stand founder).
Let’s say that the Searcher finds a business to buy with $2m of profit at a price of $10m. She finds a lender to provide a loan of $4m, convinces the Seller to finance another $2m, and now needs to obtain $4m of equity. The original investors who each bought a unit for $50k agree that this company is worth buying and each put in follow-on checks of $250k. That money ensures them at least 75% of the business’ equity and 8% preferred. Now, each investor owns about 5% of the business and the Searcher has the ability to own as much as 25% of it.
On the other side a typical self-funded deal looks a bit different for investors: a company making $750k in profit selling for $2.2m, with a $1.5m loan, $450k in seller financing, and $250k in equity. The Searcher gets five investors to contribute $50k each. In return, the investors receive 25% of the common equity and a 10% preferred return. Preferred return is basically a bond. For putting in 10% of the enterprise value investors get 25% of the common stock, plus their money back and 10% interest on their money until it is repaid.
If the Searcher spends five years paying down their debt and sells the company at the same price, without growing it at all, the investor will get ~3X ROI and depending on how they pay out their investors over time a 24% to 32% IRR. All the Searcher has to do is not screw things up for five years, keep the business steady enough to pay down debt. If they grow the business or increase the exit multiple, investors will do even better!
Typical Search Fund Performance
Say that this company and Searcher happen to meet the average performance for the Search industry. Excluding unicorn performers, if we suppose that the company is run by the Searcher for ~5 years and exits, netting an IRR of 28.3% and an ROI of 3X for its investors over 5 years of Operating. It is typical for an investor to expect, for a Searcher who buys a company and keeps it profitable, anywhere from 2X to 7X return on their investment.
However, the latest data suggests that a full 30% of Searchers (those who successfully start a Search Fund) FAIL to acquire a company. Thus, the initial $25k those investors put into the Search Fund could be for naught. Of the ~70% who acquire a company, 30% of Operators will take a loss (that is, ~20% of all Searchers). This means that after investing $25k in the Search and another $250k in the company, an investor will lose some, if not all of their investment. About two thirds of the time, there is only a partial loss and some of the money is returned to investors.
We’ve just established that 50% of Searchers fail in some capacity and investors will lose $25k+. But keep in mind that of the 50% who acquire a company and make profit: 33% (16% of the total) will return 2X to 5X, another 26% (13% of the total) will return 5X to 10X, and 12% (6% of the total) will return more than 10X. It stands to reason that if you build a portfolio of 10 Searchers it would be reasonable to assume you’ll hit that average of ~3X ROI.
What’s the average investment size for a Search Fund?
Though most of the above covers the Traditional Model, Self-Funded Searchers exist that finance their own costs initially. They do not seek out ten to twenty investors for $25k-$50k in financing. However, it is on different terms. Because they are ‘on their own’ initially, and because they personally guarantee their debt, use more leverage, often obtain lower acquisition multiples, and think longer term: these Searchers are usually able to keep 51%+ of the business for themselves. Most keep 60% to 80% of the equity. This means that investors own a minority stake from the start.
Check sizes may be smaller too: many Self-funded Searchers are usually looking for $50k to $250k vs. Traditional Searchers who typically require $200k – $1m+ equity checks. There are bigger deals but on average it’s smaller. The calculus involves a combination of smaller businesses, lower prices, and more leverage. This does not necessarily lead to lower returns: because you only invest at the acquisition stage, the risks are lower. While Self-funded Searchers use more debt, the combination of a personal guarantee and better financing terms can often lead to a lower fail rate during operation. The Searcher is putting 100% of her life into this: if she loses your money, she also loses everything she has! Typically, self-funded investors can expect somewhere between a 2x and 7x return on their investment. That isn’t to say some Searchers don’t lose money or need to go back to their investors for fresh capital.
Where can one go to find a Search Fund to invest and how does one conduct due diligence?
Well, the community has grown pretty significantly over the last few years. Below are some places to find Traditional Searchers to invest in.
- Top MBA Programs. Several top schools (Stanford Graduate School of Business, Harvard Business School, MIT Sloan School of Management, Booth School of Business, etc.) hold events once a year that many aspiring Searchers attend.
- Online. There is a ‘social network’ of sorts for Search called Searchfunder.com, and one can create an Investor profile to try to participate in some deals.
- Funds of Search Funds. Some of the original investors have started to allow outside investors in on deals. They manage the funds and choose the Searchers to invest in on behalf of these investors.
Where can you find these self-funded deals?
- Easy, the same places you would find Traditional deals! University events and Searchfunder.com are great resources
- Ask us, we keep an active list of self-funded Searchers and their process in the Search / can reach out when someone is seeking capital. Just sign up as an investor.
- Find a search fund accelerator – These organizations try to reduce the failure rate of Searchers: instead of 30% of them failing to acquire a business, this group tries to teach them best practices and provide tools to drop that to 0. One of the first and biggest of these Accelerators is the Search Fund Accelerator, or SFA. Others include SPUR, NextGen, and GTE.
If you’re considering investing in an alternative asset, this is a fast-growing option. In 2014, there were only two or three schools that mentioned the topic. Back then, the course on Search Funding at HBS was half empty and half of those students were taking the class for fun. Today, their courses on Entrepreneurship through Acquisition are oversubscribed, and close to a dozen schools deliver at least one lecture on the topic. One of the hindrances to the industries continued growth is a lack of available capital. Its record of success speaks for itself and while historic returns are never an indicator of future returns, this is an interesting model to support current small businesses, communities, and young go-getters while trying to make some money!
In a future section you will learn how to analyze Search Funds, how to pick the right Searcher, and how to analyze potential deals. you will learn how to analyze Search Funds, how to pick the right Searcher, and how to analyze potential deals.
***Important Disclaimer: all Searchers are bound by SEC Regulations. You need to be an Accredited Investor to partake. This is defined in Rule 501 of Regulation D of the U.S. Securities and Exchange Commission. There are possible exceptions for some of the smaller Self-Funded deals but as a general rule you, as an individual, must have earned $200,000 ($300,000 if married) of income for each of the prior two years with a reasonable expectation for the same income in the current year; or have $1,000,000+ in investable assets (excluding primary residence) to be an investor in this asset class***
There are many ways to consider a Search investment. Traditional Search Funds generally require two phases of Due Diligence: first on the Searcher raising the fund, and then on the deal for which they need equity financing.
Investing in the Searcher
A typical Searcher has limited experience. They are likely between the ages of 28 and 35. Between college and obtaining their MBA, they probably have less than ten years of work experience. If you value the MBA, that might count for experience. If you value the pedigree (which schools they attended, what company/brand they worked at) that may also count for a bit of experience. That said, it is unlikely that someone who is thirty years old has much “real” experience. They have probably worked for six to seven years, in two or three different jobs; possibly even in two different careers! It is highly unlikely that they spent much of that time managing other people or making significant decisions. I have only met a small handful who have hired or fired anybody; these are key parts of running a small business!
Now that we have addressed the “lack of experience,” we can luckily say that it might not matter too much. Look at the results over the last thirty-five years. Recent MBAs who form Search Funds do quite well for themselves and their investors. There is no “silver bullet” for what a great resume looks like when conversing with a thirty year-old. McKinsey might be a spectacular experience or it might be something else in their history…whatever it is, we know they do not need to have run a department or company in their past.
What are you looking for in an individual to run a company on your behalf?
Potential. You’re betting on a thirty year- old who has a deep desire to generate wealth. In a Traditional model, that is what you have most in common with the Searcher. Yes, you both want to see a company grow, a local economy become stronger, a young person gain management experience, et cetera. That said, you mostly want your investment to pay off. The Searcher also wants to make millions over the next seven years. Otherwise, they would not give up typical $250k+ job offers out of their MBA program to be paid merely $100k for two years. They want to run a company themselves and make money. Though not their only priority, it is something you both share. Additional questions to ponder:
- Why else are they doing this?
- Are they sick of working for someone else?
- Are they tired of the bureaucracy in big business?
- Do they have a passion for small business that their track record has not yet indicated?
- Perhaps a history of working in a small business but no ability to run the company themselves?
Many answers to the above are fine.
That said, be sure that money is not the Searcher’s sole motivator and that their past experience can contribute to running a small business. If the Searcher has never held a job for more than two or three years, you want to make sure they can and will commit to a seven year venture; one in which two or even three years could be spent NOT running a company but looking for one to buy!
Purchasing the Right Business
You are a passive investor. You will receive ~5% of ownership in this small business. Some questions to ponder:
- What type of business do you want a piece of?
- What kind of business do you think your Searcher would do well running?
- Do your fellow investors have connections or experience in this particular industry?
- Is the company cyclical or subscription-based?
- If cyclical, are you at the peak of the current cycle?
- How will this business hold up in a given economy?
- How does that impact your personal finances?
- Will the business survive given the debt being taken on and a new, inexperienced, manager?
Many businesses that have low correlation to the general economy cost a fair bit more. You can buy a construction business for 3X EBITDA, however, a subscription-based SaaS company might cost 11X EBITDA. Similarly, a good manufacturing business that is moderately tied to the economy might go for 5X EBITDA, but a pest control company may well cost 7X.
Is your Searcher getting a good deal on the business?
A small and poorly-run pest control company might only cost 4X EBITDA. That said, going from $1M EBITDA that was poorly managed to a well-managed firm generating $3M EBITDA may be quite difficult. Maybe the owner has no management team in place and the company has been going downhill for years. Perhaps all of the workers are older and underpaid so expenses will increase after its purchase because you need to hire someone new.
Compare that to a business that has grown 10% per year consistently and is at $2.5M EBITDA. This firm may be overly reliant on the owner, but everybody is paid well, young, and one or two current employees have management potential. Add some structure and a sales team and the company is primed for growth, working with the good momentum it already has. You might be paying 7X instead of 4X but you are acquiring a business that is easier to manage and grow, particularly for someone without experience in the industry! Grow it to $5M EBITDA in five years and sell it for the same multiple and all parties walk away having done well for themselves financially.
The point is: even within a single industry you will see different multiples – your Searcher needs to bring you a good deal on a good company and you must realize that neither you nor your Searcher may be in a place to know if you’re getting a good deal!
Who else is Investing?
Perhaps one of the Board members has direct experience in the industry. If this individual had run a similar company, they can be an invaluable adviser. On the other hand, maybe they have made similar investments either in other Searchers or in PE; this would also hint that you are investing alongside someone with knowledge and expertise. Especially if this person’s prior investments were successes! In either situation – you are not guaranteed success because another investor had prior success. Herd mentality of any kind is not helpful in picking investments; even if it’s a small herd. As you independently analyze a business, fellow investors can serve as a valuable resource and their investment can be a good sign.
While it was a broad overview, we touched on what makes for a good investment. A good Searcher, a good business, and good investors. These three components are also referred to as: the jockey, the horse, and the trainer.
A Concrete Example: Plumbing
You have a 30 year-old, recent MBA, who has worked for Goldman Sachs and Boston Consulting Group. These are illustrious and elite firms in investment banking and management consulting, respectively. This person has actually worked on a plumbing acquisition in the past. It was a $300M company with dozens of staff and a professional management team full of MBAs.
Your Searcher is now talking to a $25M revenue plumbing company. This $25M company is run by the founder; someone who barely graduated high school but rapidly became a Master Plumber and decided to start his own business. Suffice it to say, the Searcher is not convincing a bunch of MBAs anymore. Instead, the goal is to get this plumber to retire from a company he built with his own hands over decades!
Yes, plumbing requires certifications, it’s dirty, there are challenges just like any business, especially a small one. However, this company has $25M in revenue that is highly tied to three year contracts with local commercial landlords; $3.5M of EBITDA; ten Master Plumbers, thirty Journeymen, fifteen Apprentices, an office staff of five but no sales or marketing team; the founder is 72 years old, spending three days a week checking in on clients and the work that his team is doing on-site. It has not grown much over the last few years, but its clients keep re-signing new contracts.
Do you think it is hard to mess that company up? There is definitely room to grow and it may require the skills of an MBA, NOT a plumber, to do so! Even if the Jockey makes mistakes, there is some room for error because this Horse is so good. Would it be better if you could hire the ex-CFO of a $500m plumbing company who knows the ins and outs of the industry already? You bet. That said, you would probably have to pay a LOT of money for that person in salary, bonuses, and equity to convince them to run this company, let alone find it and convince the founder to sell it!
Wouldn’t it be great if this 30 year-old from Goldman Sachs who just graduated from Stanford Graduate School of Business found this plumbing company, convinced the owner to sell to him, and the lead investor was the ex-CFO of a $500M revenue plumbing company (who started working at the company when it only had $50M of revenue) and agreed to act as a mentor / Board member to the Searcher?
The above would be a great combination of a good, dedicated jockey, a great horse, and an excellent trainer. In all, a wonderful recipe for success.