In its most general sense, a search fund is simply an entity that looks to acquire a revenue-generating business. Under that definition, many private equity firms are “search funds.” So we should add a restriction: a search fund looks to acquire a smaller business: say businesses that cost anywhere from $1MM to $20MM. It’s “micro PE.”
A searcher will usually only buy a single business and she’ll operate the business post acquisition, but this isn’t a hard-and-fast rule.
Here, I’ll explain the three basic models of search funds. Barr Dynamics doesn’t fall neatly into any of these categories for reasons I’ll explain in a later post, but calling it a search fund is the best description I know!
The Traditional Search Fund
Search funds trace their origin to 1984 when Stanford professor H. Irving Grousbeck first envisioned them. Traditionally, a search fund consists of one or two individuals, usually newly-minted MBAs, who raise about $250k ($500k when there’s a partner) from 5-20 individual investors to fund a two year “search” (I’ll assume we have one-person search fund for the rest of this explanation). That initial investment funds the search itself. Over the two years of searching, a searcher will look for a small business to buy and operate. If/when the searcher finds a business, she’ll go back to her initial investors and present the opportunity. The initial investors have the option, but not the obligation, to put up more capital to fund the acquisition itself. Even if an initial investor declines to provide further funding, he’ll still receive a preferential treatment of his initial investment: e.g. if he provided $50k in search capital and that capital had a 25% discount if an acquisition occurs, he’ll receive the equity equivalent of a later investor’s $62,500 commitment. Besides equity investors, the searcher may fund the investment with bank loans and seller financing. Once the deal closes, the searcher will operate the company and own a substantial equity stake. The investors, meanwhile, sit on the board. Often, the searcher will run the company for 5-10 years before, with board approval, selling the company for a healthy profit for the shareholders.
When I first tell people about a search fund, the first objection I hear is almost always: why would an investor back an inexperienced person to find and run a company? Even putting aside the total work experience of a searcher (although more and more searchers are no longer young MBAs), searchers often have no industry-specific experience. A former software engineer might buy an air conditioning repair company. A former investment bankers might buy a window cleaning service. The answer is simple: searchers restrict themselves to businesses that they can understand and which offer a financial margin-of-safety when screwups inevitably occur (e.g. only buying smaller businesses in the $1-$10MM range, where the sale price relative to fundamentals isn’t aggressively bid up by private equity firms). Those two restrictions drastically restrict the kinds of businesses searchers can/should purchase.
The next objection is almost always about returns: there’s no way investing in an inexperienced CEO is a good idea, right? The best data available begs to differ. From 1984 through 2019, the $1.4B of equity invested in search funds has grown into $6.9B of equity value for those investors and $1.8B for the searchers. That reflects an eye-watering 32.6% pre-tax internal rate of return (IRR) and a 5.5x return on invested capital (ROIC) (2020 Search Fund Study: Selected Observations, Stanford Graduate School of Business). All that said, there are limitations to the study’s conclusions: problems with the data (e.g. whether the Stanford study collected enough data on the search funds that failed) and whether future performance will look like the past. Critically, given that 70% of search funds fail, any single search fund investment is more likely than not to be a failure; an investor should probably want/be able to invest in multiple search funds. But there’s clearly something to the model!
The Single-Sponsor Search Fund
The difference between a traditional search fund and a single-sponsor search fund is in the number of investors. In a single-sponsor search, the searcher is backed by a single investor, or “sponsor.” That sponsor, which may be a family office, ultra high-net worth individual, or a search-specific fund like Search Fund Accelerator, will provide both the equity capital for the search itself and the acquisition. The most obvious advantage of a single-sponsor search is in its simplicity. There’s no hunting for a dozen investors to back the search, there’s no need to go back-and-forth with the search investors for add-on funding, and there’s rarely a need to plug equity gaps.
Especially in the case of a search-specific fund, searchers sometimes underrate the benefits of advising and processes. Although a traditional searcher can and should get advice from their investor network and informal advisors, having a single entity (or even being in an office surrounded by folks experienced in searching!) can make things substantially easier. And the back office support is almost always the exclusive domain of Search Fund Accelerator and its ilk.
Of course, while a searcher only needs a single entity to say “yes” to a deal, a single entity can also kill a deal. A traditional searcher can have 8/10 investors give the green light for a deal and still go ahead. A single-sponsored searcher can’t.
The Self-Funded Search Fund
If traditional and single-sponsor search funds are micro private equity firms, then self-funded search is nano PE. Totally self-funded searchers might buy a business for $750k-$2MM. These businesses would be too small for outside investors, but perfect for a searcher who would own about 100% of the equity. A searcher may also self-fund just the search itself and seek out outside investors for the acquisition, in which case the acquisition price would likely be in the range of a non-self-funded searcher’s.
Why would a searcher elect to self-fund the search?
- Geographic flexibility: Outside investors want to back searchers with a wide geographic focus and a narrower industry focus. A prospective searcher who wants to live within a two hour drive from Boston, perhaps because of her family or her spouse’s job, isn’t likely to be a great candidate for an outside investor.
- Part-time searching: If an investor wants to back a search, they want the searcher to be all-in. A searcher who wants to search part-time, even if it takes five years, will tend to self-fund.
Why would a searcher elect to self-fund the acquisition as well as the search?
- Larger equity stake: Some searchers want a higher degree of control. They want the opportunity to eat all of what they kill and don’t want any interference from a board.
- Long-term holding : Investors often want their capital back eventually, even if its 5+ years down the line. A searcher, meanwhile, might want to operate a business for 20+ years or until they physically can’t.
- Better valuations for smaller businesses: Just using the very rough measure of multiples to compare price vs. value (whether EV/EBITDA, P/E, etc), there’s a premium for larger businesses. A searcher might find an HVAC repair company for $1MM and $350k in earnings (PE=~3) while a comparable company that sells for $10MM has only $2MM in earnings (PE=5). Now, there are good reasons why larger companies could deserve higher valuations relative to their financial fundamentals, like by having good processes that don’t exist at smaller companies, but a hungry searcher might rather put in the sweat to grow the company, put in those processes, and receive multiple expansion as a result. Meanwhile, a searcher with outside investors might be stuck with the choice of buying a richly valued company or having to shut down their fund.
In the case of a self-funded acquisition, you might be wondering how a recent MBA could finance even a supposedly “nano” sized purchase of ~$1MM. As far as I know, few searchers are sitting on that kind of cash. A searcher will put some cash into the deal, but they will get much of their cash from one or more of these different sources:
- Unsecured loans: like in traditional search, this is often an SBA 7a loan, which has many restrictions, but the most salient one is its personal guaruntee. A searcher should be very confident in their future success to take out one of these!
- Secured loans: if a searcher buys a business with significant assets, like a manufacturing facility with valuable machinery or an operating business along with the real estate its situated on, some of the transaction could be financed by secured loans from a bank.
- Seller financing: again, like with the other types of search funds, seller financing may be an option.
A Final Note
I’m writing in generalities here. For example, you could have a single-sponsor search where the single sponsor funds the search itself then you raise money from a group of other investors for the acquisition. I’m just trying to give you an overview based on my experience and research. For more information on the different types of search funds, read Funding the Search from Jim Stein Sharpe’s blog. In fact, read as much as you can from his blog if you’re interested in search funds!
As always, I welcome your comments, corrections, and complaints. Feel free to contact me via the methods listed on this site or my email: charles ( at ) barrdynamics.com