The Searchfund Searcher has returned to discuss Part II of his guide on investing in Search Funds. Today you will learn how to analyze Search Funds, how to pick the right Searcher, and how to analyze the deal. You can find Part I of this guide here.
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 three or four 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 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.