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, obtain a loan to cover most of the expense, 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: 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 Networth (UHNW) individuals to fundraise ‘units’ in their Search Fund. They 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, convince the Seller to finance another $2m, and now needs to obtain $4m of equity. The original investors 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. Now, each investor owns about 5% of the business and the Searcher has the ability to own as much as 25% of it.
This is a typical deal: 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.
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, just 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 everything 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 SearchfundSearcher, who keeps 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 Part II of our Search Fund guide, 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***