For those entrepreneurs who want to run a company but prefer to skip the start-up stage, search funds offer a possible alternative. A specialized form of private equity first launched in the mid-1980s, search funds are becoming increasingly popular — and their supporters claim they can offer investors attractive returns and business owners a compelling exit strategy. What does this trend in private equity mean for investors, and for small businesses that might be acquisition targets for these funds? Robert Befidi, Jr., and Mark Sinatra, managing directors of Gordian Capital in New York City, spoke to Knowledge at Wharton about the pros and cons of search funds.
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Knowledge at Wharton: For those who are not familiar with search funds, what exactly are they and how do they differ from other investment vehicles?
Befidi: Search funds are an alternative investment vehicle. They are typically considered the most direct way for someone with limited capital or financial resources to run a company that they partially own. It’s a four step process:
In stage one, the search fund entrepreneurs raise what is known as the search fund. This is a pool of capital that supports them in their search of a company in a highly fragmented industry with strong growth potentials. Particularly, they are looking for companies that have succession planning issues, where the owners are looking to get out of day-to-day operations.
Stage two, which is considered by far the toughest part of the search, is really identifying and making an acquisition. Once a company is identified, the search funders then make a second capital call to their angel investors and close on the transaction.
Stages three and four really are about operating the company, growing it and potentially exiting the investment. One thing to note is that there’s a lot of flexibility on the exit, depending on the investor mix. Traditionally, search funders have individual investors, and as a result they can hold on to companies much longer than traditional private equity funds.
Knowledge at Wharton: Mark, is there anything you would add to that?
Sinatra: There is just one minor thing to add. Typically, when there is the capital call for the acquisition capital, studies have shown that 90% of the original investors have invested in the actual acquisition. One of the benefits of the model is that the search fund managers have already identified and pre-screened investors, therefore allowing for a very timely transaction execution.
Knowledge at Wharton: What’s been driving the growth of search funds? I believe that they have been around since the mid-1980s. Could you tell us a little bit about how many of them are active today and what kind of returns they earn?
Sinatra: With respect to your second question, I think that there are probably around two dozen active search funds today — which is quite remarkable. Studies have shown that the average IRR [Internal Rate of Return] of investors in search funds has been around 37%. So, it’s been a compelling form of investment for them. Stanford School of Business does a study, I think, every two years — so some of those stats may be updated when the next study comes out later this year.
But with respect to your first question, what’s been driving the growth of search funds: From the supply side, in terms of the number of search funds, I think the increased awareness of the model has definitely been one primary driver, and having some of the business schools — such as Stanford, Wharton, Harvard and others — incorporate search funds as part of their curriculum. I think that this has really increased the acceptance and the overall knowledge of the model on behalf of the potential search fund managers.
From the demand side, I would try to couch “demand” both in terms of business owners and investors. From the business owners’ side, I think that they, in turn, are also becoming more familiar with search funds and the benefits that search funds [offer], particularly for those business owners who have a succession planning issue and are looking to not only reach a liquidity event, but are also looking to exit out of running their company.
With respect to investors: [according to] the statistic that I cited earlier, there have been investors that have done quite well in investing in search funds. These are typically a mix of individuals and some institutions that invested in search funds early on. They have done well, and they continue to buy into and believe in the model.
Knowledge at Wharton: You mentioned the research at Stanford University which pointed out that many young MBAs and law school graduates are using search funds to become entrepreneurs, but they seem to lack operating experience. Could either of you explain the process by which these young entrepreneurs go about raising capital and identifying targets for acquisition?
Befidi: Certainly — I’m going to talk about raising capital. Again, it’s similar to other investment vehicles during the capital raising phase. You’re looking to convince high-net-worth individuals, institutions, family offices and also a network of experienced search fund investors to essentially back you in your strategy. And, just like any other investment capital that is raised, you need to get out there and speak to them and convince them that your team is one that will be able to create value for them.
When it comes to identifying targets for acquisition, generally referred to as deal sourcing, it’s a three stage process — from generating deal flow, screening potential candidates and assessing seller interest. With respect to deal flow generation, some strategies call for an industry centric approach, where you are targeting certain industries, or a location centric approach where you are targeting certain geographies.
For the most part, search funds are focused on the continental U.S. But, we are seeing potential for search funds actually going overseas as well. In terms of how you actually find the companies, you would look at strategies that we would call, in the search fund world, mainstream deal sourcing or proprietary deal sourcing. On the mainstream end, we would typically be working with business intermediaries and looking at mid-market brokers for companies that are for sale.
On the proprietary end there really is a big reliance on the personal and professional network — business associations, business advisors, whether they would be consultants, attorneys or accountants — really anywhere that you can find a deal that has not been shopped actively, but where there is an interest from the owners to sell the asset.
Knowledge at Wharton: You talked earlier about the fact that there are exit strategies for companies that are looking for a liquidity event. One thing that is going to happen over the next few years is that a number of small business owners, who are baby-boomers, will be looking to sell their businesses. What kind of opportunities do you see this creating, both for those business owners and also for the search funds that might be looking for acquisitions?
Sinatra: I think that’s a great question. It creates tremendous opportunity for both the business owners and for the search fund managers. On the business-owner side, as you duly noted, there’s going to be an increasing number of businesses run by baby-boomers who are going to be looking to retire in the next several years.
And what the emergence of search funds is going to do is create an attractive liquidity option for them. This is because quite often these baby-boomers, or just people in general, who want to sell their company and either retire or move on to another venture or something else — their options are limited if they want to remove themselves from running the business.
The fact is that most traditional private equity investors really seek to have senior management stay on post-acquisition. So that can restrict the ability of the business owner in terms of looking at potential liquidity options. Another option for that business owner is to sell to what we call in the industry a strategic acquirer — one of their competitors in the industry. There are business owners out there who certainly see this as a viable option.
But then there are also business owners out there who, for either confidentiality reasons or emotional reasons, just don’t consider this a viable form of exit strategy. To answer your question, I think that the search funds and the emergence of search funds will increase the liquidity options for business owners in the foreseeable future.
For the search funds, it creates a great opportunity because search funders are people who are motivated not just to find and invest in a company, but really to operate a company and continue to keep the infrastructure intact, and to grow the company for the long term. So, I think there are some great opportunities on both ends.
Knowledge at Wharton: Could you offer some examples of transactions involving search funds? How did they turn out for their investors and for the entrepreneurs?
Befidi: One example that comes to mind that has been reported somewhat broadly is a company known today as Asurion. In 1993, Jim Ellis and Kevin Taweel, both Stanford graduates, launched a search fund and they started targeting towing companies. Eventually, they bought a Houston-based dispatch service firm called Road Rescue for about $8 million, I believe, in 1995.
The company blossomed into Asurion, which is a wireless player as well as dispatcher, and it’s now valued at over a billion dollars. So, that’s sort of the “home run” of the search fund world. There have been a few more stories of companies being bought and being operated for over ten years that are out there as well.
Knowledge at Wharton: Are there any horror stories as well?
Befidi: There are — 25% of search funds actually don’t close on an acquisition. And so there have been a lot of cases where the search funds close without buying a company. There have also been cases where the companies went bankrupt, and in those cases, typically they were acquisitions for capital intensive companies and the capital structure just couldn’t sustain moving forward — and the growth wasn’t there as previously anticipated.
Knowledge at Wharton: So,if there is a small company that is looking to be acquired, how would dealing with a search fund differ from dealing with traditional private equity?
Sinatra: Well, search funds tend to focus on opportunities where owners are looking to transition out of day-to-day operations. But, as you know, there are going to be opportunities where the owner will look at private equity investors and for a search fund.
When search funds in general go to companies and take a tour of their operations, they’re not only looking at that company from an investment point of view, but they’re really trying to put themselves in the shoes of that owner and asking themselves: Is this a company that we see ourselves running? So, that is an added dimension that search funds incorporate into their deal evaluation process.
I would also say, with respect to structuring a transaction, that search funds in general have the opportunity to be more flexible than traditional private equity deals. The reason for this is that the owner, in most of these search fund deals, is not going to stay on for more than six months or more than twelve months after the deal closes. Typically an Earn-Out provision may not be part of the transition consideration. As a percent of total acquisition consideration, that may result in more cash upfront to the owner, which may be something attractive to that business owner.
In addition, search funds approach deals from a longer-term investment horizon. The reason for that is search fund investors are a mix of, I would say, mostly individuals, but with some institutions as well — whereas with private equity funds, their mix is a little bit more slanted towards pension funds and more institutional investors that have a stricter investment horizon. The fact that search funds are backed by individuals for the most part enables search funds to have a longer-term investment horizon.
The other [difference] is that the value creation in many search fund deals is focused on driving revenue growth versus cost enhancement, or I would say cost cutting measures. In a lot of private equity deals, both on the small scale and the large scale, you really see both happening. This is because they’re really IRR driven deals — whether it’s cutting cost or whether it’s driving revenue. Whatever it takes to drive a reasonable IRR, after a holding period of two to five years, that’s what they’re going to do. [For search funds,] value creation is, again, focused on revenue growth. And what that means for the owner is that our focus is really on preserving the culture and legacy of the founder.
Knowledge at Wharton: Well, for those who do invest in search funds, what are the risks?
Befidi: As with other alternative investment vehicles, the risks of investing in a search fund are mostly of a financial or personal taste nature. From a financial perspective, there is the potential that the management team of the search fund will not acquire a company. And, as we noted earlier, 25% of the search funds do not acquire a company.
The one silver lining here is that search fund capital, in stage one, is typically in the order of $30,000 to $50,000; so investors are out $30,000 to $50,000 versus $1 million. So, it’s not so bad, but there is a risk there. Also, because private equity has been targeting the lower middle-market, there is now higher competition in that space and that’s driving prices up. So, to the extent that the management team doesn’t do a good job of sourcing proprietary deals, that risk is a little more magnified.
There is also the risk that once a company has been acquired, the company will actually perform poorly and will end up going into bankruptcy, which would result in a total loss for the investors. And even more important is the fact that investment in search funds, and in private companies in general, is illiquid — there’s no public market for their unique area of interest — and as a result they really can’t get out of [the investment] on their own, so to speak.
From a personal taste perspective, it is possible that the search fund entrepreneurs would come up with a deal that is not to the personal liking of the investor. In that case, they have the option of not doing the follow-on capital call, but they will receive consideration for their first stage capital contribution.
Knowledge at Wharton: Is it typically the same investors who invest initially in the search fund who also invest in the follow-on capital?
Befidi: With respect to the equity portion of the deal, yes, that’s usually the case. Ninety percent of search fund investors in round one invest in round two. There is a network of very experienced search fund investors who take a portfolio approach to search fund investing — that’s what they do, and they enjoy doing it.
Knowledge at Wharton: I was very struck by the fact, which was mentioned earlier, that many of these search funds are begun by relatively young people who may not have operational experience, and it seems to me that that might be quite a significant risk as well. Would you say so?
Befidi: The beauty of the search fund model is that most of the investors are really not only putting capital to work, but they’re putting in their own experience. So, in a lot of the cases, the quasi-mentors — the search funders — are chosen because of their operating knowledge. They’re chosen because they have industry knowledge, above and beyond just their financial knowledge.
Knowledge at Wharton: Are search funds regulated in any way? Who exercises the oversight of them and how?
Befidi: Search funds are regulated in the same way as most alternative investment vehicles, with no one in particular exercising the day to day oversight of them. However, the capital raising activities are regulated by the securities laws, which are administered by the SEC.
Knowledge at Wharton: Where do you see the future of the search fund model going?
Sinatra: We think that there is going to be a continued proliferation of the model. As I noted earlier, there are about two dozen active search funds out there. We’ve seen an increased acceptance of this model from potential search funders and interest from business and law school graduates. We think that is going to continue….
We have also seen increased investor demand, both from an individual side and also from institutions. For example, lower middle-market private equity funds: As Robert noted earlier, there is increasing competition for many of these lower middle-market deals. As a result, this places a greater premium on finding attractive investment targets, which is what the search fund model is designed to do.
In terms of investment size, there could very well be a trend towards larger transactions, maybe in the total enterprise range of $15 million to $30 million. Traditionally, many of these total enterprise values have been in the $4 million to $11 million range. We’ve seen some great companies that have done extremely well with cash flow in the range of $4 million to $7million; and some of these companies are going to be attractive search fund acquisition candidates.
In terms of investment sectors, traditional search funds have been focused more on manufacturing or “old-line” economy deals. We think that there is going to be more of a transition towards business and outsourcing services companies, just reflecting on the overall nature of the U.S. economy.
Geographically, I think that Robert noted earlier that we are not aware of any search fund investments that have been made outside of the continental United States. But, given the increasing globalization of the world’s economies, we would have to think that there could very well be a search fund acquisition outside of the U.S. in the next few years. I don’t see any reason why that couldn’t happen.
Those of just some of the thoughts that we have on the future of the search fund model.
Befidi: One additional thing is [that] we are seeing more and more experienced operators who are coming out of their corporate roles and embarking into the search fund world. Traditionally, the supply of search funds had been driven by business school graduates. That is shifting more and more, now that the model is getting more popular.
