A search fund is pot of money raised by a group of aspiring entrepreneurs who use the capital to acquire a business. The “aspiring entrepreneurs” usually receive a salary during the search process. Search funds typically acquire companies that are worth between $5 and $30 million.
The capital is fronted by high-net-worth individuals who believe in the skills and capabilities of the entrepreneurs managing the fund and the subsequent business that is acquired. The primary reason that a search fund is different from private equity investments is that the entrepreneurs are planning to buy and operate a single business, whereas with a private equity fund is looking to make investment without much of an operational role.
When Did Search Funds First Become a Viable Investment Vehicle?
In 1984, Stanford University Professor Irving Grousbeck – who was the Director of the Centre for Entrepreneurial Studies – pioneered the concept of search funds to help some of his students acquire a small business. In excess of 600 search funds have been formed since the eighties, with more than 170 of those coming from alumni of the Stanford MBA program.
How Do Search Funds Work in Practice?
In most instances, it takes search funds between 18 and 24 months to acquire a company, with the average starting capital of search funds sitting at $426,000. Search funds often target family-run businesses that are looking for new management or long-running companies whose founders are looking to step aside, usually due to retirement. While every acquisition is slightly different, they typically progress in the following way:
Step One: Capital Acquisition
As you might have guessed, every search fund begins with capital acquisition. The entrepreneurs that form the search fund (typically recent graduates) are tasked with approaching high-net-worth investors to pitch their ideas. The budget for the search fund considers wages, salaries, administrative costs, travel, attorney fees, and various other costs.
Most search funds start with a pot of capital of less than $500,000, acquiring up to $50,000 from each individual investor. Equally as important as the capital is the input from the investors, who are tasked with supporting the fund with structure, investment opportunities, deal evaluation, and various other guidance.
Step Two: Company Research
It’s not easy for search funds to identify companies that will be open to the idea of acquisition. The process of researching potential companies is long and cumbersome and often involves lots of cold-calling and pitching, which is the reason that the acquisition process can take up to two years.
Guided by experienced investors, search fund management teams often target high-margin and high-revenue businesses that have significant scope for growth in the near future. When the entrepreneurs have identified the company for acquisition, the investors decide how much to invest and how the new company will be structured.
Step Three: Company Acquisition
The investors will decide among themselves how much money to front to acquire the new company. Most search funds acquire companies worth between $5 million and $30 million, and the new investors take part ownership of the new company in return for their capital.
At this stage, the entrepreneurs and investors conduct due diligence, negotiate equity allocations, and agree on the structure of the transaction.
Step Four: Post-Acquisition
The new CEO of the company is appointed from within the group of entrepreneurs – usually, the Search Fund Manager – and several of the investors take on an active role on the new company’s board of directors to guide and inform the new CEO.
As soon as the structure of the new company is ironed out, the entrepreneurs set about adding value to the business, which is achieved through add-on acquisitions, market expansion, and various other means.
How Much Can Investors Expect to Make from Search Fund Investments?
As an asset class, search funds are extremely successful investments. Research indicates that the pre-tax internal rate of return on a search fund is 34.9%, which equates to around ten times the amount of capital invested.
What’s more, search funds are economically viable for entrepreneurs, with searcher salaries averaging $130,000 and CEO salaries starting at $180,000. When managed correctly by people with the required skills and abilities, search funds can be exceptionally lucrative for those involved.
Are There Any Drawbacks to Search Funds?
Of course, there’s no such thing as a perfect investment. While search funds are an excellent investment opportunity for many and yield excellent returns, some of the drawbacks include:
Most search fund entrepreneurs need to commit to 5-7 years, which is similar to the time commitment of most venture start-ups. And the earnings of search fund entrepreneurs can be modest when compared to start-ups that make it to the big time.
Geography & Industry
The majority of search funds acquire businesses in Middle America, which isn’t necessarily where young entrepreneurs want to find themselves. What’s more, the industries that search funds acquire businesses in are typically industrial, which is far from exciting for young and budding entrepreneurs.
Harder to Get Off the Ground
The cold-calling and research required to get a search fund off the ground are certainly not for the faint hearted. Trying to convince old-time business owners that you are perfectly positioned to buy their decades-old business is not straightforward, and there’s no playbook to follow. But that being said, when you finally seal the deal, you will be equipped with a successful business that is ready for accelerated growth.
Search funds present young entrepreneurs and seasoned investors with an attractive alternative investment vehicle. Instead of risking capital in a venture start-up, search funds present a viable opportunity to acquire a long-established company and make it even more successful. It promises to enrich entrepreneurs and investors alike and is well worth considering if you are looking for a long-term investment strategy.