Search Funds Defined: Pros and Cons

Search funds make good potential buyers for small- and middle-market business owners looking to exit their companies. H. Irving Grousbeck, a professor at Stanford University’s Graduate School of Business, created the search fund concept in 1984, and by 2020, the number of search funds had grown to over 400.

Search fund entrepreneurs differ from private equity investors, as they actively run the acquired business and grow it. So, what is a search fund?

Search Funds Explained

Investors who believe in the skills and abilities of one or more talented individuals (searchers) back them and their companies by raising capital in a search fund. The searchers or search fund partners are usually fresh MBAs or business graduates with entrepreneurial aspirations.

These investors want to grow and build companies to gain leadership experience but do not have the wherewithal to build businesses. Therefore, they look to acquire small- or middle-market businesses valued between $5 million and $30 million. They choose industries that are easy to understand and not restricted by rapid technological change, such as healthcare, financial services, education, etc.

Their target companies are often businesses with owners who want to retire or step back. Searchers select companies with already established market positions upon which they can build.

It may take a few years for searchers to identify a suitable investment using the funds raised by the investor group. After identifying the target company, they carry out the due diligence processes. They may partly fund the purchase with equity from the investment group and the rest with external debt. Usually, the searchers retain 8% to 25% of the target company after the acquisition.

The investors not only provide funds but also mentor and guide the searchers to create an environment for success. The ownership transition resembles a management buy-in for which the searchers take up the management role and participate in running and growing the business.

Post-acquisition, the searchers work to increase the profitability and value of their first business. A respectable return on investment is also one of the reasons why investors support search funds. A Standford study suggests that the aggregate pre-tax internal rate of return for search funds in 2020 was around 33 percent, and the investment multiple for the investment capital was 5.5 times.

After maximizing the business’ value, searchers seek to exit by selling the business for a much higher price than they initially paid to acquire it.

Search Fund Pros

The nimble size of search funds makes them successful. They focus on acquisition details and work closely with selling business owners. They differ from private equity funds, as their business fundamentals include sustainable growth and stable cash flows. Due to this reason, investors find search funds attractive.

Search funds differ significantly from venture capital in their target businesses. Venture capital firms usually target start-ups with high-growth opportunities, while search funds seek established companies with high-profit margins and proven track records.

The due diligence process that the search funds follow helps searchers and investors to identify business risks and investment failures during the early stages of acquisition.

Benefits for Search Fund Entrepreneurs/Searchers

Credibility. Usually, selling business owners are skeptical about the searchers’ financial capabilities to conclude the business transaction. The backing of a group of credible investors helps searchers secure acquisition transactions by reinforcing access to capital and validating the searchers’ abilities.

Financial support. Investors raise capital for a search fund and pay salaries to searchers from it while they search for the right acquisition target. The search fund also provides funds to meet office space, infrastructure, travel, and due diligence-related expenses. Searchers also benefit from the investors’ relationships with legal and accounting professionals to close the acquisition transaction.

Broad-based access to capital. Search funds usually have broad-based access to capital as there are 10 to 20 institutional or individual investors. If some investors pass on the required investment, others in the group fill the funding gap. It improves the probability of searchers closing their targeted acquisition.

Diversified collaborative experience. Varied investors bring their unique experiences and networks to the search fund, providing an immense advantage for searchers. It helps them conduct better evaluations of industries, target companies, and acquisitions. The network help searchers execute operational initiatives after acquiring a company.

Active investment. Most searchers come from top-tier MBA programs but have no executive experience acquiring or operating a company. Search funds provide much-needed guidance and expertise. Investors mentor searchers throughout different aspects of their search and also serve on the board of directors post-acquisition to help them execute growth strategies. This guidance and motivation play a critical role in the success of the searchers and the acquisition deal.

Benefits of Search Funds for Selling Business Owners

Business continuity. Traditional private equity and strategic buyers look to downsize the headcount and infrastructure of the acquired company by making it a part of a larger entity. On the other hand, searchers look to work with the existing management team to grow the business post-acquisition. They target small- and middle-market companies and fund transactions through internal cash and debt. The selling business owners benefit from business continuity by transacting with search funds.

An experienced board of directors. The investors in the search fund join as the board of directors after the searcher acquires a business. They share their experience in operating and governing the company responsibly. As most small- and middle-market companies do not enjoy the benefit of an experienced board of directors, transacting with search funds provides it to them.

Longer-term investment. Selling business owners benefit from responsible, long-term investment management with search funds. While most investors expect an early liquidity event, search funds hold on to a company for an average of seven years, or even over ten years.

Co-investment opportunity. Many business owners like to retain equity in the company even after the acquisition to benefit from the growth that the acquiring owners create. With search funds, they can maintain their stake in the company and earn substantial profits at the next liquidity event.

Search Fund Cons

As search funds intend to provide executive experience to the searchers, they require managers to devote their entire time and energy to the target company search and, later, the acquired company.

Substantial capital is not enough for the acquired company to succeed. Searchers also need the investors’ feedback and guidance, considering their limited experience in running a company.

Due to their limited experience, search fund partners (searchers) often fail in executing complex operations. That leads to the loss of competitive advantage for the acquired company.

Searchers’ knowledge is primarily academic, which falls short on the practical aspects of running a business. The management team and board of directors may not have the expertise needed to grow the company, resulting in its failure.

Consider Carefully

While search funds provide several benefits, they are not without drawbacks. Selling business owners should be wary of searchers’ limited industry experience and business acumen, which poses a high risk for a company’s continued prosperity.

Know when you need professional assistance to complete an ownership transition with a search fund. Connect with us to know how we can help small and middle-market business owners optimally utilize the exit option of search funds.