Search Funds: A Guide To Getting Started With Investing

Search funds are an alternative asset class in private equity that allows aspiring entrepreneurs to raise capital from investors to acquire and lead an existing company. Search funds are typically used to purchase small- to medium-sized businesses valued between $5 million and $30 million, with the goal of improving their profitability and overall value before selling them at a higher price. Search funds are often self-funded by the entrepreneur or financed through investors such as high-net-worth individuals, private equity firms, and family offices. The search fund model offers investors the potential for significant financial returns and an active role in mentoring and guiding the entrepreneurs.

Characteristics of Search Funds

Search for and acquire a company

Search funds are an investment vehicle through which an entrepreneur raises funds from investors to acquire a company in which they wish to take an active, day-to-day leadership role. Search funds can also be financed through self-funding, where the entrepreneur uses their own resources to purchase and take ownership of the business.

The search fund process can be broken down into four stages: the search stage, the acquisition stage, the operational stage, and the exit. Here is a detailed guide on how to search for and acquire a company using a search fund:

Search Stage:

• Establish a motive: Before considering a business acquisition, it is crucial to have a clear understanding of why you are acquiring the business. Common motives include expanding into new markets, gaining access to new technologies or talent, or increasing economies of scale.
• Determine search criteria: Based on your motive, establish specific criteria for your target company. Consider the markets they operate in, their customer base, synergies you are looking for, financial criteria, and other relevant factors.
• Conduct in-depth research: Utilize online databases such as M&A databases to identify potential target companies that match your search criteria. Compare different companies and their purchase prices to make an informed decision.
• Begin outreach: Contact potential target companies or their bankers to express your interest. Be prepared to sign non-disclosure agreements (NDAs) and provide confidential information about your acquisition strategy.

Acquisition Stage:

• Schedule intro meetings: Meet with the owners of the target companies to build rapport and assess the company's culture and operations.
• Make an offer: Balance your purchase criteria, market comparables, and the owner's expectations when making an offer. Avoid low-balling, as it can be seen as an insult and risk alienating the owner from future deals.
• Conduct due diligence: Before finalizing the deal, conduct thorough due diligence on the target company's financial history, operations, and legal standing. This is your chance to identify any potential issues or risks associated with the acquisition.

Operational Stage:

• Establish a board of directors: Once the acquisition is complete, set up a board of directors to provide oversight and guidance.
• Implement value-creating strategies: Work with the board to develop and execute strategies to increase the company's value. This may include correcting operational inefficiencies, expanding facilities, making add-on acquisitions, or improving technology.

Exit:

• Prepare for the exit: Monitor the company's performance and the market conditions to identify the optimal time to exit.
• Exit the investment: Depending on the circumstances, you may choose to exit through a direct sale, public offering, or alternative liquidity event. Ensure you comply with all legal and regulatory requirements during this process.

It is important to note that acquiring a company is a complex process, and seeking legal and financial advice is crucial. Additionally, be prepared for challenges and remain resilient throughout the search and acquisition process, as it may involve dealing with rejection and conducting extensive research.

Raise initial capital

Raising initial capital is the first step in establishing a search fund. The amount of capital needed depends on the projected administrative costs, salaries, attorney fees, and other related expenses. Generally, search capital ranges from $250,000 to $750,000, with an average of around $426,000. This initial fund is typically raised from a group of investors, with each contributing between $30,000 and $75,000.

Young search fund entrepreneurs should focus on securing investors who can also mentor and advise the target company. These investors can provide valuable guidance on deal evaluation, capital structure, locating new investments, and new product releases.

The search capital phase covers the salary and wages of the partners, administrative costs, and other expenses incurred while searching for target companies. Frequently, an investor's initial investment of search capital includes a pro-rata right-of-first-refusal to invest in an acquisition. This gives search capital investors the right, but not the obligation, to invest additional capital in an acquisition.

The acquisition capital phase comes into play once due diligence on a target company begins. If the search is successful and a suitable company is identified, the acquisition capital package must be put in place. The average purchasing cost for a company falls between $5 million and $30 million. The partners first request additional capital from their original investors, and if that is not sufficient, they approach new equity investors, lenders, and even the target company's seller for additional financing.

Overall, raising initial capital for a search fund involves finding investors who can contribute to the search and acquisition capital phases, with the understanding that they will have the opportunity to invest further in the acquired company.

Due diligence

Preliminary vs. Confirmatory Diligence

Financial Diligence

Financial diligence focuses on verifying the accuracy of the seller's historical financial statements and making adjustments for projection value. This helps assess the company's earning power and influences the final purchase price and deal terms. It is crucial in determining whether to complete the acquisition.

Legal Diligence

Legal diligence evaluates the legitimacy of the current owner's identity and their ability to fulfil the company's past promises. This aspect is essential for a smooth transfer of ownership and building transaction terms.

Commercial Diligence

Commercial diligence involves using public resources and paid databases to assess the industry's overall health and the target company's position within it. It helps compare the company to its competitors and understand its industry standing.

Customer Diligence

Customer diligence involves analysing customer data and perspectives to understand which customer needs are being met and to gauge current and potential customer loyalty. This analysis provides insights into the company's customer satisfaction and retention capabilities.

Technological Diligence

Technological diligence aims to assess the company's vulnerability to inept technology and evaluate the people managing the technology tools. It helps identify potential risks and weaknesses in the company's technological infrastructure.

Human Capital Diligence

Human capital diligence uncovers the owner's motivations for selling, explores employee retention issues and incentives, identifies top performers, and examines company culture through surveys and interviews. This aspect provides insights into the workforce and potential human resource management challenges.

Operational Diligence

Operational diligence focuses on understanding the step-by-step processes required for the business to function effectively. It also evaluates time and cost efficiencies in customer service to identify areas for improvement.

Additional Considerations

Other crucial aspects of due diligence include seeking expertise from industry experts in niche areas, such as environmental and insurance matters. Additionally, due diligence requires exceptional relationship management with the seller, capital providers, and advisor networks. It is important to be mindful of seller burnout, provide quality and frequent communication to capital providers, and strategically select third-party servicers to control costs while benefiting from their expertise.

Post-acquisition management

Post-acquisition, the search fund partners will take on management roles in the company, such as CEO and President. Their goal is to increase the company's profitability and overall value before exiting the investment at a higher price than initially purchased.

During this stage, the search fund entrepreneurs implement their value-creating strategies, which may include correcting operational inefficiencies, facility expansions, add-on acquisitions, or technological improvements. The involvement of investors as mentors and advisors is crucial at this stage.

The search fund entrepreneurs typically operate the company for three to seven years before exiting the investment. The exit stage could involve a direct sale of the company, a public offering, or an alternative liquidity event.

It's important to note that the search fund model is predicated on a strong symbiosis between the searchers, the company/industry, and the investors, who support inexperienced but talented and motivated CEOs in their journey. Active investors can add significant value by playing a more active role and leveraging their operational and deal experience.

Exit the investment

Exiting a search fund investment is the fourth and final stage of the search fund lifecycle. The ultimate goal of a search fund entrepreneur is to increase the company's value and eventually exit the investment at a profit. This can be achieved through a direct sale of the company to a larger company, a private equity sale, or an alternative liquidity event, such as an initial public offering (IPO). The proceeds from the sale are then distributed to investors, providing them with a return on their initial investment.

The decision to exit the investment is typically made once the entrepreneurs have implemented their value-creating strategies and an opportunity to exit the business materializes. This could be after operating and managing the acquired company for three to seven years. It is important to note that not every search fund will successfully close a transaction within the designated timeframe, and challenges may arise along the way.

When exiting the investment, search fund entrepreneurs should effectively communicate and collaborate with investors to determine the best course of action. This may involve extending the search period, pivoting or refocusing the search criteria, or winding down the search fund if it becomes evident that closing a transaction is unlikely or not feasible.

The exit stage of the search fund lifecycle marks the culmination of the journey, offering investors the opportunity to realize their gains and the entrepreneur the chance to pursue new ventures or opportunities.

Frequently asked questions