Search Fund

An investment pool for entrepreneurs looking for capital

What is a Search Fund?

A Search Fund is an investment pool aspiring entrepreneurs use to raise capital from investors in order to acquire a business and step in as CEO and operate the company. Search funds mainly search and acquire companies that are valued between $5 and $30 million. The funds used to purchase the companies are obtained from high net worth investors who place trust on the aspiring entrepreneurs to successfully run the business. Unlike in traditional private equity investments, the managers of a search fund take an active role in operating a business once the acquisition is completed. The management team often receives guidance from the investors of the fund.

 

Search Fund infographic

 

History of Search Funds

The concept of search funds started in 1984 at Stanford University Graduate School of Business. It was pioneered by Professor Irving Grousbeck, the Director of the Center for Entrepreneurial Studies. Since then, over 542 traditional funds were formed, with Stanford University documenting more than 177 search funds from its alumni of elite MBA programs. Majority of the successful search funds were started by entrepreneurial book-smart graduates who lack experience in managing a business.

Today, an average search fund takes approximately 19 months to find and acquire a company and starts off with a capital of $426,000. Search funds target companies whose founders are about to retire or a family-run that the founders want to put under new management. The company must possess a solid track record and a strong potential for growth. Once the company is acquired and the new management team takes charge, investors inject the company with the capital needed and provide mentorship to the inexperienced management team.

 

How Does a Search Fund Work?

The first step when establishing a search fund is to raise capital. The amount of capital depends on the projected administrative, salaries and wages, attorney fees and other related expenses. When sourcing capital, young entrepreneurs should also focus on getting investors who would be willing to mentor and advice the company. Investors can provide guidance on deal evaluation, capital structure, locating new investments and new product releases. Investors initially provide capital that is enough for the search, typically below $500,000. The capital can be raised from several investors, with each investor raising between $30,000 and $50,000.

Before making an acquisition, the management team must do research, cold-call, and pitch the businesses that want to be acquired. The goal of making an acquisition is to create value for themselves and the investors, and therefore, the management team must scrutinize all the potential companies’ financials to make sure they are making the right choice. Typically, search funds invest in high revenue, high growth and high margin companies that will yield positive returns in the future. Once a company is identified, the investors evaluate the deal and decide how much to invest in the company. The investors get part-ownership of the company depending on the amount of their contribution in the acquisition stage, as well as in the initial search phase. The acquisition process also involves conducting due diligence, negotiating equity allocations, and determining the structure of the transaction.

Once the acquisition is complete, the search fund manager takes over as the company’s new CEO. Some of the investors may sit at the company’s board to provide advice to the young entrepreneurs. After the management team has gained trust in the business, the next step is to start creating value. They can venture into add-on acquisitions, geographic market expansion, renovating business premises, and investing in aggressive marketing. The team runs the company with a long-term outlook, usually 3 to 7 years, while the most successful search funds exist for more than 10 years. Some investors may require liquidating their investments before the 10 years are over through a variety of options. These options may include issuing an IPO, equity recapitalization, an outright sale or the investor disposing of his/her part ownership of the company.

 

Expected Returns of a Search Fund after Acquisition

A 2013 study conducted by the Center for Entrepreneurial Studies at Stanford Graduate School of Business revealed that a portfolio of first-time search funds yielded an aggregate pretax return of 35%. The aggregate return was ten times the amount of invested capital. According to a 2016 study conducted by the same institution on 258 search funds, the aggregate rate of return before tax to be 36.7% and the pre-tax return on invested capital to be 8.4 times.

A typical example of a search fund is VRI, a company that provides remote monitoring services that help patients take rest at home rather than prolonging their hospital stay. Chris Hendricksen, the co-founder of VRI, graduated from Stanford Business School in 2006. During an interview with the Forbes, Chris said he preferred forming a search fund because it is easier to “accelerate the car rather than build a new car.” Chris and his business partner grew the business to over $30 million in revenue and later disposed of the company to a private equity firm. He mentioned that he preferred running a small business without prior business experience rather than getting stuck with a start-up company that would yield $0 to $1 million in revenue.

The number of search funds continues to increase throughout the world, with regions like United States, Western Europe, Latin America and India being on the lead. In 2011, Stanford University partnered with the IESE Business School – University of Navarra in Barcelona, Spain to conduct a separate analysis of international funds in Europe, Asia, and Africa. Stanford University studies search funds located in the United States and Canada only. Through December 2015, there were 45 first-time search funds, of which 12 were in the United Kingdom, 11 in Mexico, 9 in continental Europe, 7 in Latin America, 2 in the Middle East and one in Africa, according to a study by IESE Business School in 2016.

 

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