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 in the aspiring search fund 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. And the management team often receives guidance from the investors of the fund.
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 funds have been formed, with Stanford University documenting more than 177 search funds from alumni of its elite MBA program. The majority of the successful search funds were started by entrepreneurial book-smart graduates who lacked experience in managing a business.
An average search fund takes approximately 19 months to find and acquire a company. The average starting capital of a search fund is approximately $426,000. Search funds commonly target companies whose founders are about to retire or a family business 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 management team.
How Does a Search Fund Work?
The first step in establishing a search fund is to raise capital. The amount of capital depends on the projected administrative costs, salaries and wages, attorney fees, and other related expenses. Young search fund entrepreneurs focus on securing investors who are willing to mentor and advise the target 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 less than $500,000. The capital can be raised from among 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 they potentially want to acquire. The goal of making an acquisition is to create value for themselves and the investors. Therefore, the management team must carefully scrutinize the potential target company’s financials to make sure they are making the best choice.
Typically, search funds invest in high revenue, high growth, and high margin companies that are expected to yield high positive returns in the future. Once a target 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 both the search phase and the acquisition phase. The acquisition process involves conducting due diligence, negotiating equity allocations, and deciding on the structure of the transaction.
Search Fund Companies Post-Acquisition
The search fund manager usually takes over as the company’s new CEO once the acquisition is complete. Some of the investors may sit on the company’s board to provide advice to the young entrepreneurs. The next step is to start creating value. The management team can venture into add-on acquisitions, geographic market expansion, renovating business premises, or invest in aggressive marketing.
The team runs the company with a long-term investment horizon, usually three to seven years. Some of the most successful search funds exist for more than 10 years. Some investors may need to liquidate their investments before the 10 years are over. Liquidation options include issuing an IPO, equity recapitalization, an outright sale of the business, or the investor disposing of his/her equity interest in the company.
Expected Returns of a Search Fund after Acquisition
A 2013 study conducted by the Center for Entrepreneurial Studies at the 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 was 36.7% and the pre-tax return on invested capital was 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 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 worldwide continues to increase. The leading regions for search funds are the United States, Western Europe, Latin America, and India. In 2011, Stanford University partnered with the IESE Business School – the University of Navarra in Barcelona, Spain – to conduct a separate analysis of international search funds in Europe, Asia, and Africa.
As of 2016, there were approximately 50 new search funds being established throughout the world each year.
Thank you for reading CFI’s guide to search fund. To learn more about business financing, private equity, and acquisitions, see the following resources: