- Search funds
- The search fund model: How do search funds work?
- Raising capital
- Identifying a target company
- Managing and growing the target company
- Exiting the investment
- Search funds vs. traditional private equity
- Portfolio construction
- Fund size
- Investment size
- Role of the fund manager
- Risk profile and return potential
- Pros and cons of search funds
- Search fund pros
- Search fund cons
A search fund is a type of private investment fund used by entrepreneurs who are seeking to acquire and take operating control of a small business.
Unlike traditional private equity funds, which own multiple companies and operate in partnership with company leadership, the manager of a search fund (also referred to as a “search fund entrepreneur” or “searcher”) acquires just one company and typically installs themself in a high-ranking role, such as CEO or president. Search funds fall under the category of entrepreneurship through acquisition (ETA) and are often used by relatively inexperienced entrepreneurs as a way to gain control of a company and shepherd its growth without having to found their own startup.
The search fund model: How do search funds work?
At a high level, search funds function in a similar way to venture capital funds and PE funds: The fund manager raises capital from investors and uses that capital to make an investment, with the goal of increasing the company’s value, selling at a profit, and returning the proceeds to the original investors. But the details of this process are often specific to search funds.
Raising capital
The manager of a search fund typically raises capital from other successful entrepreneurs and investors within their professional network. In many cases, search fund managers are MBA graduates or other aspiring executives who don’t yet have extensive track records.
Search fund investors often will agree to provide mentorship, guidance, and advice to the fund manager in addition to capital. Some search funds might have a small handful of investors, while others might have many. The size of search funds can also vary, typically ranging from hundreds of thousands of dollars to a few million.
Identifying a target company
At some point during or after the process of raising capital, a search fund begins searching for a company to acquire. This search process of finding and researching potential targets is similar to the investment due diligence process undergone at VC and PE firms.
While search funds can acquire any number of different companies, they are most frequently used to buy small businesses with strong revenue and growth metrics (e.g., cash flow, EBITDA, or ARR) that are seeking a change in management, perhaps because the current owner is looking to retire or liquidate their stake. Since search funds are used to acquire a single company, rather than several, they typically have a less defined investment sector focus than VC or PE funds.
This search phase can be a drawn-out process, often lasting for many months or multiple years. Once a search fund identifies a target, the fund manager works with legal and financial advisers to negotiate terms of the acquisition and eventually finalize a deal.
Managing and growing the target company
A search fund typically acquires a company with the idea of owning and operating the business for many years, often as long as a decade. This makes for a longer timeline than is typical in traditional VC and PE investments.
The process of managing and growing a portfolio company (portco), however, can look quite similar for a search fund manager and other types of private fund managers. In each case, the fund manager might deploy any number of operating or financial strategies to improve the company’s growth and revenue margins, including the addition of new business lines, the pursuit of new customers, major or minor pivots in strategy, or restructuring the company’s debt.
Since the fund manager typically installs themselves as CEO or to some other high-ranking position post-acquisition, they are fully empowered to pursue whatever strategies seem most likely to help grow the company’s valuation.
Exiting the investment
After holding the target company for some period of time—usually at least five years, and sometimes more than 10—the manager of a search fund will typically pursue some kind of exit event that will allow them to distribute returns to the search fund’s original investors. The motivations for exiting an investment from a search fund are the same as for exiting a portfolio company held by a VC or PE fund.
The most likely exit pathways for these various fund types are similar, too. Like a VC fund or a PE fund, a search fund is most likely to exit its investment through an initial public offering (IPO) or an M&A transaction, such as a sale to a corporate buyer or a buyout with a private equity firm.
Depending on the terms of the exit, the search fund manager may or may not retain some sort of leadership role at the target company, for example, they may hold a seat on the board of directors.
Search funds vs. traditional private equity
A search fund is a type of private equity fund, in the sense that it raises capital from outside investors to acquire a stake in a privately held company. However, there are some significant differences between a typical search fund and the standard private equity investment vehicle.
Portfolio construction
A search fund is used to acquire a single company. Most private equity funds, on the other hand, invest in many different companies. This means PE firms typically have some sort of cohesive strategy for how they will approach and manage multiple investments, which is not required of search funds.
Fund size
While both search funds and private equity funds can vary greatly in size, private equity vehicles are typically much larger. Many PE funds raise hundreds of millions or billions of dollars, while search funds are rarely larger than a few million dollars.
Investment size
On average, search funds pursue smaller investments than private equity funds. The price of search fund acquisitions is usually six, seven, or eight figures, while some PE funds pursue deals worth billions of dollars.
Role of the fund manager
When a search fund entrepreneur makes an acquisition, they typically plan to act as an owner-operator by taking over as CEO or playing some other highly active role in the company’s operations. When the manager of a PE fund makes an acquisition, they typically retain outside managers who are independent of the fund to run their portfolio companies.
While PE fund managers often maintain close oversight over company management, the fund managers are not themselves responsible for day-to-day operations, as is the case with a search fund.
Risk profile and return potential
Because a search fund invests in just one company, instead of many, the risk profile for LPs is more concentrated than it is for a private equity fund. However, this does not necessarily mean that any single search fund is inherently riskier than a single private equity fund. In both cases, the equation of potential risk and reward can vary widely on a fund-by-fund basis.
By investing in companies with low revenue and the potential for rapid growth, some search funds attempt to produce venture-type returns, which can be higher than the typical return on a buyout of a more mature company. Some PE firms aim to produce higher returns in other ways, such as investing in distressed companies that carry an increased risk of financial failure.
Pros and cons of search funds
The potential benefits and risks of search funds can be highly variable depending on the specific traits of the fund. In broad strokes, however, search funds tend to share certain pros and cons for entrepreneurs and investors:
Search fund pros
For an entrepreneur, a search fund offers a path to gain control over a potentially high-growth company without having to build the company from scratch. The investors in a search fund typically provide guidance to the fund manager in addition to capital, which can help inexperienced entrepreneurs develop their management chops while under the expert eye of a mentor or mentors.
For an investor, search funds provide the opportunity to invest in and support an entrepreneur who the investor believes can be successful as the operator of a single company. If the fund manager finds the right target company and successfully implements their strategy, a search fund can produce impressive returns on a relatively modest initial outlay of capital.
Search fund cons
For an entrepreneur who’s looking to grow a young business, acquiring a company through a search fund can require a much greater lump of initial capital than founding a company as a startup. While many startups are also expensive to run, they don’t require an initial purchase. Many entrepreneurs lack the financial resources and fundraising connections needed to launch a successful search fund.
For an investor, search funds present a more concentrated risk profile than a traditional private equity fund, as covered above. If the target company fails, a search fund does not have other investments to help mitigate the loss. Search funds also tend to operate on longer timelines than venture capital and private equity funds. This means that investors’ capital may be tied up for longer before they see any returns.
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