• Bocconi Students Private Equity Club

Search Funds: an asset class that relies on small-scale human interaction

Updated: Dec 16, 2020


Written by Michele Conte and edited by Florian Kramer


Search Funds are a niche asset class based on high-potential entrepreneurs who locate, acquire, manage, and grow a privately-held company. The investment vehicle is managed by an entrepreneur called “the searcher” who collects funds to finance the search and the acquisition of a single company, where they will have the opportunity to become equity-owning CEOs of a business early on his career.


Search Funds are becoming more and more popular because they are very interesting from different points of view. First, they represent a formidable opportunity for young professionals to start a career as CEOs without going through the hustle of starting a company. Second, they represent an opportunity for SME owners to exit their company without selling to a competitor, as targets are often too small for PEs and too big for VCs. Third, Search Funds offer investors an average of 25.8% IRR (to date, of all funds excluding the top 5) paired with an important role within the company because the entrepreneur usually leverages their knowledge and network for strategic development. Overall, Search Funds represent an interesting innovation in the field of alternative investments which bears potential not only because of its returns, but also because it brings high-potential entrepreneurs to small companies which often fail to grow for lack of vision.


In its structure, a Search Fund is similar to a PE-backed LBO: leveraged acquisition, operational improvements, and multiple expansion. However, the difference in scale is critical. A PE fund will need to deploy a large amount of capital over its investment phase as capital has been committed prior to any acquisition. Thus, it will avoid small-size deals with less than €50m in acquisition price and will instead focus on a variety of deals that decrease risk and employ the committed capital. On the other hand, a Search fund is a focussed investment in a single company with no diversification and no amount of capital committed prior to the acquisition that therefore would need to be deployed. Hence, the most important aspects of the deal are the entrepreneur’s abilities, the investors’ quality and network, and the seller’s motives. These elements interplay and create a fundamental human interaction that is key to a Search Fund’s success.


A great example of this critical human interaction is the acquisition process during which the searcher seeks to convince investors to commit the acquisition capital. Investors are usually ex-entrepreneurs themselves or experienced managers with significant wealth. They play a fundamental role, given that the whole deal rests on the investors’ trust in the entrepreneur and their ability to pick and run the company. Since funds perform only single acquisitions, investors have to diversify their portfolio themselves, sometimes contributing to different funds at the same time. Over time, an investor community has developed (in the US) which now also works as collective selector of searchers. If there is a well-known investor who has experience in the industry of the target company, the others will wait to see whether they will invest or not before they make their own investment decision. This mechanism works best with investors that are experts in particular industries or even smaller sub-sectors where the investment decision of the most experienced investors has a pivotal role in the acquisition process.


Another peculiar human component of Search Funds derives from the characteristics of the target company. The target size for acquisitions ranges between €2m to €30m in revenues with ideal EBITDA between €1m to €5m with stable and recurring revenues. This range of financials characterises SMEs that are often too big and mature for VCs and too small for PE funds. Therefore, acquirers are most often competitors who seek to gain market share. However, most companies of this size are family-run, implying a strong emotional attachment of the potential seller to the company along with its corporate culture and employees. To give an example, in Italy there are around 14,000 companies that fit the criteria, 40% of which are headed by CEOs who are over 60 years old. Hence, motivation to sell becomes a critical factor. It’s most often the case that a family-owned company has no suitable successor to run the business and is thus forced to close or sell to competitors. Companies with these characteristics are the perfect picks for Search Funds, which often offer to maintain relationships with the seller through seller debt as well as retention of the seller within the company for the first year after the acquisition.


In a way, the entrepreneur will step in the family business and carry it on without sweep changes and radical manoeuvres, but instead focussing on growing the business organically. The relationship that is created with the seller is a fundamental factor to the success of a Search Fund because it eases the change in management and helps with the retention of key employees. In addition, SMEs of this size are often a “one-man show”, where the CEO accumulates fundamental human capital such as relationships with clients and key employees as well as operational know-how which is pivotal for the success of the business, and should be retained by the searcher through a friendly relationship with the seller. Ultimately, SME owners often prefer the level of human interaction of a Search Fund over the sale to a competitor or to a PE fund.


To conclude, Search Funds should be considered as an important opportunity for young talent to gain experience as CEOs early-on in their career and tap growth potential in small companies that lack educated leadership or suitable successors. It represents an opportunity to learn and work in top positions, which are usually scarce and hard to arrive at in larger and more established companies or requires that one starts an entrepreneurial venture from scratch. Thus, “entrepreneurship through acquisition” constitutes an attractive alternative. For investors, investing in a Search Fund allows for above-average returns as the lack for competing potential acquirers lowers acquisition multiples. At the same time, investors have the opportunity to actively take part in the development of the company through advising the searcher on strategic decisions, thus contributing with their own industry expertise. For company owners, selling to a Search Fund solves the issue of succession and like for investors, allowing for an ongoing relationship with the company as they are often retained in the board or as strategic advisors.


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This article was first published on Bocconi Students Private Equity Club website on 4th of December 2020.


Sources:

Molinari A., Search Funds: Un Nuovo Strumento a Sostegno della Piccola Impresa e del Rinnovamento Imprenditoriale, Guerini Next, 2019

Stanford Graduate School of Business, 2020 Search Fund Study, 2020

Stanford Graduate School of Business, A Primer on Search Funds: A Practical Guide for Entrepreneurs Embarking on a Search Fund, 2020


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