SANDRO MINA & MARTIN STEBER
Co-Founding Managing Directors
This post, originally published in 2015, has been updated with relevant and current content.
No one needs to be told that generating superior investment returns requires buying low and selling high. In terms of the latter, auctions are usually the best way to generate a higher valuation, but unfortunately, in terms of the former, auctions at the point of acquisition also meaning paying more – and establishing a higher basis to weigh down returns.
The best scenario, naturally, is to avoid auctions on the way into an investment, and run one on the way out; and that is greatest strength of the Search Fund investment model. For associates in a traditional private equity firm, who are tasked with generating constant deal flow, the most efficient approach is to develop relationships with intermediaries. While this means that there will be a constant stream of transactions to be presented to the partners, it also means there will be an attending auction process to drive up prices.
The difference is in the motivation
The Searchers also have another driving motivation not present in traditional private equity deal-sourcing practices: they will have to re-sell the deal to the Search Fund investors in order to secure the acquisition capital. Search Fund investors have provided the capital to fund the search in order to ensure that the Searchers fund a proprietary deal that has not been set up for an auction process, meaning that the Searchers have to dig deep to get beyond the flow generated by the intermediaries and find a acquisition direct from the owner.
Passing The Baton
Finding a deal that is truly proprietary is hard. Search Fund investors know the search will be difficult, which is why they are willing to pay for an 18 month, full-time quest to find an acquisition meeting the best criteria. But the investment returns that are possible when buying a solid business whose valuation has not been artificially inflated through several rounds of bidding make the patient approach worth the effort.
An interesting dynamic that has emerged over three decades of Search Fund transactions is that the seller is often not particularly concerned with getting the highest possible price. The reason is that the seller is often the founder, and is almost as concerned with the preservation of his legacy and the protection of his long-serving employees as he is about the amount of cash he will pocket.
When presented with an offer from a competitor for more money, that will result in the business effectively being closed down, and an offer from a couple of driven, young entrepreneurs who have plans to grow the business, but who are offering less cash, the business patriarch usually takes the Searchers offer.
“But the investment returns that are possible when buying a solid business whose valuation has not been artificially inflated through several rounds of bidding make the patient approach worth the effort.”
Burning the Boats in the Harbor
Like the Norsemen who burned their own ships upon invasion to make retreat impossible, the Searchers are similarly committed. Having contributed their own cash, and having committed to move to wherever the best acquisition is found, their target company identification, research, and analysis is imbued with a sense of life and death that is just not found in more standard private equity deal-sourcing. For an associate in a traditional buy-out firm, bringing in a bad deal in which the fund loses money could tarnish their career; for a Searcher, sourcing and completing a bad deal will damage their life, and leave them stranded with no career.
Of course, there is also a financial incentive for Searchers to find a solid acquisition target and pay a non-auction price. With success, the Searchers vest into a greater share of the equity of the acquired company, and the potential return from a liquidity event will be much greater than just about any other career path that recent MBA graduate could have possible chosen. The math is simple: the lower the entry price, the larger the gain, and the more money the Searcher ultimately makes.
Search Funds have returned an average IRR of 34-37% over the course of 30 years for several reasons, but one of the most overlooked is the superior deal-sourcing that the Searchers are motivated for several reasons to generate.