The Underlying Stability of Search Funds
SANDRO MINA & MARTIN STEBER
Co-Founding Managing Directors
Posted July 2017
Image via IESE Business School, University of Navarra, Spain
This post, originally published in 2015, has been updated with relevant and current content.
Search Funds are private equity firms focused on acquiring stable, profitable companies in the lower middle market, generally at an enterprise value below the typical point for triggering a formal auction process. Search Funds are structured in a unique two-stage investment process: the ‘Search’ in the name represents the first stage in which young, energetic managerial talent (the “Search Managers”) raises a small amount of capital to fund the hunt for an attractive acquisition target.
The second stage is the acquisition of the target, in which the Search Managers raise additional capital from a combination of the initial investors (the “Search Funds”), which convert their previous capital contributions into equity in the new entity at a premium (usually 50%), and other outside investors depending on the purchase price. The Search Managers then become the management of the acquired company and, with the assistance of the Search Fund, increase the value of the company and, after a few years, begin to look for an exit for the shareholders.
The Four ‘Gems’ That Make Search Funds Outshine Alternative Asset Classes
First & Foremost: Profitability
The central investment thesis undergirding Search Funds is that a small, but stable and profitable, company can be grown through the introduction of the drive, ambition, and hunger that a well-prepared new MBA graduate will bring. There are several important parts to that strategy, but none more so that the core profitability of the company being acquired.
Search Fund managers are not turn-around specialists, nor are they start-up inventors; Search Fund investors are seeking to inject new energy into an already fundamentally stable company, not save one that is struggling or build a new one from the ground up.
At the time of acquisition, Search Fund investors conduct due diligence to ensure not only profitability of the target asset, but stability as well. The hallmarks of an attractive Search Fund acquisition are consistent percentages of profitability, low volatility or seasonality, and an absence of one-off revenues that artificially make the company profitable.
Recurring Revenue Base
No transition involving a change of company management occurs without some disruption, and responsible investment analysis requires that such challenges be included in the planning. In every transaction, however large or small, there will be a short period required for the new management to get settled. In Search Fund investing, that potentially tumultuous period is substantially ameliorated through the involvement of experienced Search fund investors, who have been through such transitions many times before, and the seller of the business, who wants to make sure his former company and employees are still on stable footing.
Knowing that such a transition period will occur places greater importance on ensuring that the target company has a reliable set of recurring revenue streams. Effective due diligence in this regard serves as a prophylactic measure against the business struggling during the early unsettled period. It also gives the new management the comfort of knowing that the financial projections underlying their growth plan are reliable.
Marketing consultants are fond of saying that a ‘brand’ is a relationship, and it is true that customers tend to stay with the same companies year after year. Hence, the many studies calculating how much more expensive it is to acquire a new customer than it is to keep an existing one. The most attractive candidates for a Search Fund acquisition are those companies that have long-standing customers who are unlikely to defect to a competitor in the event of a minor misstep by the new management team.
One of the most damaging failures in any relationship is taking your counterparty for granted, and in the case of older companies, that complacency has very often begun, and a certain coasting effect becomes the norm. The Search Fund managers are the perfect antidote to this creeping malaise; their youthful enthusiasm for the company, and their facility with new technologies to increase interaction, can often reinvigorate commercial relationships that have grown stale.
Leveraging Vendor Relationships
It goes without saying that a company can’t sell anything without suppliers, and this area is one of the strongest legs in the Search Fund chair. By focusing on companies with long-standing stability, the new management team has a bedrock of credit relationships that can be leveraged and grown. Much like with customer relationships, the new management team’s drive to grow the company will excite the existing vendors who view the change as a way to grow their own businesses as well.
Unlike pure venture capital investments where the company has no credit, or distressed situations where the company likely has bad credit, in a Search Fund investment, no resources need to be used in establishing the incoming flow of goods and services needed. Frequently, as well, such small long-standing companies already have in place strong banking relationships and undrawn credit lines that can also be used to fuel growth.
“When search Fund investing is done in a disciplined manner, the risk is more likely to be a lack of growth rather than a failure of the business.”
Private equity investing in all classes requires an analysis of the down-side risk as well as the potential gain. Search Fund investing, through its focus on (usually unglamorous, but) stable companies with long-running profitability, significantly mitigates the risk of loss. When search Fund investing is done in a disciplined manner, the risk is more likely to be a lack of growth rather than a failure of the business.