RELAY

What Investors Should Know About Search Funds

SANDRO MINA & MARTIN STEBER

Co-Founding Managing Directors

Posted August 2017

Image via iStock by Getty Images.

This post, originally published in 2015, has been updated with relevant and current content.

In the 20+ years since Search Funds were invented at Stanford Business School, they have become one of the fastest-growing niches in the alternative asset management space, rising dramatically both in terms of the number of funds in the market and the capital available to back them.  They have also formed one of the best performing asset classes in terms of returns, averaging approximately 34 – 37% across all funds over the past two decades.

As Search Funds have received an increasing amount of attention in the financial press, most of the articles have focused on the opportunities for entrepreneurs looking to secure an acquisition and business owners looking for an exit.  Little has been written, however, about Search Funds from the perspective of LPs.  That is the focus of this article.

Most recent data from the latest Stanford Graduate School of Business’ 2016 Search Fund Study points to a growing investment class that’s delivering uniquely robust investor returns.

US & Canada Search Fund Performance

Total SFs: 303

Avg. MOIC: 8.4x

Avg. IRR: 36.7%

International Search Fund Performance

Total SFs: 45

Avg. MOIC: 2.8x

Avg. IRR: 33.4%

Sources: 2016 Search Fund Study, Selected Observations, Stanford Graduate School of Business, 6/27/2016; International Search Funds-2016, Selected Observations, IESE Business School | EIC, June 2016.

80% of international search funds have been raised after 2008, resulting in lower historical performance since the highest performing business have had less time to compound.

Stanford GSB and IESE study figures as of 12/31/15.  Past performance does not guarantee future results.

As Search Funds have received an increasing amount of attention in the financial press, most of the articles have focused on the opportunities for entrepreneurs looking to secure an acquisition and business owners looking for an exit.  Little has been written, however, about Search Funds from the perspective of LPs.  That is the focus of this article.

“[Search Funds] have also formed one of the best performing asset classes in terms of returns, averaging approximately 34 – 37% across all funds over the past two decades.”

What a Search fund Is and Isn’t

Search Funds are a unique approach to investing in the lower, middle market.  At their core, Search Funds exploit an opportunity to match hungry, ambitious managerial talent with successful — but stalled — profitable companies with longstanding stability.  When executed properly, the business gets a needed jolt of energy and the introduction of better business practices, and investors get cost-effective access to solid deals and the opportunity for excellent investment returns.

Search Funds do not invest in venture capital, turn-around, or start-up stage businesses.  The focus is purely on established companies which have demonstrated profitability over many years, and usually, decades.  Unlike the types of investments noted above, there is no risk that the underlying investment target is a viable business; the real risk instead is that the management team may fail to fully seize the opportunities for growth.

Team Risk And The Search Period

The danger that the management team backed in a private equity investment will itself derail the potential for returns, either through a collapse of individual character or devolution of the team dynamic, is an under-reported investment risk.  The structure of a Search Fund investment provides some protection against that risk.  The time spent working with the team during the initial search stage (often 12 – 18 months) provides investors with a valuable period to further vet the Search Managers before the larger amounts of capital are committed for the acquisition.  The working relationship during this period will provide much better information regarding the managerial styles of the prospective management.

This period also affords the investors with time to install the corporate governance and reporting procedures required to provide the transparency of management and visibility of business prospects investors need to be able to assess the value of the investment and the relative attractiveness for follow-on capital.  Another bulwark against team risk is the commitment by the Search Managers themselves of their own capital prior to an actual acquisition having been identified and funded.  This commitment, occurring before a salaried job is secured, demonstrates a level of commitment not always seen in standard management buyouts, where the executive is either already securely in place or has been recruited with a large pay package.

Transaction Risk and the Avoidance of Auctions

In an increasingly competitive M&A environment, LPs must always be concerned that the fund in which they invest may fail to close enough deals to deploy sufficient capital, may overpay in its investments to avoid that exact risk, or simply expend an excessive amount of capital on broken deals.  There are two elements inherent in the Search Fund structure that guard against that risk.  First, Search Funds operate at a level of enterprise value just below the usual auction process.

Second, the searchers themselves are aggressively researching, pursuing (cold-calling as needed) trying to unearth an attractive investment opportunity, rather than sitting back waiting for brokers or other intermediaries to approach them to solicit a bid.  Moreover, the Search Managers, having identified a viable acquisition candidate, are supported by a large, experienced Board of Directors, and a highly useful cadre of investor advisors, relationships that have existed from the start of the investment.

Investment Risk and the Consistent Historical Returns of Search Funds

Search Funds have generated average historical investment returns of 34-37% across all funds investing in the space. There are several reasons for such a high return rate, but the primary reason is that the Search Fund structure creates more opportunities than is enjoyed by other similarly-sized investment firms to find solid companies to acquire outside the auction process.

The unique Search Fund model also provides protections against downside risk.  First, when a Search Fund investment fails it is usually pre-acquisition, thus mitigating the amount of capital that could have been lost.  Second, the investment focus is on already solid, profitable companies: all the Search Managers need to do to return the invested capital (without investment gain) is not actively destroy value.  As noted before, when executed properly, the Search Fund strategy’s primary risk is not a failure of enterprise, but a failure of growth.

Unique Benefits and the Right to Co-Investment

For LPs often the most dramatic investment gains can be realized through direct co-investment alongside the fund into portfolio companies.  The unique two-stage investment process attending Search Fund affords this option better than other private equity fund investments: first, at the point of acquisition there is an opportunity for co-investment, and second, at future points when the acquired company needs growth capital, there are further opportunities for direct investment.

Search Funds generate many more investment opportunities on a per investment professional basis than more typically structured funds, which in turn, can lead to better deal selection and better returns.  The reason for this increased access to transactions is the role of the Search Managers: while similarly-sized private equity firms focusing on the same lower middle market will typically have one or two persons based in their office responsible for generating deal flow, each Search Fund investment will usually have at least two persons in the field hunting for a good acquisition candidate.  The result of this extra deal-sourcing manpower is the capacity to find and evaluate many, many more deals.

Avoiding Auctions

Investing In Stable Businesses

Sourcing Proprietary Deals

Some Of The Investor Benefits of Search Funds

The Search phase also serves as a form of leverage

For much less capital than would be required to participate in a single investment, a Search Fund can receive committed equity positions in several investments, and after the learning that necessarily flows from the search period, can allocate its capital to the strongest ones at the time of acquisition.

Liquidity and the Routes to Realization

The search period at the start of the investment process is sometimes mistaken as a delay in the deployment of capital, and thus a significant elongating of the holding period.  However, this is not necessarily the case.  Because each of the Search Managers are performing deal sourcing, due diligence, and initial transaction negotiating activities on behalf of the Search Fund, it is able to move forward on more deals simultaneously than a typically structured investment firm.

Although there are no studies to measure the comparative time to full capital deployment, the simultaneous nature of the Search Fund’s transaction advancement is unlikely to be dramatically longer than the necessarily sequential nature in which a traditional firm approaching the same market would deploy its capital.

A useful analysis would be to look at where Search Fund investments would be relative to a traditional private equity fund’s investments at four years.  At approximately eighteen months, at the time of acquisition, the Search Fund investment will have received a boost from its conversion premium (usually 50%) into shares of the acquired company.  From that point, the new management team will then have a solid ten quarters to show a bump in the business, which is ample time to show attractive investment momentum sufficient to entice secondary investors, if the LP needs liquidity.

Conclusion

Despite increased attention on Search Funds, substantial growth in AUM, and burgeoning transaction activity, there remains some confusion as to how the asset class has consistently generated 34-37% returns over two decades.  The reason for that performance lies in a targeting of stable profitable companies that are too small to attract auctions, and in a structure that leverages young energetic managerial talent as force-multipliers in the search phase and returns-generators in the management phase.  

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