Institutional investors eye search fund model

Search funds are usually established by recent MBA graduates who raise capital from a pool of investors in order to find, acquire and lead a privately held company. The investors provide financial support, as well as advice and know-how, to guide the aspiring entrepreneur in the management and development of the business.

According to recent studies published by Stanford Graduate School of Business and IESE Business School, search funds' activity has hit an all-time high. A record 17 companies were acquired by search fund entrepreneurs in 2017 in the US, and 21 new search funds were raised in the rest of the world. Furthermore, the aggregate IRR for all search funds through the end of 2017 was 33.7%, and the aggregate average return on investment was 6.9x.

Despite gaining worldwide popularity in recent years, the search fund model remains highly centralised in the American market, where it originated in the 1980s. In Europe, where this approach is only beginning to come to fruition, 90% of the activity is concentrated in Spain, the UK and Germany. Additionally, search funds have also been launched for the first time in France, Italy, Belgium, Poland and Switzerland.

"The development and spread of the search fund model in Europe is much more recent and less broad than it is in the US. This implies that searchers need more time and effort to convince the investment community of the validity of this model given the lack of familiarity with its structure," says Jan Simon, managing partner at Vonzeo Capital Partners, a private equity fund focused on investing in search funds based outside the US. "However, this also provides a large array of opportunities for investors able to understand and embrace this highly profitable and innovative investment model."

On the hunt
Search funds usually focus on deals of around $10-15m, targeting a space that has often been neglected by more established players, because it is primarily composed of very small businesses that still lack sophistication and modernisation.

"The search fund model has been very popular and profitable because it is able to target the lower-mid-market, an extremely attractive and fast-growing space, which is below the radar of most private equity firms," says Alex Wang, managing partner at Riviera Capital.

As search funds' popularity increases, several private equity vehicles have been launched to focus exclusively on this type of investment. The capital raised by these funds comes from a variety of LPs, primarily family offices and high-net-worth-individuals, but also an increasing number of institutional investors.

"Originally, the LP base was mainly comprised of successful entrepreneurs and family offices that were affiliated with Stanford University, where the search fund model was initially developed," says Wang. "In the last decade, more traditional family offices have invested in searches, and recently an increasing amount of capital has come from institutional investors and private equity funds like us."

Helping hands
Despite the presence of a growing number of institutional players, the approach followed by search funds is very different from that employed by more traditional private equity firms and is based on a cooperative strategy between investors. Says Wang: "Even if we have the capital to take down an entire deal by ourselves, we prefer not to do so because we really value the collaborative approach of a diverse investor group, and feel that this is part of the magic formula, and a critical element of the success of the search fund model."

The investor syndicate behind a search fund is usually formed of 10-15 players, which deploy the initial investment units for the acquisition. The capital is raised in different stages: an initial round is collected for the search phase, primarily to pay for organisational and due diligence expenses, while a second stage of fundraising occurs once a target company has been identified and selected.

In exchange for the search capital, initial investors are guaranteed two important benefits: pro rata follow-on rights – not obligation – to invest in the equity required to finance the acquisition; and a stepped-up conversion, which means that the initial amount invested will step up around 1.4x to compensate them for the initial risk.

"We typically write cheques between $1-5m at the acquisition stage of our investments and we co-invest with up to 10 other investors," says Jeff Stevens, managing partner at Anacapa Partners, one of the largest private equity funds investing exclusively in the search fund model. "Subsequently, we follow on with additional growth capital when the cash that the business produces is not sufficient to support growth initiatives."

Hyper selection
The investment criteria that is used to select the target companies are very strict given the high risk involved, and include recurring revenues, high EBITDA margins (generally north of 20%), and a stable cash flow history. The businesses acquired are usually in the 5-6x EBITDA multiple range.

"We only buy companies that are profitable, and usually generating EBITDA of between $1.5-5m," says Stevens. "They also have to be predictable in terms of the revenue model, have relatively low capital intensity and operate in very fragmented markets. These characteristics allow us time to develop the business and the team with less external pressure."

In terms of sectors, the industries most targeted by search funds are business-to-business services, software, IT, healthcare and logistics. Anacapa's Stevens says: "We almost exclusively focus on business-to-business services. We do not invest in manufacturing and consumer retail, because these sectors are often not predictable enough and are susceptible to several elements that we are unable to control."

The use of leverage in the search fund model is quite conservative, around 2x EBITDA, to make sure that the target company is not burdened with excessive obligations and has the energy to grow further. "We normally use equity coupled with debt, which can be either senior bank debt or mezzanine, as well as seller financing," says Riviera's Wang.

Endgame
After the company has been acquired and managed for four to seven years, the search fund enters the exit phase of its cycle and seeks an acquirer, usually an industrial player or a financial investor, often a mid-market private equity firm.

This year, Blue Sea Capital bought Anacapa-backed Krueger-Gilbert Health Physics, a diagnostic medical physics provider, while in February 2018 Accel-KKR acquired FastSpring, a subscription-based platform for powering digital commerce. PEC Safety, a contractor management software and learning content provider, was sold to Thoma Bravo a few months later.

"We've noticed an increase in the number of private equity houses that have come downstream and are looking at smaller companies managed through the search fund model," says Anacapa's Stevens. "These firms appreciate that we invest heavily in training a talented individual in how to be a CEO, and that we spend a lot of time professionalising the business, and building the infrastructure, financial organisation, data system and sale structure that it usually lacks."

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• Topics
• Fundraising
• Search funds