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As the incredible success of private equity over the past couple of decades has made clear to many aspiring company owners and investors, if you can find and acquire a decent company, it’s possible to earn great returns. This has fueled a new class of individuals seeking to launch their own search funds. But how to start a search fund that wins at the acquisition game?
This guide to starting a successful search fund answers the questions: What is a search fund? And, How can I start a successful search fund?
Let’s explore.
The Stanford Graduate School of Business Center for Entrepreneurial Studies explains search funds this way: “The model offers relatively inexperienced professionals with limited capital resources a quick path to managing a company in which they have a meaningful ownership position.”
Inexperienced professionals? Limited capital resources? It doesn’t exactly sound like a recipe for success.
But it can be.
What is a Search Fund?
The concept of a search fund started more than 30 years ago at Stanford University.
It’s a simple idea: There is a supply of businesses in the $5 million to $30 million price range. There also is a supply of “searchers” – company buyer wannabes looking to buy existing businesses rather than take the riskier route of starting their own.
The searcher recruits a group of funders who support her during the search phase and take an ownership stake in the company after the deal is done.
When this concept began in 1984 as the brainchild of Stanford professor (and Boston Celtics co-owner) H. Irving Grousbeck, it was seen as a vehicle for recent graduates of MBA programs to acquire and run high-performing small businesses.
Today, the searcher is just as likely to be a middle-aged executive who is ready to take his operational experience and use it to own and run a company.
A search fund primer published by Stanford GSB quotes Grousbeck as saying a search fund is “the most direct route to owning a company that you yourself manage.”
3-Sided Search Fund Market
Alex Schneider, who teaches at Northwestern’s Kellogg School of Management, describes the search fund process as a three-sided market:
1. Businesses with Untapped Growth Potential or No Succession Plan
On one side are small businesses of the mom-and-pop variety. The businesses are strong, with solid recurring revenue and the potential to do even better. The owners are ready to move on but have no succession plan. They want to leave the company, their legacy, in good hands.
2. Aspiring Company Owners & Entrepreneurs
On another side is an aspiring company owner or entrepreneur hungry to build on and wring more value from a solid, existing business rather than taking the riskier approach of a startup. He (and increasingly, she) have been taught how to evaluate risk, what can be mitigated, and how to create value.
3. Private Equity Funds Seeking Opportunity
Professor Schneider says that on the third side are established private equity funds with acquisition capital in search of opportunities. Those funds are likely to pass on businesses in this “super inefficient market” because they are too small. Other investors would broaden the definition to include family offices and individual investors seeking to back an eager investment seeker.
Increased Odds of Success
When those three elements come together, a search fund acquisition can be a synergistic success, creating value for the company and its new owners.
Robert Jordan, CEO of InterimExecs, says the best way for funds to increase their odds for success is to align with expert interim executives.
They will cheer the search funds along during the search and help identify targets. Then, the interim can serve in fast-deployment roles, increasing the chances of successfully bringing the seller to the table. Once the deal is complete, interim executives can take leadership roles where the searcher is inexperienced, allowing the investors and new owners to hit the ground running, much faster than on a cold start.
How Does a Search Fund Work?
Here’s how it worked for one successful search fund entrepreneur, Ray Fan:
As an aspiring company builder, he headed to Northwestern’s Kellogg School of Management for an MBA.
Unlike most of his classmates who were prepping for a career in consulting or consumer product marketing, Fan wanted to buy and run an already established company that he could make even more successful.
“What I saw was: in a typical search fund, you come out of school, you’re essentially running your own private equity fund, but then who am I? Really nobody,” he says. “It takes time to establish relationships with investment bankers and brokers, and source deals. I wanted to expedite that process and increase my probability of success so I partnered with people who could help me get a leg up.”
That means he became an “executive in residence” with Gemini Investors, a private equity firm in Boston.
Under their partnership, both sides were identifying prospective companies. Gemini was interested in traditional investments in target companies that would continue to be run by the existing executive team. Fan was interested in companies in need of a new executive because the founder wanted to sell, retire or just take a back seat to running the business.
The approach worked. Stanford says searches often take 24 months or longer and one-third of searchers never acquire a company. Fan and Gemini identified a strong prospect in less than six months.
Ramping Up Value & Making Add-On Acquisitions
His target company was a dermatology group in Los Angeles.
The practice was owned by the two doctors who founded it. They wanted someone else to run the business so they could concentrate on the medicine.
“For a lot of these solo practitioners, they’re doctors, they’re business people, they’re office managers, they’re marketers. And that’s a lot, right? As smart as you are, there are only so many hours in a day,” Fan says. “Bringing on somebody like me allowed them to spend more time in the clinic generating revenue.”
The practice had three locations and Fan acquired another practice with a single location that became part of the initial deal. Fan and his team later added five more acquisitions in a two-year span.
Then they ramped up marketing.
“These acquisitions have 5, 10, 15 years of patients, but they’re not engaging those patients enough,” he says.
His approach involved reaching out to all of those patients and encouraging them to come back for an annual skin exam.
“We would get a 30, 40, 50 percent lift in revenue by just re-engaging patients,” Fan says.
The system involved six touchpoints. “Patients don’t really get annoyed at you, even though you’re sending them reminders; they actually appreciate it. And, after six touchpoints, I can get 75 percent of those people back in the door.”
At the same time, Fan and his team were making all of the locations more efficient. For example, more thoughtful scheduling got patients in the door sooner so the doctors stayed busier. Revenue jumped.
“That’s when the doctors started seeing the symbiotic relationship between business people and medicine,” he says.
After two and a half years, Fan successfully sold the significantly larger business.
The Search Process Requires Patience
According to the Stanford primer, “To reach a successful outcome, the process of searching for an acquisition target requires a keen focus and a systematic approach.”
It also requires patience.
“In general, the search process can be long, tiring, and full of rejection. A successful search is often seen as a ‘numbers game,’ in which a searcher may contact 1,000 companies, visit 50, submit a Letter of Intent (LOI) to 10, and undergo due diligence on perhaps one to three companies before an acquisition is consummated.”
Brian O’Connor, founder of a Chicago-based search fund investment company called NextGen Partners, says the successful searcher has “heart, hunger, hustle, and humility – plus raw horsepower.”
“This is not a model by which companies are acquired and a 30-year-old CEO operates it in isolation. That’s a recipe for disaster,” says O’Connor, who also teaches at the University of Chicago’s Booth School of Business and is host of the “Entrepreneurship Through Acquisition” Podcast.
Instead, the search model investment vehicle “takes businesses that were sleepy in markets that haven’t had a lot of tech to scale up or marketing firepower and adds a fresh perspective.”
Company Ownership: Taking the Reins
Once the deal is done comes the challenge of running the company.
That’s where the traditional search fund model really outshines traditional entrepreneurship, Northwestern professor Schneider says.
“These aspiring owners are given lots of guide rails by search fund investors and the search fund model. While they don’t have a lot of direct experience running a business, the search model is very mentorship oriented.”
Sometimes the mentors come from the acquired company. The founder/CEO will stay on to provide guidance informally or formally as a member of the board. In some cases, the owners even offer seller financing to assure the interests of the seller and the buyer are more closely aligned. In other cases, the acquiring company can bring experienced interim CEO, COO, CFO or CMO — whatever role or roles are needed. (Ask yourself 3 questions to know whether an interim executive is right for your company.)
O’Connor says the most successful searchers are “hungry for feedback, advice, and counsel. They’re willing to admit when they don’t have all the right answers.”
In addition, because the search fund model is focused on finding strong businesses with solid cash flows, the searcher CEO can make mistakes without jeopardizing the underlying fundamentals of the business, Schneider says.
The Future of Search Funds
Search fund growth has been dramatic. In 1996, the Stanford Graduate School of Business Center for Entrepreneurial Studies identified 20 first-time search funds. The number of search funds grew to 401 by 2020 and search fund creator H. Irving Grousbeck says he expects that the use of search funds will continue to grow.
“It’s the most direct way I know for aspiring MBA entrepreneurs to get into business for themselves. And now that there are many experienced search-funders out there, those who have gone earlier are advising those who have come along more recently. Our objective is to have the search-fund model grow, flourish, and be self-supporting, as one wave helps the wave behind it.”
Schneider, of Northwestern’s business school, says the search fund community has grown too, with about one-quarter of his 65-student class now women and minorities.
There also are a growing number of business opportunities. Baby boomer business owners are looking for an exit strategy beyond an employee buyout via an Employee Stock Ownership Plan (ESOP).
There is growth in the international market.
“There are still many available businesses out there and sophisticated investors will be eager to put money in,” Schneider says. “It will be a more difficult fundraising environment, but some of the best outcomes come out of investment in recessionary periods.”
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