As the incredible success of private equity over the past couple decades has made clear to many aspiring company owners and investors, if you can find and acquire a decent company, its possible to earn great returns. This has fueled a new class of individuals seeking to launch their own search funds. What exactly is a search fund and how do you become successful at it? 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.
Alex Schneider, who teaches at Northwestern’s Kellogg School of Management, describes it as a three-sided market:
- 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.
- 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 start a new one from scratch. He (and increasingly, she) have been taught how to evaluate risk, what can be mitigated and how to create value.
- Private Equity Funds Seeking Opportunity: Professor Schneider says that on the third side are established private equity funds looking for opportunities but likely would 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.
When those three elements come together it can be a synergistic success.
History of Search Funds
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 who want to buy existing businesses rather than take the riskier route of starting their own. The searcher recruits a group of investors 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 recently minted MBAs to acquire and run highly performing small businesses.
Today, the searcher is just as likely to be a middle-aged executive who is ready to own and run a company.
A search fund primer published by Stanford Business School quotes Grousbeck as saying a search fund is “the most direct route to owning a company that you yourself manage.”
How Searching Works
Here’s how it worked for one successful search fund operator, 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 backseat 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 touch points. “Patients don’t really get annoyed at you, even though you’re sending them reminders; they actually appreciate it. And, after six touch points, 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
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 where 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 University of Chicago’s Booth School of Business and is host of the “Entrepreneurship Through Acquisition” Podcast.
Instead, the search model “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 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.
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 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. That number grew to 325 by 2018.
Schneider says the number of searchers 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 selling to their employees via an Employee Stock Ownership Plan (ESOP). There is growth in the international market. And it’s still unclear what impact COVID-19-related business closings will have on small businesses, which could open up even more search fund opportunities.
“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 fund-raising environment post COVID-19, but some of the best outcomes come out of investment in recessionary periods.”
What’s Ahead for Ray Fan
Since selling his company in October 2019, Fan is taking a one-year sabbatical.
“One of my philosophies is ‘go slow to go fast.’ When you’re in it, it’s tough to think about anything but whatever you’re in. And so I wanted some time for my mind to breathe and think about things.”
One of the things he’s thinking about is efficiency. He’s interviewing 100 business operators across a wide spectrum of industries, geographies, business functions, and company size. He wants to “figure out how people tackle the same challenges and whether there are some optimal solutions or key insights each operator has learned along the way.”