What is a search fund?
What is a search fund?
Recently, I was browsing Reddit and I found out about a type of investment I had never heard of before: the search fund.
Search funds are basically tiny private equity funds. A small group of people (1-4) will raise money to search for and find a business for sale, within a given price range, in an industry where they have some expertise. If they succeed in finding a target business, they do their due diligence and raise money to purchase it. Their search fund investors can range from wealthy individuals and family offices to friends, family and even private equity funds themselves.
How do search funds work?
Search funds operate in two stages. The first stage is the search itself. In the beginning, the investors are simply financing the travel expenses and due diligence costs of the team that is searching for the business. Usually the search will be financed for two years, with the understanding that at the end of that time frame the team may or may not find a suitable business to invest in. If they don't find a business, then the investors lose 100% of their investment.
If they do find a business that they want to purchase, then stage 2 begins. The team raises more money from their existing investors and potentially new investors as well. The initial investors usually receive equity equal to double their original investment in the search at the start. In other words, if Investor A put $50,000 into the initial search, then they would receive $100,000 worth of equity when a business is found and purchased. This compensates them for the risk of the team not finding a company.
In addition to equity, most search funds will finance 25%-75% of their purchase with debt. This leverage can be dangerous, but it has the effect of massively magnifying positive returns as well.
To compensate them for their time and efforts, the search team will also receive a large chunk of equity in the business that vests over time. In this way, search funds function similar to startups in the sense that the "founders" may not have much money in the business but their efforts in improving and expanding the business may result in a lucrative stake in a relatively short amount of time.
Once the business is purchased, the search team will take executive roles at the business and run it for 3-6 years, with the eventual goal of selling the business or potentially buying out their investors and continuing in their leadership roles.
What are the success rates for search funds?
This is where things get interesting. You might think that search funds are incredibly risky, but compared to other small and medium sized business investments they actually have a high success rate. This is largely because the fund is usually purchasing a business that has already had some success, and customers, but may be under managed or undercapitalized. In other words, it's much easier to add fuel to the fire than starting the fire in the first place.
The visualization below shows success rates over time. Around a quarter of search funds will not result in an actual purchase, which is obviously the biggest risk. But, of the 73% that lead to a purchase, at least 54% of those companies (54% of 73%= 40% of the total) end up in positive territory, and only 21% end in a loss. Of the companies with a gain, at least 66% end up with a 2x+ return. That's over a quarter of the total population in the study (40%*66%=26%)!
In short, search funds are a fantastic investment opportunity and, potentially, a very interesting way to become an entrepreneur.
Why I think a search fund could be my potential future job
I've always struggled getting into the job that I really want. When I was in college, I wanted to go into finance. Since I graduated in 2009, that route wasn't open to me so I took a job as a data analyst in marketing. It's worked out well, and I've been successful moving up the ladder. At the same time, there's a big part of me that wants to do something more financial, or at least something where I can see and influence the dollars coming into and out of the business more directly.
Unfortunately for me, the only way to change tracks into private equity, wealth management, or investment banking would be an MBA. I am too far along in my career to be willing to sacrifice two years of my income so I can go back two steps on the corporate ladder. I could start my own company, but the odds are awful. You also need a great idea for a startup, and I don't have one.
Obviously, I need a different option and I think that search funds could be that option. I can be entrepreneurial and own or run my own business. I can (potentially) make a great deal of money. I can do it without getting an MBA, and I could even potentially use the expertise I have gained over the years as a marketer, so it wouldn't go to waste.
In fact, if I were to do a search fund, I would probably focus on marketing agencies. I understand the fundamentals of the craft, and I have been a customer of many marketing agencies so I have seen the good and the bad... and the ugly.
For now, I am going to sit tight and wait for my current company to IPO. In the interim I've got a very interesting topic for further study.