Search Funds

What

Approximately  $4.8  trillion  of  net  worth,  representing  the  largest inter-generational shift of wealth in U.S.  history, will be transferred over the next 20 years as virtually all closely-held and family-owned businesses will lose their primary owner to death or retirement (Meru Capital). How will these business owners "exit" these companies and get an acceptable buy-out that will let them retire on their hard-earned wealth?

A "search fund" is one possibility. Conceived in 1984, the search fund is an investment vehicle in which investors financially support a  manager’s efforts to locate, acquire and manage  an  existing  private  company. Over 100 search funds have been raised to date, predominantly by recent graduates of Harvard Business School and Stanford Graduate School of Business. In a search fund model, capital is raised in two distinct  rounds  of  financing.  In the first round, funds are invested into the search fund entity  (e.g.,  FIRMNAME)  to cover operating expenses and to allow the "Principal" (a budding entrepreneur/CEO) to draw a modest salary while conducting a professional search to acquire an existing private company. In return, search fund investors obtain the right, but not the obligation, to invest in the second round of financing, the acquisition round.  All funds invested in the first round are typically automatically converted to securities in the acquired  company, usually with a premium step-up percentage "add" (e.g., stepped-up by 50%), structured as a combination of equity and subordinated debt such that for every $1.00 invested in FIRMNAME the investor will receive $1.50 of securities of the acquired company (entire paragraph Choate, Hall, & Stewart, LLP).

As the Principal who creates a search fund company (the ambiguously referenced FIRMNAME above), you will convince investors to put money into your search fund company to allow you to find an attractive existing private company whose owners are ready to cash out. You will pay yourself a modest salary out of this fund and draw money from the fund to pay for your expenses. You will be on the road. You'll talk to the owners of prospective acquisition targets about their desires to cash out and the operating health of their business. Once you've found the most attractive company to buy, you'll alert the investors in your search fund that you'd like to acquire and run that company. Your investors have the right, but not the obligation, to invest further capital toward the purchase of the company. The funds they invested in the initial round to support your search will automatically convert to ownership of securities at a substantial premium in the company, and they will become owners of more securities in the company if they decide to invest in its acquisition. Most deals are structured such that they keep the existing owners on the job for another few years while you learn how to run their business; when they exit you are usually the person who becomes CEO and takes over the running of the company. You have just helped an aging owner cash out of his/her biggest investment so s|he can retire, likely prevented the business from becoming defunct, and helped to preserve the jobs of everyone else at that company. 

Lower Middle Market Businesses

There are thousands of opportunities  to acquire businesses in the so-called "lower middle market." Firms that are grouped under the lower middle market category realize an annual revenue that ranges from $5 million to $50 million (CorporateFinanceInsitute.com)."Supply" of these businesses will be greater than demand, as these businesses typically fall below the investment parameters of most traditional buyout firms and are often too large for private  buyers. Furthermore, direct sourcing of these opportunities requires a significant time investment that is oftentimes not feasible for private equity firms due to their limited professional staffs.  As a result, acquisition multiples in the lower middle market are lower than those found up-market (Choate, Hall, & Stewart, LLP). In other words, the valuations of those lower middle market firms are not as pricey as the up-market companies most private equity firms go after.

Learning Objectives

Upon completing this module YOU should be able to:

• describe the different stakeholders involved in supporting a search fund

• specify the attributes of an attractive acquisition target and explain how those attributes contribute to a likely successful buyout

• describe the activities the "Principal" engages in during the professional search for a potential acquisition target

Instructions

• Watch the assigned videos and presentations; 

• Read the assigned readings; 

• Complete the practice quiz or other assigned practice activity

• Complete the assessment;

• Complete the "Mark as Complete" checklist.

View

Read

Choate, Stewart, & Hill, LLP. 2020. Private Placement Memorandum Template - Search Fund.

Corporate Finance Institute. 2020. What is the Lower Middle Market? CorporateFinanceInstitute.com, accessed August 10, 2020.

Gbadebo-Smith, O. 2017. Why More Entrepreneurs are Choosing To Build Search Funds over Startups. Toptal.com, accessed August 10, 2020.

Ketabchi, N. 2020. How Freelance Private Equity Consultants Unlock Shareholder Value. Toptal.com, accessed August 10, 2020. 

Ruback, Richard S., & Yudkoff, Royce. 2017. HBR Guide to Buying a Small Business. Boston, MA: Harvard Business Review Press. (found the entire book in PDF format; you might consider buying the book from Harvard Business Review Press)

Practice

Assessment

Feedback for Me

Mark as Complete