Tuesday, September 6, 2011

The Search Fund Fallacy

For the last few months I have been studying Search Funds and trying to understand their nuances as they have been applied across the world. I have learned a lot, but one thing continues to eat away at me: I still don’t know what a Search Fund is. I know how it is defined. I know how many entrepreneurs have described it. But these definitions are either awkward or vague – they lack the precision and clarity necessary to identify a Search Fund when you see one.

Two examples highlight this point. Consider a Search Fund that does not acquire a company, but instead identifies an excellent opportunity to start a new venture. The investors agree to back the new venture and a successful business results. Is this a Search Fund?  Or consider an entrepreneur that raises capital to search for a distressed business to buy. Again, supported by their investors, the entrepreneur identifies and acquires a slightly distressed business. Is this a Search Fund? By the strict definition put forth by the Stanford Primer on Search Funds, neither of these examples would qualify. However, they both feel a lot like a Search Fund to me.

How can this be reconciled?

In my view, the term Search Fund is difficult/confusing to define because it mixes a strategy with a financial structure. The strategy is to purchase a business that meets as many as possible of the standard “Search Fund Criteria” (found in many notes on the subject), and the strategy is executed using the financial structure we associate with Search Funds. This is like defining a hedge fund as “an investment fund that uses short positions to make money”, or like saying “Private Equity Funds only use financial levers to create value”.  These definitions are incomplete and wrong. Instead, Hedge Funds and Private Equity Funds are defined by what type of securities and financial structures they employ, not the strategies they use to chose between opportunities (i.e. Private Equity goes after equity positions in privately held businesses, while Hedge Funds employs riskier/more sophisticated securities and strategies than more conventional investment funds).

Extending this argument to Search Funds, a more appropriate definition is: A Search Fund is an investment vehicle that finances an entrepreneur’s efforts to locate, acquire, manage and grow an entrepreneurial opportunity. The subtle change from the traditional definition is in the last two words. Search Funds target entrepreneurial opportunities. What that opportunity is, i.e. the fund’s investment strategy, will be defined by each fund and should be chosen to based on the skills of the entrepreneur and the characteristics of the Search Domain (the geography and industries of interest).

Nonetheless, the characteristics chosen by most Search Funds are very similar to those chosen by the first Searchers. In many circumstances this remains an excellent strategy. However, as the model becomes increasingly popular, and as the type of people engaged in Search Funds, and the Search Domains chosen, become increasingly heterogeneous the strategies/target opportunities should also become more homogenous. Remember, the original strategy was built specifically for new MBA graduates, with limited operational experience, searching in the US. It is not unreasonable to think that more experienced professionals with different skills and backgrounds can, and perhaps should, target opportunities defined by different characteristics. At the very least, entrepreneurs searching outside the US, or with a significantly different professional profile than the ‘standard searcher’, should consider what differences could/should be employed by their Search Fund. 


Monday, September 5, 2011

What is the downside?

A Search Fund is a risky undertaking. As an entrepreneur the downside is split between the financial performance of the Search Fund, the opportunity cost of pursuing a Search Fund, and reputational risk.
Downside Due to Financial Performance of the Search FundThe strong returns of Search Funds as a group (IRR of 37% according to Stanford’s 2009 Study) are widely distributed and a minority of Search Funds deliver positive returns. The following excerpt from Stanford’s 2009 Study on Search Funds illustrates the significance of this risk:

“Return data was calculated for 79 funds … Of these 79 funds, 59% suffered a partial or complete loss of capital. However, about a third of these were instances where no acquisition was made, so only the initial search capital was lost. Because of these "low-cost" failures, these 59% of funds represent only 44% of capital invested (search capital and acquisition capital provided by Search Fund investors). Similarly, 38% of funds (representing 56% of capital invested) produced a gain for investors. Two funds shut down and returned all capital invested after the principals elected to pursue a different model.”

This distribution has serious implications for Search Fund entrepreneurs – the potential value of the earned equity is a significant portion of their expected compensation and negative returns equate to zero equity value for the Searcher. However, the high aggregate return numbers of Search Funds indicates that successful funds are delivering significant returns to both investors and entrepreneurs.
The Opportunity Cost of a Search FundProspective Searchers should be wary of the potential opportunity cost of a Search Fund. A Searcher’s compensation is a combination of a discounted salary while searching (and likely while operating) and the highly uncertain value of the Searcher’s equity interest in the acquired company. This compensation structure dictates that if strong returns are not achieved, or an acquisition is not completed, the Searcher will bear a significant opportunity cost.

For many Searchers, the fact that their compensation is heavily weighted towards equity drives them to make an acquisition. While this is the intended incentive, Searchers should also recognize that making a bad deal is far worse than not making a deal at all. In the event of a poor acquisition, the Searcher’s opportunity cost increases dramatically as they dedicate months, and often years, of their career to a business that will realize little, if any, equity return.

The Reputational Risk of a Search FundA Search Fund is an incredible opportunity to make or damage your reputation. A well executed and financially successful Search Fund will change the trajectory of the entrepreneur’s career and cement their reputation. A poorly executed or financially disastrous one can just as easily put a black mark on their reputation that will be difficult to shake.

Many prospective Searchers see failing to make an acquisition as a negative. However, so long as the Searcher has worked hard, experienced investors disagree. A Searcher who has given their best effort but has not made an acquisition likely has the discipline to avoid making a deal for the sake of making a deal. Moreover, making a poor deal may have serious consequences for the entrepreneur’s career and their reputation with investors. Similarly, the impact of the financial performance of the acquired company on the entrepreneur’s reputation is highly dependent on the performance of the entrepreneur – a business that fails because of the manager’s poor decisions is very different from one that fails in spite of the manager’s good decisions.

In short, the reputational risk/reward of a Search Fund is dependent on the perceived quality of the decisions taken by the entrepreneur and is amplified by the resulting financial performance of the Search Fund.


Where should you search?

Search Funds target specific geographical regions and industries in their search for acquisition opportunities. These restrictions are necessary due to the vast array of small businesses that exist and help the Searcher focus on areas where they are most likely to succeed.

Most Searchers choose to prioritize geographies that they know well over geographies that they do not know well – familiarity with the geographic region is chosen over fast growing regions (such as India and China). This is both a practical and a personal choice. From a practical standpoint, the Searcher must be able to legally acquire a business in the region of choice, should be familiar with the business practices of the geography, and should be a good cultural fit (i.e. language, religion, etc). However, these factors are minimum requirements to successfully operate a business. In addition, a Search Fund requires the entrepreneur to raise money for the search and to generate deal flow, and in particular, proprietary deal flow. In both these activities, the Searcher’s personal network is an invaluable resource. As such, Searchers tend to focus on regions where their network is already strong.

The personal considerations of the Search geography is a direct result of the time commitment demanded by a Search Fund - the lifecycle of the median Search Fund that successfully acquires, grows, and exits a business is over 8 years (from raising search capital until exit). The length of this period dictates that Searchers must also consider the implications of their geography of choice on their personal life. Consequently, many Searchers restrict their geographic focus for personal reasons.

The industry focus of a Search Fund is typically dictated by the specific requirements of the Search Fund model and a combination of the industry attributes and the Searcher’s experience and skills. For example, the Search Fund model inherently demands rapid growth (investors typically an expect IRRs of more than 30%), and a profitable and growing industry makes achieving this level of growth much easier. Similarly, the Searcher’s experience and skills may be better adapted to certain industries, and the Searcher may be well served to focus on businesses from these industries.

Unfortunately, there is no short answer as to where the Search should be focused. Nonetheless, it is a question that must be answered before starting a Search Fund. Fundamentally, the choice of target geography and industries is a question of where is the Searcher most likely to succeed. The Searcher must evaluate for themselves what geographies they are best suited to (personally and professionally), what industries are best suited to the demands and restrictions of Search Fund model, and what type of businesses they are most likely add value to. With these questions answered the Searcher can identify the best combination of geography and industries for their search.

Finally, while targeting a specific geography and set of industries will help the Searcher focus on opportunities that are more likely to meet their investment criteria, it is important to recognize that these are soft restrictions. A typical Search Fund evaluates over 300 potential opportunities before making an acquisition, and the Search focus must be broad enough that sufficient deal flow can be generated. Moreover, many Searchers have been well served by being open to opportunities that fell outside their initial strict criteria, and even the most focused Search should remain open to these possibilities.


Why do a Search Fund?

Prospective Searchers find this model attractive for several reasons. First, for many would-be entrepreneurs coming up with an ‘idea’ for their business is a major hurdle, and one that cannot be overcome. The Search Fund model removes this hurdle by shifting the focus to evaluating existing businesses and their potential for growth.

Second, many talented and ambitious individuals strive to run a company. However, it is very difficult to obtain these positions early in your career - a typical career requires these individuals to invest significant time before they are able to progress to the top levels of an organization. In contrast, a Search Fund provides these individuals with the opportunity to run a company early in their career.

Third, a Search Fund has two attributes that make it lower risk than a startup for the entrepreneur. Because a Search Fund targets an existing and profitable business, a significant portion of the business risk associated with a startup is eliminated. A profitable business is in essence a validated business model. The business concept clearly has value in the marketplace and the business model is effectively capturing that value. Moreover, an existing business already possesses a certain amount of organizational, process, and IT infrastructure which supports the continuing operations and can be a platform for growth. The second risk mitigation factor is the Search Fund itself. In particular, the entrepreneur receives a salary throughout the search process, and the investor group of a Search Fund can be an invaluable source of mentorship and guidance that early stage companies do not always receive.

Finally, a Search Fund may provide the entrepreneur with a broader experience than is available elsewhere. The life-cycle of a Search Fund is extremely demanding on the entrepreneur, in large part because of the broad range of roles they are asked to fulfill. For example, the entrepreneur must be able to raise capital to begin the Search Fund, source deal flow, identify attractive industries, evaluate deals, execute an acquisition, guide a management transition, lead an operating company, grow a business, find an exit opportunity for their investors, and execute the exit. Few, if any roles exist that offer such a broad experience.

Friday, August 12, 2011

How do you get paid?

The payment scheme of the Search Fund model is both potentially lucrative and heavily dependent on performance. While the Searcher does earn a salary throughout most of the Search Fund life cycle, this portion of the compensation tends to be substantially below what could have been earned in an alternative career. To compensate, the Searcher earns equity in the company they acquire and participates in the returns they generate for shareholders upon exit.

An equity scheme for a Search Fund typically gives the Searcher the opportunity to earn upwards of 20% of the common equity of the acquired company. The equity stake is usually earned based on three metrics. At acquisition, the Searcher typically earns the first portion of their potential equity stake. The second portion is frequently earned over time, and the final portion is often earned based on the exit IRR. It should be noted that the precise amount of equity that the Searcher can earn and the metrics it is tied to are negotiated with investors and may vary from what is described here.

Without question, the potential to earn a substantial portion of the acquired company’s equity makes Search Funds very attractive. However, potential Searchers should note three important effects of the Search Fund structure.

Investor capital is senior to common equity
While the potential equity stake in the acquired company is significant and the potential payoff is large, Searchers should be aware that that the investor capital is senior to the common equity earned by the Searcher. In a typical acquisition, the investor capital comes in the form of preferred equity and subordinated debt. As such, the common equity, the equity that the Searcher participates in, is junior to the investor capital, and the Searcher only participates in the upside after the investor’s capital has been returned. Moreover, the investor capital usually has a coupon or dividend associated with it (frequently capitalized) meaning that the pool of investor capital grows at a compound rate over time. As a consequence, the company must generate value faster than the rate at which the pool of investor capital is growing for the common equity to grow in value. If it does not, the value of the Searcher’s equity stake will be zero.

Search capital is diluting to your equity position
For would-be entrepreneurs, Search Funds often appear attractive because of the pool of funds raised to fund the search process. While these funds do reduce the initial risk to the entrepreneur by paying a salary and expenses, they come at a substantial cost.  A typical Search Fund will have a 50% step-up on the Search Capital at acquisition. This means that $400,000 of Search Capital will be converted to $600,000 of investor equity at acquisition. This acts as a burden on the entrepreneur’s equity as this capital must also be returned before value begins to accrue to the common equity. As a consequence, potential Searchers should consider carefully how much Search Capital must be raised, and its impact on their equity stake.

The greater the potential equity stake, the harder it is to achieve the IRR hurdle
Many potential Searchers believe that the larger the potential equity stake the better off they are. In the most optimistic case, where they earn all of their equity, this is certainly the case. However, a significant portion of the equity is tied to the investor’s returns (typically measured with IRR), and a larger potential equity stake may make it harder to earn the full equity stake. More specifically, because the entrepreneur is entitled to a greater portion of the common equity, the company must grow more for investors to receive the same IRR on their investment (they are entitled to a smaller proportion of the value created). As a consequence, entrepreneurs who push for a higher potential equity stake may find themselves at exit with a smaller piece of the pie than if the potential stake was smaller.

Wednesday, July 27, 2011

How are Search Funds different from Private Equity and Venture Capital?

Venture Capital
The BVCA describes venture capital funds as typically, “…back[ing] concepts or ideas brought to them by entrepreneurs, or young companies looking for financing to help them grow. Since businesses at the concept stage are nascent, venture capital investors will take a disciplined approach to evaluating not only the viability of the business idea, but also the motivation and background of the entrepreneur…”. In comparison, Search Funds typically target established profitable businesses that have a high potential for growth. These businesses are often mature (in contrast to being in the conceptual stage), but are well positioned for another period of growth. Moreover, Search Fund investors are typically investing in the potential ability of the entrepreneur (the Searcher) to run and grow an already healthy business -  in essence, the viability of the Searcher to be a strong manager.

Private Equity
The BVCA defines private equity as, “… a medium to long-term finance provided in return for an equity stake in potentially high growth companies, which are usually, but not always, unquoted…”. Based on this definition, a Search Fund is clearly a Private Equity vehicle. However, Search Funds further restrict the private equity definition. More specifically:

Search Funds look to acquire a controlling interest in a healthy company
Search Funds are explicitly seeking a controlling interest (if possible, usually 100%) of a healthy firm and will replace the existing top management upon acquisition. Moreover, it is the principles of the Search Fund who identify and acquire the business, and who take over the management role. In contrast, private equity covers a much broader range of opportunities. For example, healthy or distressed businesses may be targeted, majority or minority interests may be sought, and management may or may not be replaced.

Search Funds typically target smaller businesses than traditional private equity funds
One of the strengths of the Search Fund model is the leverage on human capital it provides investors. Searchers are typically talented individuals who would command significantly higher salaries in a traditional corporate role or at a private equity fund. In exchange for this discounted salary, Searchers receive an equity stake in the acquired company. This “discount” reduces the cost of sourcing potential deals for investors and provides them with potentially higher returns and access to smaller deals that cannot be targeted by a conventional private equity fund – to recoup larger deal sourcing costs, investors require a higher percentage return on the same size deal or the same percentage return on a larger deal.

Sunday, July 24, 2011

Searching is bootstrapping

A common metaphor for the search phase is fishing. Even the best prepared and most diligent fisherman requires a certain amount of luck to catch a championship fish. And a championship fish is exactly what a Searcher is looking for. However, given sufficient time and effort, a skilled fisherman will find the fish he is looking for. This is what a Search Fund is designed to do: it gives a skilled fisherman time to find a great fish. However, the declining balance of the fund represents the time you have left to fund an acquisition, and when it goes to zero you are done.  With this in mind, Searchers are well served to employ a bootstrapping mentality to the search phase (bootstrapping is  getting a lot done on very little cash and is common for many early stage companies).

A few examples include:
·         Do as much initial due diligence as you can on your own – professional due diligence will consume your funds quickly, and a couple failed deals can consumer your entire fund.
·         Leverage your time with interns – many highly qualified interns will work for experience or modest compensation in exchange for exposure to investors and deal exposure. Consider what ‘experience’ you can offer to attract and ‘compensate’ talented interns.
·         Compensate advisers and consultants with equity, good will, and in-kind services.
·         Eliminate overhead costs as much as possible. Can you share office space? Can you meet in hotel lobbies? Etc.
·         Call in past favours and rely on personal relationships to get things done for free.
·         Use lawyers and accountants to help you with judgment issues, not basic education issues. Negotiate the delay of payments for services until the company is funded. Use public sources to learn the basic parameters before starting the fee clock.
·         Be frugal everywhere-drive instead of flying, choose cheap hotels, and use your personal computer and printer.
·         Network everywhere to leverage connections and personal introductions by others.