Are we entering the age of the search fund?

Are we entering the age of the search fund?

The DealRoom looks at the growing popularity of the search fund as a less-trodden path to entrepreneurship. While still niche, the concept seems to be going global.

World-renowned Barcelona-based business school IESE recently announced it was funneling €3 million into a seed fund to help MBA students launch startups. While there’s no question that the notion of being the next tech wunderkind is becoming more glamorous, it’s the IESE’s mention of also earmarking the funds for financing and promoting search funds that raises an eyebrow.

The concept of the search fund hinges on “entrepreneurship through acquisition”: Investors back a promising individual (often fresh out of school), known as a “searcher,” paying them a nominal salary and expenses as they hunt for a business to acquire and take over as CEO.

“The growth [of the search fund] has been phenomenal,” Karen Spencer, COO of searchfunder.com, a networking site for searchers and investors, recently told Heather Endresen of Live Oak’s Mergers & Acquisition lending team in an article. According to searchfunder.com, the number of search funds has grown by 428 percent over the past half-decade, climbing by 40 percent each year. “There’s also the global expansion—now that there have been successful search funds in other markets, people are looking to do that.”

The birth of the search fund

The concept for the niche private equity investment vehicle was pioneered by Stanford University in the 1980s. H. Irving Grousbeck, then-director of the Center for Entrepreneurial Studies at the Stanford Graduate School of Business, set up the search fund as a way to help recent MBA students finance their path to entrepreneurship.

It’s since spread throughout North America.

In the beginning, searchers raise anywhere from $350,000 to upwards of $750,000. The money functions partially as a salary and partially to float administrative, travel and deal-related expenditures. The search for the right company to acquire usually takes around 19 months.

Typically, these search funds are targeting “profitable, mature companies in growth industries with earnings before interest, tax, depreciation, and amortization (EBITDA) of $1 million to $5 million and total value in the range of $5 million to $20 million.”

Taking this approach, searchers are slipping past institutional investors who tend to ignore deals this small, while reaching beyond what angel investors are not big enough to target.

Once searchers have locked in on a target, it’s up to them to run the show – from negotiating the structure of the transaction to spearheading due diligence. They’ll be in charge of sourcing debt financing, securing equity commitments, and laying the framework for the post-transaction transition. It’s a trial by fire approach with the added benefit of being backed by potential mentors.

In a lot of cases, the strategy pays off.

A 2013 study by Stanford found that search funds averaged an 8.4 times return on investment and an internal rate of return of over 36 percent.

A new way to search

The model has since evolved into several different permutations outside of the traditional approach where searchers raise capital from a group of investors who in turn get the right of first refusal on any deals. According to searchfunder.com, 627 search funds have taken this route, with 198 ongoing, according to crowdsourced data from the site’s membership.

But there’s a new crop of self-funded searchers who are financing their own hunt, drawing in outside capital only once a deal has been found. Self-starters tend to negotiate terms on a “deal-by-deal basis.” As of May 2018, there are 155 of these types of search funds, according to searchfunder.com, with 94 ongoing.

The third variant of the search fund concept is the single-source approach, where the search is backed by a single investor rather than a group. On occasion, they co-locate with the investor. The mentor-mentee relationship is an underutilized form of the search fund with only 41 of searchfunder.com‘s members fitting in this category, 22 of which are ongoing.

Regardless of the strategy, the concept continues to proliferate outside of North America, with business schools like IESE running Search Fund conferences.

And with the growing allure of entrepreneurship, search funds are apt to become another path forward for business grads looking to elbow their way into the business world, even if they don’t have a startup idea of their own.

As Grousbeck said: “It’s the most direct route to owning a company that you yourself manage.”