By Massimo Tiozzo Netti and Francesco Carraretto
Back in the ’80s, some ambitious entrepreneurs designed a miniature model of the typical private equity fund. Forget about pools of cream-of-the-crop professionals: search funds are a businessperson’s stepping stones to achieving their pipe dream position as a CEO. Although it sounds like a solo trip to success, these operating managers are backed by capital from a group of advising investors. And despite not being PE funds, by listing few other search fund techniques (e.g. the combined usage of debt and equity, exit-plans and the characteristics of target firms), one will stumble upon major common features shared between the two.
If truly so uncannily similar, why do search funds sound so… exotic? The vital ingredient setting search funds apart from PE funds is their identity as investment vehicles rather than conventional funds: investors are essentially purchasing the model and the reliability of an operating manager, who will ultimately acquire and revamp a single business. Besides, entrepreneurship through acquisition means radical facilitation of the private equity method. The eschewal of an extensive portfolio of firms leads to the selection of an individual company to acquire – typically in the $5m to $30m price range, which should fit the manager’s inclinations.
The Search Fund Life Cycle
Venturing into this new trend means estimating how long it takes to cash in profits. Figure 1 presents a schematic breakdown of the acquisition stages.
Figure 1: A Primer on Search Funds – Stanford Business School, 2017.
In opposition to PE funds, initial capital is raised in two separate stages. Search capital is the amount initially provided by investors (who will frequently receive a 50% step-up of the initial equity contributed) to cover the entrepreneur salary and any expenses related to the origination of the deal. The latter is requested from investors by search funds once the entrepreneur supplies a proper offering memorandum, which includes a detailed overview of the forecasted activity of the fund and a comprehensive outline of the capital structure of the investment. Acquisition capital is raised immediately after the identification and negotiation phases and used to cover the purchase price of the target company. In order to settle an amount of capital granted by investors, the manager will perform due diligence and will arrange the debt eventually raised from third parties. The follow-up question is which firms to target. Search funds customarily approach companies they deem healthy and profitable, ideally avoiding turnarounds. Prevailing criteria are revenues between $5m and $25m, EBITDA north of $1m, simple business models and immunity from technological changes. Target industries are generally vanilla: one should bear in mind that operating managers have limited experience, therefore they avoid intricate and highly technical businesses (although they can capitalize in such sectors with the proper acumen and/or vocational training).
After closing the acquisition, the operating manager enters the target and becomes accustomed to its operating activity over a significant transitional period. This progression lays the groundwork for imminent changes carried out to pursue value creation. Those modifications will involve a selection from the following menu: revenue growth, improvements in operating efficiency, proper use of leverage, organic expansion, add-on acquisitions and/or multiple expansion upon exit. Despite search funds sharing exit alternatives with private equity firms, the former can decide to honor their managerial role for longer terms.
Capital Structure and Returns Distribution
Like PE funds, search funds are sensitive to the financing of the deal. Upon completion of the origination phase, it is therefore crucial to install a proper capital structure which aligns incentives from counter-parties in order to maximize their returns. In contrast to PE players, search funds try not to employ debt as their central source of funding for the acquisition. Indeed, given the modest size of the target companies and the first-time ownership of the managers, far too many uncertainties exist to hamper any form of leveraged buyout. As a result, investors’ equity, in its various configurations, prevails as the dominant capital source when arranging these deals.
Despite the acquisition capital being provided by advising investors, the entrepreneur participates in the business as well. As a matter of fact, the entrepreneur will own only a small stake in the company during the early stages of the holding period. Search funds will then follow a similar ownership scheme as PE investments which offer an equity kicker allocation regularly linked to performance benchmarks after the initial investment. In the search fund, the entrepreneur typically receives a total of 15% to 20% of equity participation. As for the remainder, preferred shares are commonly allocated to investors. That being said, combinations of returns and participation rights may differ.
Diving deeper into investors’ stakes in search funds, preferred stockholders are entitled to (i) the initial equity value plus the accrued unpaid dividend and (ii) the total common equity less the entrepreneur’s vested equity. Preferred equity can either be redeemable or non-redeemable. Redeemable stocks can be repurchased ahead of a recapitalization or a liquidation process. On the other hand, non-redeemable equity cannot be redeemed before any liquidation proceedings.
Redeemable preferred stocks work with remarkable similarities to debt instruments. Indeed, they do not have any form of participation rights, but they have attached fixed interest payments comparable to bonds. Evidently, over the course of the investment phase, it is quite rare that the acquired company would issue dividends; hence, the accrued return will be paid out once the shares are redeemed.
Despite the above mentioned trends, several combinations of equities can be used. Each form of equity implies a different incentive strategy, both for the entrepreneur and investors. For example, a structure of only redeemable preference shares (with a relatively high coupon attached) and potential vested common stock, may create an incentive for the entrepreneur to quickly reimburse the preferred “principal” (treated as senior debt), in order to boost IRR and take the remaining upside. In this way, the structure of the returns of redeemable preferred shares works as a call option for the entrepreneur.
Are Search Funds an Opportunity?
The real issue as far as investors are concerned is the high level of skewness in returns. Stanford reports from both 2018 and 2017 (Figure 2 and 3 respectively) affirmed that, on average, search fund returns outperformed other forms of safer fixed-income investments. However, the distribution of returns slants into red numbers with many funds conceding a loss while a small portion generated excess returns.
In all likelihood, the primary reason behind this phenomenon is the relative risk involved. Inexperienced search fund entrepreneurs identifying companies that, on average, are not market leaders, have a large probability of failure – even more so when subject to adverse conditions. Correspondingly, when successful, the returns are prominent. Yet the trend remains that, as both the home-run search funds and partial loss funds are becoming scarcer, the distribution is beginning to normalize. Realistically, this is because of temperate market conditions, increased due diligence by both the searcher and investors and higher quality entrepreneurs as a result. Therefore, if this stabilization of returns is to continue, future placements into search funds may be less of gamble and a more reliable option for investors.
Figure 2: Search Fund Study – Stanford Business School, 2018.
Figure 3: A Primer on Search Funds – Stanford Business School, 2017.
Editor: Eric Peghini
Authors: Massimo Tiozzo Netti, Francesco Carraretto