Search funds are different from any other type of investment vehicles. They involve the acquisition of a small or medium enterprise by an entrepreneur, that may come from a diverse set of backgrounds from private equity to engineering, from investment banking to management consulting, backed in his search for a potential acquisition target by a group of investors. If this search is successful, those investors have the possibility to invest further capital for the acquisition of the selected target, while also contributing with their expertise to the success of the investment. This process is able to generate high returns, with an average IRR between 1984 and 2020 of 32.6% in North America.
There are many different aspects of these operations that deserve a closer look, but for this article we decide to focus on the capital structure of such transactions. Similar to other types of M&A transactions, the use of leverage is key to increase the IRR of the investment, with debt usually accounting for 50% to 70% of the total transaction value. The remainder tends to be composed in full by equity capital, but occasionally hybrid funding may be employed.
Senior and Subordinated Debt
The largest source of debt is senior debt, usually issued by a bank. For this tranche repayment is prioritized over any other debt obligations. Senior debt can come in many forms, including but not exclusively: first lien term loans, first lien revolvers and asset-based loans. It is quite rare that this source of funding amounts for the totality of the debt funding as a bank is unlikely to expose itself so much on such a risky investment (8.25% of successful searches still result in a complete loss of equity capital). Due to its safer nature with respect to the other debt obligations that are included in the deal, the interest rate is between 5% and 12% (mostly close to the lower bound of the interval).
In addition to senior debt, there may be use of second-lien or mezzanine debt, issued by specialized financial institutions, that is guaranteed a higher interest rate.
It is also frequent to see the usage of seller debt, that on average represents roughly 30% of the total debt financing. This materializes in a lower initial payment to the seller, which then is given a chunk of the company’s debt. One of the main reasons for this is to keep the seller close to the company for the period right after the acquisition, in order to facilitate the transition to the acquiring entrepreneur. Seller debt is subordinated to all other debts and has no collateral, thus being the one with the highest interest rate, in the range of 8% to 14%. Somewhat related to this is the usage of earn-out clauses, which represent an additional payment that is conditional on meeting certain performance criteria.
Lenders will often impose covenants on all types of previously mentioned debt instruments, in terms of debt-to-equity ratio, debt service coverage ratio, fixed charge coverage ratio and others, alongside setting reporting requirements, with yearly, quarterly, and monthly reports alongside compliance certificates.
The composition of the equity capital employed in the transaction, although highly situational, tends to follow a common thread, also due to the structure of search funds. This is as in all funds there is a distinction between search capital, contributed by the investors (and potentially also by the principal himself, with the extreme being the one of a self-funded search) at the signing of the private placement memorandum, the acquisition capital, contributed mostly by the same investors that took part of the search capital funding, and the equity that is given to the fund manager. Occasionally, some common equity may be given to the seller as an incentive.
The treatment given to the equity contributed by investors is different from the one received by the principal. The search capital is often, as a remuneration for the higher risk subject to investing before the search with respect to after, converted into capital of the target at a ratio higher than one (the most common practice is recognizing 50% more than the capital contributed). After the target is identified, those who backed the search have the possibility but not obligation to contribute capital for the acquisition in a given common amount (“unit amount”), chosen by the principal. In case one or more investors do not exercise their right, others would be sought, in a task that is obviously easier than it was in the search phase as the transaction has already taken shape. Both the search and acquisition capital are usually converted in preferred stock securities.
Preferred stock securities are junior to all debt obligation but senior to common equity. These are often issued as participating preferred stock securities, meaning:
- They hold the right to the initial value and unpaid preferred dividends (if present).
- They hold the right to all the common equity at sale or liquidation, with the exception of the part belonging to the manager.
It has to be noted that “participating” securities are quite different in the US from other countries. Furthermore, preferred stock can be issued in two different ways, that can also be used in a complementary fashion:
- Redeemable preferred stock can be fully or partly redeemed before sale, liquidation, or recapitalization. After redemption, these stocks are no longer part of the capital structure. These usually have a coupon attached to them (e.g. between 10% and 17%).
- Nonredeemable preferred stock that cannot be redeemed prior to the previously mentioned events. These may or may not have a coupon attached to them (if the transaction involves both redeemable and nonredeemable preferred stock there tends to be no coupon, while if only nonredeemable ones are used the coupon is in the range of 6% to 8% in the US).
Given the possibility of having only nonredeemable preferred stock or both types, we shall discuss the pros and cons of the two alternatives. A preferred stock structure composed of only nonredeemable stock has the main advantage of leaving the return uncapped on every unit of capital contributed by the investors and being a well-known and common arrangement. Its biggest drawback is connected to the whole amount contributed having a coupon payment attached to it, which will require higher cash generation throughout the holding period and may disincentivize the manager if the accrued amount of dividend to pay becomes excessive.
The mixed structure is a good incentive for high early cash generation and quick redemption for the redeemable part, that boasts the return on investment for all parties. This also gives the opportunity to the investors to use the redeemed capital to pursue further investments while still maintaining the upside on the search fund. The largest drawback of this structure is the possibility of the accrual of high coupon payments on the redeemable part becoming significant if they are not repaid quickly. Given this trade-off, three fourths of the latest US search fund transaction have deployed a capital structure that involves both redeemable and nonredeemable preferred stock.
Lastly, it often happens that preferred stockholders are given the right to a share of the cash left at the time of the exit, usually 75% of the total, with the remaining 25% in the hands of the principal.
The manager equity completes the picture on the capital structure of search fund transactions. Agreed upon with the signing of the private placement memorandum, it is structured in different tranches of common stock that the manager will receive as he meets some pre-specified objectives. The final amount may reach 25-30% of the equity capital of the company. The most common structure involves three tranches of equal size: a first one received at the moment of acquisition, the second when the holding period surpasses a threshold, usually four or five years, and the last when a predetermined hurdle rate for the investor’s returns is passed. The hurdle rate could be defined both in terms of IRR or MOIC and is usually calculated through a leveraged buy-out financial model. If no liquidity event yielding a tangible valuation of the company has happened recently and the principal wants to receive this last tranche, he may request a third-party valuation of the company. As manager equity is issued in common stock, the manager is the residual claimant in case of liquidation. The reader shall also notice that this is not the only type of compensation for the manager, as he also receives a salary from the company he operates. It is of absolute importance to remind the reader that what previously stated is a general framework, and any transaction is different from the rest. Potential diversions may include hybrid instruments, additional sources of debt, and the usage of other types of shares, such as deferred shares. Furthermore, the capital structure evolves throughout the holding period, and is never the same at acquisition and exit. Leverage can here be used for value creation, in a similar way to any other leveraged buy-out.
Goodwin Procter LLP, The Art of Leveraged Finance: Key Components to Consider in the Search Fund World, 2020
Molinari A., Search Funds: Un Nuovo Strumento a Sostegno della Piccola Impresa e del Rinnovamento Imprenditoriale, Guerini Next, 2019
Stanford Graduate School of Business, 2020 Search Fund Study, 2020
Stanford Graduate School of Business, A Primer on Search Funds: A Practical Guide for Entrepreneurs Embarking on a Search Fund, 2020