Though it’s only recently really become established on the tech side of things, the search fund concept is nearly forty years old, originating at Stanford Business School. In the model, investors, financially support an entrepreneur’s efforts to find, acquire and grow a privately held company, often serving as mentors in the process. The model offers relatively inexperienced entrepreneurs who have limited capital resources a quick path to owning and managing a company—finding an opportunity that already has product market fit, but needs additional effort to take it to the next level.
As one of the quickest routes to becoming a CEO, search funds attract many young business school students interested in private equity and entrepreneurship. Courses in entrepreneurship through acquisition are starting to be offered at top business schools, taught by those who know the process first-hand.
Search funds are still primarily a North American phenomenon, across Canada, Mexico and the US. However, the model is beginning to catch on in Europe and Latin America as well. Searchers hail from a variety of backgrounds, typically private equity, investment banking and management consulting.
From 1984 through 2019, something like $1.4 billion was invested in traditional search funds and their acquired companies, generating, in total, approximately $6.9 billion of equity value for investors and an estimated $1.8 billion for entrepreneurs so far. Search fund deals have gotten smaller as the hot M&A environment has pushed all financial acquirers downmarket, with median acquisition price around $10 million across industries. Searchers buy every kind of company imaginable, but healthcare has been the most popular, amounting to 35% of recent search fund acquisitions.
Tech M&A is becoming more and more popular among search funds, and I’d say that the majority of our clients these days have been approached by a searcher in one form or another. We’ve sold a number of technology companies to search funds, and have one under LOI right now. They can definitely be the right buyer—but ultimately, you want to undersdtand the good, the bad, and the ugly.
First, the Good. Search funds are fast responders. As individual searchers, they have the time to work with sellers. Search funds are often more flexible than other buyers and can help drive other interest in the market. For founders & CEOs concerned with legacy and the future of the business itself, a search fund can be a good match, because the new owner will generally have those interests at heart as well.
The key metric in the success of a search fund is a fit between the company and the searcher. Especially in a situation where a technical founder has built a great product and laid the groundwork for a great business, having an energized, business-savvy new CEO taking the reins can be the perfect match.
However, we do have to talk about the Bad.
The proliferation of search companies has definitely added to the signal-to-noise ratio when it comes to M&A. They often lack the tech expertise, ready capital and clean structure to make a deal feasible.
Tech deals are usually deeply strategic and technology companies most complex entities around. Successfully running a tech company is far beyond the capabilities of most searchers. About 85% of them raise a search fund just a couple years after getting their MBA and are generally far less experienced than the CEO of the companies they’re acquiring. Furthermore, the typical search fund’s more generalist outlook versus the deep technology backgrounds of strategic acquirers and even most of the Private Equity funds we tend to work with just doesn’t usually match up.
There are some self-funded searchers out there, but the majority answer to investors. Those “committed funds” tend not to be quite ready to deploy as anyone would like, and you typically end up selling the company twice—first, the searcher, then their investors. Search funds are also notorious for more complex, less seller-friendly structures that aren’t competitive. The median EBITDA multiple for search fund deals has consistently hovered around 6.0x—that looks more like a sales multiple for a healthy SaaS company than an EBITDA multiple.
Search funds also need to have ready cash flow from the company they acquire, in order to to service the debt on the funds that they raise. That cuts them off from many good tech companies where it makes more sense to run at break-even or even negative EBITDA to drive growth.
Finally, the Ugly.
Selling the company twice is bad enough, but search funds do the same in due diligence. A Search Fund needs to secure their loan partners to provide the funds to get the deal done when they are in due diligence with the seller. Then their lender partners need to do their own due diligence on the agreement, elongating the process. Regulatory processes multiply that time even further.
With multiple lender partners in the data room simultaneously, each doing their own diligence, if you don’t have a strong, competent VP of Finance on the seller side, it could be a nightmare. Search funds move serially through diligence to minimize the dollars spent if there are deal killers, which is less efficient overall, and creates more opportunities for things go wrong, more deal fatigue, and a higher temptation to try to re-trade the deal.
Search funds only have to do one deal—this means, unlike all the other buyers we work with, there are fewer downsides to bad behavior. Private equity funds and technology companies can’t afford to get a bad reputation and lose out on deal flow, but if a searcher—or their investor—sees an opportunity to get more for less, they are more likely to take it, even if it leaves a bad taste in everybody’s mouth. With essentially a single stakeholder, a fickle searcher can kill a deal in an instant, over nothing. We once had a deal blow up because of an employee’s poster with a quote from Ghandi!
All of this leads to a higher mortality rate among searcher deals, even those that reach the Letter of Intent phase and exclusivity.
However, even with all that, it is worth including search funds in your M&A process. A search fund matches your vision for your company can be a great fit, especially if they also bring sector experience, technical expertise and ready access to capital.