All You Need to Know About Search Funds in 20 Minutes

Introduction to Search Funds

Search funds are a unique investment vehicle that enables entrepreneurs, often recent MBA graduates, to find, acquire, and operate a privately held company. Originally conceptualized in the 1980s at Stanford University, search funds have grown in popularity due to their appeal to those looking to fast-track their entrepreneurial careers without starting a business from scratch. The model allows for the acquisition of established businesses, often with stable cash flows, providing a lower-risk path to business ownership.

Origin and History

The concept of search funds was pioneered by Professor H. Irving Grousbeck at Stanford Graduate School of Business in 1984. Grousbeck’s aim was to provide aspiring entrepreneurs with a pathway to business ownership without the high failure rates associated with startups. Initially, the model was slow to gain traction, but over the past few decades, it has become a well-regarded method for acquiring businesses, especially among MBA graduates. The number of search funds has grown from a mere handful in the 1990s to hundreds globally today, particularly in North America and Western Europe.

What Makes Search Funds Different?

Unlike traditional private equity (PE), search funds typically target smaller, often family-owned businesses with stable cash flows and strong fundamentals but limited growth due to lack of strategic direction. The search fund model is distinct in that the entrepreneur is involved from the search phase through acquisition and operational management, essentially acting as both investor and operator. This hands-on approach contrasts with the more hands-off strategies of traditional PE firms.

Who Are Search Funds Suitable For?

Search funds are particularly attractive to individuals who aspire to become CEOs but lack the capital or experience to start a business from scratch. Typically, searchers are recent MBA graduates or professionals with a few years of experience in fields like consulting, investment banking, or general management. Investors in search funds are often experienced professionals, including former searchers, who provide both capital and mentorship.

Pros and Cons

Pros:

• Lower Risk: By acquiring established businesses with proven cash flows, search funds mitigate the high risks associated with startups.
• High Potential Returns: Search funds have historically delivered strong returns, with studies indicating average IRRs in the range of 30-40%.
• Entrepreneurial Experience: Searchers gain valuable experience running a company, which can be a stepping stone to future entrepreneurial or executive roles.

Cons:

• Inexperience: Many searchers lack significant operational experience, which can pose challenges in managing the acquired company.
• Limited Market: The niche nature of search funds means there is a limited pool of investors and targets.
• Time-Consuming: The search process can be lengthy, often taking 12-24 months to find a suitable target.

The Search Fund Process and Lifecycle

The lifecycle of a search fund typically unfolds in four key stages:

1. Raising Initial Capital: Searchers raise funds from investors to cover the costs associated with searching for a suitable acquisition target. This stage often takes 2-6 months.

2. Search and Acquisition: This phase, which can take 12-24 months, involves identifying, evaluating, and negotiating the purchase of a company. Searchers often rely on cold-calling, networking, and due diligence to find the right business.

3. Operation and Value Creation: Once the acquisition is complete, the searcher assumes the role of CEO, working to improve the company’s operations and increase its value. This phase can last 3-7 years.

4. Exit: The final stage involves selling the business or executing another liquidity event, such as a recapitalization or IPO, to provide returns to investors.

Searcher and Investor Profile

Searcher Profile:

• Age: Typically between 28-35 years old.
• Education: Most searchers hold an MBA.
• Background: Common backgrounds include management consulting, investment banking, and general management.
• Motivation: Driven by the desire to own and operate a business rather than start one from scratch.

Investor Profile:

• Experience: Often former searchers, private equity professionals, or seasoned executives.
• Motivation: Investors are typically drawn to the high potential returns and the opportunity to mentor young entrepreneurs.
• Investment Size: Initial investments are relatively small, but investors may contribute additional capital during the acquisition phase.

Risk-Reward Profile

The risk-reward profile of search funds is unique. On the one hand, the acquisition of established businesses with steady cash flows offers a lower risk compared to startups. On the other hand, the potential returns can be substantial, with many search funds achieving multiples of invested capital. However, the success of a search fund largely depends on the searcher’s ability to manage and grow the acquired business.

Timeline of a Search Deal

A typical search deal timeline is as follows:

• Initial Capital Raise: 2-6 months
• Search for Acquisition: 12-24 months
• Acquisition and Transition: 3-6 months
• Operation and Value Creation: 3-7 years
• Exit: 6-12 months

Are Search Funds an Asset Class on Their Own?

Search funds straddle the line between private equity and traditional entrepreneurship. While they share similarities with PE, particularly in their acquisition strategies, they are distinct due to the searcher’s dual role as both investor and operator. Some argue that search funds are a subset of private equity, focusing on smaller deals (often SME-sized) with a hands-on management approach. However, their unique structure and high potential returns at a relatively safer risk profile suggest they may deserve recognition as a distinct asset class.

Search funds offer a compelling pathway to business ownership, particularly for those with an MBA and a strong entrepreneurial drive. They provide a unique blend of lower risk, high potential returns, and hands-on management experience. While they may not be suitable for everyone, those who succeed in the search fund model often go on to enjoy lucrative and fulfilling careers. For investors, search funds represent an opportunity to mentor the next generation of entrepreneurs while potentially earning substantial returns.

Join VCII

Venture Capital Investment Institute (VCII) is dedicated to providing education and resources for those interested in search funds and other investment vehicles. Whether you are an aspiring searcher, investor, or simply interested in learning more, VCII offers a range of programs and events to help you succeed in this dynamic field.

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