The Search Fund Model: A Pathway to Entrepreneurship

Vital Addition

November 16, 2023

In recent years, search funds have been growing in popularity as an asset class. A search fund serves as an investment vehicle whereby investors finance an entrepreneur to source, purchase, operate and grow a privately held company. This approach, known as Entrepreneurship through Acquisition (ETA), offers a unique pathway for budding entrepreneurs to helm a venture and reap profits without the challenges of building a business from the ground up.

What Are Search Funds?

So, what is a search fund? Contrary to traditional entrepreneurship, where the focus is on starting a new venture, search funds revolve around acquiring an existing business. A search fund is essentially a route to entrepreneurship taken by individuals who establish an investment vehicle in collaboration with a group of aligned investors. 

Search funds technically fall under the private equity umbrella since their purpose is to acquire and operate private companies. What sets them apart from traditional private equity is that the searcher not only acquires, but also actively participates in running the business after the acquisition.

The Origins of the Search Fund Model

The concept of the search fund model can be traced back to Harvard Business School (HBS) in 1984 and was introduced by renowned entrepreneur-turned-academic, Irving Grousbeck. While juggling responsibilities at HBS and overseeing his latest venture, the Boston Celtics, Grousbeck devised this model to provide talented, yet unestablished business people a streamlined route to company ownership and wealth generation.

The Profile of a Searcher

The typical profile of a searcher is usually young, ranging from 24 – 54 years old, with a median age of 32, generally hailing from professional backgrounds in private equity, general management, management consulting and investment banking. According to the Center for Entrepreneurial Studies, 82% of searchers have MBAs, 72% of all first-time searchers are solo founders rather than co-founders and only 5% of all search entrepreneurs are women.

Understanding the Search Fund Structure

The journey of a search fund can be divided into four distinct phases:

  • Fundraising
  • Search and Acquisition
  • Operation and Value Creation
  • Exit

Fundraising Stage

Typically spanning between two to six months, this initial stage sees the principals actively raising funds from potential investors.This involves raising two types of capital:

  • Search Capital: Funds used to search for a suitable business.
  • Acquisition Capital: Funds reserved for the actual business acquisition.

Search and Acquisition Stage

This stage is dedicated to utilising the raised capital to acquire a profitable, high-margin business. The process can extend from twelve to twenty-four months and is dedicated to generating deal flow via two primary avenues:

  • Broker Deal Flow: Broker deals are businesses actively up for sale through brokers. Given their visibility to multiple buyers, the competition often drives up the price, making them pricier acquisitions.
  • Proprietary Deal Flow: Proprietary deals are businesses not actively on the market, allowing for acquisitions at more reasonable prices. Generating such deals is intricate and mirrors a sales process. It entails identifying potential acquisition targets and initiating contact, often through cold mailing and calling.

Operation and Value Creation Stage 

This phase, lasting anywhere from four to seven years (or more), marks the end of the search. Once the acquisition is complete, the entrepreneur takes charge of the company, transitioning to the role of CEO, assembling a team and focusing on scaling the business towards an eventual exit. 

The former owner collaborates with the new CEO, ensuring a smooth understanding of the business and fostering stakeholder relationships. It’s essential for the former owner to exit the business, relinquishing control to the new CEO within 6-12 months. 

Exit Stage

This is the culmination of the search fund’s journey, where the initial investors realise their returns. The exit can take various forms, including a private equity sale, acquisition, an IPO or a management buyout. The average holding period for search funds stands at seven years, contrasting with private equity’s three to five years. The exit’s timing hinges on market conditions and investor profiles. 

While individual investors might exhibit flexibility, some even opting for indefinite holds, institutional investors usually have a contractual obligation to return capital to limited partners within 5-7 years.

Search Fund Model Lifecycle and Returns

Due to the expenses incurred during the search, which can extend up to two years, the fund operates at a loss during the search stage. As a result, the fund’s lifecycle mirrors the J-curve typically observed in venture capital (VC) funds and startups.

Historically, the returns from search fund models are impressive, with an ROI of 8.4x and an IRR of 36.7%. Such promising returns, coupled with a relatively higher success rate compared to venture-backed startups, make search funds an attractive proposition for both entrepreneurs and investors.

Potential Pitfalls and Risks

Like any investment vehicle, search funds come with their set of challenges. These include:

  • Extended Search Duration: The search for the right business can take longer than anticipated, leading to increased costs and investor impatience.
  • Inadequate Due Diligence: Overlooking critical issues during the evaluation phase can lead to post-acquisition surprises.
  • Overpaying for Acquisitions: Due to competition or over-enthusiasm, searchers might end up paying more than the business’s actual worth.
  • Failure to Adapt to the CEO Role: Transitioning from a searcher to a CEO can be challenging, given the different skill sets required.
  • Resistance from Existing Employees: Current employees might be wary of changes or the new management.
  • Misalignment with Investors: Investors and searchers might have differing views on the business’s direction or exit strategies.
  • Exit Strategy Complications: Finding the right exit opportunity that satisfies both the searcher and investors can be difficult.

Is a Search Fund Right for You?

Search funds offer a unique pathway to entrepreneurship, especially for those looking to acquire and grow an existing business. While it presents an exciting opportunity, there are other alternative models available. If you’re intrigued by the search fund model and wish to explore it further, reach out to Vital Addition. Our team can provide guidance tailored to your entrepreneurial aspirations and help you choose an entrepreneurial path that aligns with your goals, risk appetite and vision for the future.

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