Search Funds, interesting returns from micro-buyouts

If you haven’t heard of search funds, you would be far from alone. Yet while this form of investment remains under the radar of the vast majority of investors, the search fund is becoming an increasingly popular vehicle for entrepreneurs from a wide variety of backgrounds to run established businesses and help them grow, while also generating attractive returns for their backers.

An idea that originated at Harvard Business School in the mid-1980s and popularised by Stanford Graduate School of Business over the following decade, search funds are vehicles created by one or two individuals who raise money from a group of investors to fund the identification and acquisition of a privately-held company. The business is then managed by the individual(s) over a number of years before exiting and returning capital to investors.

In some ways, this approach is similar to angel investing in that investors have the opportunity to back entrepreneurs they believe to be highly skilled to support their efforts in growing a business. It gives investors the chance to gain exposure to small but promising companies in a less institutional and therefore less competitive setting. And, given that most search funds target smaller businesses, the capital required is not excessive and well what is needed for regular venture and private equity funds. Stanford’s latest biannual Search Fund Study reports that the average purchase price of businesses acquired by search funds was US$13.1 million as of 2018. In addition, somewhat similar to an angel network, investors that have initially backed a search effort are offered an option to invest if a suitable business is found (although they are not obliged to do so), which requires due diligence on the part of the investor.

Yet the similarities end here. One of the defining features of angel investing is that it tends to be high risk. A 2016 study on angel investment returns in North America completed by the Angel Resource Institute found that angel investing had a 70% failure rate – seven in ten angel investments resulted in a loss for investors – and IRRs overall were 22%, with a cash-on-cash multiple of 2.5x. By contrast, the Stanford Study, which tracks first-time search funds in North America, found aggregate IRR to be 33.7% for 312 funds raised from 1984 to the end of 2017, with an ROI of 6.9x. 29% of companies acquired lost money. A sister study on international search funds, conducted by IESE found a similar result – an IRR of 33.3% across 28 funds, albeit with lower ROI of 2.3x.

Data suggest that search funds offer investors an unusual mix of lower risk but higher returns than more traditional angel investing. Part of this is down to the type of business they target. While angel networks are often focused on early-stage opportunities that may not yet be generating profits, search funds can offer investors exposure to small but more mature profit-making businesses with potential for growth, often at attractive valuations. EBITDA1 at purchase stands at around $2 million across all funds raised, with a median purchase price to EBITDA multiple of 6x for North America and 4.9x in other regions. In addition, 98% of companies acquired by search funds since 1984 were profitable (they had positive EBITDA margins at the time of purchase).

Another key benefit for investors is that, for a small initial outlay, they can back a promising individual or pair of individuals to fund the search, getting to know them before making a more substantial investment. While the amount invested per angel round is on average around $35,0002, Search funds typically range from $300,000-$500,000, funded usually by 12-18 investors (typically $25,000-$35,000 per investment unit).

Investors can also play an important role in the company development, with seats on the board and the ability to make decisions on areas such as acquisitions, making this type of investment particularly suited to family offices and high net worth individuals with experience of company management. Yet, as with any investment, there are risks. Key among these is that the search fund is unable to find a suitable acquisition target. Of the 233 funds that have concluded a search, 73 (or 31%) ended without an acquisition, according to the Stanford study. Another is, of course, that the acquisition is ultimately unsuccessful and all or part of the capital invested is lost. There is also a wide variance in returns, with the top performing 12% of funds generating an ROI of 10x or more, while 29% of those making a profit returned under 2x capital invested.

So, while we believe search funds offer a compelling investment opportunity, it’s important for investors to appreciate that picking the winners relies on sound knowledge of who is in the market (no easy task, given the lack of efficiency and available information in this area), plus solid due diligence on the individuals raising the search funds and then on the business identified.

Notes: 1median figures, 2according to a 2017 report by the Angel Capital Association, while the amount invested per angel round can go as high as $750,000, the average check written is around $35,000, with a smaller median of $25,000.