“How do I interface with a search fund?” — This is a common question that sell-side firms face when they encounter a search fund team, simply because there aren’t many search funds out there. Consequently, many sell-side firms are apt to dismiss the search fund. This practice is misguided; while there are differences in the scope, scale, and interests of a search fund compared to a traditional private equity firm, keeping search funds on the buyer list can be useful when deal situations arise where the search fund’s goals are more aligned with the company looking to be sold.
Search funds are typically comprised of individuals who are seeking to buy and then personally operate a company that is usually smaller in size than the typical target for a private equity firm. Nevertheless, both private equity firms and search funds are often financially oriented buyers at the core, looking for businesses that have solid historical performance, and seeking opportunities where growth can be derived from scaling their investment. The similarities just about end there for these two categories of buyers. Upon understanding the many differences between private equity firms and search funds, sell-side firms can be more nuanced in tailoring deals to meet the needs of potential search fund buyers.
1. Search funds may have equity funding sources that are not yet committed
While most private equity firms have committed capital with an LP structure that is familiar to most professionals, search funds are more often structured with “contingent” capital that requires approval of the specific deal that is being evaluated. For example, a search fund may have access to $3 million in equity to invest, but these investors need to understand the deal on the table as an initial search fund will often only invest in one or two companies. As a result, there are inherent risks to closing a deal with a search fund given that securing equity financing may be a longer process than typical. On the other hand, this process of reviewing the deal with capital sources can prove for a faster due diligence process as well.
2. The operating experience and the industry experience of the search fund team will be more critical to the seller of the company
Because search fund members are looking to buy and then personally operate the business that is bought, the operating experience and industry fluency of the search fund members will be critical to the seller, especially if any seller financing or performance-based payouts (earn-outs) are incorporated into the deal. While this may be also true in a sale to a private equity firm, in the case of the search fund, the seller has unique visibility into the background of the team that will manage the business post-transaction. This can be an advantage of the search fund.
For example, in a medical billing business transaction I advised, the sellers of the business were comfortable with a structure that allowed them the benefit of payouts based on the post-transaction performance of the business. The search fund that ultimately bought the business was able to cultivate the confidence of the sellers because they could say the new operating team was sitting across the table from the sellers throughout the negotiation process.
3. Location of the business may be important for the search fund team
Search fund members are looking at the process of purchasing a business from the more holistic perspective of their lives over the next five to seven years. Therefore, lifestyle factors such as the location of the business are much more critical to the search fund than a traditional private equity firm. If a search fund member is not looking to live outside a major city, he or she can not seriously consider a deal in Wyoming. As a sell side firm, it is important to vet these personal considerations adequately so as to not waste time with a search fund that might not have the personal capacity to engage with a deal to completion.
For example, I advised a search fund that was looking at purchasing an LTL freight carrier because of their experience in logistics and interests in the sector. However, when opportunities arose, acquiring the business meant moving from San Francisco to a semi-rural location or facing an extremely long commute. Since operating the business was part of the value proposition, this reality should have been considered earlier, but rather came to the sell side firm to discover in negotiation.
4. The search fund team could offer more than just terms when negotiating with the seller
In some cases, the seller of a business is interested in factors in addition to the financial terms of the deal. As a sell side firm, the right search fund team could allow a business owner an alternative option that he or she may not have considered with a private equity firm, and it may be one that they choose to pursue.
For example, in a business that I bought several years ago, my initial offer was not the highest price for the business. However, since I was the person who was going to personally operate the business post-transaction, I was able to clearly delineate how I would run the business, my vision for where growth may lie in the business, and how I intend to cultivate the employees at the company. This complete picture of what lies ahead for the company that the owners had managed for many years was the clarity that drove them to choose a deal that on paper was not the higher offer.
5. The bank financing could be more integrally tied to personal financials
Cash flow based lenders will most likely require a personal guarantee on the loan that they extend to facilitate the purchase of a business by a search fund. This can be an emotional roadblock for search fund members as they approach the close of a transaction.
I have often commented that buying a business is like jumping off a cliff, and it will take you three to six months post-transaction to see where you will land on the other side. If a search fund member is not willing to take that jump, then a sell side firm is not going to get its deal done. Therefore, it is critical to vet the search fund to make sure that they have emotionally made the commitment necessary to carry a deal across the finish line.
Ultimately, the search fund buyer can be an important option for sell side firms to approach and consider, especially when a company does not meet the size, industry, or operating criteria of private firms that are looking at the business. Moreover, the search fund buyer can offer advantages over a private equity firm or can be a partner to a private equity firm for certain deals. In the end, once you have made sure that the members of a search fund have been adequately screened, the opportunity to enhance options for your clients can make this effort fruitful.
Pankaj Amin founded SC Ventures as a search fund in 2001 and bought Affinitel Communications, a telecommunications company he subsequently ran for seven years. SC Ventures currently has professionals in New York and Chicago and serves private equity firms as operating executives. Pankaj has a BS from Princeton University and and MBA from the Harvard Business School.