The Middle Market Review Insights on the Middle Market.
Ever since H. Irving Grousbeck proposed the idea of a search fund in 1984, the entrepreneurial investment vehicle has been a point of controversy. Are search funds legitimate buyers or are they just MBA grads looking for the fast track to the C-suite?
While many sellers tread carefully around search funders, there are some signs that suggest the model is here to stay. In a study published last year, Stanford’s GSB found that the number of funds started has grown steadily (even with the drop during the economic crisis).
Even more importantly, many search funders are beginning to recognize their niche and are running more targeted processes. The Stanford study identified that many search funders are now spending more time identifying the right companies before engaging in “serious discussions.”
Steve Jordan, a successful ex-search funder who acquired a healthcare services company a year ago, helped explain the search fund process from the other side of the table. He explained that while most search funds have a broad range of industry and financials, they can be particularly well-suited for smaller companies and owner-operator run companies.
Jordan explained that, while a search fund model might not be right for all sellers, it has distinct appeal for many. One such group is owner-operators who are concerned about the future of their business and their employees. “Many search funds target older owner-operators that are looking to step out of the business in a year or two,” explained Jordan.
“While a PE fund could bring in an executive team, many of these owner-operators would prefer that not to happen. I think a search fund could be a more attractive model for them because the search funders will be just as invested in the business as they were and will be ready to take the time to live and breathe the business.”
This focused, all-in mentality was echoed by several other search funders. One explained, “The biggest value you get with a search fund is that the funder is committing nearly everything to the company. The funder will spend nearly all his time on the company, most likely move for the company, and be effectively just as dedicated as the original owner-operator. It is hard to match that kind of dedication.”
Jordan identified another type of company that should consider search funds: those in the micro-middle market. He explained that, in addition to owner-operators, search funds are appealing to very small companies. “Many search funds target business that are a little less appropriate for larger financial institutions and private equity groups, either in size or scope,” explained Jordan.
Given the size of these companies, they can be particularly difficult to find. “We did everything under the sun to source deals,” says Jordan. “We went through industry trade journals, scouring fast growing companies lists, networking, researching niches and industries, etc.”
It took Jordan and his partner nearly two and a half years of sourcing before they were able to acquire a company. “It is hard to find a seller that has an attractive business, that wants to sell, and is willing to speak to you.” Ultimately their deal came through a broker, which appears to be a developing trend among search funders.
Still a Challenge
Although there is a niche opportunity for search funds, there are still sources of resistance. “There was definitely a small hit rate, and it is probably lower for search funders because they don’t have a committed fund or dedicated capital,” says Jordan. “We reached out to several thousand companies during the search process and heard back from maybe 10%, and had conversations with 5%.
He continued, “We almost closed a couple of times during the search, but for one reason or another, the deal fell through. Even for firms with committed funds, deals very often fall through, and we knew that going in.”
Ultimately, the search funder’s biggest hurdle is his ability to convince the seller that he is a worthwhile buyer. Jordan explained, “There is no formula for convincing a given buyer — you definitely need to feel the person out. While you hope to demonstrate to everyone that you have done your research, know the market, and have the ability to run the business, how you effectively convey that varies from seller to seller.”
While search funds are not appropriate for every buyer list — particularly ones for larger, more traditional deals — it might be worthwhile to consider a search funder for those smaller, owner-operator deals.
Note: Some names have been changed for confidentiality purposes.
Thanks to Images_of_Money for the photo.