How to select industries for your search fund PPM

The search fund PPM

The decision to launch a search fund is a milestone in an entrepreneur’s journey. It comes after much internal and external debate, doubt, fantasy, and planning. Equally, the decision itself conjures a buffet of emotions in the entrepreneur, a buffet that can be temporarily overwhelming. Sometimes the buffet has bottomless champagne.

But when the party dies down, the searcher must inevitably get to work climbing the dreaded first mountain - raising search capital. 

When I made the decision in 2012 to launch a search fund, I had never raised a dollar of capital before, nobody had raised search capital out of INSEAD before, and I had a very strange CV to present to investors. Naturally, I was nervous.

In addition to the support I received from my mentors and my unbelievably forgiving and supportive wife, I found solace in Stanford’s Search Fund Primer. Among this treasure trove of search fund resources was a sample Private Placement Memorandum (PPM), which is the document I would need to produce and share with prospective investors. I loved the fact that there was a formula (in a prior life I wanted to be a math teacher), a fill-in-the-blank path toward raising search capital. 

There was nothing left to do then except, well, fill in the blanks.

What investors care about

As with many aspects of the search fund model, the standard PPM is fairly prescriptive. And although the searcher is welcome to change any part of it, most choose to rock the boat as little as possible. After all, this boat has been sailing well for quite some time.

There are, however, a few sections that need special attention from the searcher, and because these sections are the only variable parts of PPMs for most searchers, they are also the parts most heavily scrutinized by investors. They include:

1. Principal Background: summary and highlights of the searcher’s experience, motivations, and attributes

2. Search Strategy: mostly boilerplate narrative of search fund tactics, apart from one differentiating factor - industry selection

Investors will also typically scan the rest of the PPM in search of any anomalies, but in general they expect to see industry-standard structure and terms throughout.

Now let’s talk about those italicized words above, industry selection. When I was crafting my PPM, I panicked a bit. “I don’t know what industry I’m going to buy in yet! I suppose it should be something related to my background, but what if I can’t find anything there? What will investors say if I bring them a deal outside of the industries I’ve chosen in my PPM? What industries are investors looking for anyway?”

Reality check

First of all, sit down, grab some sake, and chill. As prescriptive as the search fund model may be, it’s important to bear in mind the ways in which the model is also flexible and pragmatic.

Most investors are well aware of the high probability that you will buy a company outside one of your chosen industries. After all, the best industry selections are narrowly-defined, and even the sum of a few such industries will cover a tiny fraction of the total market. Chances are you’ll start searching in industry A, which will lead you to industry A2, which will open a door to industries B, C, and D, which is where you’ll find your business.

It’s not uncommon for a searcher to cycle through several dozen narrowly-defined industries before closing a deal. While you should have a reasonable degree of certainty that you’ll start with the industries you’ve identified in your PPM, you needn’t feel committed to searching exclusively within those industries. 

Criteria

The search fund industry has found success in buying a certain kind of business, and unless you bring deep domain expertise in an industry that falls outside of the usual bounds, it’s best to stick within them. 

The typical industry criteria have been framed in various ways by investors and searchers, but the different takes are usually directionally aligned. On several occasions I’ve heard Will Thorndike, one of the search fund world’s most respected investors, list the three primary attributes he looks for in a deal:

1. Industry growth - Generally investors are not looking for skyrocketing growth here, just above inflation. We want to avoid contracting industries.

2. High return on tangible capital - Look it up.

3. Recurring revenues

This trio works particularly well in a search fund deal, because search funds are typically trying to buy a company that a super smart, but relatively inexperienced, CEO can do well with. It should be predictable, should have good margins to allow for the occasional hiccup, and should benefit from a rising tide, or at least not have to fight against a falling one. Criteria 2 and 3 can be assessed at both the deal level and the industry level.

While these are the three biggies, an industry can also score points by displaying other attributes, for example:

• Large enough in both $ and # of companies

• Low cyclicality and seasonality

• High barriers to entry

• Low concentration

• Low regulatory/tech/environmental risk

And if you have some professional experience in the industry, all the better. But again, don’t stress about this. 

Process

Here’s where your analytical skills need to shine. Investors care less about the industry you choose than why you chose it. They want to see you don your investor hat, thinking critically about opportunity and risk and developing an investment thesis. 

Spend time on this. Consider it an academic assignment. Do your research, back up your hypotheses with data and logic. You won’t find answers for everything, but you can make logical deductions and comparisons. If the grade schooler in you is asking, “how many pages,” then the teacher in me would say 1.5-3 pages for 3 industries.

Don’t simply copy other searchers. Investors roll their eyes when they see the same industries over and over again. Not every industry you choose needs to be a brilliant discovery (investors have seen most of what’s out there), but they should at least show your ability to arrive at hypotheses independent of your peers.

Be specific. Developing an investment thesis for “healthcare” is not helpful. There are so many business models, moving parts, and uncorrelated trends within this giant sector, that it is impossible to arrive at a sensible investment thesis. By contrast, you could hypothetically develop a fairly clear thesis for dialysis clinics in France. I made this mistake when I initially named “education” as an industry I’d like to target in my first PPM. A kind, but brutally honest, investor provided the above constructive criticism, and I honed my industry selection accordingly.

Always keep in mind your role and approach as a search fund entrepreneur. You’re not a startup entrepreneur, and your investors are not VCs (for the most part). Resist shiny objects.

Download a list of industry ideas here. Very little analysis has been done on these industries, but hopefully they’ll get your creative juices flowing.

A note about search fund PPMs

All that said, we don’t ask for PPMs at SMEVentures. Search fund terms are generally standard, and we don’t need a PPM to educate us on the search fund model. 

We therefore ask only for the meat of what investors really care about - you and your industry selections, which are really primarily a way of getting to know how you think. 

So I guess all we really care about is… you.