Talent, sourcing, coaching, and focus. That's why.
As an asset class, the search fund model has outperformed most others. It has consistently produced outstanding returns over its history, and investors who have built a portfolio of search funds have generally done very well. Inquiring minds therefore want to know...
Why has this model produced such high returns?
With so many variables, known and unknown, coming into play in each search fund deal, I’m hesitant to draw any definitive conclusions. However, I’ve identified four elements of this model that differentiate it from most others: talent, sourcing, coaching, and focus. I don’t claim to know the relative importance of each of these ingredients, but it stands to reason that perhaps in aggregate these features have something to do with the model’s outsized returns.
Talent
In most standard private equity buyouts, the buyer incentivizes the current CEO and management team to stick around for a period. Then, when appropriate, the buyer may source a new CEO and/or management team to replace the legacy team.
Search funds, by contrast, start with the management solution (the searcher) before even identifying the target company. Indeed, it is the searcher herself who is responsible for sourcing the buyout opportunity. Even in PE firms with an entrepreneur-in-residence (EiR) program (or similar), the EiR may do some sourcing, but the bulk of the sourcing effort is typically driven by the firm’s business development resources. The concept of giving the future CEO the entire responsibility of sourcing the buyout opportunity is fairly unique to the search fund model.
In addition, the typical profile of the search fund entrepreneur is surprising to many. According to the 2018 Stanford Search Fund Study, the median age of a searcher at the start of her search is 32, and the median number of years of post-MBA experience is 3. About 81% of searchers have historically had an MBA.
Why does this profile work? Again, I will refrain from concluding any causal relationships, but common stories include the following:
Top-tier MBAs are more likely to join large brand-name firms, and relatively few join SMEs, especially in the unsexy industries of which the search fund model is so fond. Therefore, there may be opportunities to bring ideas and tools to an SME that have not been previously implemented at that SME or perhaps even in the industry.
The seller has often been running the business since she was of a similar age to the searcher. The seller can therefore identify with the searcher, and the two can build a special relationship. This relationship can both increase the probability of a successful closing and support a successful transition post-acquisition.
The relatively young searcher is more energetic, hungrier, and less jaded than the more seasoned operator. She is also sometimes more willing to throw herself fully into the business.
Sourcing
The fact that the CEO-to-be is leading the sourcing effort also changes the conversation with the seller-to-be. If a business owner has received a previous buyout solicitation, it was likely from either a) a competitor or industry player (i.e. strategic buyer), or b) a private equity group (i.e. financial buyer). The strategic buyer’s plan is usually some version of rolling the assets into its existing operations to realize synergies, which often entails layoffs, relocation, rebranding, and the effective disintegration of the acquired company. The financial buyer may do some of the same if it sees synergies within its portfolio, but it also has the reputation of descending upon the acquired company with its restructuring team before gutting the company to reduce costs and expand margins and put it back on the market for a quick gain. These characterizations are of course generalizations, but they are based in some truth and represent some of a business owner’s worst fears for the business she has spent years, or perhaps decades, building.
Then along comes a searcher with a very different message. “I’m an entrepreneur looking for a business to run. I’d really like to step into your shoes and run your business largely as you have been the past x years, adding value where I can. I’d like your team to stay if possible so we can build on your success.” For many sellers, this message is a breath of fresh air, and the relationship begins on the right foot. If the business owner cares about her legacy and the future of the business, she may be more likely to respond to this message than to a message from any number of PE groups. She also likely finds the idea of selling to another entrepreneur easier to swallow than the prospect of selling to a competitor, against whom she has been fighting for years.
In aggregate, this differentiated messaging and approach may mean that the search fund entrepreneur is able to uncover opportunities that are unavailable to the traditional strategic and financial buyers.
Coaching
While the typical searcher profile has its benefits, the typical searcher has also, in most cases, never bought a company or been a CEO before. Coaching and mentorship, therefore, are critical components of the search fund model. Right from the beginning of the search phase, investors are economically tied to the success of the searcher, and they are incentivized to help that searcher. Then, once the investors have written the larger check at the deal phase and the searcher-CEO is operating the acquired company, they have more skin in the game and are increasingly incentivized to support the searcher. Perhaps more importantly, many serial search fund investors want to engage with the searcher because they enjoy the mentorship activity and derive satisfaction from helping that entrepreneur achieve her goals.
Some investors are more involved than others, and some investors are more effective coaches than others, but usually the searcher ends up communicating frequently with a few of her investors that, for whatever reason, have taken the lead on the deal. Those same investors might well be more passive on another deal, allowing other investors take the lead. In addition, the searcher-CEO may well involve a non-investor on the board, as an advisor, or as an informal mentor.
While the format, frequency, and substance of the coaching and mentorship is not prescribed or uniform across the search fund ecosystem, and while we have no empirical data on the causal impact of this coaching, the coaching element is nevertheless universally understood to be a critical element to the model’s sustained success.
Focus
Now that we understand that the search fund model is designed for the first-time CEO, it stands to reason that the investment thesis should accept that premise. While successful search fund deals have been done across a wide range of industries from home brewery ecommerce to crop dusting, the intended investment focus leads to several commonalities across most search fund deals.
First of all, because this is a model designed for the first-time CEO, the target should be a company that can absorb the new CEO with minimal disturbance. These companies often share the following characteristics:
Capable middle management team in place and willing to stay
Predictable revenues, ideally with long-term contracts in place
Healthy margins
Revenue growth
Low levels of operational complexity
Likewise, the industries in which searchers acquire often share characteristics that improve the probability of success for the new CEO:
Steady growth, but not skyrocketing growth
Minimal external risks (e.g. technology, environmental, regulatory, cyclical)
The search fund entrepreneur is not looking at distressed assets, turnaround situations, or opportunities that require a material change to the core business model. Rather, the target is a healthy, steady company, and the value creation strategy is relatively straightforward and as risk-mitigated as possible. While the searcher will often employ an element of tech enablement, make some key hires, and professionalize processes, the investment thesis is generally not predicated on radical modifications of the core business model. Rather, value is most often created through professionalizing processes and systems, applying elbow grease to growth strategies, identifying and seizing incremental opportunities when available, and paying down debt.
Searchers are prone to stray from this focus. They will inevitably come across a (seemingly) no-brainer turnaround opportunity, or a roll-up play, and their spreadsheets will tell them that these are opportunities not to be missed. Confirmation bias sets in, the emotional attachment stiffens, and… the rest is history. Whoever is assuming the role of the coach or mentor, therefore, must serve as the reliable backstop, saving the searcher from herself and keeping her focused on the opportunities and industries that fall within the tried-and-true framework of the search fund model.
Action Items
In your conversations with searchers, ask them what role they think each of the above ingredients has played in their venture.
Read Everything is Obvious, and share your reactions.
