Notes on “A Primer On Search Funds” produced by the Stanford Graduate School of Business
“The Search Fund”
- Greater than 20% of search funds have not acquired a company
- Stages of the Search Fund model:
- Raise initial capital (2-6mos)
- Search for acquisition (1-30mos)
- Raise acquisition capital and close transaction (6mos)
- Operation and value creation (4-7+ years)
- Exit (6mos)
- SFs target industries not subject to rapid tech change, easy to understand, fragmented geographic or product markets, growing
- Highest quality deals are found outside broker network/open market due to lack of auction dynamics
- Research shows that partnerships are more likely to complete an acquisition and have a successful outcome than solo searchers (71% yielded positive return, 15 of top 20 performing funds were partnerships)
- Principals budget a salary of $80,000-120,000 per year w/ median amount raised per principal $300,000~
- Majority of the economic benefit of SF comes through principal’s earned equity; entrepreneur/partners receive 15-30% equity stake in acquired company in three tranches
- Investors typically receive preference over the SFer, ensuring investment is repaid, with return attached, before SFer receives equity value
- Individual IRR from 2003-2011 median was not meaningful, heavily skewed toward 75th percentile where median was 26% in 2011; 57% of individual IRRs were not meaningful in 2011; the median fund destroyed capital in 2009 (0.5x) and 2011 (0.8x); 58% in 2011 broke even or lost money
- Half of the funds that represent a total or partial loss were funds that did not acquire a company; biggest risk is in not acquiring a company at all
- Median acquisition multiples: 1.1x revenues; 5.1x EBITDA
- Median deal size, $8.5M
“Raising a Fund”
- Search fund capital should come from investors with the ability and willingness to participate in the acquisition round of capital raising
“Search Fund Economics”
- Search fund investors often participate at a stepped up rate of 150% of original investment in acquired company securities
“Setting Criteria and Evaluating Industries”
- Desirable characteristics for a target industry: fragmented, growing, sizable in terms of revenues and number of companies, straightforward operations, early in industry lifecycle, high number of companies in target size range
- Desirable characteristics for a target company: healthy and sustainable profit margins (>15% EBIT), competitive advantage, recurring revenue model, history of cash flow generation, motivated seller for non-business reasons, fits financial criteria ($10-30M in revs, >$1.5M EBITDA), multiple avenues for growth, solid middle management, available financing, reasonable valuation, realistic liquidity options in 3-6 years
- Key challenge is “know when to take the train” lest a SF never leaves the station waiting for the perfect opportunity
- Ideally, seller is ready to transition out of the business for retirement or personal circumstances or has something else they’d like to do professionally
- Experience shows it is better to pay full price for a good company than a “bargain” for a bad one
- Idea generation: SIC and NAICS codes, Yahoo! Finance, Thomson Financial industry listings, Inc. 5000 companies, public stock OTC and NASDAQ lists and even the Yellow Pages; generate a list of 75 potential industries to start
- Target industries buoyed by a mega-trend
- Can also target an industry in which the SFer has worked and possesses an established knowledge base and network
- Some focus on 2-3 “super priority” industry criteria (eg, recurring revenues, ability to scale, min # of potential targets, etc.)
- Objective is to pare down the industry target list to 5-10 most promising
- Basic industry analysis (Porter’s five forces, etc.) is then used to narrow from 10 to 3; SFers use public equity research and annual reports for market size, growth, margin benchmarks; also Capital IQ, Hoover’s, Dun & Bradstreet and One Source
- Industry insiders (business owners, trade association members, sales or business development professionals) and industry trade associations or affiliated ibanks and advisory firms are primary methods of research and often have general industry research or white papers available
- Next step is to create a thesis to codify accumulated knowledge and compare opportunities across common metric set in order to make go/no-go decision
- In order to become an industry insider, SFers typically attend tradeshows, meet with business owners, interview customers and suppliers and develop “River Guides”
“The Search”
- Median # of months spent searching, 19
- 54% spend less than 20 months searching, 25% spend 21-30 months, 21% spend 30+ months
- Track acquisition targets with CRM software such as Salesforce, Zoho, Sugar CRM
- Bring up financial criteria and valuation ranges as early as possible when speaking to potential acquisition targets to save everyone time
- A company that is too large or too small as an acquisition target may still be worth talking to for information
- You must immediately sound useful, credible or relevant to the owner; deep industry analysis should already have been performed at this stage
- Trade shows can be a critical source of deal flow
- If a particular owner is not willing to sell, ask if he knows others who are
- “River Guides” are typically compensated with a deal success fee, usually .5-1% of total deal size
- Boutique investment banks, accounting firms and legal practices specializing in the industry in question are also a good source of deals
- The business broker community itself is extremely large and fragmented; could be a good rollup target?
- Often, brokered deals are only shown if a private equity investor with committed capital has already passed on the deal, presenting an adverse selection problem
- Involve your financing sources (such as lenders and investors) early in the deal process to ensure their commitment and familiarity
“Evaluating Target Businesses”
- Principles of time management: clarify goals of each stage of evaluation and structure work to meet those goals; recognize that perfect information is an unrealistic goal; keep a list of prioritized items impacting the go/no-go decision
- Stages: first pass, valuation/LOI, comprehensive due diligence
- It is in the best interest of the SFer to tackle core business issues personally during due diligence as it is the best way to learn the details of the business being taken over
- Adding back the expenses of a failed product launch rewards the seller for a bad business decision; adding back growth expenses gives the seller the double benefit of capturing the growth without reflecting its true cost
- Due diligence may also uncover deductions to EBITDA or unrealized expenses that reduce the “normalized” level of earnings (undermarket rents, inadequate insurance coverage, costs to upgrade existing systems, etc.)
“Transitioning Ownership and Management”
- Create a detailed “Transition Services Agreement” with the seller, a legal contract where specific roles, responsibilities, defined time commitments and compensation are agreed prior to the transaction close
- The first 100 days should be dedicated to learning the business
- Businesses consist of people, and people need communication; great leaders are always great communicators
- “Don’t listen to complaints about your predecessor, this can lead to a swamp and you don’t want to be mired there.”
- The goal is to learn, not to make immediate changes
- Outwork everyone; be the first person in and the last to leave
- Many SFers insert themselves into the cash management process during the transition period by reviewing daily sales, invoices and receipts and signing every check/payment made by the company
- The company’s board should be a mix of deep operational experience, specific industry or business model experience and financial expertise
- The seeds of destruction for new senior leaders are often sown in the first 100 days
A House Rises 