Notes – Stanford Graduate School of Business Search Fund Primer

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

Recession Risk, The Ultimate Risk Paradigm Of Modern Business Operations

The business cycle rotates periodically between boom and bust. This is one of the inevitable consequences of centrally planning the economy’s interest rates and forcing them below their market equilibrium levels. Because it is inevitable, it is “predictable” and thus every business person must conduct their affairs in light of the fact that at some point in the future they will be faced with a recession. The key measure of risk for a business person operating in a central bank-managed economy, then, is “How will I feel when the recession comes?”

If a recession poses no risk to the financial structure of his holdings and he is positioned in his operations to weather a storm, he may be termed “low risk.” If instead a recession represents an existential threat and/or the potential for severe hardship for his operations, he may be termed “high risk.”

As an ideal, a sufficiently low risk operator should eagerly anticipate a recession as it will represent a cheap buying opportunity during which he will consolidate the failing enterprises of his competitors, scooping up their assets at bargain prices and thereby leap ahead of them without the use of leverage or cheap competitive tactics. Conversely, a sufficiently high risk operator will find the economic Sword of Damocles plunging through his neck in a recession, permanently severing the connection between himself and his former assets. How then to manage financial and operational risk so that continued growth can occur in a manner that is sustainable in all possible economic environments?

In terms of financial risk, we could sort our assets in two ways, by asset quality and by financing quality. The asset with the highest asset quality is the one which has the largest earnings yield relative to its current value. The asset with the highest financing quality is the one which is cheapest to own (ie, annual interest cost).

Practically speaking, sorting assets by asset quality and financing quality and then selling low quality assets and paying down outstanding debt would move an organization toward a more favorable balance between asset quality and finance quality, with an emphasis on equity in the balance sheet. The capital that is freed up in the process is now available to purchase a higher quality asset in the future.

In a recession, the cash flows from low quality assets dwindle while the finance charges on debt remain fixed; not only does such a mixture create a problem in a recession but it falsifies the true “free cash” position of the company in a boom because, to operate prudently, extra cash must be maintained on the balance sheet to offset the risk this low quality asset and debt represent should a recession appear.

The insistence on focusing on the management of financial risk first offers us clues as to a sound growth strategy overall. To be successful and sustainable through all potential economic conditions, growth must be purposeful and planned and should only occur when three conditions are met: there is abundant free cash on the balance sheet, the organization has people “on the bench” and ready for new opportunities and a good buying opportunity (represented by a fair or discount to fair value price) presents itself.

A debt-laden balance sheet is not cash rich because the cash which may be present is actually encumbered by the debt as an offset in a recessionary environment. When we are talking about a cash rich balance sheet, we’re by implication talking about an unlevered balance sheet. Otherwise, the cash is not “free” but rather is “phantom” cash– it will disappear the moment adverse economic conditions present themselves.

The organizational bench condition may be harder to evaluate objectively, but there is a decent rule of thumb. When people in each position in the organization are sufficiently organized to handle their own responsibilities with time to spare, there is organizational bandwidth to spend on promotions and new responsibilities, such as management of newly acquired assets. In contrast, when people in relatively higher positions within the organizational hierarchy are spending their time doing the work of people relatively lower in the organizational hierarchy, it indicates that there is a shortage of quality personnel to fill all positions and that those personnel available are necessarily being “mismanaged” with regards to how they are spending their time as a result.

Further, it implies the risk that growth in such a state might further dilute and weaken the culture and management control of both legacy assets and those newly acquired. This is a risky situation in which every incremental growth opportunity ends up weakening the organization as a whole and creating hardships to come in the next recession. If it’s hard to find good people, inside the organization or without, and there is a general attitude of complacency about what could go wrong in a recession, it is a strong indicator that underperforming assets should be sold and the balance sheet delevered to reduce organizational risk in the event of a recession.

Growth should be fun, exciting and profitable. If it’s creating headaches operationally, or nightmares financially, it should be avoided. You shouldn’t own or acquire assets you don’t love owning. Perhaps the best rule of thumb overall is to ask oneself, “Does owning this asset bring us joy?” If yes, look for opportunities to buy more. If no, sell, sell, sell!

Ultimately, there are three ways to get rich: randomly, with dumb luck and unpredictable market euphoria for the product or service offered (billion-dollar tech startups); quickly, with a lot of leverage, a lot of luck in terms of market cycles and a lot of risk that you could lose it all with poor timing (private equity roll-up); and slowly, with a lot of cash, a lot of patience and a lot less risk while taking advantage of the misery of others during inevitable downward cycles in the economy.

If you were fearful in the last economic cycle, it suggests your financial and organizational structures were not as conservative as you might have believed. It may be an ideal, but it’s one worth reaching for: a recession represents a golden buying opportunity for a cash rich organization to leap ahead of the competition and continue its story of sustainable growth and success.

Video – Hugh Hendry Visits The Milken Institute

Hugh Hendry interviewed in a panel discussion at the 2012 Milken Institute Global Conference

Major take-aways from the interview:

• Global economy is “grossly distorted” by two fixed exchange regimes: the Euro (similar to the gold standard of the 1920s) and the Dollar-Renminbi
• China is attempting to play the role of the “bridge”, just as Germany did in the 1920s, to help the global economy spend its way into recovery
• Two types of leverage: operational and financial; Germany is a country w/ operational leverage; Golden Rule of Operational Leverage, “Never, never countenance having financial leverage”, this explains Germany’s financial prudence and why they’ll reject a transfer union
• Transfer of economic rent in Europe; redistribution of rents within Europe, the trade is short the financial sector, long the export sector
• Heading toward Euro parity w/ the dollar, if not lower; results in profound economic advantage especially for businesses with operational leverage
• “The thing I fear” is confiscation: of client’s assets, my assets; we are 1 year away from true nationalization of French banks
• Theme of US being supplanted as global leader, especially by Chinese, is overwrought
• Why US will not be easily overtaken: when US had its “China moment”, it was on a gold standard…
  • implication, as an entrepreneur, you had one chance– get it right or you’re finished
  • today is a world of mercantilism, money-printing, the  entrepreneur has been devalued because you get a 2nd, 3rd, 4th chance
  • when the US had its emergence on a hard money system, it built foundations which are “rock solid”
  • today, this robust society has restructured debt, restructured the cost of labor, has cleared property at market levels
  • additionally, “God has intervened”, w/ progress in shale oil extraction technology; US paying $2, Europe $10, Asians $14-18
• Dollar is only going to go one way, higher; this is like early 1980/82
• “I haven’t finished Atlas Shrugged, I can’t finish it”: it’s too depressing; it reads like non-fiction, she’s describing the world of today
• The short sale ban was an attack on free thought; people have died in wars for the privilege to stand up and say “The Emperor has no clothes”; banned short selling because truth is unpalatable to political class; the scale and magnitude of the problem is greater than their ability to respond
• We are single digit years away from a most profound market-clearing moment, on the order of 1932 or 1982, where you don’t need smarts, you just need to be long
• Hard-landing scenario in Asia combined w/ recession in Europe would result in “bottoming” process, at which point all you need is courage to go long

The Student Loan Scam

I saw this story on “What Student Loans Are Really Spent On” at ZeroHedge:

Robert Thomas Price Jr. borrowed about $105,000 for his tuition at Harrisburg Area Community College from 2005 and 2007, federal authorities say. It doesn’t cost anywhere near that much to study at HACC, though.
So Price, 45, of Newport, is facing federal student loan fraud and mail fraud charges.

A U.S. Middle District Court indictment alleges that Price spent much of the loan money on crack cocaine, cars, motorcycles, jewelry, tattoos and video games.

U.S. Attorney Peter J. Smith said today that Price secured about $92,000 in private student loans and around $13,000 in federal PELL grants and Stafford loans. Price was aided in the alleged scam by his ex-wife, a former HACC employee who is not charged or named in the case, Smith said.

Granted, this is anecdotal– one hapless fraud a pattern does not make.

But the fact that it even happened highlights a couple things of import in my mind:

1. This guy was in his late 30s when he committed this fraud; I bet the average person would be surprised to know what the demographic profile is of the average student loanee, my guess is it is not a starry-eyed, hard-working, bright-but-unresourced 18yo kid just looking to make it in this cold, harsh world
2. If it happened once, it’s possible it’s happened more than once; how much of the $1T+ in outstanding student loan debt is being spent in frivolous or fraudulent ways? Reminds me of David Einhorn’s book on a SBA loan-backed fraud he shorted and exposed. Fraudsters flock to government handout programs like flies to dung because the government has less of an incentive to catch and punish them given it doesn’t cost them anything but bad press if it takes place, there are always more taxpayers to steal from if fraudsters take a piece of the pie
3. Student loans are leverage, and they are leverage used to engage in consumption; these kids with student debt don’t suddenly become ascetic monks while they scrupulously work toward their degree and eventually paying off their debt… they continue to live and spend like the college kids they are, just with someone else’s money

To the last point, I chuckled at this response from a friend to whom I sent the ZeroHedge article:

Oh yeah, big time. One of my really good friends that I’ve known since senior year HS, who has never really been a big spender or a big earner, is now a third (or fourth?) year medical student, and he is really living the life of the young adult…through loans. He has a loft in downtown [city withheld], has a HUGE flat-screen tv, bought a new car a couple years ago, and adopted a dog (granted, [name withheld] the dog is super sweet). I seriously doubt he 1) had all that money laying around before, and 2) would spend his own money like that. I’m 99.9% sure it’s all loans because he’s never spent money like this, even when he had a serious gf in college whom he loved and wanted to marry.

I think this article really connects with the last one you sent about vomitus whores. Student loans are essentially enabling all that behavior. Here’s some money, go to “school,” attend some BS classes and write some BS essays, then go drink with this free money. Or perhaps you can go buy a new fancy, shiny thing to show off so that girls will want to sleep with you. *sarcastic thumbs up

I certainly think there is some causation-via-correlation here, though how much exactly is uncertain. Young people are pretty stupid, levered or not. I mean, look at how they vote! What dopes! It’s like they get off on being debt slaves or something.

Anyway, that link in the quote is worth checking out. It’s a riotously funny post from today by Kid Dynamite on the shocking idiocy of the modern American collegiate zeitgeist. Brings new meaning to the term “idiot savant.”