The latest buzzword in finance-speak across Harvard Business School and Stanford University almost evokes images of a deep-sea rescue mission. Called a “search fund”, this mission-oriented investment vehicle—pioneered by Irv Grousbeck, a Stanford Business School professor, in 1984—has gained unprecedented popularity across the investment world in recent years. It’s probably as entrepreneurial as one can get in the world of high-street finance, allowing aspiring entrepreneurs the opportunity to search for, acquire, grow, and sell a company—all while securing financial gains commensurate with private equity (PE) and venture capital (VC).
Rapidly gaining popularity across the US and Canada, the number of search funds has tripled over the past decade—from just 50 in 2001 to over 150 today. The entrepreneurial aspect, the challenge of growing an existing company, and the independence the search model provides draw many people to it, as does the 37% internal rate of return (IRR) and 13.5x multiple of investment for search funds as an asset class. Search funders skilfully create value through revenue growth, operating improvements, appropriate use of leverage, organic expansion, mergers and acquisitions (M&A), or multiple expansions.
So how is a search fund different from traditional investment vehicles such as PE and VC? Well, unlike traditional funds that invest in several companies, a search fund raises capital to invest in just one. The search team then takes full responsibility for actively managing (and growing) the business. Once the search fund’s members decide to become operators, usually co-CEOs of the acquired company, their only objective is to build upon the strengths of the core franchise such that the business grows at least four to five times in profitability over the next five to seven years, fetching attractive financial returns on exit. In summary, the process consists of four stages: fund-raising (six months), search and acquisition (12-18 months), operation (five to seven years), and eventual sale or liquidity event (six months).
The investor base for search funds is also different. Instead of billion-dollar pension funds or university endowments that usually back PE funds, search funds rely on high net worth individuals and angel investors, often raising from a set of 12-18 sponsors who fund in two tranches: one to run the search process (“search capital” of $20,000-50,000 per sponsor) and the second towards the actual purchase of the company (“acquisition capital” of $0.5-0.6 million per sponsor). The average search fund target has an annual revenue base of $8 million, with earnings before interest, tax, depreciation and amortization of $1.6 million and a headcount of about 50 employees. The typical deal size, or purchase price, for such a company is $8-10 million and search funders usually receive a 15-30% equity share in the company, which is awarded in three equal tranches: the first upon acquisition of the target, the second over the next four-five years of operation, and the third when performance benchmarks (e.g. IRR hurdles) are realized on eventual sale of the company.
Search funds generally target industries that are not rapidly transforming (e.g. high-tech), are not too complex (e.g. speciality food services), and are fragmented (e.g. hospitality). Within these, they prefer market-leading companies that are healthy and profitable, and offer opportunities for improvement and growth (as opposed to complex turnaround situations, which typically serve as great leveraged buyout candidates).
Do search funds hold promise in India? Well, ample. To play in India’s highly competitive market, investors have historically had to go head-to-head with established bulge-bracket PE funds for big businesses or battle VC players for small, but promising, start-ups. However, search funds could offer an untapped middle ground, a sweet spot that only this breed of investment vehicles is uniquely designed to access. These funds could seek out flourishing, small-to-medium-sized enterprises that want to sell, but can’t find buyers (PE funds find them too small-sized, while VC funds find them too late-stage).
There are several reasons behind this shift in mindset: first, a slew of recent mid-market deals at blockbuster valuations have created a perception among first-generation entrepreneurs that booking financial gains is sensible, especially until the euphoria lasts. Many entrepreneurs who didn’t sell at the right time ended up destroying value and passing on uncompetitive businesses. Also, the flurry of outbound M&A opportunities has compelled Indian companies to focus on their core businesses, thus spinning out their non-core assets. In addition, global macroeconomic volatility has led to multinational companies facing strain in their home markets, with some putting their Indian subsidiaries on the block. Finally, succession issues stemming from familial disputes at second- and third-generation family-owned businesses have led to companies putting themselves up for sale.
Mayank Singhal works for a leading global investment fund.
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