12 WAYS TO CRATER YOUR SEARCH FUND
Search funds are built to be relatively low risk.
Find a recurring revenue business with sustainable profit margins in a growing market that has never been professionally managed. Convince the owner to sell without an intermediary. Install a really smart young CEO, and strong advisory team, to gradually improve what is basically an unbreakable asset.
The data supports this idea. The 2018 Stanford Study shows that 69% of searchers make an acquisition. Of those acquiring a company, 71% make money on the investment. The average returns across the entire asset class are 33.7% internal rate of return (IRR) and 6.9x return on investment (MOIC).
But you can fuck this up.
I will give you 12 ways how. Not all are fatal, but most will cause you a lot of pain. Some might get you fired. The last way will cause you to both fail and be fired. All are completely avoidable.
1) Fail to Develop a Truly Proprietary Deal Flow. These days, it’s common for a deal to attract three or four searchers bidding against one another. This fact makes me want to puke. It shows an utter lack of originality by the searchers involved. Great investments are always made by going where the rest of the world is NOT. Great search fund investments are made by discovering a solid company with lots of upside and is owned by someone who knows that he or she has to sell but hasn’t started a process (best-case scenario, doesn’t even know how). There is exactly one buyer because the seller has fallen in love with you. You have gone through a rigorous and disciplined process to find him or her.
Brokers and for-sale websites don’t cut it. I advise having an in-depth industry analysis and focus, including cultivating “river guides,” attending industry conferences, and following a well-organized and efficient outbound marketing process to dig up proprietary leads and qualify them. If you are in the right industry (that hasn’t already been picked over) and use the right process, you will ultimately find the right seller.
2) Build a Bad Board. A great board is a huge asset that dramatically improves your chances of success. A bad board sucks up your time and distracts you from creating shareholder value. A great board depends on each member’s ability to add value to your company in a specific area. Equally important, the board members should be able to function well as a group. Three great board members are way better than five mediocre ones. Their commitment to understanding the intricacies of your business will directly impact your ability to execute quickly.
Start with is the investor who has been the most helpful to you during the search phase and with whom you have already built a strong working relationship. Look for someone local if yours is an international search. You will need someone who understands the local laws, especially on HR and taxation, as well as the local market. Look for domain expertise in your industry and in areas such as finance and sales and marketing. Look for successful searchers who have exited.
Ensure that they all share the same level of your commitment to the success of your company and will make time whenever you need help. Make certain that they are fairly compensated. Use your board members. Trust them. Listen to them when the chips are down.
3) Fail to Build a Great Team. Being a great CEO is more than anything an HR issue. It’s about recruiting, inspiring, and leading people. In almost every search fund acquisition where I had been involved, the incoming CEO found little to no senior management ability on the ground. Partnered searches are helpful in that you start off with two people who are capable of professional management.
The single most important question facing you as a CEO is whom and when you should hire, as well as how you can successfully recruit, develop, and retain your team. In most situations, it is not possible to build the whole management team at once. It means making do with the incumbent personnel for a period of time and getting as much as you can out of people who are not used to being managed and definitely not used to being managed by a really young person.
“Recruiting talent not only about having the right mindset and will power,” a search CEO recently told me. “Location, cash availability, and competition with more structured career options are all forces that row against searchers,” he said.
“I’ve always said a CEO’s job is strategy, vision, and culture,” another CEO told me. “As CEO you need to find the right people to champion and execute on those things. It takes time to realize if the asset is what you thought it was. What I thought I needed at the time of acquisition is different a year later. I learned the competencies of the incumbent people. I try to hire slow and fire fast.”
You need to build a detailed and realistic plan to assemble a great team. It may take years to execute. It may change over time as you learn the business from the inside. You may change your mind about certain roles. You will make mistakes (half of hires do NOT work out so work that fact into your plans). But get going.
You cannot create shareholder value on your own. You need to build a culture of excellence and a team of great people who share your mission, vision, and drive.
4) Create Unrealistic Budgets. The annual budget is your chance to financially articulate your plan for the year ahead. It’s the measuring stick by which you expect to be evaluated. Generally, your budget should be related to the financial model in your investment memo and to your overall goal of providing 35% annual returns to your investors.
However, creating an unrealistic budget can be highly demotivating to your company. Certainly, you want to show progress and set a goal where everyone has to work their ass off to achieve it. But as CEO, you need an extremely high degree of confidence that (short of a major unexpected external event) you will beat your budget. You want to build credibility with your board and investors. Additionally, you want your employees to feel the positive momentum of beating the goal set out for them. There is nothing worse than telling your leadership team, that you have sold on your vision, that they are not getting a bonus for all their hard work because the budget was too aggressive.
As the CFO of a public company, I was immersed in the expectation game. In terms of guidance I gave Wall Street, I always believed that it was prudent to take all the information at my disposal and come up with my best estimate of future performance. Then discount that number by 10%.
Setting a budget is similar. Under promise, over deliver.
5) Attempt Too Much Too Soon. The temptation as a first-time CEO is to want to hit the ground running and do everything right away. DO NOT. Historically searchers have been coached to learn the business (and your job) in the first year, try some stuff out in the second year, and do more of whatever is working in the third year.
It may not be possible to go that slowly. If your house is on fire, yes get a hose and put out the damn fire. But to the extent possible, take your time. Great search fund investments are held for a decade or more. It’s much easier to fuck up in the first six months than it is to create enormous shareholder value out of the gate.
6) Underestimate Churn. The search fund model is based on the idea that you are buying an unbreakable asset and finding ways to improve it once you are on the job. The unbreakable part is premised on an assortment of the previously mentioned attributes, with the most important being a reliable recurring revenue stream. Customers stick around for a long time and typically pay on a monthly basis. Baseline revenue is highly predictable, with the only possibility being upward movement.
With due diligence, it’s imperative to spend considerable time on pressure testing this hypothesis. A sure way to fail, or at least greatly slow down the progress, is to buy a company and then unexpectedly lose a big chunk of the customers. This puts enormous pressure on your ability to improve, market, and sell the product to new customers just to get back to where you started from.
7) Underestimate Organizational Strain of Prior Growth. “My company had grown fast in two straight years prior to our acquisition,” one CEO told me. “Coming in Day One, it was evident that the company had outgrown its shell. This meant extra cleanup needed to happen. Top-to-bottom there was lack of process, talent and structure. This could have caused us to topple without proper focus. We now have enough structure, but it was a huge challenge early on.”
8) Be too Slow to Uncover the True Drivers of the Business. A key here is implementing solid reporting. By this, I mean monthly and quarterly managerial reporting of results compared with those of the prior year and the budget (occasionally, when a company was in a particularly important period, we broke it down to weekly reporting). This will include financials but also other key metrics which drive the business.
The key is to show, understand, and explain variances in the metrics and results. This is the only way to hold everyone accountable for company performance. In doing so, you can build predictable growth through a deep understanding of the performance drivers by implementing effective strategies to move the dial in the right direction.
I was an investor and a board member of a competitive telephone company serving the SME market in second-tier cities. It took plenty of work on the operations side, but the product was essentially a commodity—identical to those of our competitors. What drove performance in this case was simply week-to-week, brute-force sales effectiveness.
We had a superior sales leader who constantly recruited new talent for his 100-person organization via well-developed acquisition methods. A quarter of his team comprised long-term “A” players whom he could count on to bring in the majority of his quota. Half of his team were relatively new and on their way to either belonging to the “A” category or being at risk. Those in the bottom quarter were on the cusp of being fired.
Every Monday, he had individual calls with his eight managers in reverse order of their performance, with the priority order starting at 6:00 a.m.
This method worked amazingly well and depended on our VP of Sales having granular weekly financial information, a weekly set of goals down to the level of individual sales people, and a constantly updated salesforce pipeline of opportunities. In the end, he drove his people because he was responsible for delivering the goods to the CEO and the board who had access to the same reporting he did.
This is a sales example but the same applies across all departments of a company. Reporting creates a virtuous circle of goal setting, responsibility, action, and complete transparency of outcomes that repeats every week, month, quarter and year.
Financial reporting is the informational lifeblood of any good company. Without it, you are driving blind and have little chance of success.
9) Fail to Drive Goal Setting and Variable Compensation Deep into the Organization. Recently, I visited a company where the most important three-year goal was literally painted on almost every wall. There was no way that every single employee didn’t know what the goal was and understand the path toward achieving it. I am equally sure that progress toward that goal, and the component metrics that would drive it, was rewarded with variable compensation at every level of the company.
As a CEO, you need a vision of where you want to take your company. You should be really excited about it. That excitement will be contagious. Your vision must include a concrete set of both short- and long-term goals. In the best-case scenario, you should develop these goals with your senior management team so that they buy into doing their part to get there.
Achieving your goals should align with creating a ton of stakeholder value. You and your board should be willing to share some of that value with the employees who are tasked with making it happen. The incentive package should take the form of variable compensation plans built around each interim step toward the final goal.
10) Invest in a Dying Industry. Some things are cheap for a reason. They are part of a macro trend that is taking the company in question to the funeral home. Don’t try to talk yourself into selling the fixtures off a sinking ship.
I recommend focusing on businesses where the macro trends are in your favor. You’d like a decent chunk of the 35% annual IRR goal to be generated simply by market expansion. At the very least, you want stability of the industry that you are buying into, with no way that a technology or an external force can take you down.
There are rare exceptions where buying into a declining industry gets you access to growing customers or allows you to change the product to create growth (flipping enterprise software to SaaS, for instance). But in general look for stability if not growth.
11) Count on Multiple Expansion and Other Gifts on Exit. Here’s the thing: you might get lucky on exit, particularly if you have chosen your industry wisely and your company is at the front end of a steep macro-growth curve. You may also get paid simply for increasing the scale of the organization. A $10-million EBITDA business in a given industry will generally trade at a higher multiple than a $2-million-dollar one.
But don’t count on it.
Identify what the key metric or metrics are for your industry to determine enterprise value and then calculate your progress against your entry point by USING THE SAME MULTIPLE you purchased at. Only two things should enter into the math tracking increase in equity value: increase in valuation metric(s) that drive enterprise value and free cash flow which allows you to pay down debt.
I’ve seen too many CEOs circulate return-on-equity estimates that depend on multiple expansion rather than the actual hard work involved in operating performance. Markets are fickle, going up and down. The only certain thing is how much you have improved your company since you bought it.
12) Be a Closed-Minded, Insecure, Arrogant, Selfish, and Uncoachable A-hole. For the first-time CEO, the questions of charisma, leadership style, motivation, communication, and effectiveness are all front and center.
The answer is humility.
Building a great company has nothing to do with your ego.
The best leaders view their jobs as serving their employees, customers, and investors. In this pursuit, they are always open to criticisms, questions, and learning something new.
They consciously hire people who will challenge them—those whose experiences are superior to their own—rather than try to consolidate power by hiring inferior candidates whom they can manhandle. A new search CEO has generally never hired a head of finance, product, development, marketing, sales, or human resources. A true sign of humility is admitting ignorance, rather than going it alone, and relying heavily on your board and advisors to try to get it right.
Arrogance is the single biggest killer of Searchers and CEOs. Jeff Bezos has recently said that his #1 hiring criterion targets people who are frequently wrong. It means that they are constantly learning and growing. Arrogance shuts you off from the world and demotivates everyone around you.
I have a son who graduated from West Point (WP), whose stated mission is to teach leadership. When things go well, a leader at WP always deflects the congratulations to his or her troops. This is called “humble brag” among my son and his friends. You don’t take credit. You just take responsibility.
I take back my introductory comment about all these 12 ways being avoidable. No human being is perfect. Every search fund with which I have been involved has struggled with at least one of these issues to some extent. They are part of the game. Each company’s success or failure has depended on how the searcher/CEO has responded to the challenge.
Hopefully, this road map of pitfalls will allow you to see them coming. And in so doing, I have given you a framework for success.