Defining Industry Boundaries for a Search Fund

I’ve worked with search fund* entrepreneurs who came straight from banking, from private equity, from business school and from law school. Some have a background in operations, some in consulting, and some are more transaction oriented.

Whenever I meet with a search fund founder, I always listen to their background and then ask them to articulate what industries they are going to focus on and why. I’m not evaluating the attractiveness of the sectors themselves; in fact, by investing in search funds, I have found myself ultimately betting on extremely diverse industries such as specialty finance in Mexico, point of sale software for multi-unit hair salon owners, and billing/collections for chiropractors. That’s the fun (and portfolio diversification impact) of search funds to me. 

What I’m really listening for is how the search funder thinks about industry. What sectors do redacted find attractive and why? How are those sectors related in any way to their past experience, their network, the things that they have already done? How do they think about generating deal flow in these sectors? What are they actually planning on doing, when they hit the ground, to start the process that they hope will end with them buying a company and becoming CEO?

Certainly there are investors who favor their searchers being broad and opportunistic in approach instead of narrowly locked into one industry segment. But I’ve been through the process enough times now to begin to see patterns in what really works and to give a little advice to potential searchers just putting their decks together.

In the end, focus is hugely important. I think of it like looking for a vein of gold. You may have several ideas of where to dig, but it takes a lot of spadework to figure out exactly which narrowly defined industry sector is going to prove to be THE ONE. Note I did not say the spadework is what leads you directly to the closed transaction. An unexpected but recurring theme in my search fund investments is that the good searchers ultimately find a very specific market. They have a river guide or two in that market, they have made inroads in the ecosystem around the market, and have generated solid deal flow.   They sign an LOI on a transaction, do exhaustive diligence, and are about to close###-###-#### when something goes wrong. The seller gets cold feet, a stupidly high offer by a strategic appears out of nowhere, or an important customer reference comes back horrible.

Here’s the interesting part: the lost deal is like the writer getting that first shitty novel out of the way before writing the masterpiece. When the first deal dies, all the spadework about the micro-sector is immediately transferrable, and a new, better deal emerges in months, if not weeks. And this one closes. 

Having said all the above, it is generally impossible to know the micro-industry focus ahead of time. That’s what the first six to twelve months of a good search is all about: testing your hypothesis, doing basic research, looking at tons of deals, talking to industry experts, going to industry conferences. In short, digging your ass off.

My general advice is to go into a search with four industries that you have thought through enough to impress some schmuck like me. Be able to rank those four in your mind. And have a very clear plan of attack in terms of how you are going start digging for industry knowledge and deals.

Within the first three months, the goal is to narrow the field from four industries to two: what I would call 1 and 1A. As quickly as makes sense, you want to focus on the one that has the most promise and go deep.   But make sure to identify a backup and keep it warm in case you hit a dead end with the first one.

Don’t be afraid if your research leads you to places that were not part of the plan. My best search fund to date turned out not to be a search fund at all in terms of the buyout aspect. Two brilliant entrepreneurs did a massive amount of basic research about the specialty finance industry in Mexico. They looked and looked for the right company to buy but ultimately realized that the company they were looking for simply didn’t exist. That was both a good and a bad thing. It was good in that it presented a huge opportunity, but bad in that they would have to convince their investors to pony up $10 million—not in an existing company with ongoing profits and asset value—but a green field startup. They did just that, and the company now has over 600 employees and well over $100 million in assets.

I’ll try to summarize:

1. Start with three or four industries that are attractive which you have unique insight or network into why.
2. Use the scientific method to attack these industries once you are on the ground to test their relative attractiveness. Build a deal flow machine (former associates from PE firms do this instinctively, and if you are not one, find one to talk to). Find river guides. Go to industry conferences. Do your own basic research (the Mexico guys had a management consulting background which helped here). Repeat.
3. Narrow from four down to a primary and secondary industry you are pursuing. Continue to look for the particular parts of the industry that are most attractive. Narrow down the search even inside that industry until you hit a dead end and then broaden back out until you find another niche.
4. The first deal you find is kind of like your first love: great, necessary###-###-#### but unlikely to be your long-term spouse. There are cases where that first deal is the one, but it’s the minority of successful search funds.
5. Once you have found the micro-market you believe in, stick to your guns. You will find the right transaction. 

* A redacted is an investment vehicle, conceived in 1984 at Stanford Business School, through which investors financially support an entrepreneur's efforts to locate, acquire, manage, and grow a privately held company.