My guest on this latest episode is @tsludwig, a search fund investor through his firm Ohana Capital who has invested in 75 deals over his career. Near the end we talk about a few exciting/dangerous study abroad stories! Check it out, this was a great one!

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Transcript Part 1:

Tell us a little bit about how you went from previous careers to now buying or investing in searchers, and why you decided to invest in searchers versus buying the companies yourself.

It's been a meandering road to get to this point. Coming out of college, I started out as a management consultant, went back to grad school after a few years, knowing that I wanted to do something a little bit more entrepreneurial, that was in[redacted]So, the original internet bubble was still expanding, it hadn't yet blown up. And I was looking at all sorts of entrepreneurial things to do when I was in grad school. And somehow, in that era, I stumbled across search funds, and the light bulb went off. This is an amazing model, there's people out there that would actually fund somebody like me to go out and buy a business and run it. And I thought that was pretty incredible, I got pretty excited about it. I did whatever research I could at the time, it wasn't like today where you can just go to a website and dial it up and watch tens of hours of videos and case studies.

You actually had to mail things and send away for it. And so, I did that, I wrote to Harvard Business School. And I think, there were three or four case studies at the time that they sent me. And then, Irv Grousbeck, who is the father of search funds, had relocated to Stanford. I wrote to his office, they sent me some more materials. And I was thinking seriously about raising a search fund at the time. I was at the University of Michigan, which was not the hub of search fund activity. It was still, at that time, largely Harvard and Stanford, and a little bit of Wharton. And ultimately got sucked up into the internet vortex and moved out to Seattle after grad school and joined a venture backed startup. That, like many of the companies of that era, raised lots of money, and then, very quickly imploded.

And I spun out of there with my first entrepreneurial venture, bootstrapped a small online publishing company. So, finally, a couple years after grad school, got to fulfill that entrepreneurial itch. And did that with a partner, it was modestly successful. We were generating revenue, we'd identified a good market niche. But, I don't think either of us really had our hearts fully into it, and it was a fairly small market. So, around that time, I had gone down to San Diego to a friend's wedding, met a woman, we were getting more serious. My business partner at the time, said, "I'm thinking about going back to grad school." So, the tea leaves were indicating that we were probably not going to run full steam ahead with the venture that we had started.

So, we sold it off, I moved down to San Diego, got involved in real estate for about the next six years, doing all sorts of things with my wife's family. And we had good timing, this was 2001 to 2007 timeframe. So, everything that we touched was turning into gold, and it was a lot of fun. I was learning a new discipline and it was really exciting to have a physical product that we were working on all the time. And that was a great run. And then, the last couple of deals that I was involved in, it was very apparent that we were headed towards change in the market and things were not going to be as rosy over the next few years as they had been for the previous few years. So, I had good timing and was able to get out of the real estate market and wasn't sure what I was going to do next, I ultimately decided that I was going to do a self-funded search.

Started to ramp up those efforts and just go look for a small business to buy on my own. I'd been successful enough in real estate, that I had a little bit of capital that I could scrub together to use as a down payment on a business. And as I started to get more serious about that, I sat down with my wife and I said, "Would you be on board with this? I'm not sure that we're going to be able to stay in San Diego if I go down this path, because I want to find a really good business and I don't want to be looking for ever to do that." So, bless her heart, she said, "If that's what you really want to do, I will do it." But we just had our first child a few months before and she was nesting, and her whole family was in San Diego. So, there was a lot of inertia to stay put.

And so, I said, "Before I commit this down this path, let me just take a pause, and see if there's something else that I can think of that would keep us here, that would allow me to still fulfill this ambition that I have of going out and owning a business." And as I was going through the list of possibilities, I remembered search funds. And I thought, "Oh, that's still a really novel idea. Maybe I could be an investor in search funds, rather than an operator. That way, I'd get to stay in San Diego, taking the amount of capital that I had, I'd get to spread it across a range of businesses, instead of a single business." And I'm a business junkie, I love learning about new businesses and the way people that have figured out to extract a living from what they're interested in. And it was a path towards me being able to learn a lot in a very short period of time.

So, I started to reach out to people in the search fund community, they were incredibly gracious, it's a super collaborative model. They welcomed me with open arms. And I had really good timing, this was early 2008, when the prospects for MBAs was not as healthy as it was a few years before that. And Stanford, every other year, publishes a research study that touts the returns across the asset class. And the results that year were extremely high, driven by a few large outcomes. And the New York Times started to gather some interest in the space and wrote a couple of pieces about the search fund model. So, there was this explosion of interest around the same time that I was walking onto the stage, which is good, because I had no relevant background really to the search fund model. I hadn't gone to one of those top business schools, I had never raised a search fund myself, I didn't come out of private equity. But I just had an interest in it, and I knew about the model.

So, as I was pulling all that together, I had a few friends and family say, "Hey, if you do this, we would love to contribute some capital." And some of the people on the investor side that I was speaking with, said, "Here's some deal flow." And before I knew it, with very little effort, I was in business. I started a small operation called Ohana Capital, raised first fund of friends and family money and hung out my shingle in 2008 and started to invest. And that's largely what I've been doing for the past 10 plus years now, is staying active in that community. So, it was really more driven by lifestyle than anything else.

So, you didn't go through the analysis of, what does my financial picture look like if I invest directly in the companies, versus just investing in the search funds? It sounds like it was more of this investing in search fund just gives you more flexibility, where you can live and gives you... Is it true that you don't have to do quite as much legwork, if you're investing in the searchers who are going out to find the business, versus going to find the business yourself?

It's a different kind of legwork. But, arguably, yes, that's true. A traditional private equity firm that does all of its own deal sourcing has all of that in-house, this is more of a distributed model, where the backers of the searchers in that private equity field, outsource to these ambitious MBAs, all of the legwork of going out and identifying the company, negotiating and structuring it, which is the lion's share of the work from an hour standpoint.

So, is your day-to-day mostly focused on working with your existing portfolio companies through searchers and helping them operate businesses? Or, is it pitching to new searchers? Or, are they pitching to you in the opposite direction?

It's more inbound in terms of the deal flow generation. So, the community of investors in the search fund market is still pretty small. There's a handful of dozens of them at this point, and they're pretty easy to identify. You can go to other search funders websites and see who their limited partners are. And if you do that enough times, you develop a pretty comprehensive roster. And if you talk to other searchers, you can get their contact information pretty easily. So, a lot of the deal flow from an investor's perspective tends to be inbound, you can go out and beat the bushes and go to business schools and talk to people and raise awareness even higher, and generate deal flow that way. But, it's not terribly necessary, I find. And then, a lot of the rest of the day-to-day is evaluating searchers, helping them during the search.

And then, after the search, whether it's in a board capacity or just as an informal advisor or an investor about particular areas where you may have some expertise and relevancy.

Search funds have become much, much more popular over the last few years, has that impacted your ability to invest in search funds at all?

I'd say, the growth has made it easier, I have actually reduced the frequency of investing in search funds that I've done over the past 10 years, over the past couple years. But, there's more search funds than ever, so, to have an opportunity to put capital to work for an investor right now, it's better than it's ever been.

So, the searchers are pitching to you as the investor, not the other way around? I.e., there's more supply of searchers than there is capital to invest in them, or investors to invest?

I think people are looking for a match, ideally. And that's how it works in the best cases, where, a searcher or a team of searchers is evaluating an investor or a group of investors, and the investors are likewise evaluating the searchers. So that, hopefully, they find a connection there that will withstand a long duration of a relationship. I mean, a lot of times, it has gone for a decade or more.

What things do you look for in your searchers? Or, characteristics that you're seeking out?

I think, humility. Most of them, in terms of just raw intellectual horsepower, they have that in spades. Just, I think, self-selecting into the model, they have enough common sense and know-how and they're adept learners. So, charisma, I think, and some ability to sell or persuade, I think is vitally important. Work ethic is really important. Humility, sense of curiosity, I think those are some of the main ingredients.

How do you know if a searcher is going to be a good operator? Do you know based on... Or, do you look at their prior experience that they've had in operator capacities? Or, if searcher hasn't had any operating experience, how do you evaluate whether they're going to be a good candidate for you?

I don't know that I can do that, it's a really difficult thing to do. Yeah, I don't know that my predictive abilities about who's going to be a good operator are anything more than throwing darts at a board. And it also depends, not just, will they be a good operator? Will they be a good operator for the business that they ultimately acquire? It could be that in a different situation, they would be much better or much worse than what they actually end up being, because of the fit between them and the market and the people in the company and the customers that they have. So, you really need a lot of stars to align, but some people, obviously, are just generally better at it than others. And you get two years, roughly, that's about the average time it takes for a searcher to find a business, to oversee and watch and make your own determination about what kind of an operator you think they'll be. And nobody's perfect, everybody has gaps in their skill sets.

And so, it's also helpful to understand those, so that maybe you can work with them or help them identify resources where they can fill in those gaps, so that you bolster them in areas where they may need some more development. But, a priori, being able to identify who's going to be a top-notch operator, a lot of times, it's very difficult.

Do most of the MBAs and searcher candidates you look at, do most of them have operating experience? Or, is this the baseline to have generally some experience in corporate environments, but not necessarily small business ownership and operation? Almost none have small business ownership and operation experience. They all have work experience, I would say. But, not even always leadership experience. Sometimes they'll have managed to one or two, or a handful of junior associates. Some people that come from more operating intensive roles will have had an opportunity to lead larger groups of people, or people that come from a family business background may have grown up around small business. But, more and more, there's a real diversity of backgrounds and skill sets among searchers.

Can you walk us through some of the history of the search fund model, both as a searcher and an investor? I remember on our phone call, I asked you a little bit about it, and you had a great breakdown of the 20 year history or so. Would you be able to share some of those points?

Sure, yeah. And my experience doesn't go back 20 years, so, some of this is just what I've gathered, and it may not be entirely accurate. But, I believe the first one was raised in 1984, and that was a very successful search fund, ultimately, I think that one had a very long life and returned significant multiple of capital to its investors. And from there, for a long time, I think, it just was one or two new searchers a year, maybe not even every year. Largely driven by Irv Grousbeck, first to Harvard, and then at Stanford, who was very much a mentor to the initial searchers. Worked closely with him, first as a professor and a student, in that relationship.

A lot of times, then, they would come on and become case writers, after they had graduated. And wrote about small business issues or things that Irv was interested in. And from there, they would move on to actually running a search fund. And then, I think, some people in those communities, on the investor side, started to be brought into those deals, to be able to co-invest and to participate, maybe that started from day one. And it remained very much a very strong mentorship model, where there was a lot of very close collaboration and connection between the LPs and the searcher. Then, as the model started to expand and more searcher started to do this, the connection became a little bit harder to maintain.

And I think, over the past five or 10 years, that's been one of the themes, is that, investors portfolios have grown very dramatically at any given time, having a small stable of search funds in their investment portfolio to, some people now probably routinely have 40 or 50 or more, and there's collectively people that have invested in over a hundred search funds. So, when your portfolio of companies expands the size, I think, just by the virtue of the large number of investments that people have, it becomes harder to have oversight of those. And so, the searchers, I think, started to see more dispersion among the investor base, they weren't getting quite as close to the connection, there's also been a rise of a more institutional class of investor out there, that have brought a lot of value to the community.

But it's also changed a little bit, they write larger checks, they have the ability, I think, to influence outcomes, perhaps, in some cases. A bit more search funders come from a much broader array of schools than they used to. And so, they have, I think, less of the ingrained culture sometimes. But, there's also a lot more information available, and there's a lot more searchers to connect with. So, the information has also become easier to access. It's a maturing asset class, which is really exciting in a lot of ways. And there's starting to be permutations of that, there's groups that are accelerators out there now, that are running cohorts of searchers under one umbrella. There's people that are seeking out single limited partner relationship, so they don't have a distributed investor base, it's a very concentrated investor base. There's people that are starting to specialize by geography a little bit more, or by industry type.

So, there's really been an explosion over the past five plus years, of a lot of diversity within the model, which has been great. And then, macro factors over the past, for at least, my investing time period, we've been in a long bull market, credit is much more available now than it was when I started, when we were in the depths of the recession. And there's a lot more interest in software businesses and SaaS businesses than there used to be. Sellers are much more educated about the M&A marketplace than they ever have been. Technology tools have greatly impacted search funds and allowed search funds and intermediaries to reach out to larger numbers of sellers than ever before. So, the old situation where maybe you would run into an old retiring seller that had never been approached before is becoming much harder to find than it used to be.

I mean, if there's seller that hasn't been contacted by an intermediary or a prospective buyer, at least, once a week, if they have a good business, that would be surprising today, I think. So, there has been a lot of change in the marketplace, in the lower middle market, which is how a lot of people define this range of businesses as one to $3 million in EBITDA, has become a lot more liquid over the past 10 years than it was before that. And so, I think, the level of competition for each deal has gone up over that period of time.

Yeah. How do you differentiate yourself when you're trying to contact and buy from owners who are getting a call or email once a week? How do you make yourself look different?

It's challenging. I think, searchers can still differentiate based on the fact that they are buying a single business, it's not a portfolio play. They've got an experienced group of investors behind them, they won't have a long-term mindset, there's no fun to driving them to sell within a certain time period. And then, they can also differentiate based on expertise. If they pick an industry sector and really decide to go deep in there, they can develop relationships, they can learn the ins and outs of the industry, and I think, separate themselves from the crowd, by knowing more about a particular seller's business before they even approach them, than another buyer might.

Are searchers able to get proprietary deals? Or, do they just need to knock on enough doors and differentiate themselves that way? And if they do, do most owners respond to those advantages? Or, are the vast majority of owners, they just don't care, they just want the largest check?

I think owners are individual people and they all want different things. To many of them, especially owners running bootstrap businesses that they founded and have led and have seen through really tough times and really great times, there is an emotional attachment both to the business that they built and to the people that work there, the customers that they serve. And so, they don't want to just sell it to the highest bidder, although, some people are just motivated by that, and that's what's important to them. Or, other people, maybe there's a catalyst that's forcing them to sell with some degree of urgency. And so, the certainty of close becomes really important. Other people don't have a family member that they can have as a successor to them, and they see a bright, young, ambitious MBA, as the child that they didn't have, that loves their business. And so, it's a very emotional sale. And so, that helps in that case.

So, there's probably as many different reasons about why people sell and who they sell to, as there are business owners.

And you mentioned that there's a few searchers that have a single LP model. Along that spectrum of single LP to diversified investor base, where do you prefer to land with a searcher?

Well, I don't have the balance sheet to be the single LP, so, I can't land there. And I've only worked in the search fund community where there's a fairly distributed limited partner base. And I think that works well. It's what the model was founded on, and I think it continues to be a model and a structure that works well for both investors and searchers.

Yeah, I'd imagine with the diversified base, you get just more experience that way. Exactly, right.

Are there some disadvantages that come with that, that you don't get with the single LP model? I think from the searcher perspective, there's always a question about, will I be able to raise the capital? Right? If everybody's writing smaller checks, will I have a gap? And if it's a strong deal, those gaps inevitably close. But, the other disadvantage potentially is, if your LP base is too large, you spend more time doing investor relations, than you do the actual activity of searching or running a business. Other than that, I can't really think of too many downsides.

I'd imagine, with a single LP, you're limited in that, all your risk is concentrated in one investor, from the searcher's perspective. Right. If you find a business that they don't like, and they say, "No, we don't want to invest in this," you have to then go out and raise the capital with a fresh group of investors that don't know you as well.

It leads to a discussion around the search fund accelerators, which are becoming more popular. Is that a similar disadvantage with search fund accelerators, in that, an accelerator might be your only investor? Or, there're just investors behind the accelerator?

I'm not familiar enough with... There's a few accelerators I'm familiar with, but I'm not familiar enough with them, to know how those deals get funded inside those entities. Some of it may be a deal by deal case, where they pass the hat to their group of limited partners. Other case is, they raise funds, and it's probably at the discretion of the accelerator operators. And in that case, it probably is more similar to a single LP, where you incur the same or similar types of risks.