Reframing the Search Model

December 29, 2020

by a searcher from Miami University of Ohio in Barcelona, Spain

I wrote this essay a few weeks ago on twitter, I thought it was relevant for the forum, interested to hear your thoughts:

Search funds are LBO acquisitions, done by recently graduated MBA’s. Investors give them funds to pay their “Search” a###-###-#### months process to acquire and run a small, healthy business. I attended my first search fund conference in 2016 at IESE in Barcelona. I was a startup entrepreneur curious about the system.

I came away feeling like the search model was interesting, but the structure and incentives didn’t make sense. I understood that recent MBA graduates were foregoing larger salaries, and they had debt. I understood the historical returns search funds generated (so who am I to question it?), but I left with a few doubts:

1. Why searchers gave up so much potential equity to receive a 24-month salary? The searcher would still be taking on financial risk (personal guarantee), and operational risks post-close. 2. After speaking to a few failed searchers, I felt the investors and searchers were fixated on finding the perfect deal. Both searchers and investors killed deals because it didn’t tick every box.

After starting two companies, I think the ETA model is the most de-risked starting point for an entrepreneur. However, I feel the independent sponsor model offers the best alignment for investors and entrepreneurs. The investors get a fully vetted company, with a motivated operator. The entrepreneur is compensated for their risk with a majority equity share.

In LMM acquisitions all deals have warts. I believe the search fund should be reframed as the first step in creating a larger holding, or fund. Focusing on the perfect deal keeps the entrepreneurs out of the arena. Once you are an owner, finding attractive acquisitions is far easier.

Reply by a searcher
from Harvard University in Colorado Springs, CO, USA

I'm a self-funded searcher myself, but I don't think the incentives or economics are wrong for the "traditional" model. If you compare it to the private equity 2/20 model, it's pretty similar. The LPs pay a fee that is enough to pay basic salaries, rent, and diligence for the firm (equivalent to the search capital) and then receive 80% of the carry (compared to only 75% in a search fund).

The only thing that makes a self-funded deal work is the fact that it's small. If you keep the equity check significantly below $3mm, you stand a good chance of raising your equity from the doctor/lawyer/dentist crowd--ie. those with enough money to want to invest in alternates, but not enough so that the 10% of their portfolio that should be in alternates meets the minimum for a PE firm to take on as an LP.

If you end up with a $3mm EBITDA company under LOI as a self-funded searcher and need an equity check north of $5mm, you'll probably end up having to get capital from significantly more sophisticated investors who will insist on terms that are either the same or at least very similar to the standard PE/Traditional Search model.

Having said that, I totally agree that ETA is the most de-risked way to start out as an entrepreneur. I also appreciate that there are as many ways to search as their are searchers and I think that every method has it's pros and cons. It's just a concept that covers everything from an e-commerce roll up to a fundless sponsor or a search venture firm. Why more don't do it, I'm not sure.

Thanks for the post!

Reply by a searcher
from University of Texas at Austin in Fort Worth, TX, USA

From the searchers I've talked to, they all realize the economics are more favorable to self fund their search period. But specific circumstances may push them towards it anyway, like student debt, a spouse that isn't fully on board yet, the fear of not finding a deal that's worth it, and / or not wanting to be subconsciously pushed to act too quickly. Depending on the financial commitment of both parties, there may be some tension where the searcher is fine buying a harrier deal with more risk because their downside is limited. Their most valuable asset they are bringing to the table is time, so better to acquire sooner than later. While the investor is the one that stands to lose the most so they have to fight this potential tendency. I.e. An investor should be more picky imo. Lastly, to your point that search funds should be reframed as the first step to creating a fund or holdco... That's great for the entrepreneur, for obvious reasons, but probably not preferable for the investor. If I am invested in a search fund, I want that entrepreneur focused solely on that business through the exit. The process of building a fund / holdco from the one business starting point would inevitably distract the searcher and hurt returns. If a search fund leads to an independent sponsor or holdco model, I think it should be done with separate investors in a separate structure with the intent outlined from the beginning. Just my two cents.

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