Reframing The Search Model

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[redacted]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.

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searcher Harvard University - Harvard Business School University of Oklahoma United States Air Force Academy - 12/30/2020

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!

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searcher Miami University of Ohio University of Illinois - 01/02/2021

I agree the economics are similar. However, I think he scale of a fund makes the structure more adequate. As I said, I think the search should be reframed as step one in building a fund, so for me that compensation structure does make sense.

I just get surprised when I hear about searchers over bidding, or how many don't close. I think if the goal is to get a deal done, the investors should encourage flexibility. Once they own something, it's way easier to build a portfolio or fund.

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searcher Harvard University - Harvard Business School University of Oklahoma United States Air Force Academy - 01/08/2021

True. I also think that most traditional searchers are looking for 5-year exits, which is part of the impetus to avoiding the "portfolio" model. That being said, almost all of the most successful search fund exits included purchasing more businesses along the way.

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searcher George Washington University Utah Valley University - Woodbury School of Business - 12/31/2020

Totally support the idea that the independent sponsor model should be in the mind of both investors and searchers as the next step in an evolving economics and financially rewarding model.

searcher INSEAD Creighton University - 12/31/2020

This is a good point. I am an independent searcher, but as Mike said - the challenge can be with financing. If you are looking at a $500k EBITDA business, it's not going to be hard to raise $2-3mm, even if you have to cobble it together. However, if the check size is bigger, it becomes harder to find "LPs" that are willing to invest in the deal at favorable terms and will still write larger checks.

With that said, I think if the financing can be solved, the independent sponsor model is a much more economical way for a searcher to get more equity on the back-end. The other consideration is if someone is coming out of an MBA with few savings, it would be very difficult to fund a self-funded independent sponsor model without taking some search capital. Those who can fund the search themselves are in a much better position in this respect.

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I agree, the terms will be different, checks bigger. Honestly, I think in many cases these searchers would be better served with a 500k€ business as training wheels, then moving into larger portfolio of businesses.

searcher Harvard University - Harvard Business School University of Notre Dame - 12/31/2020

There are many ways to pursue ETA, and they've all proven to be successful. Which path one pursues comes down to right-fit for the searcher--why are they doing this, what is it that they want to achieve, what constraints do they have, what is their confidence level and know-how in running a deal process, what is the purpose of the Board to them if they have one, etc. I believe the correct frame starts with someone taking an honest assessment of themselves, their goals & ambitions, their constraints, and their family to set the right course.

I agree they are successful historical returns, however a LOT of searchers don't close deals, or over bid.

University of Texas at Austin Southern Methodist University - 12/31/2020

Agree with Joseph. There are many flavors to any deal/investment type. One of the primary considerations of starting a "fund" or a "HoldCo" as you've mentioned is the "starting" part. To do this well, typically requires full=time dedication. Many folks simply can't afford to take no income from 24 months and thus need to go the search-fund route.

searcher INSEAD Tsinghua University - School of Economics and Management University of Liverpool - 01/01/2021

Thanks for sharing the insights.

REFRAMING THE SEARCH MODEL

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