Search fund basic questions

July 29, 2024

by a searcher from University of Florida in Virginia, USA

Hi all,

I’m an ex-MBB consultant launching a search fund with my wife who works in financial services, redacted

washingtoncapitalassociates.com

We have a few questions for the community as we wrap set up before launching the search:

- What are market rates for acquisition loans right now? 10%? E.g., SBA
- What are market rates for seller financing and what are the typical terms and duration?
- When we contact a seller, how does the process work in terms of financing? How do you engage in a serious conversation with a seller if you don’t have the full financing on hand? E.g., an SBA loan
- Does anyone have any financial model templates that includes a calculation on a return/salary for us and all the other inputs? E.g., price, ebitda, revenue, financing, etc. We have one, but curious what else is out there.
- To raise capital to close our financing gap, we are considering offering non-equity loans in $100k units at 10% over 5 years, a 27.5% effective rate of return, which is competitive. How should we think about sourcing investors for this vehicle? We understand it isn’t traditional to source debt vs. equity investment but there is demand bc we’ve gotten a few investors and this is the only way a search will be worthwhile for us in terms of economics and control. Else, we would stay at MBB and Finance. We have 5 units left if anyone is interested.
- What tasks do you have interns work on? We’ve hired 2.

Thanks all,
David

Reply by a professional
from University of New Brunswick in Saint John, New Brunswick, Canada

1. In Canada - we are 6-7% with conventional lenders and 8-9% with non-conventional (BDC, Scotia Roynat, etc), unsure about credit unions. 2. This comes down to what you can negotiate. I've done anything from 0% to 5% on seller notes. We often give a lift on valuation for seller financing, e.g. if the seller is looking for 4x EBITDA, i'll offer them that in cash or 4.5x in seller financing, if I give a lift i'll push for 0% interest. Conversely, If they're overly ambitious on their valuation, i'll offer 4x seller financing and 3.5x in cash. Terms are the same, most of the sellers we encounter want 5 years. Ideally you can do interest only for the first 2 years, or do a balloon payment at the end. Banks will consider certain postponement terms as equity. Sometimes, you can also re-negotiate the VTB part way win, say you're 2 years in, offer them to pay it all now but it's some percentage of it, 50% or 75%. To do this you need to make sure the bank would allow it, they're always first in line. Don't take a PG for the VTB, that's not market in my experience. 3. At the start of any search, I like to connect with all the banks for 2 reasons, 1 - to see if they have leads 2 - to warm them up and let them know i'll be soon asking for discussion papers/term sheets on opportunities. Also gives me a chance to understand what they're seeing in the market and how hungry they are to lend. After that, i'll usually call them once I have the financials normalized and agreed to by the seller, and the valuation done and agreed to by the seller, and some draft structure models. I don't get too far into the modelling because I need to know what the sandbox is. With a quick call the banks can usually tell me what % of the purchase price they could finance, then i'll go back to the seller and start working on a structure together. If I know the banks can go all the way to 75% then I know what I have to work with. Once I am mostly aligned with the seller on structure i'll ask the banks for a term sheet/discussion paper. This usually takes them a few days. The bank's feedback is helpful in the negotiations too, they're privy to other transactions / multiples so it can help strengthen your case. There's been a few occassions where we have had a joint call with the seller and bank so they could hear it straight from the source. 4. I can send you a model 5. We are seeing 12-14% for private lending. The economics should be fine if you secure equity and they take a minority position. Model in a 5 year hold, 20-30% position, and a lift on the takeout multiple. It should work out to a 5x MOIC and 25-35% IRR. It should actually work out better than debt as it would only pay out dividends if there is cash flow available. Hope this helps

Reply by a searcher
in Boston, MA, USA

David, YMMV, but:

1) I’d expect to most SBA loans going Prime +0.5 to Prime +2.75 (the SBA max), depending on the deal – price, compelling narrative on the business, amount of senior debt, total debt, etc. So 9-11%, and declining.

2) What I’ve seen recently is still 10-25% of Enterprise Value, 4-5 year term, 6-10% interest rate (more commonly fixed than floating). Amortization is all over the place from interest-only with a bullet to fully amortizing

3) Depends on proprietary vs. brokered outreach and numerous other factors. But in general you’d benefit from establishing a relationship with 1-2 lenders who may be willing to offer you a “letter of support” or something similar. It’s fairly noncommittal, but official looking, and demonstrates that you’ve had serious conversations with a lender and they think you at least sort of know what you’re doing such that they’d seriously consider a deal you bring to them. Don't present this as more than it is, but this should be enough to get your foot in the door and be considered seriously.

4) (Skipped)

5) Interesting to see more innovation in capital structure. Pro forma projection on returns looks low for self-funded search norms (27.5% vs###-###-#### %), and the structure is a significant departure from the “usual” Class A Preferred / Class B Common equity raise. Being third in line behind senior debt and seller note, without the upside of actual equity, I would expect it to be challenging to round out a raise, but as you said you’ve already gotten traction which is great! I also wonder about how bankable a deal would be with this structure - i.e., can you meet the minimum equity injection requirements? Can you be sure of making your payments with that much debt on the business? Would love to hear what your response has been, both from investors as well as from banks. Also not sure I understand the math on how a 10% interest rate turns into a 27.5% rate of return…

6) List-building for the most part – create and scrub lists of possible businesses for proprietary outreach meeting your criteria. Do deeper research into specific opportunities to help you make a better impression on initial outreach. Maybe assist with some industry research as you explore new niches.

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