THE RISKS AND REWARDS OF THE INTERNATIONAL SEARCH FUND
The first search fund I ever did was in Mexico. My introduction to my Mexican searchers, before I had even met any domestic search fund founders, came purely by chance. A friend of mine, who has been a search fund investor for decades, handed me their deck and told me I might enjoy meeting with them.
We spoke about the opportunity to build a specialty finance company in Mexico. A big part of the appeal from my perspective quickly became the contrast between how Mexico was perceived by U.S. investors at that time and the fundamentals of the economy on the ground.
This was five years ago and the Mexican drug war was everywhere. To read U.S. papers you would believe that no matter where you lived in Mexico you were destined to show up on the side of the road with not just your head but your arms and legs chopped off. Nowhere was there discussion of a stable currency, of strong GDP growth, of low national debt, or of a growing middle class (unlike the shrinking one here at home). Nor was there any discussion of the net flow of immigration from the U.S. back to Mexico in search of economic opportunity (if Trump builds a wall it will keep people from leaving our country rather than keeping them from getting in).
All these things that no one discussed turned out to be important. Those first Mexican partners have built a very large and profitable business based, at least in part, on the strong fundamentals and growing middle class in need of legitimate personal credit. No longer are their options limited to pawn shops or black market loans.
One central reason I like international search funds is that they offer the opportunity to invest in misunderstood economies experiencing rapid growth. A second related reason is the ability to tackle relatively basic industries that are overdeveloped in the U.S. but wide open in places like Mexico. There’s no need to get too creative or identify a sub-niche industry. Find a basic business model people need in the developing world and do a decent job of execution, and you will be rewarded handsomely.
This dynamic is in contrast to what I have since noticed among U.S. searchers. Annoyingly, at least a chunk of domestic searchers seem to lack creativity in the sense that the U.S. market for appropriate companies to buy is massive compared to the rest of the world. Yet, searchers too often act like lemmings. I hear again and again about deals where there are as many as four or five searchers bidding on the same deal. Really guys? Can’t you come up with your own industry and/or geography that is virgin territory rather than trying to duplicate some past searcher’s success? If you back a searcher in Guatemala, as I have done, it’s all virgin ground.
I have grown fond of international searchers, particularly from the developing world and emerging markets, because of their character in the face of the daunting task of finding a business to buy and then running it. Having now been involved in quite a few searches both in the U.S. and abroad, I have watched many new searchers enter the process with great optimism, only to realize once they hit the ground that the undertaking was many times harder than they had expected. This particularly applies to taking over as a first time CEO of a company that is by definition dysfunctional, since a founder without the benefit of professional management training has built up the company.
Successful searchers don’t buy great companies. They build them. And that is bone-crushingly hard. Most searchers are smart and have the basic skills provided by a high-quality education. So it comes down to leadership and, ultimately, grit and determination. When I interview prospective searchers I’m always trying to figure out how well they will do, not when things go well, but when they get truly fucked up.
My sample size is not huge. However, I have noticed that searchers who have found their way from growing up in a less developed country to a top U.S. business school have a higher than average amount of the intangible character it takes to succeed when they return to their home country to do their search fund. Not that there aren’t domestic searchers who have that same quality, or that there aren’t international searchers who are deluded in their perception of what it will take to create a great company. But in general, I like betting on international searchers.
I don’t mean to sound like this asset class is a panacea. Not everything about an international search is better. There are definitely aspects that present unique obstacles, which must be kept in mind.
Legal, regulatory, and tax issues are specific to each country and will almost certainly introduce added complexity to a search fund. It’s important to get good local counsel to navigate these issues and to set up the search ownership with an optimal structure from the outset. This will mitigate these risks and insure the free flow of capital into the investment at the beginning and a maximum return at the conclusion.
It’s imperative for the searcher to have local investors and a solid network amongst the business leaders in their home country. In many cases the relative youth of the searcher will be even more of a challenge than it would be in a domestic search, both in establishing solid deal flow and in convincing a seller that the searcher is a credible buyer. Having local gray hair in the form of river guides and active investors on the ground is imperative.
A key issue for every searcher once they take over as CEO is recruiting the right senior management team. It is almost always the case that the incumbent team is ill equipped to take on the growth that will lead to an attractive return for investors and substantial equity value for the searcher. Finding qualified senior management in developing countries can be very hard because the talent pool is so limited. I’ve noticed that many of these searches utilize two partners that provide double the leadership from the start. But a great CFO, General Counsel, sales leader, or CTO can take much longer, and finding one often involves recruiting someone who might have gotten their education in the United States to come home.
A lot of creating a great company is building a consistent and strong culture of hard work. Not all economies foster that kind of culture on a broad basis. It may take additional training and reinforcement of the company mission and workplace expectations of performance and effort to get an entire company moving at the speed necessary to succeed.
As an investor I always learn exponentially more about what is going on at a company when I visit to talk to employees at a variety of levels, and dig well below the investor or board deck. Doing that on a regular basis with international searches is not as easy as driving across town. I enjoy my trips, but not everyone is up for visiting a search fund in South America as it’s a time consuming endeavor.
Perhaps the biggest risk is currency. There is really no way to hedge out an open-ended equity investment in a search fund without a certain exit date. By investing in developing country, search funds are investing in the currency of that country, which can be volatile. You also have to negotiate with the searcher about how their economics will be denominated. At the end of the day you have to get comfortable with the risk, and hope that that the underlying success of the search will outstrip any potential negative impact of currency fluctuation during the holding period.
Despite these risks, I’m bullish on the asset class. Somehow since my first Mexican search fund, I have reached a status I sometimes jokingly refer to as the “Great gringo hope for central and South American searchers.” These types of searchers seem to seek me out. To be clear, I don’t speak Spanish and my background as a U.S. media company CFO and venture capitalist give me no particular qualification for such an exalted place in the ecosystem.
At this point, half of my active searches are international (with the other half loosely focused around domestic SaaS which provides its own challenges to the old school search model that I’ll try to write about soon). I like it that way. I get to learn about these countries in depth and root for a group of searchers doing something new and important in their home countries.