It's been a while since my last post, the MBA was tough for the last couple of weeks.
I've been diving deep into search funds lately. Thought I'd share some insights I've gathered. I am doing this post to help whoever starts this journey after me, so they can benefit from my learnings.
Phases of a Search Fund:
A search fund typically goes through several phases:
Raising Initial Capital for the Search: This is where it all begins. Usually, the capital for the search is divided into 10 to 16 units. On average, about $448k is raised, with each unit being $28k (so 16 units).
Due Diligence of the Target: Thoroughly evaluating the potential acquisitions to ensure a sound investment.
Acquisition Phase (Raising Capital for Acquisition): Once a suitable company is found, additional funds are raised to finance the acquisition, often a mix of equity and bank debt.
Operation: Post-acquisition, the focus shifts to operating and growing the company.
Exit: Eventually, the goal is to exit the investment, hopefully realizing significant returns.
Value for Initial Investors (initial search):
Equity Increase: For early investors, there's a significant incentive. After the acquisition, each unit increases by 50% in value. So, a $28k investment becomes $42k in equity in the acquired company. This compensates them for the risk during the search phase.
Pro-Rata Rights: Each search phase unit grants the right to acquire additional equity in the acquisition target. If some investors choose not to exercise their rights, those are redistributed among the remaining investors.
Unexercised Rights Compensation: Investors who don't exercise their rights still benefit—they receive the 50% equity increase on their initial investment or are compensated in cash.
Shareholder Agreement (SHA):
Signing Before Funds Transfer: Immediately after fundraising and before receiving funds, a Shareholder Agreement must be signed with the investors. This agreement guides the process and outlines the rights and obligations of each party.
Role of Lead Investor: The lead investor adds significant value by negotiating terms on behalf of all investors. While they play a pivotal role, it doesn't mean other investors are just along for the ride—they're expected to add value too.
Binding Obligations: By accepting the funding, the searcher is bound to the defined obligations—like focusing on certain industries or geographic locations.
Search Phase Expenses:
The initial capital raised covers: Setup costs Due diligence for potential targets Travel expenses Interns Searcher salary (adjusted based on the searcher's profile) About the Acquisition: Financing Mix: Acquisitions are typically financed through a combination of equity and bank debt. Returns on Investment: The average ROI for funds in the US and Canada is 32.6%, and 28.7% for funds in other regions. Return on Invested Capital (ROIC): Pre-tax ROIC averages 5.5x in the US and Canada, and 2.4x in other geographies.
Compensation for Searchers:
Equity Stake: Searchers usually receive a 25-30% equity stake post-exit.
Phased Granting:
33% granted after finding and closing the acquisition—this rewards the effort in securing the deal.
33% vested over 4 to 5 years while operating the company.
33% is performance-based, depending on the exit price (aiming for a 20% to 35% IRR).
Equity Caps for Larger Deals: In bigger acquisitions, there have been equity caps for searchers at 23%, with up to 50% of this equity being performance-based.
Forming a Board:
It's advised that the searcher forms a board both before and after the acquisition:
Investor Involvement: The majority of board spots are filled by investors. This is why it's crucial to select investors who can mentor and be actively involved where you need the most guidance.
Complementary Profiles: A minority of board members should complement the searcher's profile. This could include:
Operators in related industries
Former successful searchers
Sellers
Sales executives from large companies
CFOs of mid-sized companies
Areas of Support from Investors:
Fundraising: Introductions to other investors, feedback, and support.
Deal Sourcing: Advisory roles, guidance, networking with potential targets, and on-site due diligence.
Acquisition: Assistance with due diligence, deal structuring, and general process guidance.
Management: Support during management transition, board participation, and informal mentorship.
Exit: Guidance on the exit process and connections to potential acquirers.
For selecting Investors important considerations include:
Sector expertise
Capacity to provide capital
Need for liquidity events
Reputation
Investor profile (local vs. international, funds vs. individuals)
Familiarity with the search fund model
Preference for hands-on vs. hands-off involvement
Legal Counsel:
Early Engagement: It's crucial for searchers to engage with legal counsel early on to create the appropriate vehicle and ensure compliance with all laws. Experience Matters: Ideally, the legal counsel should have experience with the search fund model to navigate any complexities effectively.
That's a snapshot of what I've been learning about search funds. It's a fascinating model that blends entrepreneurship with investment, and I'm excited about the possibilities it holds.
If you have any thoughts or questions, feel free to share!
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