In today’s low-interest rate environment, investors are increasingly exploring alternative asset classes, with private equity continuing to command significant capital flow. However, a relatively obscure and niche asset class holds the potential for remarkable market performance: search funds. This article delves into search fund investing from the investor’s perspective, examining its key aspects and unique benefits.
Executive Summary
- Search funds are emerging as one of the most exciting asset classes in private equity.
- Investors can deploy capital in three different stages of a search fund’s life cycle.
- Search funds provide portfolio diversification and align well with active investors aiming to create value.
Toptal Finance Expert Toby Clarence-Smith, who has a background in investment banking, venture capital, and private equity, highlights the advantages of search funds while reviewing how they function from the investor’s point of view.
What Are Search Funds?
Search funds are investment vehicles established to fund entrepreneurs in searching for, acquiring, and managing privately held businesses. Unlike unfunded searches, search funds rely on investor backing to provide the entrepreneur with capital during the search phase, distinguishing it from a traditional acquisition process.
While search funds have gained traction in recent years, many investors remain unaware of their potential. This article complements prior discussions on search funds by shifting the spotlight to the investor experience, showcasing why these vehicles could redefine private equity investing.
Search Fund Stages for Investors
Search funds have four main stages, allowing investors to contribute capital during three phases—search, acquisition, and operation.
1. Search Capital Phase
The first stage involves raising capital to fund a search for a business acquisition, typically lasting up to 24 months. Entrepreneurs use this pool of funds for operational costs such as market research, salaries, and outreach. The amount raised is generally between $350,000 and $500,000, depending on the search’s specifics.
Investors typically receive two key benefits for participating in this phase:
- Pro-rata follow-on rights: Investors are given an option to invest proportionately during the acquisition phase.
- Stepped-up conversion: The initial investment is converted into securities issued during the acquisition stage, often on favorable terms.
This setup allows investors to gauge the entrepreneur’s performance during the search phase prior to committing additional capital in later rounds.
2. Acquisition Financing
Once a suitable company is identified, funding the acquisition becomes crucial. Investors play a significant role, contributing equity alongside other forms of financing like bank loans and seller financing.
Search funds typically target smaller companies with $10–30 million in revenues and EBITDA above $1.5 million. Acquisition values usually hover around $10 million. Based on benchmarks, a financing package might involve preferred equity, mezzanine debt, or seller financing.
Investor contributions during the acquisition phase frequently take the form of preferred equity with terms such as:
- Preferred returns of 5–8%.
- Participating preferred equity with a liquidation preference.
- Occasionally, redemption rights depending on the deal structure.
3. Operational Phase
Following the acquisition, investors may have additional opportunities to invest further capital for growth projects, acquisitions, or operational efficiencies. These post-acquisition capital deployments allow investors to double down on their most successful search fund investments, potentially yielding outsized returns.
Attractive Returns and Diversification
1. High Returns Compared to Other Asset Classes
Search funds have consistently delivered strong returns. Studies from Stanford Business School and IESE Business School suggest the asset class has historically provided IRRs north of 30%, outperforming other private equity categories like venture capital and growth equity.
However, returns can vary widely depending on the success of the acquired business. The search fund space is notable for its “winner-takes-most” dynamic—while the top-performing funds generate significant profits, others may produce more modest results. Diversification across multiple search funds is key to mitigating risk.
2. Improved Portfolio Diversification
Search funds operate in a niche segment of private equity, targeting small but established and profitable businesses often overlooked by venture capitalists or larger private equity funds. This makes them a viable addition to broader private equity allocations, further enhancing portfolio diversification.
Moreover, unlike traditional private equity or venture capital, search funds avoid management fees, reducing costs and focusing compensation on performance outcomes. This alignment of incentives is increasingly attractive to investors wary of fee structures in other funds.
Adding Value as an Active Investor
One of the most compelling aspects of search fund investing is the opportunity for active investor involvement. Search funds thrive on a symbiotic relationship between entrepreneurs and investors:
- Entrepreneurs bring energy and ambition but often lack experience.
- Investors contribute decades of knowledge, guidance, and mentorship, significantly influencing performance.
For those eager to actively participate in their investments, search funds offer frequent opportunities to join boards, guide strategy, and oversee business operations directly. Unlike traditional limited partner roles in institutional private equity funds, search fund investors can play a hands-on role in nurturing businesses.
Challenges and Considerations
While enticing, search funds are not without challenges:
- High Risk and Illiquidity: Search funds involve long-term, illiquid investments. As such, they require careful allocation within an investor’s overall portfolio (typically 5–15% of alternative assets).
- Diversification Hurdles: With a limited number of search funds globally, building a well-diversified portfolio can be challenging. Experts recommend investing in at least 10 search funds to spread risk.
- Scaling Commitments: Initial investments may seem small (e.g., $35,000–$50,000), but investors should prepare for larger commitments during the acquisition phase, often running into the hundreds of thousands.
The Value Beyond Financial Returns
Search funds offer something more than just financial returns. Investors often find supporting talented, driven entrepreneurs deeply fulfilling. Many seasoned investors view their involvement in search funds as a way to give back, mentoring young leaders and fostering growth in smaller, often family-run businesses that could benefit from professionalization and expansion.
The collaborative nature of search funds fosters a tight-knit community where investors and entrepreneurs work closely toward shared success. For those who value purpose-driven investing, search funds provide a rewarding avenue beyond pure profits.
Final Thoughts
Search funds represent one of the most exciting opportunities in private equity today. They deliver a unique combination of high potential returns, portfolio diversification, and the chance to play an active role in fostering entrepreneurial success. While they come with risks and require careful consideration, for the right investor, search funds could be the key to unlocking outsized returns and fulfilling partnerships.
Potential investors are encouraged to evaluate the asset class thoroughly, using tools like the Chicago Booth School of Business checklist to assess suitability. By combining strategic diversification with an active involvement ethos, search funds can be a powerful addition to a well-rounded investment portfolio.