Hunting for the Deal: 7 Stages of the Search Fund Model

With average returns of 37% and initial investment returns of 13.5x, it’s hard to ignore some of the successful outcomes search funds have produced. One of the most publicized search fund acquisitions was Asurion Corp., which sold for $4.2 billion 12 years after being bought for $8 million by a search fund founded by Stanford Graduate School of Business (GSB) students. Examples like these are why the search fund model has challenged skeptics and built a network of successful alumni who nurture and mentor candidate companies.

By no means are search funds a new investment vehicle. Professor Irv Grousbeck at the Stanford GSB originally conceived the model in the mid-80’s. Providing investors with a unique investment opportunity, fledgling entrepreneurs use the model to create a fast track to the CEO spotlight.

7 Basic Stages of the Search Fund

1. Decision – The search funder, most often a recent graduate of a top-tier MBA program, commits to raising a search fund.
2. Select the Investors – Because investors have a right to first refusal once the search funder selects a company, it’s important the search funder strategically selects value-adding investors.
3. Raise the Search Fund – An initial amount is raised ($150,000-$350,000) over about three months to fund the search for a company.
4. Deal Flow Generation & Screening – Lasting about two years, this stage involves researching industries, networking, identifying deal sources, sourcing deals, conducting due diligence, showing interest, and signing LOIs.
5. Deal Negotiation – Lasting about six months, the search funder negotiates the purchase, debt leverage, investment, and equity allocation to close the deal.
6. Running the Company – The search funder becomes entrepreneur. This is the longest stage as the search funder becomes in charge of the ownership and operations of the company.
7. Sell the Company – Once the search funder-turned-entrepreneur has a sale opportunity and decides to end the life cycle of the search fund, the company is sold and investors make a return (assuming a successful exit).

Who’s behind the fund?

Historically search funds have been a way for MBA grads, from top-tier business schools like Stanford and Harvard, to raise a small round of capital to fund the search and selection of a target company. If they successfully identify a target that is amenable to a transaction, they raise a subsequent round of capital specifically to buy the target company.

According to Pankaj Amin, a graduate of Harvard Business School and successful search funder, only a handful of graduates from each MBA class commit to launching a search fund. Through the model Pankaj launched his search process in 2002 and subsequently in 2004 acquired AffiniTel, a San Francisco-based telecommunication systems integrator. After running the company for seven years he sold the business in early 2011 to launch a new fund, SC Ventures, located in New York City.

Another subset of search funders includes experienced finance professionals looking to step out of the corporate world. These types usually adopt the model because they have more of an interest in running an operating company – skipping the early venture stages of a startup.

The Search for Deal Flow

According to those familiar with the process, it takes an average of two years for a search fund to identify a target acquisition. During this stage, deal flow is cited as one of the key challenges. Networks such as Axial can help. According to a 2009 study from Stanford, the survey estimates that 129 search funds have raised capital, 41 of which were in the search phase. 20 search funds belong to the Axial network and collectively have seen and reviewed over 6,000 relevant acquisition opportunities that have come to market.

Generating quality deal flow is a primary focus of any investor, whether you’re a one-person effort or a few hundred strong. There are several non-mutually exclusive approaches: fill the front-end of your funnel by scouring business broker networks, get introductions through your LPs or investors, procure proprietary deal introductions, and take advantage of the newest technologies like Axial.

Search funds find themselves in an unusual and precarious position as they begin to generate deal flow. Considering their lack of committed funding and relative lack of experience, buy-side advisors, business brokers, and others tend to approach them with lower quality deals, assuming that they don’t have the credibility, capital, or industry expertise to be the seller’s buyer of choice. To counteract this, search funds have traditionally limited the scope of their search by geography or industry. With a geographic limitation, the search fund focuses its network and establishes credibility within a specific community. Hunkering down in, let’s say, the Southeastern US will of course limit the scope of deals, which might cause a search fund to miss that founder who is selling “the perfect business” in Michigan, but the focus helps guide sell-side advisors and other sources of deal flow that the search fund interacts with. Meanwhile, certain industries (consumer/business services, manufacturing, low-tech, etc.) have faster learning curves, allowing the search funder to increase credibility, apply due diligence from company to company, and essentially become an expert in a field or two.

While focusing on a particular region or industry may be a good way to specialize your individual expertise, it limits the search. Private equity firms with the bandwidth are constantly looking for new sources of deal flow, wherever they may surface. Search funds must take advantage of the latest tools and technologies to make up for their lack of resources.

Regardless of the deal sourcing and relationship management obstacles search funds face, many argue the model provides the best of both worlds for a select type of aspiring entrepreneur. Through raising the initial funding, structuring subsequent debt and equity investments, and conducting due diligence, the search funder plays the role of a Private Equity investor. From both the buyer and seller perspectives, the search fund sees the deal through the buyout steps of due diligence, LOI, negotiation, and closing. And as CEO, the search funder steers the ship hopefully in the right direction for the benefit of the learning experience, investors, and people involved with the organization.

Keep an eye out for an upcoming post about search funds from veteran search funder Pankaj Amin.