Search Funds: Over-performing and Underutilized

Stellar returns are the least interesting part

According to the 2020 Search Fund Study by Stanford Business School, search funds have generated an aggregate IRR of 32.6% and 5.5x amongst all known successful transactions.  One-third achieved a 3x return, with a full 11% achieving 10x or more.¹

Here is what that looks like compared to other asset classes:

How is this possible?  While every other asset class grinds it out for every little penny, are search funds exploiting a wormhole to huge returns?

First, what is a search fund?

Traditionally, it is a fund dedicated to one person to buy and run one business.  The fund covers the cost of buying the business, and sometimes, the individual’s personal runway to find the right business.  Once the business is acquired, the new CEO and his anchor investor, the search fund, aim to grow, operate, and (usually) sell the business. 

There are many variations⁵, but this is the basic model that has been wildly lucrative to date. It is also known as entrepreneurship through acquisition, or ETA.

So why are they outperforming by so much?

I suspect it is simply a nascent industry.  As I’ll go into later, returns are eons from being competed away.  Since 1984, there have been 401¹ total search funds formed in the US and Canada.  That’s just over ten per year.  It’s a sampling bias because those ten (more lik3 30-50 in recent years¹) great deals are getting done.  

To understand what makes search funds such a ripe place for financial and societal innovation, there are two more details worth understanding:

• We’re talking about acquiring long-running, stable, EBITDA-positive businesses.  As opposed to the “startup” metaphor of building a plane while you learn to fly it, this is stepping into the cockpit of a plane that has been cruising for years and learning to fly it as quickly as possible.  Historically, 91% of businesses maintained or grew EBITDA after being acquired.  As a result…

• Debt usually covers 80-90% of the acquisition cost.  This means, for a $1M business acquisition, the search fund may only need $200k, with the other $800k coming from an SBA 7A loan* or often seller financing.

There is ample room for more search funds and exceptional returns.

That is far from what makes search funds so interesting.

When I think of the search fund industry today, compared to its potential, I see a giant lever being used to pry up the tab of a soda can.

And here’s how AI sees that…

Here’s how I think that lever could be put to better use.

Portfolio Approach - The very fact that “search fund” generally refers to a portfolio-of-one is ludicrous.  To be fair, many “portfolio of search funds” do exist.  As the asset class matures, a true “portfolio” approach of many businesses will common practice.

When scaled across portfolios, search funds begin to have a really interesting potential for change too.  In 2019, a (meager) peak of 25 search fund acquisitions occurred¹.  I see no reason why that shouldn’t be 25 portfolios of even ten companies, making for 250 businesses acquired by “search fund portfolios.” 

A portfolio is just table stakes for the industry to become more widespread.  Growth for the sake of growth is still uninteresting.  

A mature search fund industry finally becomes interesting when its newfound critical mass is pointed toward the economy we actually want.  Search funds can become a powerful vessel for change.  

1. The Silver Tsunami

The Baby Boomer generation accounts for an estimated 2.3 million small businesses in the U.S. Additionally, 78% of boomer businesses are profitable, making them the most profitable age group of small business or franchise owners. Furthermore, experts estimate that roughly 10,000 Baby Boomers retire each day.³

Meanwhile, we’re discussing an industry with an applicable response to this phenomenon that completed 25 transactions in its largest single year.  In every small town, there are likely a handful of businesses looking for new ownership with many years of stable financial performance; in a big city, there are likely thousands.

Many of these business owners value the transfer of responsibility far more than deal terms too.  

Did I mention seller financing?  Stable cash-flowing businesses provide, well, stable cashflows to business owners - the same ones hoping to get out of the business.  As a result, 45% of search fund deals include seller financing, which had an 8% or less rate 86% of the time².  For many boomer businesses, any opportunity to gracefully transition ownership is better than none.  This tilts terms in favor of the search funds, further insulating the financial opportunity from erosion.

Search funds are an actionable way to take advantage of this wave with favorable dynamics for driving real returns.  This is a multi-trillion-dollar opportunity with a gazillion percent mismatch between supply and demand right now.

Why isn’t this a primary strategy for economic development organizations?¹

An undoubtedly incomplete list of local economic development-minded search funds:

• Goodworks Evergreen (Montana)

• Sudu Partners (Philadelphia)

• Reef Point (Midwest)

• Sleeping Giant Capital (West Michigan)

2. Don’t forget, search funds inherently place their own CEOs into successful businesses.  This is a perfect opportunity to implement overdue change at the top.

Entrepreneurship is overwhelmingly titled towards those who can afford the risk.  

We often assume entrepreneurship is the only path to business ownership, thus, net worth continues to consolidate to those who can afford the risk.  

It doesn’t have to be this way.  As is the theme of innovative finance, there are more pathways available.  

Search funds trade in old ownership and leadership for new.  This is a huge opportunity to tap the countless pools of well-qualified talent that has been systematically sidelined to date.

The median total compensation (salary and bonuses) for CEOs was $253,000.  For the CEOs who found exits, their equity was worth a median of $3.25 million¹.  This is a plug-and-play opportunity to put generational wealth into the hands of those who are qualified but overlooked.

Here are some folks who are already thinking about and/or doing this:

• Promise Venture

• New Majority Capital

• Black Search Network

• Womens Search Network

• Black Entrepreneurship Through Acquisition Incubator

• Social Capital Partners (foundation seeking to back more inclusive search fund models)

3. Search funds can channel the silver tsunami towards important societal outcomes.

Once again, search funds offer a more direct path to change.

The venture playbook, for comparison, is to adopt a thesis thesis, build expertise and network to support it, and then wait for entrepreneurs to come into the crosshairs to get the firm’s funding and support to implement said change.  It is an indirect way of affecting change through business.

In contrast, search funds simply need a CEO who agrees with the thesis for change, and then to go buy the vessel for it - the company.  Not to diminish the task of business acquisition, but it is a lot safer bet to being able to implement a policy or strategy compared to the odds of a single VC-backed startup seeing its vision through to scale.  Sure, it isn’t a “disrupt the status quo” type of innovation, but 2.3 million businesses are ready for new ownership³, so they might as well be readied for new paradigms.

Of course, there are already some search fund players who are aiming to drive today’s businesses toward a better tomorrow:

• Impact Search Investors (“stealth mode”) - buying businesses and then reducing their CO2 emissions 

• Beagle Services - next generation plumbing company that also acquires existing plumbing businesses 

• Regenerative Capital Group - purpose-driven search accelerator and fund focused on long-term ownership for Canadian small businesses.

4. Search funds offer a much-needed window for shared ownership transitions

Business ownership is one of the most important factors in long-term wealth.  There is no reason that should be constrained to founders, investors, and the C-suite only.  In fact, while we rejig the demographics of those roles, there is good reason⁴ to go ahead and distribute ownership amongst everyone else, now.

Redistributing ownership requires transferring ownership from current owners to new owners - employees, suppliers, community, etc.  While a lot of work has been done to lower the bars for these transitions, the rate limiter is business owners.  Yvon Chouinard is, unfortunately, an outlier.

Meanwhile, everyone with a business imagines a payday where they get a large check for the summation of their life’s work and get to call it quits.  That’s the search fund product.

While this window in incentives is currently used to buy equity and then resell it (aka flip businesses), there is no reason it has to be built around the exit.  That same arbitrage of incentives and terms can be built around exiting to a new class of shareowners.

How?  It’s as simple as building the transition into the search fund economics.  The post-acquisition cap table provides ample room for this reset.  

After the acquisition, the primary stakeholders will be the search fund and new CEO (and maybe the old owner too).  Rather than relying on an exit, search funds can structure an exit of their ownership (or a fraction of it) to be a performance-based redemption.  Who gets these shares?  Common holders.  Employees.  Anyone deemed to be important to the company and worthy of a stake in its long-term success.

So who is ahead of me here?

From what I have found, there are a few folks thinking along the same lines, but none doing exactly this.  Maybe they know something I don’t.  Nonetheless:

• Teamshares ( they likely wouldn’t call themselves a search fund, but it sure seems to resemble one)

• Social Capital Partners (foundation seeking to back more inclusive search fund models)

Too good to be true?

If plotted on the Dunning Kruger line, this writeup is surely on the initial, naive rise in understanding.  I’m in the honeymoon phase of understanding.  Plenty of folks in the search fund industry and/or listed above know all the reasons it is not as simple as I am proposing. 

• Where my thinking here is incomplete?

• Who else is doing interesting things with the search fund model?

• What kind of support do innovative search funds need?

Nonetheless…

• Search funds as an asset class are nascent, if not infant.

• The positioning of the search fund lever, at the point of leadership and ownership transition, is powerful.

• The number of search funds compared to the size of the opportunity is absurd.

This makes the return and impact potential appear undeniable.

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 1 - https://www.gsb.stanford.edu/faculty-research/case-studies/2022-search-fund-study-selected-observations

2 - https://www.searchinvestgroup.com/study

3 - https://resources.liveoakbank.com/blog/how-the-silver-tsunami-provides-acquisition-opportunities-for-veterans

4 - https://hbr.org/1987/09/how-well-is-employee-ownership-working

5 - https://yale.app.box.com/s/mqbcrk2gxey2fkesextgq4ij6oufe8w0

* Yes, SBA 7A loan rates, and all rates for that matter, have gone up a lot, which will dampen the deal for search funds significantly for the foreseeable future.

Thank you to Dave Knox for first introducing me to the search fund economic development potential, Turner Wyatt for editing and evolving this piece, and Kiah Hochstetler (preemptively) for playing devil’s advocate.