Investors looking to diversify their holdings from traditional private equity may want to look at search funds. These funds debuted in the mid-1980s, but have gained traction in recent years due to the exponential increase in funding numbers and consistently attractive returns. This blog explores search funds, what they are, how they differ from private equity, and why you should be on the radar of some investors.
What is search funds?
A search fund is an investment vehicle formed to find, acquire and operate a closely held business. The fund uses specified investment standards such as minimum EBITDA and revenue, industry, and geography. The funding was conceived in 1984 by IRV Grousebuck, an MBA class professor of management at Stanford University’s Graduate School of Business in 1980. Since then, over 700 search funds have been launched, creating an entire ecosystem known as entrepreneurship through acquisitions (ETA). There are currently search funds operating in Europe, Latin America and Asia.
There are two major types of search funds. It’s a self-funded and traditional model. The third relatively newer model, the independent sponsor model, is beginning to gain traction.
In a self-funded model, entrepreneurs use savings and family contributions to fund marketing, subscriptions, travel and more. Term loans and government support programs typically fund acquisitions, depending on the market run by the entrepreneur. However, most self-funded entrepreneurs partner with several investors to fund the share portion of the transaction.
Under the most common traditional search fund model, entrepreneurs raise capital by selling units to investors. These units represent entrepreneurs’ shareholdings in the Search Fund. Capital covers search-related costs between 24 and 36 months. Investors who purchase units at this stage are not obligated to participate in funding the acquisition, but will receive the right thing. They have the right to first refuse to fund the entire share portion of the acquisition before the entrepreneur approaches the outside of the investor. The Advisor Committee provides guidance and support to entrepreneurs during the search phase and provides a full board of directors once the acquisition is made.
After acquiring the investment horizon, it ranges from four to seven years. However, recently, search funds have adopted long-term hold strategies to maximize value creation. The Search Fund ecosystem is driven by major business schools such as the University of Virginia’s Darden Business School, Harvard University, Stanford University GSB, and the Chicago Booth School of Business. These schools have identified search funds as a path graduates can take to become CEOs of small businesses.
Search funds target small to medium-sized businesses (SMBs) in immaturely supervised markets, creating opportunities in areas that are often overlooked by private equity funds. Unlike private equity, which targets large companies with high competition, search funds operate in a niche with low ratings and less contested transactions. Additionally, PE funds are designed to invest in multiple companies, while search funds are designed to invest in a single company. Many search funds tend to target companies serving local or local markets and provide important products and services that can be expanded with proper management. An ideal acquisition is a strong management team that generates consistent positive cash flow, generates repeated revenue, has few customer churn, minimum $1 million EBITDA, and low exposure to external risk. Opportunities lie in the value-creating capabilities of the Search Fund.
The latest search funds are independent sponsored models. This model allows entrepreneurs to pursue acquisitions without raising traditional search funds in advance. Instead of securing dedicated capital before identifying and negotiating a transaction, independent sponsors will first identify the transaction, then raise fairness and debt financing from investors on a transaction basis. This approach offers flexibility and allows searchers to leverage their network and expertise while tailoring the profits of investors to specific opportunities.
Value Proposal
The Stanford University School of Business 2024 Search Fund Survey (Figure 1) analyzed 681 search funds established in the US and Canada since 1984. The fund reported an internal rate of return (IRR) of 35.1% and a return on investment (ROI) of 4.5 times. Consistent performance over the decades highlights the resilience of search fund models and the potential for long-term value creation despite changes in macroeconomic conditions.
Figure 1 | IRR and ROI for each year of company acquisition.
Search Funds offers a compelling investment model by working seamlessly with the long-term strategic goals of most investors who prioritize sustainable growth with a rapid exit. Unlike traditional private equity, search fund entrepreneurs emphasize post-acquisition operational value creation, focusing on practical management and value-added activities that increase business efficiency and profitability, resulting in enhanced operational performance. Search funds target uncapital to medium-sized businesses, unlocking unique opportunities in undiscovered sectors and have great growth potential. This combination of integrity, operational focus and access to undeveloped markets positions search funds as an attractive tool for investors seeking both financial benefits and lasting impact.
Given the role of business schools, family offices and institutional investors can partner with MBA programs to create structured programs that provide search fund accelerators, capital, mentorship and networks, specialize in the ecosystem and reduce risk.
future
The search fund model is gaining momentum with increasing adoption in Europe, Latin America and Asia, and is gaining momentum with growing interest from institutional investors seeking alternatives to traditional private equity. This extension reflects the appeal of the model. A high potential return from entrepreneurial talent in underserved markets. Technology is poised to accelerate this trend as AI and data-driven tools streamline the fund search process. Search funds benefit from faster target identification, due diligence and increased post-acquisition operations through predictive analytics and increased efficiency.
Search funds stand out as valuable alternative asset classes, offering diversification, alpha potential, and operational benefits in underserved markets. Their lower capital requirements, practical value creation and collaboration with long-term investors’ goals make them a compelling counterpoint to traditional private equity. In addition to investment possibilities, search funds represent opportunities to support entrepreneurial talent and reshape the way value is generated in the private market.
