SPACs or Special Purpose Acquisition Companies have grabbed the headlines over the last 6–7 months. But another tends with a similar function is quietly gaining steam as a new and disruption market on the lower end of the capital stack and venture market. Search Funds.
What are Search Funds? Good question, a Search Funds operates similar to a SPAC in that it is “searching” (hence the name) for an acquisition target. But instead of raising hundreds of millions and looking at large, later-stage private companies. Searcher target $2–10M startups to either buy out or take a majority stake in.
Searchers, like SPACs, are backed by LPs, typically groups of High Net Worth Individuals and other institutional investors provide the searchers with $250–750K to finance search activities including salaries, travel, etc. The searcher then uses those funds to go hunting for startups in that $2–10M range and a value of $5–25M. Usually, these are profit-bearing companies that are in niche industries or have stagnated growth. The initial “searching” investment is usually made as ownership units of an LLC that have 150% step-up rights when those units are converted into securities in the target company. These investors typically have pro-rata rights as well.
The searcher then negotiates the terms of the buyout and takes it to their LPs who help finance the acquisition through equity and debt (given that these companies are profit-generating or break-even they can support debt).
The searcher typically installs themselves as CEO or lead operator and puts a game plan in place to help grow the business. The goal is typically 5–7 years of operation and then to flip the company to a larger PE fund or a strategic buyer. A few Search Fund companies have one IPOd!
The most intriguing part? 258 Search Funds have completed an exit to date with an average internal rate of return of 37% and an 8.4x return on capital. 70% of funds that find and close a target return some form of capital to their investors.
Search Funds present an amazing opportunity for capital allocators and entrepreneurs alike. An exit strategy for the massive volume of startups that either bootstrapped or raised venture dollars and growth stalled. These businesses can be flipped to brilliant operators who don’t want to start something from scratch. For capital allocators, you get to deploy capital into stable, proven, and often profit-generating businesses and still generates strong returns (37% IRR, Venture Capital Avg is 18%)
It is an intriguing new opportunity and a fast-growing segment of the venture/PE market. Capital allocators are increasingly being intrigued by search funds as they see the fee and compensation structure of these funds more aligned with outcomes than other fund types. Search Funds typically charge 10–15% carried interest and a 10% success fee. It will be exciting to see as more and more capital flows into alternative assets, how search funds are viewed by LPs who are increasingly looking for diversification and new opportunities.