Issue #7 - Why Search Funds Work
Why Do Search Funds Work?
Search funds are like the platypus of the investment world: part operating company, part LBO, mixed with a combination of seasoned investors and ambitious aspiring CEOs. To an outsider, it all seems highly improbable that they exist at all, let alone that since 1984, as an asset class search funds have generated more than a 30% annual compound return to investors. In fact, the most common comment I've received over the past 15 years from people unfamiliar with search funds is this:
“I'd never allow a young, inexperienced professional (top MBA or not) to run a business in which they had no prior experience. That's crazy!”
But is it really crazy? If you look at the facts, more often than not, it works, and it works well.
So how do search funds defy conventional thinking and generate consistently good outcomes?
My belief is that it is because they follow a proven playbook that focuses on:
Buying simple, scalable, resilient companies in growing, but off-the-beaten path industries;
Backing the most exceptional raw talent; and
Adhering to a few key value-adding structural elements
Let's look at each in turn to understand the formula for success.
Buying "Unbreakable" Companies
The typical acquisition profile has consolidated around businesses with:
A high proportion of recurring revenues
Operations in fragmented, growing industries that are also often recession-resistant (e.g., B2B services, healthcare services, essential software)
Low capital intensity
Low customer concentration
Strong margin profiles (gross margins in excess of 50% and EBITDA margins of 15-20% or more)
An astute reader will analyze those characteristics and conclude that a business that meets those criteria will be relatively hard to break, which is precisely the point!
Given the relative inexperience of most search fund CEOs, many of whom are assuming that title for the first time, pairing them with a company that is durable and consistent dramatically lowers the risk profile.
Further, even though these companies are healthy and growing, many are in need of professionalization. By doing some things slightly differently such as systematizing core workflows, collecting and using data to drive decisions, and hiring skilled managers to lead functional areas of the business such as HR, IT, and operations, a new CEO is able to unlock the full potential of the business and create a foundation from which the company can grow many years into the future.
A steadfast focus on identifying companies with these attributes is perhaps the greatest reason why search funds, on average, are high-performing investments.
Humble, Smart, Driven Learning Machines
If you are ever fortunate enough to find yourself in a room full of search fund CEOs, you'll quickly identify some common characteristics. They are smart, practical, humble, driven, curious, savvy communicators, adventurous, and self-confident. You can easily imagine them being leaders of large organizations when they are older and you'll marvel at their poise given their age and experience.
Small business owners, while possessing extreme talent in some areas, often aren't able to attract or pay these types of professionals to join their firms. However, in a search fund's case, the offer of being CEO and having ownership is a large enticement and enough to cause some to make the leap to small business. Once in place, these CEOs have the resources, connections, and skills to recruit others like them to the company as they fill critical management roles driven by company growth.
All of this creates a form of arbitrage: you take energetic, smart, and growth-oriented search fund CEOs and let them compete against the owners and managers of established incumbents who have grown unaccustomed to the challenge and effort required to compete against a hungry firm eager to take market share. The result is often a rapid shift in customer buying preferences and disproportionate gains to the newly-energized search fund-backed business.
Combining these first two elements explains a lot of the success of search funds as an asset class - growing, scalable companies being led by outstanding young leaders motivated to leave their mark is a potent combination. The remaining factors are perhaps smaller, but no less vital in creating the extraordinary success found in this category of investment.
Incentives, Governance, and Leverage
The final pieces that tip the scales in favor of successful outcomes for search fund-backed companies are a mix of structural components.
First, search fund CEOs receive attractive salaries and annual cash bonuses, but the vast majority of their earning potential is in the form of equity. If their business performs well enough, the value of the CEO's equity can be worth millions of dollars. In a nod to Charlie Munger, Warren Buffett's business partner at Berkshire Hathaway, search fund investors know to never underestimate the power of incentives and use this to everyone's benefit.
The second structural element is the existence of a high-caliber board of directors, something most small companies lack. In the case of search funds, companies are able to tap their investor base to recruit members to the board. These individuals are very successful investors and operators and bring a wealth of experience. The board helps the CEO to avoid crucial mistakes, but also frequently go above and beyond to bring relationships and skills to the table that materially benefit the business.
Lastly, search funds almost always employ some degree of debt when they purchase a company. Used prudently, this helps to amplify the ultimate returns to equity holders and also often serves as a prudent governor on overly-ambitious growth plans that might just as easily light cash on fire as deliver more value to shareholders.
A 5-Star Recipe for Success
This mixture of high-potential, but largely untested operators, established, enduringly profitable companies with relatively simple and scalable operations, and the right incentive, governance, and capital structures is a well-honed recipe for investment and business outperformance.
Regardless of the role you hold in a business, understanding the characteristics and forces at play that create an indisputable competitive edge is worth careful consideration.
Coffee Chat Success!
We've finally done a final debrief on our first virtual Coffee Chats that were held in late June and wanted to share a sample of the results.
A couple of quick highlights:
82 people connected
The participants were comprised of ~⅓ searchers, ~⅓ prospective searchers, and ~⅓ SMB CEOs and operators
Three of our favorite testimonials:
“A fantastic group of people aligned around a shared mission of making small businesses better. What isn't to love!”
“I enjoyed the coffee chat and I felt like it was a great way to connect with someone else in the searcher space who I wouldn't have otherwise been able to meet. I think it's a great way to find mentors, partners, friends, and opportunities.”
“Being able to connect with someone who is in business and "gets it" was a great way to start a Friday.”