Enterprise Explains: Search funds. Exactly one year ago, we wrote about alternative investment vehicles that were popping up in Egypt’s StartupLand in 2021, including venture debt and venture studios. Today, we dive into one that is not suitable for startups, but for small- and medium-sized enterprises: The search fund.
What are search funds? These are investment outfits that raise funds from investors to acquire a small- or medium-sized business (SME) that is already operating well in the market, to then grow it and ensure return to their investors. Through the acquisition, the CEO of the company is replaced with a seasoned entrepreneur to lead the company for about 6-10 years, according to Stanford Business’ 2022 Search Fund Study (pdf).
The concept originated in academia in 1984 at Harvard Business School, Stanford writes, when director of the center for entrepreneurial studies Irving Grousbeck coined the term that would then be taught in several top-tier MBA programs around the world.
Ever since, it has been gradually gaining traction: The US and Canada have seen a total of 526 search funds raised since the concept’s inception nearly four decades ago, according to Stanford. In 2020 and 2021, these vehicles drew in some USD 776 mn of investments. Outside of the US and Canada, the year 2021 saw 44 new international search funds raised, and 23 companies being acquired, according to IESE Business Schools’ report on international search funds (pdf).
What’s in it for business owners? A chance to exit. SMEs usually don’t have a lot of investment options, our sources agree. If business owners want to retire and don’t have a succession plan in place, it becomes hard for them to exit the company in a safe manner.
What’s in it for investors? Safer, higher returns. In 2021, the aggregate pre-tax returns for investors stood at 35.3% in terms of internal rate of returns and 5.2x in return on investment in the US, Stanford writes. “Search funds have a lower risk profile than venture capital and private equity [outfits], but higher returns,” managing partner at search fund Giza Capital Partners Ahmed Raafat tells us.
What’s in it for entrepreneurs? A company to run. It gives entrepreneurs the chance to lead and grow a company without the risk and stress which usually accompanies building a company from the ground up.
So how does it work? So-called searchers — usually the entrepreneurs looking to acquire the company and lead it — reach out to investors to chip in a small amount of funding that would be able to pay the searcher’s salary and operating expenses for about two years. They then look for a company in which they acquire an 85-100% stake. Entrepreneurs then operate and grow the company for a few years, before they and other investors exit from the company.
Sounds a lot like private equity (PE), right? Well, not quite. PE firms typically have a portfolio of several companies in their basket to diversify the risk of each investment, and sometimes bring in their own management teams. For the most part, search funds are only interested in investing in one company, and the entrepreneur who raises the fund usually becomes the head of the acquired business, Australian search fund SME Ventures writes. Additionally, search funds don’t have a fixed date by which they have to make returns for their investors and have a more involved set of investors, unlike PE firms.
The size of the acquired company and the risk level associated with search funds also differ from those of PE and VC funds. We’ve heard quite a few investment values regarding the size of the to-be-acquired companies, ranging from USD 5 mn up to USD 25 mn. This is usually too small for a PE firm to look into, while PE firms also focus on having a bigger portfolio than just a single company, our experts agree. Additionally, given that search funds acquire companies that are already comfortable players in the market, they are less risky than startups that still have to gain a solid footing.
What should the company in focus look like? “We look for profitable businesses with potential growth, and where the owner has a clear need to exit,” Raafat says. More specifically, the company should have a predictable cashflow and an EBITDA of EUR 1-5 mn, with an EBITDA margin of 15% or above, managing partner of Spain-based search fund Moonbase Capital Ibrahim Abdel Rahim tells us. It should also operate in a fragmented market with no clear monopoly, he adds.
And the entrepreneur coming to take over should be seasoned. The entrepreneurs coming in to lead the company should have at least exited a business before and/or have an MBA, based on what experts told us.
Stay tuned for our next story on the status of search funds in Egypt, where we highlight the main players of the industry and the challenges they’re facing.
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