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The search fund model is a method of investing that enables entrepreneurs to take a unique path to business ownership. It is structured to help searchers (entrepreneurs who engage in the search fund model) acquire, operate and scale an existing business instead of building one from scratch.
By offering a rapid path to business ownership, and CEO status, search funds have created a new breed of entrepreneur — those who embrace the notion of plug-and-play.
A critical factor in the search fund equation is the economic upside searchers could see for their efforts. Historically, this has meant a 32.6 % internal rate of return and a 5.5x multiple on invested capital.
Related: How To Find Success During Search Fund Launches
Value creation
With competition brewing in the form of fellow searchers and even some traditional private equity funds showing interest in acquiring smaller businesses, how do searchers achieve their edge? They look towards combining two or more companies with synergies in size, geographic coverage, key personnel or supply-chain advantages — in other words, a consolidation.
Programmatic mergers and acquisitions (M&A), according to McKinsey, “remains the least risky approach with the smallest deviation in performance and the largest share of companies that generate positive excess total returns to shareholders (65%)” when compared to large one-off transactions, selective deals or organic growth.
What does this mean for searchers competing at the smaller end of the enterprise spectrum? It represents an opportunity to bring the tailwinds of M&A-based growth further downstream, and to industries it has yet to touch.
However, in a survey of 185 Entrepreneurship Through Acquisition (ETA) businesses purchased by Harvard Business School graduates in the past decade, only 8% have implemented a consolidation strategy of buying multiple businesses in the same industry vertical.
Challenges
The timeline and structure of search acquisitions are often limited to two years. Additionally, searchers are often freshly minted MBAs with limited operational and M&A execution experience, which makes adding an additional business target to acquire a daunting task. However, the benefits vastly outweigh the possible downside.
Related: Search Funds: What You Need To Know About This Investment Model
Advantages
With this business strategy inherently being an operational play, key considerations when looking for a second (or more) target could include financial and further operational synergies in the form of:
- Capital structure improvements from the combined larger size of the businesses
- Ability to take on additional debt at a lower rate
- Capital intensity reduction
- Shared fixed assets, working capital and capital expenditures
- Margin expansion from greater purchasing power and unit economics
- Valuation multiple arbitrage
- In a similar vein to “greater than the sum of its parts,” businesses when combined, often command a higher value than if they were to stand alone
Related: Data Security and the Downside Risk of M&As
Picking an industry
With that, what can searchers do to further de-risk a search consolidation? The answer to this lies in a refined thesis. Searchers with a background operating in a specific industry (i.e., healthcare) have an inherent advantage in launching a search with a focused thesis.
Finding an industry to commit to can be challenging for those with multiple passions. However, the following markers could indicate the right fit:
- Fragmented industry landscape (i.e., medical, dental, and veterinarian practices)
- Industries in which business owners primarily operate a single entity or location
- Mature and standardized industry operations
- Businesses that have relied on tried and tested practices over the years
- A large number of companies
- Many businesses serve a similar customer profile but in different geographies
- A large number of companies within the target enterprise value of the fund
- Understanding the average value of a business in a target industry can help filter out opportunities that are either too small or too large
- Historically stable growth and sustainable profit margins
- Businesses that have operated profitably for many years and serve customers who have (if B2B based)
Picking a business
Zooming in a layer deeper, companies characteristic of success in the search consolidation model touch on a combination of the following elements:
- Competitive industry advantage
- intellectual property, proprietary software, etc.
- Seller motivated to exit
- retirement, change in a succession plan, career transition, etc.
- Historically stable recurring revenue
- Strategic avenues for growth
- geographic expansion, marketing strategy, recruiting key personnel, etc.
- Alignment with the financial mandate of the search fund
- Viable exit vision over a five to seven-year horizon
Eight percent is a small but growing fraction of the ETA community that has chosen to tread the path of consolidation. As more seasoned operators and mid-career searchers get involved, the odds of a consolidation strategy becoming more commonplace is only set to grow. This next wave of search fund entrepreneurs could bring revolutionary methods in creative financing, operating and growing businesses — a win-win for budding entrepreneurs and seasoned operators alike!
Karl Eshwer
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