So what is a Search Fund anyway?

Earlier this year I was invited to speak with some of my Search Fund colleagues at the Growth Capital Forum in Sydney. The brief was to talk about the relatively recent emergence of Search Funds in Australia. Heading in to the event, I was unsure of what to assume regarding the audience's level of Search Fund knowledge / experience, so I kept an open mind.

On reflection, and following a number of conversations over drinks after the event, it was clear that I should tell the story of my journey with Search Funds as a method of helping others to understand what they are, how they are growing in Australia and what it might mean for them (as investors and / or entrepreneurs).

The article below was originally published in the March edition of the "Australian Private Equity + Venture Capital Journal" and I've reproduced it here for those who didn't see it there or might find it a useful reference in the future...

My Search Fund Journey so far

In late 2012, after 15 years navigating a relatively diverse corporate career, I decided that I wanted a change of scene. I wanted to own and operate my own business but I didn’t have any fantastic new ideas on which to found a start-up, so I set out with a mate of mine to buy an existing small business of our own. Six months later we bought a small mining services business and I dropped in as the new CEO. Over the next few years, we bought a few more businesses and I dropped in as CEO a couple more times. Before I knew it, I’d introduced myself to the concept of “Entrepreneurship through Acquisition” (or EtA) - even though I’d never heard the phrase!

Fast forward to 2020. I had made myself redundant from the CEO roles I had played in the businesses we’d bought and was reflecting on my next role of the dice. I loved the small business owner experience, so I knew I wanted to stay close to the action. I felt a real affinity for businesses of that size (c.10-100 employees) and the common challenges / opportunities they faced, so I didn’t want to own or operate anything much bigger. Whilst I didn’t want to jump back into the driver’s seat, I really enjoyed my role as a non-executive director, working closely with CEO’s to help them learn, grow and achieve success for these great small businesses.

I was also well aware of the challenge facing Australian SMEs, given the hundreds of thousands of business owners who will look to exit this decade but do not have a succession plan in place to do so. These owners typically have great pride in their legacy and want to leave their business and their teams in safe hands. However, many of these businesses are either too big to simply handover to management and too small to attract interest from Private Equity or Trade buyers.

So I started looking for a way to keep investing in small businesses in a hands-on way, whilst staying close to the action by working closely with CEO’s, without diving back into an Executive role. That’s when I came across the Search Fund model, which was well established offshore but still nascent in Australasia.

Essentially a Search Fund is a vehicle via which investors can back EtA in a hands-on way, through a well-aligned structure. The more I learned about Search Funds (and the more engaged I became with the global Search / EtA community), the more I was hooked. As a result, I’ve spent the last few years investing in Search and doing what I can to support the growth of EtA and Search across Australasia.

So let’s break down a few of the fundamentals. EtA is a form of Entrepreneurship whereby the Entrepreneur acquires an existing business to own and operate, rather than starting their own from scratch. This Entrepreneur isn’t looking to invest in multiple businesses, nor build a portfolio, they want to own their own business and be the CEO.

Sometimes, however, the Entrepreneur doesn’t have sufficient capital, or cash flow, to either support themselves whilst looking for a business and/or fund the acquisition of the business when they find it. So they look for investors to back them and this is when they establish a Search Fund. Unfortunately the word “Fund” can be misleading because it implies that the vehicle will acquire multiple assets, whereas a Search Fund is established to acquire only one operating business (nb: bolt-on acquisitions are possible but they are strategic trade acquisitions, not designed to build a portfolio).

There are a few variations on the theme in the market, so in this article I will focus on the most plain vanilla version of the model to create a baseline. If you come across variations, I would suggest you tie them back to this baseline and then focus on the differences to understand the variant.

From an investor’s perspective, the first unique attribute of a Search Fund is that you are backing the Entrepreneur first, rather than the business, because frankly the Searcher hasn’t found, let alone bought it yet! It’s like backing the jockey before you know which horse they might ride. There are similarities to VC, in that many VC investments ride on the Founder’s reputation as much as (if not more so than) the idea. However, it’s very different to PE, in which the business is chosen first, before the Jockey is then recruited to extract value. That said, investors in PE funds do commit capital on the reputation of the PE firm before they know the businesses that will be bought into the fund, so there is some parallel there.

Anyway, point number one is that Search Funds are first and foremost about backing an Entrepreneur to become a business owner.

The second attribute is the commercial structure, which whilst unique to the Search Fund model, has been tested over many decades across the globe and is therefore proven to work well. A few principles underlie the commercial structure:

(i) The Searcher will become the biggest single shareholder if everything goes to plan (i.e. they will be the business owner they aspired to be);

(ii) Whilst that incentive is large, it is all vested in equity only available on exit and they really have to work hard to access it (i.e. the incentive is aligned to investor returns); and

(iii) No single shareholder is in control of the vehicle (i.e. it is truly collaborative).

Every jurisdiction has its own flavour and documentation to deal with specific legislation, however in very simple terms there are two phases to the investment: Search and Operation (or sometimes “Acquisition”).

To kick off their Search phase, the Searcher will raise Search Capital to fund a nominal wage for themselves and other expenses (e.g. travel, research, interns, etc) whilst they look for a business for about 12-24 months. They usually raise c.$500k from c.10 investors (i.e. $50k each) for this phase. In return for taking on the increased risk of this “Seed” capital, the Search Investors receive two primary benefits:

(i) first rights (with no obligation) to invest in the Operation phase when a business is identified to acquire; and,

(ii) a 50% step-up for their Search capital when it rolls into the Operation phase after acquisition (i.e. $1 of Search capital rolls into $1.50 of capital alongside the additional capital raised for acquisition).

Once the Searcher secures a deal, they raise Acquisition Capital to fund the transaction that takes them into Operation. More often than not, the Searcher will raise this second round from the same investors (in the same proportion) who backed them during the Search Phase (even though those investors are not obliged). For example, the Searcher might acquire a business for $10m and fund it with $5m equity, plus bank debt, a vendor note and some element of earn-out. That $5m will constitute (say) $500k per investor. In the same way that Search Capital is a bit like “Seed”, this Operation (or Acquisition) Capital is a bit like “Series A”.

It’s at this point when the Searcher’s incentive kicks in. During the Search they’ve probably been earning c.$110k p.a. and when they take their new CEO role (given the size of the business), they’ll probably earn between $150-300k gross. Typically the calibre of most Searchers would attract much larger salaries in traditional roles, so a material equity incentive structure is used to make Search pay off for the Searcher. And simply put, it looks like this:

(i) 8% of the shares on acquisition (like an acquisition fee);

(ii) 8% over the subsequent four years (like a management fee); and,

(iii) 8% on exit if investors achieve target returns (like a performance fee),

giving them the opportunity to vest up to c.25% of the equity.

All of this incentive is held back until a full exit is achieved. This structure is a significant incentive for the Searcher and is ‘entrepreneurial’ in nature, given it’s purely linked to real value creation on exit. It’s also very reasonable for the investors over a 5-10 year hold, given there are no other fees involved.

So in summary, point number two is that the commercial structure creates tight alignment between the Searcher and the Search Investors, whilst providing excellent opportunity for returns for both.

The third unique point worth noting is the active role that all investors can (and should) play in mentoring the Searcher through the journey. Having been invented in Harvard and popularised at Stanford, the model was founded on the principle that the investors are not only there to provide capital but also to mentor the typically inexperienced Searcher through their journey to becoming a seasoned CEO and business owner.

The first two points I’ve raised above were not inherently new to me when I came to the Search Fund community. I had experienced first hand the fact that good operators, without business ownership experience, could drop in to existing small businesses and create real value. It was this third point that continues to excite me most about the Search Fund model.

One of the things that I love about small business is the hands-on nature of the investment. Even though I wasn’t going to jump into the CEO driver’s seat again, I still wanted to be close to the action and as a Search Investor I get the benefit of staying close to the Searcher / Operator throughout their journey - so even selfishly for me, this is a great attribute of the model!

Then from the Searcher’s perspective, this “Investors as mentors” approach is uniquely valuable because they know that investors in Search are keen to provide more than just dumb money - these investors really want to help and are ready, willing and able to do so! The best Searchers work hard during their fundraising to actually curate their share register by targeting a range of investors who can then provide the best bench of experience, networks and mentoring to draw on during their Search journey - what better way to start your entrepreneurial journey than with a stable of investor experience sitting behind you.

And finally, this mentor approach underwrites real collaboration amongst investors, not only on specific investments but across the community. We all want to work and co-invest with the best Search Investors because sitting alongside these great people will maximise the returns from any investment you make and as an investor you can learn heaps from your co-investors along the way!

I don’t hide the great Searchers I find and keep them all to myself - I spread the word as quickly as I can, to the best investors I can find. This gives the Searcher the best chance of closing their fund (so I have the opportunity to back them) and ensures I’m sitting with a great bunch of co-investors so that we can all benefit from each other's experience and perspective along the way.

EtA and the Search Fund model are exciting for Entrepreneurs, Investors and Business Owners alike. These key attributes I’ve described uniquely position Search Funds as a solution to one of the biggest transitions of private business ownership that we’ve ever seen in Australasia (and across the globe):

• Business Owners can achieve an exit that properly values their business and puts their legacy in safe hands.
• Investors access the unique returns profile of small private businesses whilst aligned with a capable CEO.
• Entrepreneurs can forge a path to business ownership and leadership, whilst supported by a deeply experienced and engaged register of shareholders.

We’ve only really scratched the surface of what is possible with this model in Australasia and I’m excited about what the future holds for all stakeholders. I’ll keep doing my best to support the community and back the business owners of the future. If you would like to learn more (whether you’re an investor, owner or entrepreneur), please reach out to me or any one of the great people in our community!