A little-known investing model provides Wall Street veterans and newly minted business school graduates alike a way to buy into entrepreneurship, but not without risk.
Search funds, small pools of capital that seek to buy and manage lower-middle-market companies, are an obscure investing concept that could place a budding entrepreneur on a fast track to running a self-sustaining operation. These funds also provide professionals facing an uncertain future on Wall Street with the opportunity to take the helm of a small, often anonymous, company backed by a limited group of investors.
Though search funds have realized few major successes, they do tap into a robust American tradition of rising from humble origins. Insurer MetLife Inc. traces its roots to a two-room office in 1868 where six employees built the insurer from the ground up, and Hewlett-Packard Co. famously started in 1939 with a pair of Stanford University graduates working in a Palo Alto, Calif., garage.
One of the biggest successes attributable to search funds is Asurion Corp., one of the world's largest providers of cellphone insurance, which was sold to two private equity firms for $4.2 billion 12 years after being purchased by a search fund for $8 million.
Search funds effectively function like micro buyout shops. In a typical search fund, one or two prospective entrepreneurs round up between $250,000 and $750,000 from outside investors to finance the hunt for an attractive business, a process that usually takes between a year and 18 months.
The funds typically solicit capital from high-net-worth individuals, and may also tap family and friends for cash in $30,000 or $40,000 chunks. If the search fund principals, known as "searchers," manage to broker a deal with a target's owners, they then seek a second round of financing from their investor base to buy the company.
"The essence of a search fund is that people have been buying and selling businesses for thousands of years. It's sort of a normal part of commerce," says Rich Kelley, principal and co-founder of Menlo Park, Calif.-based Search Fund Partners, created in 2004. "We are a private equity fund that invests in small LBOs, and we source 95% of our deals through the search fund model. We're normally paying around 5 times Ebitda [for a target], which is well below what the private equity market pays for their deals."
Depending on the size of the investment pool, search funds typically buy companies for between $5 million and $15 million. Investors accept equity stakes in the target, while the search fund principals seek to expand the business, generate returns and eventually sell it for a profit.
The first known search fund was founded in 1984, according to a 2009 survey by the Center for Entrepreneurial Studies at the Stanford Graduate School of Business. The survey estimates that 129 search funds have raised capital for the first time since 1984. Of those, 41 are still searching to acquire a business, 33 are operating the companies they acquired, and 55 are "terminal."
Of that last group, 20 acquired and successfully exited their businesses, 16 shut them down without selling them, and 20 others ended their search without ever acquiring a company. Stanford has published a study on the search fund world every two years since 1996.
H. Irving Grousbeck, a director of Stanford's Center for Entrepreneurial Studies, says he first encountered the idea of search funds in the early 1980s when he was teaching entrepreneurship at Harvard Business School and two students started raising money and searching for a small business to buy. "They raised $80,000, they ran through that, they raised another $40,000, then [about] another $30,000 to actually do the due diligence and close the transaction," he recalls. "This is 27 or 26 years ago, so you can make those numbers much larger now."
According to Stanford's study, the number of search funds raised has increased every year since 2005, partly as a result of the tough economic climate. Some Wall Street veterans who lost jobs during the financial crisis or are looking for new opportunities have started search funds. Investors too are increasingly turning to search funds as a more palatable alternative to other funds, like private equity.
Perkins Coie LLP partner Theodore W. Wern says the search fund model (or pledge fund, as his law firm calls it) is more flexible than the typical private equity-style committed fund. For example, it allows for one particular search acquisition to be used as a test case by those who are investing.
"A committed fund is, you make a commitment for years to write checks every time I find a deal, and you don't really have an option. You just write the check and it's a contractual obligation," Wern says. "I think those are just harder to sell these days."
Wern's practice works with about 20 search funds that originated from Harvard and Stanford. "After the financial crisis, I think there are a lot of folks who used to commit to a private equity fund that are no longer interested because of the length of the investment. You may pony up a $100,000 commitment [in that case], and then you know you're writing checks for the next four years and you may not see a dollar for eight or 10 years."
To be sure, the search fund process also requires patience. Stanford's survey indicates that the 88 search funds that responded to its poll were looking into a median number of 306 acquisition targets. Many searchers struggle for a long period to find a suitable acquisition.
"We were funded by 12 limited partners -- Search Fund Partners is one of them. We've been on the hunt to acquire and operate a small business since the end of 2008," says Charles Burckmyer, managing partner of Knob Hill Partners LLC, adding that he is searching for a technology company. "We've been rattling around, putting out offers and trying to get something done ever since."
Though it has proceeded with caution, time seems to be running out for Knob Hill. "At this point we are basically at the end of our rope in terms of funding, but we have two companies under agreement. My partner Scott [Noll] and I are each trying to close our own respective deals. We'll share the economics between them."
More to the point, even the most disciplined, business-savvy entrepreneur is not guaranteed success. According to Stanford's survey, nearly one-third of all search funds launched to date have wiped out all of their investors' money. And only 38% of all search funds have ever posted a positive return, a track record that would surely frighten the average investor. Moreover, of the 129 search funds raised since 1984, the 20 funds that have acquired and successfully exited businesses represent just 29% of all known search funds that have made acquisitions over the history of the asset class.
Without question, Asurion is the largest successful search fund exit. Jim Ellis and Kevin Taweel, a pair who had studied with Grousbeck at Stanford, bought the company in 1995 when it was a 45-employee business called Road Rescue Inc., providing assistance insurance through local wireless carriers to their users. They soon realized that they were not in the roadside-assistance business, but, rather, in the cellphone services business. In 1999, they expanded into insurance for loss or damage to cellphones.
Bolstered by three acquisitions in 2005 and 2006, Asurion grew to a company with $2.5 billion in revenue and more than 5,000 employees. In 2007, Ellis and Taweel sold the company to Providence Equity Partners Inc. and Madison Dearborn Partners LLC for $4.2 billion.
Ellis and Taweel were fortunate to buy into the business just before a huge expansion in cellphone usage occurred. "Now [Asurion] has 98% or so of the domestic market for cellphone insurance," Grousbeck estimates. "You've got to have an exploding marketplace. You're just not going to get that [growth] from taking market share away from competitors."
The original investors in Road Rescue received more than a 100-fold return on their stakes.
Another company with search fund origins is service revenue manager ServiceSource International Inc. of San Francisco, which was bought in 2003 via a search fund by David Kennedy and Mike Smerklo. The company went public on March 24 in a $119.4 million offering, selling 11.9 million shares for $10 each, greater than the estimated $7.50 to $9 per share target price range. Smerklo remains ServiceSource's CEO; Kennedy is still an investor in the company.
Despite a few success stories, pursuing a career as a searcher is somewhat of a high-risk maneuver for a classically trained M.B.A. "I think the challenge is that we're ultimately going to be making kind of a five- to 10-year bet on our lives," says Will Bressman of San Francisco search fund Rushmore Partners.
He and partner G.J. King met at Stanford, studied under Grousbeck and finished raising their fund about eight months ago after graduating. Bressman declines to say how much his fund raised, but says he and his partner are searching for a business services company to run.
If a bet doesn't pay off, an entrepreneur could damage his or her career almost as soon as it begins. Indeed, the median age of searchers among those who participated in Stanford's study was 31. "The biggest risk is that you don't find a company," Kelley says. "Then there's a 2-1/2-year hole in your résumé where you were making $90,000 a year and your peers are making $150,000 and moving on in their careers, and you've got nothing to show for it."
By Kelley's estimation, at least one-quarter of searchers fail to ever make an acquisition. The alternative could be worse, however. A fatal trap is making a bad bet, or as Kelley puts it, "raising 5 million bucks and losing it by buying a crappy business."
Life as a searcher is one under a temporal gun. "You're working against a clock. You're spending money every day, and once you run out of money, your search fund is done," says Gareth Dickens, a managing partner at Portsmouth, N.H.-based search fund Market Square Capital LLC.
Dickens says he and partner Max Puyanic, whom he met while working in the mergers and acquisitions group of Chicago's William Blair & Co. LLC in 2002, started raising their fund in the summer of 2009, amassing about $600,000 in an initial round of fundraising. "We're still searching. We talked to about 500 companies, maybe more."
Kelley explains that search fund investors are aware that they are backing a first-time executive. That being the case, one of the more bankable deals searchers can make is for a company with a recurring revenue stream and operations that are not too complex.
"We don't want them to have too many moving parts," Kelley says, citing alarm and security and software-as-a-service businesses as good examples of companies with "sticky" customers. "You're not selling to them every day; you've already sold to them, and now they pay every month," he explains.
For example, Toronto's Auxo Management LP, a search fund launched on Sept. 1 with backing from Kelley's Search Fund Partners, was seeking targets in back-office healthcare services and information technology. It closed a deal on April 8 to acquire UCIT Online Security.
"We contacted hundreds of companies; a lot of them were inbound. We got good dealflow from intermediaries," says Auxo managing partner Erik Mikkelsen. "We probably looked at 160 deals. We signed over 60 nondisclosure agreements. We knew about 20 companies we really liked and settled on this one for now."
Mikkelsen declines to reveal the price his firm paid for UCIT, but says the target had annual cash flow of about $2 million to $4.1 million. "[Search funds'] access to the capital markets has improved as the concept has become somewhat validated, and funds-of-funds have cropped up -- people raising money to invest in search funds, develop a portfolio of operating companies bought out of search funds," Grousbeck says. "It seems to be gathering a little bit of momentum in a small way, but it's still a small factor in the whole economic picture."
After all, as Kelley points out, not everyone is cut out for the search fund world. But for those who live it day to day, the reward -- if not always a monetary one -- is worth the grueling lifestyle.
"You have to be a deal guy. You have to talk to bankers and investors, and through all that, once you get a deal closed, you walk in the next day and now you have to be a CEO," he says. "You have to wear a lot of hats. ... It's [an] enormously challenging but fulfilling job."