Businesses that are looking for equity funding, but aren't quite large enough to attract private equity, have another option: the search fund. These are "vehicles for entrepreneurs to raise funds from investors interested in making private equity-like investments, but more directly and on a smaller scale," says Mark Albert, partner in the Emerging Companies and Private Equity practices at law firm Perkins Coie. Albert represents more than 35 active search funds.
Search funds are a cross between venture capital and private equity, Albert says. They're "venture-esque" in that the search fund industry remains a small one. "Everyone knows each other," he says.
But, they're like private equity in that the individuals behind the funds usually are a couple of recent MBA grads, often from an elite school, who decide to form an entity to raise money, and then search for a company to acquire and run. "The acquisition aspect is similar to private equity," Albert says. Also like private equity, search funds tend to use a multiple of earnings in order to determine an acquisition price.
There's a key difference to private equity deals, however: search funds tend to target companies that have smaller enterprise values and thus don't hit the PE radar screen, Albert says.
Many search funds target cash flow businesses, Albert says. "They're companies that have products and are making sales; they're usually cash flow positive." Most are under about $20 million in value, and many are service businesses in sectors such as health, education and technology. One reason for the popularity of service companies is that they tend to be easier to understand than manufacturing firms; there's no need to account for inventory, work in process and the like.
The search fund market still is an emerging, albeit growing one. Albert says that while three or four funds used to form each year, that number has jumped to 15 to 20 funds over the past several years. Several factors are converging to drive growth, including the fact that a number of business school graduates don't want to work for someone else, Albert says. One option is to start a search fund and look for a company to acquire. "Then, they don't have to get a real job. They can work for themselves."
Some investors haven't make out too badly, either, although it can be a wild ride. A recent study by the Center for Entrepreneurial Studies at Stanford Graduate School of Business found that the aggregate pre-tax internal rate of return of a group of 100 search funds through year-end 2011 was 34.4 percent. However, the study notes that some funds lost all the capital invested. When the researchers excluded the five funds with the highest returns, the overall IRR fell to 20 percent.
At this point, the search fund market is similar to the venture capital market in the early 1980s, just before greater amounts of money starting flowing into it, making deals more competitive, Albert says. The venture capital market currently totals between about $20 and $25 billion, while the private equity market measures in the hundreds of billions of dollars, he estimates. The search fund market, in contrast, tops out at about several hundred million dollars.
Given the sizes of the deals typically done by search funds, it's unlikely this market will grow to anywhere near the private equity market. However, "if it does get to be as big as the venture market, it would be great," Albert says.