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This episode aired on BloombergTV on Jan 26, 2013

Search Funds

Search Funds are essentially micro-PE funds, run by small teams of professionals working with relatively small pools of capital. Such funds tend to have fewer investors who contribute less capital, and operate in the middle market, where it is not feasible for larger funds to invest. This space can offer attractive returns, but of course the gross figures are much smaller than we are used to seeing with typical PE.

Q. So this is a relatively new idea, right?

A. They’ve become much more popular lately, yes, but they started back in the mid 80s at Stanford Business School. They caught on at Harvard, too, but didn’t really start to take off until five or six years ago. And the term refers, essentially, to a micro PE fund.

Q. How “micro”? How do they work?

A. It’s a really interesting development that sort of parallels, in the PE world, the “de-institutionalization” that angels have brought to the VC world. Typically, a very small team, maybe 3 or 5 young executives, form a Search Fund. They raise a couple hundred thousand dollars and then go out and scour the world for small companies they can buy for maybe several million dollars (obviously, far less than any normal PE firm’s targets). They buy them, run them, and exit them, one hopes, at a big mulitple… really, micro PE.

Q. How do the finances typically work?

A. The founding team usually raises money from a circle of, say, 10-12 investors. The investors put up maybe $25 each to start, so there’s $250-300k in working capital for the management team. They spend that on barebones offices, tiny salaries, etc. as they look for a target… which can take quite a while, maybe 18 months. But the trick is that the investors have also committed to put up the capital for the deal itself, or at least enough equity to attract debt financing to get the deal done. From there, its typical PE story… operate the business for a few years and shoot for the big exit.

Q. Are these popular? What’s the trend look like?

A. Getting much more so for many reasons. Lower middle market companies can be excellent targets, but are too small for the big shops. There are a lot of talented execs, and recent MBAs, who aren’t exactly fully employed these days. Individual investors can play the PE game this way more easily than they can invest in the giant funds. And there are now platforms available, like Axial Market, that facilitate the deal discovery process, which is the hardest element by far.

Q. And what kinds of results are people seeing?

A. Hard to draw conclusions at this point; there are stats out there that indicate average IRRs of 30%, but off a small sample base. Like angel investing, its going to be some very bit hits and some total losses. But its an extremely interesting development for investors, would be executives, and the smaller private company world.