Differences in Equity Structuring: Search Funds vs. Traditional Private Equity and LBOs

August 19, 2023

by a searcher from University of Lethbridge in Edmonton, AB, Canada

Hi Community:

I hope this message finds you well. I've been delving deep into the world of private equity investments and, in particular, comparing traditional private equity (P/E) models with the increasingly popular 'search fund' model. I'd love to solicit your insights and opinions on a few observations and queries that I have:

1-Traditional Private Equity (P/E) Model: From my understanding, the traditional P/E model typically follows an 80/20 structure. That is, 80% of the returns are allocated to Limited Partners (LPs) while the remaining 20% goes to the General Partners (GPs). This model seems relatively straightforward and has been the industry standard for a while.

2-Search Fund Model: According to studies from Search Invest Group (SIG), the equity structure in search funds tends to be quite distinct. It appears that the majority of the equity, ranging between 60% to 80%, is retained by the general partners who operate the company. This is a stark contrast to the traditional P/E model.

Points of Curiosity: My main question revolves around the fundamental reasons for these differences in equity structuring:

Do traditional P/Es not utilize debt in their transactions, similar to Leveraged Buy-Out (LBO) transactions? If they do, who typically assumes the liability of this debt? Are traditional P/Es primarily financed by equity rather than a combination of equity and debt? Why is it that in search funds, the majority of the equity stake goes to the operators (GPs) rather than the investors (LPs)? Is this due to the operational involvement of GPs in search funds, or are there other underlying reasons? I genuinely believe that understanding these nuances is crucial for both investors and entrepreneurs in today's dynamic investment landscape. Your insights and experiences would be invaluable in shedding light on these topics.

Thank you for taking the time to read and engage with my queries. Looking forward to our collective wisdom.

Warm regards,

Mason Darabi

Reply by a searcher
in Rindge, NH 03461, USA

Mason, If you think of the entrepreneur in the search fund model as a 'single entity PE firm' the equity structures are the same. They are actually identical with the exception that PE firms usually raise a fund of money before finding companies and private searchers find a company first then line up the funding. They are both entrepreneurs using other peoples money to buy businesses. Some people even refer to small searchers as 'micro-PE'. The real difference is that the PE firm managers get a lot less of the deal, so consequently they have to find deals that will explode in value so they can make sufficient money to make it worth their effort. Single entity buyers get more equity so can get paid from 1 deal, and don't need to grow company 25-50x to get paid. So their target companies are different. I think the reason why the searchers end up with more equity is they typically use mostly debt to fund deals (such as seller financing) rather then all equity cash as equity cash is the most expensive money to use. So the Searchers cost of money is a lot less then PE firms. Thoughts?

IF you look at the historical 'success' numbers in the VC world, it is akin to gambling. The majority of the investments don't pay off, the majority of funds don't pay off as desired and the majority of VC firms don't provide the desired returns. They have to 'spread the risk' by buying multiple 'long shot' companies to try to hit it rich on at least 1 of them.

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