Investor expectations on 5-year IRR?

November 08, 2022

by a searcher in San Diego, CA, USA

I am a self-funded searcher planning to raise equity for a technology service business with an annual EBITDA in the $0.7-1.3M range.

What are the IRR investor expectations assuming an exit after 5 years?

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Reply by a searcher
from London Business School in London, UK

Saadat Adhmed's reference can be supplemented by the Pepperdine Private Markets Report (https://bschool.pepperdine.edu/institutes-centers/centers/applied-research/research/pcmsurvey/#:~:text=The%20Pepperdine%20Private%20Capital%20Markets%20report%20is%20an,Banks%2C%20Venture%20Capital%2C%20Angels%2C%20etc.%29%20for%20private%20businesses.) and a similiar report from Imperial which is not open access. If the data is to be believed, IRR expectation have been decreasing, and are higher in the US. PE firms still reference high returns, investors expect what Saadat mentioned. But while the returns have decreased, as the Economist notes one thing is important to the industry - keeping standards high with fees (Google Economist Zilch Capital Investor Letter).

"Some parts of the lexicon will not see style drift. We are still trying to keep alive “two and twenty”, the industry's shorthand for 2% management fees and 20% performance fees. It is, we're sure you'll agree, important to keep up some traditions. Thank you for your continued partnership."

Reply by a searcher
from London Business School in London, UK

I would have to disagree. I have worked with PE funds and generally they are looking at an IRR of 15%, or 2x MoM over a 5 year period. (https://www.bvca.co.uk/Research/Industry-Performance#:~:text=This%20report%20demonstrates%20the%20returns,since%202012%20is%2022.6%25%20p.a.). The asset is often a low risk asset, yes their is conxentration risk ie one company but the criteria is very conservative.The reason why a search fund investor is looking at higher is probably a few things 1. The CEO is often less experienced (therefore is higher risk) 2. The CEO often doesn't put in any equity (so has no skin I the game) 3. Market dynamics (there are only a few investors who invest specifically in search funds and a lot of searchers so they get to choose terms). 4. It's a small amount of money per deal compared to PE, but since its usually individuals investing so investors factor in the above risks and need to be incentivised.

What would be interesting to see is if the expectations are adjusted due to inflation/ interest rates. As a conservative investment class, businesses which search funds invest in will now have to growth at probably a faster rate to meet what the criteria of an investor. However i think that point 3 will still hold true, and imaybe that investors derisk their investment by adjusting points 1 and 2 above, coz who wants lower returns right?

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