The Key to Value Creation in the Search Fund Model

As I have noted elsewhere, the search fund model has three distinct phases: 1)deal sourcing, 2) closing the purchase, and 3) running the company. Each of these three activities is necessary and important for a successful search fund. As I talk to current and future searchers, search fund investors, and CEOs of search fund companies, I’ve been asking myself which of the three phases of the model is the most important in the creation of value for cash and sweat investors. 

One reason that this question is so important is that certain backgrounds, interests, skills, and personalities will do better in each phase of the search fund. And each phase is extremely different in what it requires of the searcher.

My conclusion is that sourcing and closing are prerequisites for creating value in the search fund model, but they don’t generally determine the return generated by a particular search fund. I suppose it is possible, in theory, to buy an amazing company at such an amazingly good price that a chunk of return is built on day one. But I have never seen that happen.

What I have mostly seen is that a successful searcher will find a good company at a good price. And then, generally, when they get the keys to the castle, they realize that the company is actually a whole lot more challenged than anticipated. The bootstrapped businesses that show up as targets in search funds do so for a reason. The opportunity lies in the lack of professional management. Generally speaking, these businesses consist of a recurring revenue model that’s profitable despite the fact that customers aren’t really that happy, the product isn’t that good, and the existing employees are unsophisticated. Some of this becomes apparent during due diligence, but the bulk of it doesn’t really hit home until the searcher’s first day on the job as CEO. 

As a result, I would argue, the bulk of search fund returns depend upon how good the searcher is as a CEO, not how good he or she is as a searcher. To generate IRRs of 35%+ over a reasonably long period of time, the CEO of the search funded company has to get a whole bunch of difficult things right. This is important to keep in mind when thinking about whether a search fund is the right option for you as an MBA student, when evaluating search fund PPMs as an investor, and when thinking about how picky to be as a searcher in terms of target company quality and price.

In light of these considerations, the intangible that I am looking for when talking to potential searchers is maturity (which is somewhat correlated to age, but certainly not the same thing). Running a company requires leadership, people skills, an ability to absorb complex information quickly, and a knack for making tough decisions without looking back. Even the best MBA programs cannot teach these qualities. If I had to choose, I would probably prefer someone with an operating background rather than pure banking, PE, or other finance work experience. But that matters less than my general sense of how well I think the individual would do when faced with the reality of their company on their first day on the job as CEO.

As a searcher, there is no silver bullet to outsized value creation in the search fund model. As I’ve been arguing here, it’s not about buying the company perfectly at the start, it’s about the blood, sweat, and tears of running a company well over a long period. That said, here are some things to keep in mind as you do your search and dig into the real work of leading your organization forward.

• redacted Get the foot in the door with your acquisition and then figure out some way to blow it out. The sector doesn’t have to be huge to support a company that is many times the size of the one you buy. But you have to have a very clear, hopefully dummy proof, way of building scale once you are on the ground. Maybe it’s rolling up smaller competitors, or building professional sales and a solid marketing machine, or expanding into contiguous geographies. Whichever way you go about it, growth is the key. And you need a well thought out plan.
• redacted I’ve yet to be involved in a search fund where the searcher showed up as CEO and was pleasantly surprised by the quality of the employees on the ground, particularly at the senior level.   The tight-rope walk early on is to keep momentum going with the team on the field during the transition, while at the same time surgically upgrading at key spots. In the end, you will not be able to do this alone, and will need to successfully recruit great people into your organization in order to help you execute your growth plan.
• redacted Start by spending a lot of time with your customers and listening to them. Most of the search fund CEOs I’ve been involved with had been under the impression that the customers were happy when they bought the business, only to find out that the founder had propped them up through personal relationships, leaving the actual business relationships in a shambles. It is common to lose a few customers and have a horrible net promoter score right off the bat. Recurring revenue and lack of options will keep the bulk of the customers on the books; but to grow and thrive you have to figure out how to make your customers happy. So start by listening to them and build your plan based on what they tell you.
• redacted In almost all of these situations, doing more of the same will not take you to the Promised Land by itself. You will need to invest in making the product better, or perhaps even building something new from scratch to really address the market you are going after. Particularly in technology intensive businesses, building the right product is a make or break decision. That’s why my general advice is to put it off as long as you can. Stabilize what you’ve got for sure. But recruit great people into your organization, spend as much time as you can with existing customers, build a professional sales and marketing team that allows you to understand clearly what new customers really want, and build some operating momentum. Only then bite the bullet and invest in product development.
• redacted Leadership is all about communicating clearly where you want your organization to go and how you want to get there. It’s also about inspiring people to follow you. I often find that search fund CEOs underestimate the amount of time they need to invest in human resource related activities—not just recruiting, but moving existing players around into the optimal configuration, building a robust review and professional development process, goal setting, and establishing mechanisms for accountability from top to bottom. The importance of investing effort into building a positive, caring, and success oriented culture also tends to be overlooked. These things are all crucially important and very time consuming. And not every MBA coming out of investment banking is going to be naturally good at them. But if they want to build value in a search fund they will need to learn in a hurry. 

I’ll stop there. This list is not meant to be exhaustive by any stretch of the imagination, but rather just five tidbits for you to chew on as you think about taking on a search, or are already doing your search, or have just taken your seat in the CEO chair for the first time on the first day of your job.