Three Investment Firms to Build in Search by 2030 -Search Fund Secondaries Group Annual Letter

Three Firms to Build in Search by 2030 – Search Fund Secondaries Group Annual Letter The search fund asset class is rapidly growing and maturing. The number of traditional search funds raised is at least 3x that of ten years ago, the number self-funded searcher and independent sponsor worlds have similarly exploded. However, it is still very small. The annual equity deployed into search deals is dwarfed by annual value of secondary baseball cards sales ($4B), or the annual voluntary carbon credit market ($2B). There is room for investor entrepreneurs to start firms that can ride the growth of the broader asset class. Luckily, originality isn’t a requirement, as we can look at the successful firms built in the late 80s and early 90s in the broader private equity markets, the secondaries firms, NAV lenders, industry and situation specific investors and apply their models to our world of search. In April of last year I launched Search Fund Secondaries Group (SFSG), to start moving search investments from entirely illiquid positions in enduringly profitable small businesses to mostly illiquid positions in enduringly profitable small businesses. With our first vehicle almost entirely deployed, and strong initial returns, I’ll soon be raising a second vehicle to continue towards my end goal, making these investments into somewhat illiquid positions in enduringly profitable small businesses While I am focused on building Search Fund Secondaries Group (in addition to supporting my amazing wife building a Montessori preschooland welcoming our third little girl in August), I encourage other entrepreneurial firm builders to continue the development of the Search ecosystem. In additional to the traditional search path of acquiring then operating an enduringly profitable small firm, I believe there are three firms that the Search Fund world needs over the next three years are a Net Asset Value (NAV) Lender, a Post Chapter 11 Distressed Specialist, and a search focused Sales – Leaseback Specialist 1st Firm to Build, NAV Lender for Search We bought our home near Vail, Colorado in the beginning of###-###-#### Getting a mortgage meant providing close to two dozen search investment K-1s to potential mortgage providers, and explaining to skeptical mortgage officers why the large negative income reported in the K-1 didn’t reflect the reality of distributions and appreciating capital. NAV Lenders currently provide financing to PE funds and family offices using their positions in the underlying portfolio companies as collateral. Typically the NAV loans are at low loan to value rates###-###-#### %), providing strong downside protection for lender. Proceeds from these NAV loans are used to either pull forward distributions or to fund additional investments. A NAV Lender focused on search would provide loans to individuals with significant, diversified search investments and to funds investing in search. For individuals investing in search, the strong historic performance of the asset class needs to be balanced by the lumpiness and unknown timing of distributions even in strongly performing deals. This uncertainty means investors need to hold larger cash positions to ride out these distribution dry spells (or to buy mountain homes!). For funds, the expected return on additional search investments would drastically outpace the interest rate charged by a NAV lender. For this future NAV lender, I’d argue that the collateral of a diversified portfolio of search positions is superior to that of a diversified portfolio of middle-market PE positions. The leverage in search deals is likely significantly lower (on a debt to EBITDA basis, not on a Loan to Value (LTV) basis) and the expected growth rate in the value of equity in well performing deals will dwarf that of a well performing middle market PE deal. Some hurdles that this future NAV lender would need to overcome are scaling transaction costs to the size of these NAV loans (in the single digit millions vs. hundreds of millions) and lack of audited financials in some search deals. 2nd Firm to Build, Post Chapter 11 Distressed Specialist for Search While search as an aggregate asset class has performed well, there still are a significant minority of search acquisitions that perform poorly. Revenue collapses post- acquisition due to a key customer departure, seller fraud means reported EBITDA never existed, or operators drive a once thriving business into the ground. Catching these falling knives is not what is needed in the search ecosystem. What is needed is a firm that supports search businesses where EBITDA has meaningfully compressed but not collapsed (think $4M EBITDA business shrinking to $1.5M in EBITDA). Due to the leverage used in the initial acquisition, the equity in these firms is deeply underwater and they are in default on their debt. In a bigger business, the answer would be restructuring through the Chapter 11 process, cramming down the debt and equity providers, and emerging as a viable business on the other side. In search, the operator and investors lack of familiarity with the rules and process of restructuring, and the potential for a personal guarantee signed by the operator, result in messy liquidations and personal bankruptcies. A firm specializing in post-bankruptcy distressed investing could offer operators of these search businesses a path to eliminating their personal guarantee, resetting their debt structure, and still seeing the equity upside. By investing through primed Debtor in Possession (DIP) financing, these firms can jump existing senior lenders rights to collateral. This DIP financing can keep the business going through the immediate post-bankruptcy filings, then be used to purchase the whole business via a 363 or converted into equity after drastically reducing the businesses debt load. This future distressed specialist would need a stable of fractional CFOs to support cash management and a strong legal team familiar with the leverage points over the typical senior lenders in search deals. 3rd Firm to Build, Sales-Leaseback Specialist for Search Debt is expensive for searchers, equity even more so. Seller owned real estate might be a solution. In a sales-leaseback, a company sells its owned property to a real estate investor and simultaneously signs a long-term lease to remain a tenant. The key driver in the valuation of the real estate is the stream of payments from the lease, not the underlying cost to purchase the land and build a comparable building. Additionally, the multiple real estate investors pay for net operating income is significantly higher (11.5x – 16.5x) than the multiple searchers pay for EBITDA (4x – 6x) In search deals, the seller often owns the commercial property the business operates out of. They’ve paid themselves some rent with the goal of tax efficiency, not paying a market rate, and as part of the acquisition are willing to either sign a long term lease with the acquirer or sell the property. An acquirer can finance a major portion of the acquisition from buying the seller’s property at market or slightly below market value while simultaneously performing a sales-leaseback at an above market lease. The search world already has the first level of specialized providers, lawyers specializing in small business acquisitions, accounts specializing in quality of earnings for search deals, and insurance providers. As search continues to grow, the next level of providers includes a specialist in sale-leasebacks for search transactions. The first mover into this space will earn a good living on commissions on these sales-leasebacks! It is a time to build, so go forth and do so! I may be one of your first customers, or at least I’ll be able to make an introduction. Andy Rougeot redacted