Transcription
A question I get asked frequently is, "What is a search fund?" Stick around to the end, and I'll share why starting a search fund might be the best way to begin your journey in private equity and how you can do it.
So, first of all, what is a search fund? A search fund is like a mini private equity fund. Typically, the way they function is you take some really bright, young, ambitious individuals—ideally, someone with operational experience running a company or being in a company. Many times, they're really bright MBAs from top-notch schools like Harvard and Stanford and so forth. They become a Searcher.
They go and raise money from investors. They raise basically two pools of capital. The first pool of capital is operational capital; it could be a few hundred thousand dollars. It's really designed to give the Searcher, the person running the search fund, enough money to cover their living expenses and operational expenses to help them find a deal.
So, they're out there hunting for a deal for a company that they want to acquire, just like a private equity fund would. The second pool of capital is a commitment. It's not really a pool of capital yet; it's more like a commitment. That commitment is designed to give the Searcher an idea of how much they can spend on a company.
If a Searcher goes out and raises, you know, a few hundred—like five hundred thousand dollars—in operating expenses to cover their salary and travel, and then they raise another 50 million dollars of committed capital to buy a business, then they know, like, "Okay, I've got, you know, until I run out of this five hundred thousand dollars to go and find a company that I could buy for 50 million dollars, maybe plus a little bit more if I'm going to use debt to help acquire the company."
Then what happens is usually that Searcher will go, they'll find a business, and they'll either take over the company and take the C-suite as the CEO, or they'll become an employee in the C-level management team and help the entrepreneur. In exchange for that, they get the money they raised for their operational expenses, and they also get a big chunk of the company when they buy it.
This can be a great way for Searchers—people that are young and inexperienced—to start their private equity career. Essentially, they can raise money, find a deal, buy the company, get in, make the operational improvements that they think would generate a ton of value, and then usually sell the business and generate a good return.
They've got meaningful skin in the game, so they're highly incentivized for it to be successful. First investors that invest in search funds have found that the performance really outweighs other private equity funds because that person is so involved and engaged in making sure it's a success.
It also is one of those things where they can put up a little bit of money and then decide later on if they actually want to invest and do the deal that that Searcher has found. They're not entirely on the hook to completely fund the deal if they don't get excited about it.
So, it's a good way to give, you know, risk a little bit of capital on a Searcher that you think could be a really good bet without having to give them a ton of money like you would in a private equity fund.
If you contrast it with a private equity fund, if I go out and I want to raise a full-fledged private equity fund, investors could be kicking in, you know, tens of millions of dollars to back me as an investor. If I don't have much of a track record, that could be a really risky proposition, right?
Put millions of dollars in, and I don't know what they're going to invest in. They could invest in really crappy businesses. I have no say because I'm a limited partner, and so I may not be super excited about that and not be willing to invest.
If you're someone that has some experience but really wants to build out their track record, doing a search fund can make a ton of sense. You can raise that money, your investors take a smaller risk on you, and then once you find that deal, you can come back and be like, "Hey, here's this amazing deal. Here's why it's an amazing deal."
You break out the whole thing for them, and then they get excited and invest. Let me tell you, as someone that's raised funds, it is so much easier to raise when you actually have a story that you're telling.
One of the challenges of being a venture investor, or to that extent, a private equity investor, is that when you go to sell, you're basically saying, "Hey, you know all that money you have? Well, I can do a better job investing it than you can, but no, I don't know what I'm going to invest in yet. But it's going to be great; just give me 10 years, and I'll figure it out."
That's a pretty hard pitch to sell versus saying, "Hey, look, I've got this business. It's generating, you know, five million dollars a year in EBITDA. I think we can buy it for, you know, 50 million dollars. We can use some leverage on it, and maybe we borrow half of that. Right off the bat, I think we can go and merge this or acquire a couple of other businesses and roll it up."
Or I think, "Hey, they need to improve all their operations here, and I know how to do that based on my job before. I can come in and add some real value, and that will drive, you know, additional revenue or additional profits, whatever it might be. Then we'll go sell it and generate a great return."
That's a much easier story to tell investors and get them excited about, right? Get them excited about the deal that you found.
So again, if you're just starting out and you've had some experience on the operational side, maybe you've gone to a prestigious school, or maybe you even haven't gone to a prestigious school, but you know you've had some really good experience that will help you identify interesting opportunities, then a search fund can make a ton of sense.
You can basically get investors to fund your full-time job while you're out there looking for your next deal. The flip side is, if you don't have any experience, then you can still borrow a lot of the same tactics that a search funder uses.
That is, keep your full-time job, but maybe on your nights and weekends, you're out there hunting for a deal and building relationships with investors so that you can pull together and package an amazing deal. Then go back to those search fund investors or other investors like them and pitch them on that deal.
Get them to invest in the company, take a piece of it yourself, and be able to then dive in, quit your full-time job, hop into that business, make it a success, and then go back and try to do it again and again. Build your own personal track record that will then allow you to eventually raise a fund where you can point back and say, "Hey, look at all of these amazing deals that I've done. I found the deal, I executed, I negotiated the terms on the deal, I got in, I understood what operational improvements needed to be made in order for it to be successful and drive incremental growth, and then look at these returns that I've generated for my investors historically."
If you can do that, and you can do that consistently—at least, you know, a few times—then you'll have a track record that you can go back to those same investors as well as new investors and convince them to give you capital in a dedicated fund.
Then they'll actually believe you when you go to them and say, "Hey, I don't know what I'm going to invest in yet, but it's going to be amazing because look at the times I've done it for these other investors, and I'm going to do it again." That's actually a winning pitch to a lot of investors.
If you're interested in starting your own search fund, there are a lot of Searchers out there. I'd recommend finding some of them, reaching out to them, asking them what their experience has been like, and seeing if they're willing to make introductions to some of the funds and investors that back them.
Search funds tend to be a relatively small, tight-knit community of both investors and Searchers. They tend to be really helpful to each other, so it's worth reaching out. Building those relationships now can be super valuable if this is the kind of thing that you want to pursue.
If search funds are interesting to you and you enjoyed this video, then keep an eye out for the video coming out soon where I meet with my friend Deb Tan, who is currently a Searcher out hunting for her next great deal.
In the meantime, check out my other video, "Why Are There So Many Layoffs?" Thanks!