Whilst private equity is a well established asset class, search funds are sometimes less well understood by entrepreneurs, investors and business owners who may be considering selling their business to either type of fund.
In some respects, search funds can be seen as a form of private equity. Both search funds and private equity aim to acquire and grow businesses, they operate quite differently. However this guide post will explore these differences, focusing on the characteristics that set search funds apart from private equity, including their unique management teams, singularity of focus, flexible time horizons, and their tendency to target different sizes of companies.
Origin and Structure: Management Teams
One of the most striking differences between search funds and private equity lies in their origin. In search funds, the process starts with the management team. Typically, driven entrepreneurs or aspiring CEOs raise initial capital from investors primarily to fund the search for a suitable company to acquire. These entrepreneurs, often fresh from business school or with some previous professional experience, take on the responsibility of finding and ultimately managing the business they acquire. This hands-on approach gives the search fund its distinct character.
In contrast, private equity (PE) firms generally begin with capital. These firms pool large sums of money from institutional investors, high-net-worth individuals, and other sources depending on the size of the fund. The objective is to identify companies with growth potential, invest capital into them, and then oversee their operations. While PE firms often bring in experienced managers or a management team post-acquisition, the initial phase focuses more on financial and strategic analysis of the target asset rather than assembling a management team from scratch.
Management Continuity
Another key difference between search funds and private equity that is somewhat related to the point above is that when a private equity fund acquires a company, they usually seek to maintain the management team, at least initially. In doing so, they will often put in place incentive structures whereby owners or managers of the company being acquired may roll over equity into the new company structure and are part of the onward growth. This may give management ‘two bites of the apple’ – effectively having two exits – one when they sell to the PE fund, and another 5-7 years later when the PE fund then sells the asset.
By contrast, when a searcher acquires a business, the traditional search fund model would see them usually step into the CEO role themselves, and so the incumbent owner/CEO would usually leave immediately or soon after the acquisition takes place. This is a major difference, and may also be an appealing route for a seller who doesn’t want to sit around waiting for years of earn outs or deferred consideration. This may give a search funder entrepreneur a competitive advantage in tabling a competitive deal if they happen to be competing with a lower middle market PE fund that’s also interested in the target.
Singularity of Focus
Search funds maintain a singularity of focus that distinguishes them from private equity firms. A search fund typically involves a single entrepreneur or a small partnership who dedicates their effort entirely to locating, acquiring, and managing just one company. This laser-focused approach allows the search entrepreneur to become deeply involved and committed to the success of the acquired business. They immerse themselves fully in the daily operations, often assuming the role of CEO or another high-level position to steer the company’s growth.
Private equity funds, however, usually have a portfolio approach. They invest in multiple companies across various industries, spreading their resources and expertise over several businesses at any given time. While this diversification reduces risk and allows PE firms to leverage industry-specific knowledge across different investments, it also means that individual companies may not receive the same level of focused attention as they would under a search fund model.
Flexible Time Horizons
Another key distinction between search funds and private equity is the flexibility in time horizons. Search funds tend to have less rigid timelines for their investments. Since the primary goal is to find a suitable company and achieve long-term growth, search fund entrepreneurs are not necessarily pressured to sell within a specific timeframe. Of course their investors expect to see a return on their investment in a reasonable timeframe, but they typically understand that value creation might take several years, and patience can yield significant rewards.
On the other hand, private equity investments are usually bound by predefined time horizons. PE firms often have established exit strategies with target times, usually ranging from three to seven years, to maximise returns for their investors and return capital to limited partners. This fixed timeline may sometimes lead to decisions focused on short-term gains rather than long-term value creation. The necessity to adhere to these timeframes could influence the level and nature of interventions in the acquired companies.
Target Companies: Focus on Smaller Enterprises
Search funds and private equity also differ in their target companies. Search funds generally focus on smaller, often owner-operated businesses that lie beneath the radar of larger PE firms. These companies may be in the £750k – £5m EBITDA range (or $1m – $5m EBITDA is often used as a reference bracket in the US), and usually have stable cash flows and less complex operations, which can be attractive to a first-time CEO or small management team seeking their first acquisition. Additionally, these companies might not be actively marketed for sale, necessitating a thorough search process by the entrepreneur.
Conversely, private equity firms typically target larger, more established companies. They look for businesses with substantial revenue and profitability that can be scaled further. These companies often present more complex opportunities requiring substantial investment and sophisticated management practices, fitting the capabilities of a PE firm’s extensive network and resources. Smaller companies aren’t typically on a PE firm’s radar unless they offer exceptional strategic value or are part of a roll-up strategy whereby they can be bolted onto a ‘platform’ company that the PE firm already owns.
Investor Involvement
Investor involvement in search funds is another aspect that sets them apart from private equity. In search funds, investors tend to be more actively involved throughout the process. They often serve as mentors, advisors, and board members, providing guidance and leveraging their networks to assist the search entrepreneur. This level of involvement is crucial, especially considering the limited experience some search fund entrepreneurs may have. It helps bridge the gap between ambition and practical business management, increasing the likelihood of success.
In private equity, while investors and firm partners play a significant role in strategic decision-making, the day-to-day operations are usually left to the management teams installed post-acquisition. PE investors may provide strategic oversight, financial expertise, and high-level connections, but they typically do not engage as deeply in the hands-on management of the companies as search fund investors do.
If you’re a searcher looking for insights on how investors look at search funds, we recommend giving this a watch:
Sources, citations and recommended reading:
- We enjoyed this blog post from SMEVentures which also looks at the differences between search funds and PE: https://www.smeventures.com/insights/isnt-a-search-fund-just-mini-private-equity
- This post from corporate finance advisory also helps to dig into the search fund model and how it’s different from PE in some respects, from the angle of experienced advisors: https://www.akerton.com/en/search-fund-explanation-and-differences-with-traditional-private-equity-firms/
- The Financial Times advisor references the key difference of management typically being incentivised to stick around in a PE deal here, as well as generally talking about how investors are becoming more interested in search funds: https://www.ftadviser.com/investments/2024/05/21/investors-are-jumping-on-board-the-search-fund-bandwagon/#:~:text=One%20of%20the%20key%20differences,to%20step%20in%20and%20take
