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Search Funds: A New Way to Find Returns

27 September 2012

By Michael Shoemaker, Principal, Andino Ventures

When Mario Sicilia entered Stanford’s Graduate School of Business in 2007, at the age of 26, he had little idea that less than five years later he would be the CEO of a USD 25 million healthcare logistics provider based in Mexico growing at over 30% a year.

Mario’s entrepreneurial success has nothing to do with start-ups, nor is it a story of family business or corporate intrapreneurship. Rather, Mario and his partner, Jose Antonio Fernandez, put their previous private equity experience and management education to work orchestrating a management buy-in of the firm he manages using a little-known investment vehicle called a Search Fund.

In short, a Search Fund is a vehicle by which investors can participate directly in the acquisition and expansion of a promising lower middle-market firm. What makes a Search Fund unique is the fact that it is structured in a way that allows investors to significantly mitigate their own risks. 

What are the sources of risk in such an acquisition? Since Search Funds seek existing firms with a solid client base and history of positive cash flows, they are not exposed to the same market risks as venture capital investments. Rather, investors point to the often semi-formal nature of target companies as a first source of risk. For example, firms of this size are frequently family-owned and often deflate earnings or inflate costs to reduce their income tax burden. This creates one of many possible contingent liabilities of which investors are rightfully wary. 

In addition, even when smaller firms have strong product portfolios and real growth potential, investing in these companies is made untenable by the presence of the owner-manager. While the founder may have sound technical or entrepreneurial skills, he or she will often lack the managerial know-how, ambition, or level of commitment needed to take the company to the next level.

A Search Fund mitigates these kinds of risks in two ways – by motivating a “Searcher” and through the active participation of a diverse group of investors. 

The Searcher, who becomes general manager of the acquired firm and earns an equity stake, is almost always a recent MBA graduate of a top business school. This implies not only a strong education in general management, but also that the individual has the intelligence, rich business experience, and powerful global network needed to aggressively grow a small or medium-sized company.

“To invest in a Search Fund is to have someone extremely qualified looking at deals on your behalf and sniffing out both opportunities and potential liabilities, at a fraction of their worth and an even smaller fraction of what it would otherwise cost you to get access to such opportunities,” says Rafael Somoza. Mr. Somoza and his partner, Jose Stella, who are MBAs from Stanford and the University of Michigan, respectively, carried out Puerto Rico’s first-ever Search Fund. Both have since become serial Search Fund investors.

The size, diversity, and active participation of the investor group helps mitigate risk by ensuring that both the Searcher and the opportunity have been thoroughly and independently evaluated before significant sums are invested in the acquisition of the target firm.

“When you invest in a Searcher,” says Mr. Somoza, “it is essentially a multi-year internship…I want to see how this person thinks, how he communicates with me as an investor, how he analyzes deals, handles adversity, copes with stress, and whether he can think strategically before putting real money behind him.” Mr. Somoza continues, “That is a lot different than, ‘Here is the deal, you don’t know me, but you have two weeks to make your decision.’”

“I absolutely feel more comfortable making an investment decision after having actively participated in some Search Funds, acting as a non-executive director or simply an advisor. And in the Search Funds where I have invested but haven’t been as active, I can rely on the judgment of others in the fund whom I know and trust,” says Rob Johnson, a serial search fund investor in Europe. 

This level of trust may come in part from the impressive track record of the typical Search Fund investor. According to Mr. Johnson, “When you look at the community of serial Search Fund investors in the United States, the majority are either VC or PE fund managers investing personally or former entrepreneurs, some of whom are now faculty members at major business schools like Harvard and Stanford.”

Mr. Johnson, a successful entrepreneur and now visiting professor at IESE Business School in Spain, is partner in a venture capital fund in London. He has invested in roughly 24 Search Funds in the UK and Europe as well as the US, and is thus very familiar with both the value of Search Funds and the difficulty of introducing them to new markets.

Search Funds have existed in the United States since the mid-1980s. The portfolio of roughly 150 Search Funds that have been carried out in the U.S. shows an average IRR of more than 37% and a median IRR of roughly 18%. With this kind of track record, one would expect Search Funds to be appearing all over the world.

However, the Search Fund model has consistently proven difficult to export to new markets because, as Mr. Johnson states, “It is always hard to get first-time Search Fund investors to believe that the model will work and that it will bring real benefits.” He continues, “Investors’ first instinct is often to think ‘Why should I invest in the search? Just find an opportunity and bring it to me.’” However, since the closed group of Search Fund investors has right of first refusal on any deal, the chance for outsiders to invest in the acquisition often vanishes.

In many respects, Search Funds seem ideally designed for Latin America. The number of SMEs in the region with great potential but in need of professionalization is significant. In addition, the model enjoys a lower risk profile than venture capital and thus is better suited to individual investors and family offices accustomed to safer investments in real estate, infrastructure, and commodity sectors. According to Timothy Bovard, Professor of Entrepreneurship at INSEAD Business School in France and Singapore, “The search fund model, if correctly executed, offers a number of very interesting risk reduction mechanisms. Unfortunately it is often poorly communicated and therefore misunderstood.” In addition, Search Funds lean heavily on investors’ business relationships and thus match nicely with the business cultures in most Latin American countries.

Still, Search Funds are just establishing a foothold in the region. At least two Search Funds have been raised in Mexico and anecdotal information points to perhaps 6-10 in Chile. A limited number have also been attempted in Brazil, and Andino Ventures, this author’s Search Fund, is the first of its kind in Colombia.

Now, with increasing numbers of Latin American graduates from top business schools hoping to follow in Mario Sicilia’s path, the region is looking at a reliable supply of future Searchers.  Yet, the question remains, to what extent will Latin American investors see the opportunity in this alternative asset class?

About the author:

Michael is Principal of Andino Ventures, a Search Fund based in Bogotá, Colombia. Originally from the United States, he holds an MBA from INSEAD Business School in France and Singapore and has extensive experience in Latin America. Formerly Michael developed and managed strategic alliances with major ERP as well as niche Software as a Service firms for the global leadership consultancy PDI Ninth House.