Search Funds – Digitizing And Accelerating Mid-Sized Business

By TrueNode
26 October 2020, 13:12

What is out there besides venture capital?

The steep rise of venture capital in the past decades highlights important lessons for investors. First, investors are searching for higher returns in times of low interest rates and are willing to incur risk accordingly. Second, venture capital investments are growing in size, e.g. Series A investments more than tripled from an average of $2.5M to $8M in the last decade, according to KPMG. Capital is available and ready to be activated. Yet, despite the current expansion of venture capital within private Equity, there are other investment vehicles out there that can be utilized and even bear some competitive advantage. This article will elaborate on such a vehicle, namely search funds, how it compares to other investment vehicles, and what role technology-enabled business models can play.

Search funds, the alternative

Search funds were conceived back in 1984 by H. Irving Grousbeck, a professor at Stanford University’s Graduate School of Business. The idea behind it was to give young, well trained but inexperienced entrepreneurs the financial support to locate, acquire, and manage privately held companies that are performing below their potential. These searchers are also referred to as principals. Common targets thus are companies that are undermanaged and are cash flow generative, as debt is used to buy the company. If the “search” is successful, the search fund model results in a relatively fast path for entrepreneurs to becoming owner-CEOs, attractive financial returns for both investors and searchers, and growing, well-run enterprises. Below an overview of all search funds up to this date is displayed, showing that 2 out of 3 acquired companies created positive returns.

Less risk and reduced capital need

The key strength of the search fund model is that it significantly reduces risk. Investors and entrepreneurs avoid having to invent their own business model that has not proven itself yet. Moreover, the average size of search funds is relatively low. Initial capital raised to fund the search of the principal averages around $429K. The subsequent acquisition, if a suitable company was discovered, averages around $10M, being less than half of the average Series B funding in venture capital that averages around $23M.

Once a company is found and acquired, how does it perform financially? The return on investment for all known investments in 2019 (>400 in total) is 5.5%, while also leaving the two principals in positions with an average annual salary of $217K. Of course, these numbers do not compare against the top quartile of venture capital funds. Yet, they prove that search funds also are profitable investment forms that require less capital, contain less risk, and rely on already running business models rather than the highly competitive start-up environment.

Search funds around the globe

As of today, the search fund model is primarily utilized in America. Europe in total only had 23 operating search funds documented. However, in the last few years, there was an increase. Especially central European countries with many medium-sized businesses show large untapped potential but may lack willing principals that go out and start a search.

Digitization and search funds – natural allies?

A prime example of a young principal that started a traditionally funded solo search fund is Kalil Diaz from the Yale School of Management. After searching for about 19 months, Diaz acquired Contact Centers Dominicana (CCD) in an all-equity transaction. Once he settled in as the new CEO he describes his experience as follows:

“Eventually, I felt like I learned the mechanics of the business, and then I shifted into work mode. I did everything in the business – sell, set up accounts, work on financials, hire, fire. There was nothing below what I was willing to do, and it was satisfying and fun.”

Diaz lays out the role of digitization while CCD transitioned from ad-hoc fixes and last-minute saves to reliable procedures and operations. He highlights that technological and digital upgrades were needed to manage this transition. Thus, digital investments converted manual processes to automation, highlighting the importance of digitization for medium-sized enterprises. Coming from an MBA background Kalil Diaz knew how to use tech to his advantage. Demonstrating that search funds and digital studios are natural allies, as they target a segment that often is not familiar with state of the art digital tools that can enhance underdeveloped businesses. Thus, digital studios can be an important value driver in the period after the initial settling in and can act as advisors to the principal as well as co-investors if they happen to have a venture arm as well.

The TrueNode experience

We as TrueNode share a similar experience when it comes to accelerating mid-sized business. The Invia Capital Team decided to acquire Infosel, a data and information company that operates in Mexico. Its business model is similar to Bloomberg’s. We partnered up to reinvent and reposition Infosels flagship product. During our 16 month partnership, we created a real-time stock visualization and enhanced their system stability by over 30%, creating an instant impact that affected their product value and ultimately helped Infosel to foster their position in the market. Stories like the one of Kalil Diaz and Infosel show how digital and search funds can work together, to revamp middle range enterprises and provide them with the necessary competitive edge to start outgrowing their peers.

Consequently, search funds can be a successful investment vehicle, if operated by a well-trained principal that is willing to listen and learn before turning an existing business upside down. Moreover, digitization has to be used to align workflows, create scalable processes, and enhance reliability.