What is the most exciting asset class in private equity?

Investors are increasingly turning to alternative asset classes in the current low-interest rate environment. Private equity continues to be the most popular, attracting the largest share of capital. Could a niche, relatively unknown asset class be the key to outsized market performances?

Toby Clarence Smith, Toptal Finance expert, explores the worlds of search funds investing. He reviews some of the most important aspects from an investor’s perspective and also explains the benefits of investing in this asset class.

In a recent article, Toptal Finance Expert Orinola Gbadebo-Smith profiled an interesting vehicle for would-be entrepreneurs to pursue an entrepreneurial path: search funds. As a brief reminder, search funds are “an investment vehicle established to house a captive pool of capital raised to support one or a pair of entrepreneurs in their search for, acquisition of, and operation through to exit of a single, privately held business.”

Ori’s piece was written from the perspective of an entrepreneur, and he did a great job of explaining the model and the pros and cons of pursuing the search fund route as opposed to the more popular startup route. A search fund can be a great way for aspiring entrepreneurs to pursue their entrepreneurial dreams, especially if they lack an idea or don’t want to take on the risk that startup founders do.

Investors play a key role in the search-fund model, just as they do with startups. The key difference between a search fund and a non-funded search to find a company is the involvement of investors in the search phase. To this end, it is not easy to convince investors to give you a half-million dollars so that you can pay yourself a wage while you search for companies.

This article was written to complement Ori’s report, which an entrepreneur wrote. It looks at this asset class through the eyes of investors. Search funds remain relatively unknown despite a recent surge in activity. Few investors are aware of search funds, and even fewer have invested. A closer look at search funds suggests that they are one of today’s most exciting asset classes within private equity.

Investors’ perspective on the Search Fund Model

The four stages of Ori’s article that Ori describes are search capital, acquisition financing, and additional investment opportunities in the operating phase.

Search Capital

The search capital can be used to finance a 24-month search for a potential buyer. The search capital is used in a variety of ways depending on the fund. However, the table below gives a good overview of what costs are incurred at this stage.

The exact amount raised depends on the circumstances of the fund, but in general, it is between $350,000 and $500,000. The table below summarizes the amounts raised as well as other metrics relevant to the search phase over the past few years.

Legally, a search fund is almost always structured as a Limited Liability Company. When investors choose to invest in a search fund, they buy Units (as opposed to shares/securities like with a C-Corp). The searcher can define the size of the unit, but most searchers are targeting 10-20 investors. Therefore, the units should be appropriately sized (typically between $35,000 and $50,000). N.B. Investors may also purchase half units instead of whole units.

Investors who participate in the search capital receive two main benefits:

Follow-on rights at pro-rata: The right to invest pro-rata equity required for financing the acquisition.

Stepped-up conversion: The search capital is converted, usually on a step-up basis. The securities are issued at 150 percent of the investment.

This clause is very beneficial for investors in search funds, as it provides a”try-before-you bu” situation, where investors can do due diligence on the quality of the searcher before the acquisition financing round.

The Acquisition Financing

Suppose the search is successful and a target has been identified. In that case, the searcher will move on to the detailed diligence and negotiations phase, which should result in a formal offer of acquisition for the company. Investors are again involved in the process of putting together the capital package before the request is made.

For an estimate of the size of your investment, it is common to look at companies with revenues between $10 and $30 million. EBITDA should be greater than $ 1.5 million. However, statistics on purchase prices show that the average deal size is smaller and tends to be at the lower end (and even below) of this range. The majority of search funds purchase companies worth around $10m.

Acquisition capital can be sourced from many different sources. The obvious reference is bank debt, but there are also other sources of funding, such as mezzanine funds. Seller financing is another common source of financing. This means that the seller agrees to accept payment from future cash flow (e.g., Earnout. Investor equity is a major part of the capital required for acquisitions. This capital is usually provided by investors who invested in search capital, given their right of refusal. In some cases, initial investors may decide not to continue (a recent Wharton Article stated that 10% of investors do not continue), in which case new investors fill the equity gap.

Investor equity can be arranged in many ways. However, it is most often provided as preferential equity. Preferred equity can be structured in a variety of ways, but it is always junior to debt securities and senior to common equity. There are some common features in the preferred share classes of search funds that are worth mentioning:

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