Corporate Finance, Transaction services
Acquisition entrepreneurs and search funds
Various economic, social and cultural forces are accelerating a change in the M&A landscape as talented and ambitious young entrepreneurs seek to conquer traditional industries.
In this case, not with challenger start-ups, but through the acquisition of established businesses. This group of business people are known as ‘acquisition entrepreneurs’, ‘search funds’ or just ‘searchers’ and, whilst the concept is a long-established one, it is growing in popularity.
What is a search fund?
Search funds are believed to have been conceived back in 1984 by Professor H. Irving Grousbeck of Stanford University’s Graduate School of Business, who was at the time lecturing at Harvard Business School.
There are three common models or types of search fund, which are as follows:
Traditional search funds
In traditional search funds, the acquisition entrepreneur will identify and engage with a group of investors prior to commencing the search for targets.
Under the traditional model, money is raised at two stages, with the first being a smaller raise to fund the search and the second a larger raise to enable the fund to complete on an acquisition.
Self-funded searchers speculate their own time and resources in the initial stages, that is in identifying an acquisition target, before approaching investors for funds in order to complete on the deal.
Single sponsor search funds
Single sponsor search funds raise funding from a single investor. The searcher will often co-invest with that sponsor once a suitable target has been identified.
Whilst called ‘funds’, searchers tend not to be not tied to any particular fund (in the traditional sense of the word), investor or group of investors. Funding for deals is generally raised on a deal-by-deal basis, although in the case of traditional and single sponsor search funds, the investors have a first right of refusal on the targets identified by the searcher.
After their first acquisition, searchers will often make further ‘bolt-on’ acquisitions to accelerate growth. This is often referred to as a ‘buy and build’ strategy.
What is an acquisition entrepreneur and what makes a good one?
Acquisition entrepreneurs are individuals with an entrepreneurial drive who want to employ their business knowledge through the acquisition and subsequent growth of an existing business or businesses. A good acquisition entrepreneur has the necessary business skills not only to maintain the level of business being achieved by their acquisition targets, but to identify and leverage opportunities for growth, which are often achieved through modernisation of certain existing processes.
It is usual for these searchers to have at least a strong academic business background, with many holding MBAs. Searchers also often have practical work experience in the fields of finance, investments or senior strategic management, too.
Why is it a popular route to business ownership?
The forces mentioned above that are driving the increase in search fund activity are further discussed below.
Having recently been through a very long period of record-low interest rates, investors have looked to deploy more cash in alternative investment classes. Backing a searcher provides a relatively easy route into private equity investment, usually without the significant minimum ticket size that comes with investing in traditional private equity funds.
Despite gradual increases in interest rates recently, from our experience, there is still significant appetite for searchers to acquire private companies and therefore for investors to back such transactions. Given the conditions and opportunities discussed above, returns from such investments can be significant and achieved relatively quickly, so it is likely that such investments will remain an attractive investment proposition for some time to come.
The baby boomer generation who, in most cases, are the incumbent owners of attractive target companies, are also the parents of a significant number of searchers. The link is this: boomers having had successful careers, made money in property, inherited, etc. are a strong backstop and safety net for their children, who can therefore be more selective about what they do for their career. They can afford to spend more time in education; take jobs just for some experience in a particular field, with no long term intention of staying within that field; and speculate time and money in identifying and building a career that is attractive to them.
With the economic and cultural forces discussed above putting Millennials and Gen Zs in a strong position to forge a successful career as an entrepreneur, the social differences between them and the older generations only add to it.
Millennials and Gen Zs have grown up with technology in a way previous generations did not. The superior technological abilities and familiarity with social media of these generations create opportunities for modernisation of existing traditional businesses and industries, which they can leverage with relative ease. In contrast, existing management may have parked such a project on the ‘too hard’ pile.
As well as this, the heightened environmental and ethical consciousness of these generations and their generally more liberal views, make it easy for them to connect with each other and improve processes within businesses and industries for the betterment of the planet.
What makes a good target for an acquisition entrepreneur?
The rise in popularity of searchers in recent years had been driven by various forces as set out above. In no small part is this down to the baby-boomer generation approaching retirement age, with many ‘boomers’ having built and managed lifestyle businesses over their working lives.
These lifestyle businesses are often doing enough to provide the owner with a comfortable lifestyle, but are not achieving their full potential. Having done well from the business over the years and usually having also been able to accumulate other assets in their lifetime (such as property, for example), an exit at the current market value is appealing to an owner-manager, who may already be set for retirement without a further lump sum. If not, they can usually achieve what they need for retirement through such a transaction.
Businesses with a profile like this are prime targets for searchers, who can acquire them at a reasonable value today, but grow them relatively easily through sweating the asset harder and modernising processes. Such modernisation can often be as simple as undertaking a digital marketing campaign, where previously the business had not.
What to look out for
Quality of historical earnings
Often searchers part-fund their acquisition with bank debt. In these situations the bank requires formal due diligence to be undertaken and will focus heavily on the underlying earnings of the business. It is important that the acquisition entrepreneur gets a comprehensive understanding of the make-up of the target’s adjusted or underlying earnings and has this corroborated by a professional for presentation to the bank.
Having established what the underlying earnings of the target were in previous years, a searcher must then turn their attention to understanding the expected future earnings. Whilst it is impossible to know without a crystal ball, the assumptions applied in forecasting future earnings from the historical underlying earnings must be reviewed and considered, and where possible corroborated (or disproved!). For example, if the target has contracted income and major contracts are nearing their end, checking the reasonableness of the assumptions around the likelihood of contracts being renewed would be an important task.
Tax and contingent liability risks
In the UK, most businesses are run through some form of incorporated entity (in most cases either a company or limited liability partnership) with this, in most cases, being a limited company. On disposal of a business which is operating through a limited company, the tax treatment for the seller is substantially more favourable if the shares of the company are sold, rather than the trade and assets of the business being sold out of the company. Because of this, the majority of transactions in the UK are effected by way of a sale and purchase of shares.
Buying the shares of a company means that everything within the company is acquired, including the history – and that presents risks. So, in order to understand what the searcher is buying, they must undertake or commission legal and financial due diligence to gain sufficient comfort in many areas, including but not limited to the following:
- that the target has complied with tax legislation;
- that there are no pending claims or legal matters, including those involving employees; and
- that the commitments and obligations of the target (such as leases, loans, etc.) are understood.
Other due diligence
It is highly advisable to undertake full legal and financial, (including tax) due diligence when acquiring a business, particularly if that acquisition is in the form of a purchase of an existing legal entity. This enables the purchaser to gain an appropriate understanding of what they are acquiring, identify and mitigate against risks and also meet the requirement of lenders and equity investors.
How Gerald Edelman can help
Sources: Search Funds | Stanford Graduate School of Business