If you take a look at the average asset allocations of investors according to net worth, you will notice a distinct change around the $1 million net worth mark. This marks the point at which an investor becomes an Accredited Investor. One will observe that the traditional portfolio of advice of “stocks, bonds and real estate” begins to give way to a focus on business interests. This is another way of saying, private equity.

Private Equity is a massive field, encompassing all tech-centric Venture Capital, massive billion dollar mergers and acquisitions and at the lowest end, a little-known alternative asset class called search funds.

What are Search Funds?

A search fund is a pool of capital raised to find, acquire, and operate a private company. Unlike traditional private equity, search funds are typically smaller and focus on acquiring a single, often lower-middle-market, business. The model is especially attractive for aspiring entrepreneurs who seek to take on the role of CEO in a company they acquire.

Search funds began in the 80’s in the halls of ivy league business schools. It was a very elite and private club. Search funds typically emphasize acquiring stable, profitable companies that have existed for decades or longer. The acquisition is done with a combination of investor equity and mainly debt. The combination of leveraged acquisition and strong fundamentals has historically created an incredible above-market return profile for the asset class, overall.

In the past, search funds have been more of an “elite club” than a proper asset class, formed by ivy league grads and ex-private equity/investment banking professionals. Commonly, accredited investors would put up minimum $50k checks per fund and $250k checks at the time of the acquisition. This has led to a difficulty in creating a diversified portfolio, consisting of a variety of investment markets and types.

Emergence of Investor Groups

Recently, Search Fund Ventures has established an Investor Group, allowing accredited investors to invest alongside our “fund-of-funds” on an ad-hoc basis. This is called an Investor Syndicate model.

Search Fund Ventures does diligence on the deal and creates a “Deal Memo” which goes out to the investor club via email. Our accredited investor partners can then express their interest in joining the deal alongside our fund. This is called Syndicate investing, commonly used in the world of Venture Capital but only recently brought to the world of Search Funds.

Risk Profile

A common question any sophisticated investor should be asking is, “how many of these investments fail?” The answer was found by Stanford, having completed a study in 2022 of hundreds of search funds deployed during the past decade. The results were staggering:

Of the search funds that are closed, 66% make an acquisition
Of those that make an acquisition, 73% result in gains
The other 27% result in losses, mainly partial.
In the case where gains are made, 27% achieved a 1-2x ROI, 36% achieved a 2-5x ROI and 27% achieved a 5-10x ROI.

In comparison with venture capital, a world in which 90% of startup investments are expected to fail, search fund investments represent a combination of incredible return profile and reasonable, easy-to-offset risks.

Investor Involvement

One of the most exciting aspects of search funds is that investors often have the ability to make a huge difference in the success of the company through advising, individual contribution and networking.

Making the transition to a value-add investor can be a fulfilling “second career.” Diving into the details of a new acquisition deal and learning about a new industry from the inside can be intellectually stimulating as well as financially rewarding.

The community of search fund investors is a notoriously friendly and collaborative one, due to the “mom-and-pop” nature of the space. Previous small business owners or real estate investors will feel right at home.

Many first-time search fund investors choose to simply invest in a “fund-of-funds” or invest with an investor group such as the Search Fund Ventures Investor Group

Challenges

Search fund investments are not without their challenges. Proper portfolio construction is beyond the scope of this article and a highly personal affair; that said, the most common challenges include:

Risk and Illiquidity: Search funds are inherently risky and illiquid, as they involve investing in a single company with no guarantee of success. This high risk is balanced by the potential for high returns, but it requires a tolerance for illiquidity and long investment horizons.
Scalability: Initial commitments to search funds are relatively small, but successful acquisitions often require significant follow-on investments. This need for substantial capital during the operational stage can pose challenges for investors in terms of cash flow and portfolio management. Investing with a group can help mitigate this risk.

Comparison to Other Asset Classes

Real Estate: Real estate investments typically offer lower risk and more predictable cash flows compared to search funds. However, they also tend to have lower return potential and less opportunity for active involvement and operational improvement.
Venture Capital (VC): Venture capital investments involve backing early-stage companies with high growth potential but also come with significant risk. Unlike search funds, VC investments are spread across multiple companies, which can provide some risk diversification. Search funds, on the other hand, focus on acquiring established businesses with proven cash flows, offering a different risk-reward profile.
Stock Market: Public equities offer liquidity and the ability to diversify across a wide range of companies and sectors. However, the potential for outsized returns in the stock market is generally lower compared to search funds, and investors have limited ability to influence the management and direction of the companies they invest in.

Conclusion

Search funds represent an exciting and potentially lucrative alternative asset class, offering high returns, active involvement, and diversification benefits. For investors willing to navigate the associated risks and illiquidity, search funds can be a valuable addition to their investment strategy. By understanding the unique dynamics and opportunities of search fund investing, investors can make informed decisions and potentially reap significant rewards.

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Search Funds: The Most Exciting Alternative Asset Class