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The search fund model is an investment method that allows entrepreneurs to embark on a unique path to business ownership. It is structured to help seekers (entrepreneurs who participate in the search fund model) acquire, operate and scale an existing business rather than building one from scratch.
By providing a fast track to company ownership and CEO status, search funds have created a new generation of entrepreneurs – those who embrace the concept of plug-and-play.
A critical factor in the search fund equation is the economic benefit that searchers might see for their efforts. Historically, this has meant an internal rate of return of 32.6% and 5.5 times the invested capital.
Related: How to Find Success in Launching Search Funds
With competition brewing in the form of other seekers and even some traditional private equity funds showing interest in acquiring smaller companies, how do seekers achieve their advantage? They seek the merger of two or more companies with synergies in terms of size, geographic coverage, key personnel, or supply chain advantages—in other words, a consolidation.
According to McKinsey, programmatic mergers and acquisitions (M&A) remain “the lowest-risk approach, with the lowest performance variance, and the highest proportion of companies delivering positive total returns for shareholders (65%)” compared to large single-action transactions, selective deals, or organic growth.
What does this mean for seekers competing on the smaller end of the corporate spectrum? It represents an opportunity to bring the tailwinds of M&A-led growth further down and into industries it hasn’t touched yet.
However, in a survey of 185 Entrepreneurship Through Acquisition (ETA) companies bought by Harvard Business School graduates over the past decade, only 8% have implemented a consolidation strategy that involved buying multiple companies in the same industry.
The timeline and structure of search acquisitions is often limited to two years. Additionally, seekers are often recent MBAs with limited operational and M&A execution experience, making adding an additional business objective to the acquisition a daunting task. However, the advantages far outweigh the possible disadvantages.
See also: Search funds: what you need to know about this investment model
Because this business strategy is an operational game by nature, key considerations in finding a second (or multiple) goal could include financial and further operational synergies in the form of:
- Improvements in capital structure due to the combined larger size of the companies
- Opportunity to take on additional debt at a lower interest rate
- Capital Intensity Reduction
- Shared fixed assets, working capital and capital expenditures
- Margin expansion through greater purchasing power and unit economy
- Valuation Multiple Arbitrage
- Similar to “greater than the sum of its parts,” companies often have greater value when combined than they would if they stood alone
See also: data security and the downside risk of mergers and acquisitions
Selection of an industry
So what can searchers do to further reduce the risk of search consolidation? The answer lies in a more refined thesis. Searchers with a background in a specific industry (e.g. healthcare) have an inherent advantage when starting a search with a focused thesis.
Finding an industry to get involved in can be challenging for people with multiple passions. However, the following markers could indicate proper fit:
- Fragmented industry landscape (e.g. medical, dental and veterinary practices)
- Industries where business owners primarily operate a single entity or location
- Mature and standardized industrial companies
- Companies that have relied on best practices over the years
- A large number of companies
- Many companies serve a similar customer profile but in different regions
- A large number of companies within the fund’s target enterprise value
- By understanding the average value of a company in a target industry, you can filter out opportunities that are either too small or too big
- Historically stable growth and sustainable profit margins
- Companies that have been operating profitably for many years and serve customers who (if B2B-based)
Choosing a company
Zooming in a level deeper, companies characteristic of success in the search consolidation model touch on a combination of the following elements:
- competitive advantage in the industry
- intellectual property, proprietary software, etc.
- Seller motivated to exit
- Retirement, change of succession plan, change of profession etc.
- Historically stable recurring revenue
- Strategic paths for growth
- geographic expansion, marketing strategy, recruitment of key personnel, etc.
- Alignment with the search fund’s financial mandate
- Realizable exit vision over a period of five to seven years
Eight percent is a small but growing portion of the ETA community that has chosen to embark on the path of consolidation. As more seasoned operators and mid-career seekers get involved, the more likely it is that a consolidation strategy will become commonplace. This next wave of search fund entrepreneurs could bring revolutionary methods to creatively funding, operating and growing businesses – a win-win for budding entrepreneurs and seasoned operators alike!