How to answer the question, "Why would I pay you to search?"
Most investors have never heard of search funds. Even most sophisticated investors have never heard of search funds. Even most sophisticated private equity investors have never heard of search funds! This is the harsh reality that meets searchers around the globe, especially those trailblazers in new markets. Unfortunately for most of these trailblazers, they have little-to-no experience pitching search funds to anyone, let alone an audience who has never heard of a search fund before. They therefore struggle in the early meetings to effectively field questions from prospective investors.
If this describes you, or could potentially describe you in the future, here’s a tip. One of the most common challenges to the search fund model is that it is seemingly nonsensical to pay someone to source a deal when they have plenty of investable opportunities arriving on their desks daily that did not require “search capital”. Unarmed with the correct response, the aspiring searcher may feel the wind being taken out of the proverbial sails when faced with this challenge.
In my experience, the effective volley contains all or most of the following components:
1) The 2-phase investment model works, and here’s the data to prove it.
Glory be to Stanford GSB for publishing that search fund study every two years. When a credible institution such as Stanford dedicates resources every two years to studying, among other things, the popularity and success rates of this asset class, it builds confidence in the prospective investor, even if that investor has never before heard of search funds. When the searcher raising capital can point to a credible study that says the model has generated a 33.7% IRR and a 6.9x ROI over the last 35 years, generating US$5.7 billion of equity value for investors, the model earns immediate respect in the eyes of the sophisticated investor. (Of course, for the unsophisticated investor, these numbers can be less meaningful.)
Why does it work? See my post on talent, sourcing, coaching, and focus.
2) The search capital deepens the talent pool.
The profile of the search fund entrepreneur is one of the reasons the model has done so well. However, many people with the target profile do not have US$500k to burn over the next two years running a search. More likely, they’re US$200k in debt from their business school studies. As much as they would like to take the entrepreneurial path, the household budget simply doesn’t allow for it unless there is some funding available, not only for their operations, but also for their personal bills. Providing this funding, therefore, opens the door to high-caliber young talent that would not otherwise be able to pursue entrepreneurship through acquisition.
Note: The investor does run a small risk that the aspiring searcher is just looking for a job and is not pursuing the search fund path for all the right reasons. The investor must therefore either be capable of spotting the right motivations or partner with people who do have that ability.
3) Funding the search increases the probability of buying the right company.
The funded search can be more effective than the unfunded/self-funded search in at least three ways. First, it economically ties the investors to the searcher from day one. Theoretically, a self-funded searcher can find mentors and prospective investors to add all the value that a committed investor would. However, the reality is that this is easier said than done. Even the most altruistic investors are more likely to spend time with you and offer their resources if they have an immediate economic interest in your success.
Second, the funding enables you to professionalize the search. It’s capital intended to be spent on your search - travel, lead generation, diligence, conferences, etc. There is no trade-off between spending that cash on your search and using it to pay your personal bills, as would be the case in a self-funded search. No, you won’t be able to professionalize to the level of Blackstone, but you will at least have the funds required to conduct a thorough search, with no confusion as to where to allocate those funds between personal and professional pursuits.
Third, having capital behind you makes you a more credible buyer. Being able to say you already have committed investors goes a long way when speaking with sellers, intermediaries, lenders, and advisors. When a seller asks you whether you have money to actually make the acquisition, your answer is “yes” rather than “I’m gonna go find it.”
Lastly, it reduces your likelihood to “panic buy”. As a self-funded searcher watching your personal bank account dwindle, you’re more incentivized to buy quickly and less likely to patiently await the right opportunity, because the sooner you buy something, the sooner you can stop draining your savings and start earning a salary. Even a funded searcher feels a strong pull to that CEO seat, and the searcher needs to surround herself with the right people to avoid succumbing to that pull. Self-funded searchers are more susceptible to this trap, and I’ve seen several self-funded searchers buy the wrong company because a) they were too hasty and b) they didn’t have the right people around them to hold them accountable until they found the right target.
4) The search capital is a very cheap option on a future buyout opportunity.
Investors new to the search fund model often see the search capital as an expense. Why would they incur this additional expense by funding your search?
In reality, it’s not so much an expense as seed capital in your buyout venture, and as would be the case in a startup, early investors receive economic benefits for being early. In this case, the search-phase investor is receiving the 50% step-up and a pro rata right of first refusal (ROFR) on your deal. The step-up effectively means that for every dollar they invest at the search phase, they receive 1.5 preferred shares in the deal, whereas every subsequent dollar invested buys 1 preferred share. (Do note, however, that historically about a third of searchers fail to make an acquisition, which, some may argue, effectively cancels out the economic upside of that step-up. Put another way, the step-up can be viewed as compensation for capital lost by searchers who fail to acquire.)
While the step-up is attractive, in reality it barely moves the needle in absolute dollar terms for most search fund investors because the search-phase investment is a fraction of the follow-on investment(s). It’s therefore the ROFR that investors really care about. They see that search-phase investment as a very cheap option on attractive future buyout opportunities. Regardless of who else the searcher may encounter over the course of the search, the investors have first dibs on participating in that deal.
You will likely hear some prospective investors say, “Come to me when you have a deal.” You might suggest to them that you would only be able to come to them with a deal if enough of your search-phase investors were uninterested in that deal. Granted, this doesn’t necessarily mean the deal is objectively bad - investors can decline to invest for any number of reasons. Nevertheless, this might help clarify the added benefit of being first to the party.
5) An economic investment deepens the access to and understanding of the entrepreneur.
When investing search capital, and effectively buying an “option” on that future deal, the investor is also buying an option on the searcher herself. Rather than being presented with an opportunity and having to assess both the target and the entrepreneur simultaneously, the search-phase investor has 1-2 years prior to the acquisition to get to know the searcher. How does the searcher think about opportunities? Communicate? Handle adversity? Manage a team? Knowing the answers to these questions will better equip the investor when it comes time to decide whether to invest in a deal and how much. Rather than writing one big check, the investor has the opportunity to phase the investment - first writing a small check to gain access to that searcher and gather data over the search period, and later deciding whether to write the larger check at the acquisition phase
Note: When raising capital, be careful to avoid bringing on investors who have no real intention or capacity to follow-on in your deal. Some lookie-loos out there are in it for the step-up only and have no intention of following on, leaving you with an equity gap come deal time.
Action Items
Rehearse. Ask a friend to interrogate you on this topic until your confident enough with your ability to respond.
In your conversations with other searchers, whether funded or unfunded, ask for their views on this issue, but watch out for confirmation bias.
