Search Funds: Is the Time Right to Go Global?
It is a well-documented fact that Africa is growing at a tremendous rate and there is no day that goes by without a story about the continent’s economic rise from all major news publishers. The stories are largely based around natural resources and large infrastructure projects. The stories have also involved a diverse group of investors contributing to the growth, mainly the private equity firms with the entry of major US private equity players such as Blackstone, Apollo, KKR and Carlyle into Africa
The stories are however incomplete and the available investors go beyond the usual private equity and venture capital investors. Indeed there are more investment and entrepreneurship vehicles that can be explored as viable contributors to Africa’s growth story. But when it comes to the Small and Medium Enterprises (SMEs), investors tend to get caught up in “analysis paralysis” largely due to lack of tangible data. One way to mitigate this is by considering an entrepreneurship vehicle called Search Funds, which was developed 29 years ago by Professor H. Irving Grousbeck at Stanford.
What is a search fund? Search Funds are a niche investment vehicle that enables high potential and entrepreneurial individuals or partners to locate, acquire, manage and grow a privately held company. It has historically been focused on the US market but have also been raised in the UK and there are a few now operating in Latin America and India. For many prospective entrepreneurs Search Funds offer rare opportunities. First of all, there is the possibility of becoming an equity-owning manager of a business early in their career. Secondly, it also offers flexibility for founders as they can take a new operating role, have a board seat, maintain equity stake, enjoy a cash out or exit entirely.
At the moment there is only one search fund operating in Africa: Impala Investment Holdings LLC. It was set up by a principal who wanted to start a business in Africa and discovered that the search fund model offered the perfect opportunity to do so. The fund has the aim of acquiring an East Africa based private company..
A Search Fund is set up in two stages: •First, a small pool of capital is raised by a group of investors in the fund to cover the search expenses and allow the lead operating manager of the pooled fund to draw a salary while searching for a company to acquire. In return, search fund investors obtain the right of first refusal to invest in the buyout and equity in the acquired company proportional to the value of their initial investment. •In the second stage, an additional (and larger) amount of capital is raised to form the equity component of the company to be bought. Initial investors have the option to invest in the second round but are not obliged to do so. Search fund principals typically look for 10 investors, all of whom are encouraged to contribute advice and expertise in addition to the capital.
The General Manager(s) of the Search Fund take operating roles in the acquired company — CEO, President and the like.
In comparison to private equity, search funds are typically comprised of individuals who are seeking to buy and then personally operate a company that is usually smaller in size than the typical target for a private equity firm.
Search funds investors also tend to provide “patient capital” compared to private equity and venture capital; they seek out flourishing, small-to-medium-sized enterprises that want to sell, but can’t find buyers because Private Equity funds find them too small-sized, while Venture Capital funds find them too late-stage.
In many respects, Search Funds seem ideally designed for Africa. The number of SMEs in the region with great potential but in need of professionalization is significant. In addition, the model enjoys a lower risk profile than venture capital and thus is better suited to individual investors and family offices accustomed to safer investments in real estate, infrastructure, and commodity sectors.
To play in Africa’s fast growing market, investors have historically had to go head-to-head with established bulge bracket Private Equity funds for big businesses or compete with Venture Capital players for small, but promising start-ups or companies. Search funds offer an untapped middle ground, a sweet spot that only this breed of investment vehicles is uniquely designed to access.
Are there challenges?
Predominantly for search funds, the operating and industry experience of the search fund team matters a lot more and will be more critical to the seller and success of the company.
While this may be also true in a sale to a private equity firm, in the case of the search fund, the seller has unique visibility into the background of the team that will manage the business post-transaction. This can be an advantage of the search fund but it can also be a detriment to the amount of investments the search funds can gather.
Furthermore as with all ventures, lack of leadership talent still remains one of the biggest challenges, particularly so in Africa. The role of the board is an aspect of management that is not widely adopted in many of the small businesses that are found across many countries on the continent largely due to lack of proper operational practices. However, if we can attract an educated base of capable individuals and provide a vehicle for transition and get them to be highly incentivised to come in and work with the founders to build a viable business, then individuals can leverage the search fund model as an innovative vehicle for unearthing entrepreneurial acquisition gems.
Indeed, large multinationals and other large companies offer attractive compensation packages to MBAs, taking their sights off the entrepreneurship route. However, if an African ecosystem is to be built in the long term, we need to look after the small businesses because they are the key to many of the economies and are the engines of Africa as it stands today.
70% of Africans currently studying towards an MBA at leading Western business schools will return to the continent to work after graduation. Of this 70%, half said they are returning to Africa to become entrepreneurs and start their own companies rather than work for someone else.
This is further evidenced by the fact that there is an increasing number of Africans in diaspora returning to their home countries equipped with great professional skills, many of them are looking to operate or start such SMEs
It is without a doubt that placing well-educated, high calibre, strongly motivated managers who have a leadership skill set from larger organisations into such an environment can mitigate the aforementioned challenges.
Risk and return:
According to the Stanford study conducted in 2011 search funds have an average annualized rate of return of 34.4 percent, so it is a relatively safe investment relative to venture capital. If angel investors are informed enough to bet on the right searcher and build a good portfolio, risks can be managed.
While the risk factor for the investor is relatively low, the risk to the searcher (i.e the lead manager of the fund) is high due to the time invested and also the process for an MBA, for instance, searching for a potential acquisition can be rather frustrating. Eventual success will depend on the direction of the growth in a particular industry and the ability for the operating team to learn and iterate quickly.
Conclusion and resources:
So can anyone start a search fund? Technically, yes. However, the global community of search fund investors is a tight-knit circle starring many successful former search fundraisers. The challenge is that the search fund path to entrepreneurship is still largely a secret but this is changing.
The niche community builds its ranks primarily through word of mouth and specialized courses at elite MBA programs, with very little recruiting or publicity for the model.
However, as with most business ventures, following the route of search funds is going to be about the individuals and the motivations behind wanting to operate a company. Investors will decide to get involved based on good rapport, charisma and vision of the operating manager as well as prospects of the company being sought.
In order to build this ecosystem, a community to support and facilitate this industry needs to be built — and that is where Search Funders International Venture (SFIV) Partners comes in. As a founder of the Venture, our mission is to partner with ambitious entrepreneurs to unearth, acquire and manage profitable micro-cap companies in Africa. Our focus is on well-managed companies with a history of profits and significant growth potential that can benefit from an injection of great talent and technology.
More information on Search Funders International Venture can be found here http://bit.ly/sfivpartners. Here is a link http://www.gsb.stanford.edu/ces/resources/search_funds.html to key resources around search funds and feel free to reach out through twitter @Searchfunders and comment or ask any questions.
Lastly this model works beyond MBAs i have seen people with deep experience in the industry who are looking for a career change looking to this model to find a great alternative.
Originally published at www.afrimind.org on June 21, 2013.
