Risky 'Search Funds' Draw Entrepreneurs, Dollars
"Search" funds, small pools of money that seek to buy and manage small companies, are drawing a record number of would-be entrepreneurs and a new crop of investors, though they have realized few successes.
Roughly 50 search funds were launched in the last three years, with each consecutive year marking a new high, according to a study by Stanford University, where the idea was born almost 30 years ago.
John Fowler, who profitably bought and sold a logistics company through a search fund, now is approached by one or two people a week looking to forge a similar path. "It was kind of just a little secret of Harvard and Stanford 10 years ago, but it's not a secret anymore," Fowler says.
Search funds work essentially like tiny private-equity shops. One or two prospective entrepreneurs round up between $200,000 and $750,000 from friends, family and outside investors to finance the hunt for an attractive business, a process that typically takes 18 months. If a deal is reached with the owners, the search-fund principals seek second rounds of financing from their initial investors to buy the company — typically for between $5 million and $10 million.
Investors accept equity stakes in the purchased business, while the search-fund principals try to expand the business, generate returns and eventually sell it for a profit.
On the map of the financial world, search funds are a tiny and little-known province; only 141 such funds have been launched to date. But the recent crisis, and the fissures that it spread throughout high finance, cultivated new interest in the strategy. Investors, soured by the performance of bigger markets, were lured to this segment of businesses too small to even gain the attention of private-equity shops. At the same time, midcareer professionals facing an uncertain future on Wall Street warmed to the idea of running tiny companies for a dedicated group of backers.
G.J. King, for example, left a job in Goldman Sachs Group's private-wealth management unit to study search funds at Stanford. King, 27 years old, and his partner, Will Bressman, started fund raising in February as they finished business school and will start their search for a target company next month.
"I feared that if I returned to a traditional job, or a place like Goldman, I would always have that what-if wonder," King said.
King and other recent search-fund players have tapped into a number of investors dedicated to the strategy. Nine out of 10 search funds are now backed by "serial" investors, according to the Stanford study. The group is so small and fraternal that it has been dubbed "the search-fund mafia," a moniker that also speaks to the collective power these investors hold to bless or kill fund-raising prospects.
Despite the new interest, however, the strategy is arguably riskier than ever. Nearly one-third of search funds launched to date have lost all their investors' money, compared with 28 percent in 2007, the last time Stanford completed a search-fund study. And just 38 percent of all search funds have posted a positive return, down from 48 percent two years ago.
Average returns, skewed by a few huge successes, were roughly 37 percent, down from 52 percent in 2007.
Alpine Investors, a San Francisco-based firm that buys stakes in small companies, steers clear of most search funds, though it has seen a spike in search-fund pitches. Founder Graham Weaver says the key to the strategy's success is finding the rare candidate who excels at both finding and buying a business and handling the duties of a small-scale CEO.
"That's a pretty unique skill-set," Weaver says. "They're teaching themselves to be a [private-equity] firm in two years. I've been in PE for 15 years and my learning curve is still steep."
The purchase of a small business is just the start of a very unglamorous race, as many search fund managers describe it. While his former classmates were cashing Wall Street signing bonuses, Peter Day was making earrings and packing boxes with coffee mugs and dog toys. Day, a 35-year-old former investment banker, has now spent seven years at the helm of Eugene, Oregon-based Oak Patch Gifts.
"It's kind of the business equivalent of owning a small family farm," Day says. "It's got a nice ring to it — a romance — but the day-to-day reality is very different from what people imagine."
What keeps everyone in the game, searchers and investors alike, is the prospect of a home run — the huge success story on which any venture-capital model depends. Several industry-leading companies have grown from search funds, returning investors' money many times over in the process. Asurion, one of the world's largest providers of cell phone insurance with more than 5,000 employees, has grown from an $8 million search-fund acquisition in 1995.
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