The formulas, tricks and trade secrets of Private Equity

Search Funds

Sample Chapter

A “search fund” is a two-stage private equity investment vehicle in which the GPs raise funds from LPs in two rounds (for an overview of the GP-LP relationship, see “A Primer on the Structure of Private Equity Firms”); the first round covers expenses to find a suitable acquisition target and the second round facilitates the acquisition. Typically, a search fund makes one acquisition and the GPs take active roles in managing the day-to-day operations of the acquired company.

In the first round, LPs (who are comprised of repeat institutional search fund investors, angel investors, high net-worth individuals, family investment offices and other private equity funds) purchase units in the fund. A unit will typically cost between $20,000 and $50,000. The GPs will look to include 10 to 20 LPs and in this first round, raise a total of $400,000 to $700,000 in capital. The funds are then used to cover the expenses of the GPs as they search for an acquisition. Expenses include such things as salaries for the GPs, deal sourcing costs, rent, administrative costs and due diligence expenses. Typically, the GPs will have up to 24 months to locate an acquisition target.

Once an acquisition target has been identified, each LP receives: (1) conversion of the capital they contributed for the search phase into equity of the acquired company and (2) the right, but not the obligation, to provide additional capital for the acquisition. In terms of the conversion of their initial capital, the LPs receive a step-up in basis, generally 50%, regardless of whether they invest in the second round. So, for example, if a LP purchased a unit at $25,000, they would receive an equity stake in the acquired company equivalent to $37,500 in value. LPs also receive the right of first refusal to elect to invest in the acquisition on a pro-rata share (meaning, if the LP held one unit and the GP sold 10 units, that LP would have the right of first refusal to fund 10% of the total investment amount). Essentially, the first round investment by the LPs are call options. If some of the LPs from the first round chose not to invest in acquisition or more capital is required, the GPs can bring additional investors into the deal.

The investment focus of search funds can vary from generalist funds to industry focused to geographic region focused. On average, search funds will target service-based companies and will typically look for companies with EBITDA between $0.5 million and $5 million.

While unlike a committed capital fund in which the LPs have signed a formal partnership agreement and are legally committed to provide the capital, the LPs have no such obligations in a search fund. However, the LPs have demonstrated a level of commitment to providing capital for the acquisition by purchasing a unit(s) to fund the search phase. If the search fund does not find and make an acquisition, the LP’s unit(s) is worthless. For their initial $20,000 to $50,000 investment, they receive nothing. It is in the best interest of the LP for the GPs to make an acquisition.

As a business owner/entrepreneur looking to sell to a private equity firm, there is a significant difference in the GP-LP structure between committed capital funds and search funds that you must consider. In a committed capital fund, you probably are not going to know who the LPs are and it is not important given the low probability of default by the LPs. However, in a search fund, you 100% should know the fund’s LPs. The key things to consider are:

  • How many LPs are there? The more, the better. If a few of the LPs do not want to or are unable to fund the acquisition, the GPs can turn to the other LPs to fund beyond their pro-rata share. And since these LPs have already shown a commitment to the GPs and it is in their best interest to see an acquisition completed, they are the best source to make up for any funding shortfalls in the second round.
  • What are the backgrounds of the LPs? Ideally, the LPs will have diverse backgrounds that combine both transactional and operational experience. The GPs can receive guidance and advice from the LPs both on closing the transaction and then leading the company going forward. It is an added bonus if the GPs have a LP with relevant experience within your or a similar industry.
  • How much capital does each LP have available and allocated to the GPs? This is an indicator of whether the GPs have the ability to fund the acquisition of your company. You would like to see LPs with significant financial resources so not only would they be able to fund their pro-rata share of the acquisition, but also make up for potential shortfalls if other LPs do not participate in the second round.
  • How many buy-out transactions have the LPs completed? Making an acquisition is more art than science. Each transaction is different and has unique nuances. As a seller, you want to know you have a serious buyer sitting across from you that understands how to make an acquisition, the appropriate diligence requests and questions, how to handle things in a confidential matter, how to secure debt financing, appropriate structuring, etc. The only way to truly understand these nuances is to have completed multiple buy-out transactions.

In our next post on private equity firm structures, I will discuss the “pledge fund”, the structure of that GP-LP relationship and the important considerations for sellers when doing due diligence on pledge funds.

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