Posted by Carol Mahamedi
May 11, 2022 | 3-minute read (559 words)
More MBA graduates are tapping in the “search fund” model as a means to become a business owner-CEO rather than launching a startup from square one. An established investment vehicle that has gained newfound favor but that is still relatively unknown outside of MBA circles, search funds allow aspiring CEOs to solicit funds to acquire a privately owned firm they can run.
Numbers from Stanford’s Graduate School of Business illustrate the growing attraction of search funds. Some 70 Stanford MBA students launched search funds in 2020, according to preliminary data from the school, versus its previous record of 51 in 2019. The school anticipates even more debuted in 2021.
Meanwhile, the University of California at Berkeley’s Haas School of Business introduced a well-attended MBA course on search funds in 2019. For MBAs who aspire to acquire a company and serve as CEO, “it doesn’t get better than the search fund model,” said Jan Simon, a former Goldman Sachs executive who teaches the course.
How search funds work
Developed in 1984, a search fund is an investment pool that entrepreneurs use to raise capital from investors to acquire a privately held business they can run as CEO. In a nutshell, it gives would-be CEOs a fast-track method to manage a firm in which they also have a significant ownership stake.
First, the searcher, meaning the CEO aspirant, looks for an inconspicuous, low-profile firm they can acquire and run as part owner. The next step is to raise capital from investors to fund the search; later they will seek funding for the actual acquisition, after which they take the reins as CEO. According to the Haas School of Business, on average, searchers hold the firms they acquire for six to 10 years.
Search fund performance
Since 1984, there have been over 400 search funds raised, but 50% of those were within the last few years. Stanford’s 2020 Search Fund Study found that 88 search funds were launched in 2018 and 2019, and roughly $1.4 billion of equity capital was invested in traditional search funds and acquired companies from 1984 to 2019.
Financial returns from search funds have been promising enough to keep enticing investors. Among the 400-plus search funds raised, 75% of businesses acquired by searchers generated a positive return for investors, with 69% of those yielding at least double the return on investment, according to the Stanford study. Overall, the pretax return on invested capital was found to be 5.5x, with a pretax internal rate of return of 32.6%.
While in pursuit of a business to acquire, MBA "searcher" students may not be on campus for important recruiting events, such as with coveted Silicon Valley and Wall Street firms.
Meanwhile, because searchers target smaller, under-the-radar firms that don’t attract attention from the typical investor, finding one can be tricky. Further, the process itself may entail dozens of cold calls to possible sellers and many likely rejections.
Finally, not every search fund is a success story. An estimated one-third of searches close without making an acquisition, according to the Haas School of Business.
Takeaway: The search fund model is a promising one for entrepreneurs interested in taking over an existing business and building it. But for those with aspirations of starting their own company, it may not be the best fit.