Latest Froth Indicator: Micro Private Equity Funds, aka “Search Funds”

Whenever the interest of graduating MBAs hits a fever pitch, it usually means a trend is past its sell by date. It now appears that the traditional path of getting rich beyond all dreams of avarice, as in joining a private equity or hedge fund, isn’t good enough for some students. They want to become their own deal-meisters sooner, and so the latest fad is scaled-down PE funds known as “search funds”.

The Financial Times explains how search funds work:

A search fund can be set up by one or two people who raise money from friends, family, business associates or other investors, to fund the cost of looking for a small company to acquire. Investors buy in before the target company is identified, covering a modest salary for the “searcher”, the costs of administration and deal-related expenses…

While a search fund may sound simple, the structure of these entities has been defined in a primer written by Irving Grousbeck, a professor of management at Stanford University, which has become the gospel of the fledgling investment community that he pioneered in 1984.

Investors buy units of the fund at about $35,000 to $50,000 each, with the fund offering around 10 units to finance a search. About 200 such funds exist, up from 46 in 2001, Professor Grousbeck says.

The typical lifespan of a search fund, structured as a limited liability company, includes two to six months to raise capital, a one to 30-month stage to search for the acquisition and six months to raise acquisition capital and complete the transaction.
The fund then has four to seven years to create value at the company. Finally, it starts the exit process – such as through a sale or initial public offering, which is estimated to take another six months.

“Students have decided they’re able to take a little more risk,” said Mr Grousbeck. “The failure rates are pretty high, but the returns from the successes have more than counterbalanced.” Mr Grousbeck estimates that one in five search funds fails to find a company.

Professor Grousbeck isn’t exactly an unbiased source of information about this investment strategy. And the part that the Financial Times does not discuss, and has me scratching my head is how this risk/return tradeoff compares to that of angel investing.

In angel investing, single or groups of investors target either very early stage and/or small companies, the idea typically being that they are below the radar of venture capital firms. Angels aren’t looking to be paid for their time as well as their capital; they are often wealthy early retirees. Think of investment bankers and corporate executives who are going to have to put their money to work somehow, and view this as a way to keep their hand in the game, earn a better return than investing only in Vanguard index funds, and provide some conversational fodder too. And while in that game is going to talk only about their winners, these investors do have some advantages. Some of them have real business/operating experience and are smart enough to choose opportunities where their background gives them an information advantage. And some also have good networks that help them in finding and vetting prospective investments.

Angel investor seek to make ten times their money in 5 years. And remember, the money (except perhaps for some travel expenses) does not leave their hands until they have found and done due diligence on an opportunity.

By contrast, these search funds sound an awful lot like the prospectus for the South Sea Company: “a company for carrying out an undertaking of great advantage, but nobody to know what it is.”
These investors are taking much more of a flier than angel investors: there’s no guarantee that the young MBA will find an opportunity, or even if he finds one, that he will be good at managing it. For instance, a prospective search fund manager interviewed by the Financial Times worked for McKinsey and KKR. He might indeed be a decent analyst, but if he’s managed anyone other than a secretary, I’d be surprised.

Moreover, the angel investor didn’t expect a return on his time. Here you have the newly minted MBA getting paid a salary, and you can rest assured they expect upside if the deal works out. So you have the deal returns diluted by the inclusion of an additional role in the equation. Yet because no deal has been identified, and the search funders will be diluted if a company is identified and the acquisition funding secured,* their return requirements should be much higher than that of angel investors.

So let’s flip this around. Angel investors, by having lower return requirements, can bid more for precisely the same sort of opportunities that these search funds are seeking. And many established angel groups advertise their presence and have organized forums where they screen entrepreneurs and let them pitch their ventures. By contrast, the MBAs have spent their last two years in school meeting other MBA…dozens of whom apparently want to compete in this business. So what little value those B-School connections have will be severely diminished by so many of the same people looking to the same people for leads.

That is a long-winded way of saying I can’t begin to wrap my mind around this investing proposition. Sure, it’s great for the young MBAs to make their mistakes on someone else’s nickel. After all, some storied investors, including Richard Rainwater and Keynes, got off to bad starts. But that learning process normally take place in organizations where internal processes hopefully limit how much damage they can do, and so they can afford the cost of the occasional overreach of youth. And indeed, the article was all about why the students were keen to take this sort of flier. But aside from QE-induced desperation, I can’t fathom what is motivating their backers.

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*Of course, the search funders may expect to participate at this stage, but if a deal is large, or they don’t like it for some reason and elect not to participate pari passu in the financing (and that can include not liking the valuation), then they will be diluted.