Search Funds vs. Private Equity
In the diverse world of private acquisition funds, two intriguing options stand out due to their unique approaches and potential rewards: search funds and private equity. While both aim to maximize returns through strategic acquisitions and management, they cater to different types of investors and involve distinct processes and risk profiles. Understanding the nuances between search funds and private equity is essential for investors looking to align their investment choices with their financial goals, risk tolerance, and operational involvement preferences. This article delves into each investment strategy, providing insights into their workings, advantages, and considerations to help investors make informed decisions.
Understanding Search Funds
A search fund is an investment vehicle where an entrepreneur, or a pair of entrepreneurs, raise funds from investors to search for and acquire one private company to manage and grow over a period. The concept, which originated in the 1980s at Stanford Graduate School of Business, represents a path for aspiring managers to step into significant leadership roles directly. It’s particularly appealing to those with a keen eye for untapped potential in small to medium-sized businesses.
The search fund process is sequential, starting with the initial capital raise, which typically funds two years of salary for the searcher(s), due diligence, and other acquisition-related expenses. Upon identifying a suitable target, the fund then secures additional financing to acquire the company. The investors in the initial fund usually get the opportunity to invest in the acquisition, often receiving preferential terms due to their early involvement.
Although comprehensive data on search funds is somewhat limited, the Stanford Graduate School of Business provides periodic updates through its “Search Fund Study” (which you can download for free from the given link). Their latest study indicates a steady increase in the number of search funds, highlighting the growing interest in this investment strategy.
Delving into Private Equity
Private equity (PE) is a form of investment that involves the acquisition of equity ownership in companies, typically ones that are not listed on public stock exchanges (although public to private transactions do occur). The private equity model aims to invest in these businesses, implement strategic improvements, and ultimately sell the stake at a profit, either through an initial public offering (IPO), sale to another PE firm, or a different exit strategy. This form of investment is known for its focus on long-term value creation and operational improvements.
PE firms raise funds from institutional investors and wealthy individuals, pooling this capital into funds dedicated to these acquisitions. The investment process begins with extensive market research, identifying potential targets, conducting due diligence, and negotiating purchase terms. Once an investment is made, the PE firm works closely with the company’s management to streamline operations, cut unnecessary costs, enhance revenue, and improve strategic positioning.
The private equity market is substantial, with billions of dollars in assets under management globally. According to Preqin’s 2023 Global Private Equity Report, the global private equity assets under management (AUM) reached $4.2 trillion in 2021, reflecting the scale and impact of PE in the financial markets and the broader economy.
Key Differences Between Search Funds and Private Equity
While both search funds and private equity aim to generate returns through strategic acquisitions, there are several key differences between the two:
- Investment Focus: Search funds typically concentrate on acquiring a single small to mid-sized company, while private equity firms may acquire multiple businesses across various sectors and sizes.
- Scale of Investments: PE investments are generally larger, given the substantial funds pooled from various investors. Search funds, being smaller and more focused, require comparatively less capital for the acquisition.
- Operational Involvement: Investors in search funds often have direct involvement in the management of the acquired company. In contrast, PE firms may take a more hands-off approach, focusing on strategic guidance and relying on professional managers to run the day-to-day operations.
- Time Horizon: Search funds often have a longer-term view, given the singular focus on one company. PE investments may have a shorter time horizon, aiming for a profitable exit within a few years of acquisition.
Pros and Cons of Search Funds
Pros:
- Direct Operational Control: Search fund investors often play a significant role in the company’s operations, allowing for direct impact on its success.
- Potential for High Returns: Successful acquisitions can yield substantial returns, especially if the company’s value increases significantly under the search fund’s management.
Cons:
- High Risk of Failure: The success of the fund hinges on the performance of a single company, making it a high-risk investment.
- Limited Diversification: Investors are exposed to the risk associated with one company rather than a diversified portfolio.
Pros and Cons of Private Equity
Pros:
- Professional Management: PE firms bring expertise in business management, strategic planning, and operational improvements.
- Diversification: Investments across different companies and sectors spread the risk, mitigating the chance that one investment failure will take down the entire firm.
- Significant Return Potential: With the right strategies, PE investments can yield high returns across multiple investment opportunities.
Cons:
- High Fees: Management and performance fees can erode returns, leaving investors with less if an investment opportunity doesn’t meet or exceed expectations.
- Illiquidity: Investments in PE are typically locked in for several years, making them a more illiquid and long-term investment opportunity.
- Substantial Capital Requirement: The minimum investment is often high, limiting access to wealthy individuals and institutional investors.
Making the Right Choice: Considerations for Investors
The decision between investing in a search fund and a private equity firm is not one to be taken lightly. Several key factors must be considered to align with one’s investment strategy and objectives:
- Risk Tolerance: Search funds, by their nature, offer a high-risk, high-reward proposition, given their reliance on the success of a single company. Private equity, with its diversified approach across multiple companies and industries, can offer a more balanced risk profile.
- Investment Horizon: Investors should consider their time frame for returns. Search funds often require a longer-term commitment as the process from acquisition to operational improvement and eventual sale can take many years. Private equity investments also require patience, but the time horizon may be shorter compared to search funds, given the variety of exit strategies employed.
- Operational Involvement: Those who prefer direct involvement in managing their investment might find search funds more appealing. This hands-on approach can be particularly rewarding for investors with a background in entrepreneurship or management. On the other hand, private equity offers a more hands-off investment, where strategic decisions are typically made by the PE firm’s management team.
- Capital Availability: Private equity investments generally require a larger upfront commitment than search funds, which can be a determining factor for individual investors or smaller institutions.
- Due Diligence: The importance of thorough due diligence cannot be overstated in either case. For search funds, understanding the entrepreneur’s vision, capabilities, and the target company’s potential is crucial. In private equity, assessing the firm’s track record, investment strategy, and management team expertise is key.
Conclusion
In the complex landscape of investment strategies, search funds and private equity present two distinct paths towards achieving financial growth. Search funds offer a unique opportunity for investors to directly engage in the management and growth of a single company, providing a hands-on approach with the potential for significant returns. However, this comes with a higher risk due to the concentration of resources in one entity. Private equity, with its diversified strategy and professional management, presents a less risky avenue, albeit with its own set of challenges, including higher fees and longer investment horizons.
The choice between a search fund and private equity ultimately depends on the individual investor’s risk tolerance, investment horizon, desire for operational involvement, and capital availability. By carefully considering these factors, investors can align their strategies with their financial goals and risk profiles, paving the way for potential success in the competitive world of investments.
