Interview on operating a search fund

Written by Jack Wong

This week, I'm pleased to share a recent interview conducted with Jack Wong, a former intern of mine who's currently making strides as a rising sophomore at The University of Chicago. In addition to his academic commitments, Jack is also an integral part of the Men's Tennis team. Alongside two of his classmates, Jack has launched Orbs Financial Research, a finance newsletter that thoughtfully explores a range of topics including renewable energy and others. It's inspiring to see young people like Jack already taking the initiative to carve out their voice early on in their career journey. Keep up the good work, Jack!

-DL

---

Could you describe what a search fund is in very broad terms? How is it different from more traditional investment vehicles such as private equity or venture capital? 

David: A search fund is an investment vehicle where investors finance an entrepreneur’s efforts to locate, acquire, manage, and grow one privately held business. It offers an alternative path to entrepreneurship for individuals who may not have a specific business idea to start from scratch or have lower risk tolerance.

Private equity, broadly speaking, refers to equity ownership in privately held assets, and in this case, private businesses. Investment strategies within private equity are typically categorized based on the company’s life cycle. These include venture capital, growth equity, buyouts, and distressed investing. When people mention private equity firms, they typically refer to leveraged buyouts, also known as LBOs. Venture capital firms are a form of private equity where investors fund startups and small businesses with high growth potential. Growth equity comes into play with slightly more mature businesses with an established product market fit and seeking to scale or expand, often in preparation for an IPO. Both venture capital and growth equity investments are typically minority investments.

On the other hand, leveraged buyouts usually involve control acquisitions, with ownership typically exceeding 51%. These acquisitions are often financed with debt. While some firms may do all-equity deals, debt helps investors increase returns by providing a lower cost of capital while taking advantage of debt paydown to create equity value. Distressed investing occurs towards the end of a company’s life cycle when it faces financial or operational challenges, such as bankruptcy.

Considering the different strategies throughout a company’s life cycle, search funds closely align with buyout firms but have distinctive advantages and differences. A private equity firm typically manages multiple investments concurrently, while a search fund focuses on acquiring and growing one specific business. On average, search deals are smaller than private equity deals. Search deals often involve elements of succession planning, which may or may not be present in buyout transactions by private equity firms. Private equity firms may bring in new management, but it’s not the primary role of general partners or the investment team to run the company themselves. They usually advise through board seats or full-time directors, which also occurs in search deals from the entrepreneur’s cap table. Search funds tend to use less debt for acquisitions than buyout firms and do not have committed capital, requiring the searcher to raise equity financing at the time of acquisition, typically from the partners who have supported the search fund. Conversely, private equity firms have committed capital from their investors. This decision-making aspect influences the deals pursued by search funds and private equity firms.

Could you provide an overview of your search fund journey? How did you get started and what motivated you to pursue this path?

David: I would say it’s the culmination of many experiences that trace back to my childhood, but they started to materialize as I neared the end of my college basketball career. Being a highly competitive person, I always had a strong desire to own businesses, even at a young age. After graduating from college, I gained valuable operational experience at great companies across various functions such as finance, operations, strategy, and marketing. This exposure gave me a solid understanding of how corporations function and how different stakeholders pursue their distinct objectives within those organizations.

Simultaneously, my interest in investing and entrepreneurship grew, ultimately leading me to pursue my MBA at Chicago Booth. It was during my time there, particularly in the ETA (Entrepreneurship Through Acquisition) course, where I was introduced to the concept of search funds. I found it to be a very dynamic career path, which greatly excited me.

I could raise capital, acquire an established business, and assume a leadership role within it. Instead of starting a business from scratch, the focus was on creating value in existing enterprises. This resonated with me as I had previously contributed to value creation at companies like Apple and Gap. 

Being a searcher also requires a diverse set of skills, many of which I have some experience in. The idea of embarking on a long-term career path that involved fundraising, searching, executing an acquisition, and operating a business was intellectually stimulating to me, and the operating phase of the cycle seemed to align well with my background.

Could you provide more like insight on the timeline from the initial proposition to create a search fund to mentioning the future exiting and sort of acquiring a business?

David: In general, the search fund life cycle is considered long term, usually spanning 7 to 10 years. For me, this journey began in the fall of 2021 when I raised the search fund for White Cedar. The fundraising process took about a month, which was relatively shorter than the typical range of 2 to 6 months. The search phase and completing a deal typically take approximately 20 to 24 months. After doing the deal, the searcher will run the business as CEO for as little as 3 years to 7 or more, depending on various factors. On average, searchers tend to remain in the operating seat for about five years, but not significantly longer than that. For some, that may mean a 10 year journey or more.

How did you identify the industries or sectors you were interested in for potential acquisition? And what are those industries?

David: I head a software focused search fund, where our targets encompass distinct B2B industries or verticals. These are not selected at random, but rather influenced by several significant factors.

Firstly, I draw upon my personal experience and expertise, targeting industries where I possess some knowledge and understanding. These include sectors of the economy where I’ve built functional knowledge through firsthand experience.

Secondly, we strive to identify businesses that are aligned with long-term macroeconomic trends influencing the US economy. These trends include the transformation of healthcare, demographic shifts, the impacts of an aging population, and the wave of certain technological advancements. I believe these trends are pivotal in shaping the future of various industries.

Given my background in retail, we’re also keenly interested in exploring software solutions integral to the broader retail supply chain. I have used my retail-focused experiences as a lens to find promising opportunities in this domain. Also, my experience in HR and operations helps us review businesses that serve the complete employee lifecycle. This includes areas like recruiting, workforce management and planning, people analytics, and employee offboarding.

In essence, my strategy is to leverage my background and expertise to identify areas where our fund might have a competitive edge over other buyers while still being opportunistic when deals outside of my initial industries come up. 

Could you share some insights into the process of sourcing and evaluating potential SaaS companies during your search?

David: In general, when it comes to sourcing and evaluating potential acquisition targets, there are several important steps to consider. Before diving into the sourcing process, we spend significant time analyzing different industries to ensure we focus our efforts in the right areas. This involves conducting industry research, developing a thesis, and clearly understanding key players and industry characteristics. We want to ensure we’re “fishing in the right pond.”

Once we have identified the industries of interest, we leverage various technologies and tools available to our team to source potential companies. This includes using extensive search capabilities to gather as much data as possible about these companies. I then reach out to business owners directly, usually through email, as I aim to connect with dozens of companies weekly, even if most is through email communication. The objective is to engage in conversations with business owners to determine if they are open to selling and if they could be a prospective target for acquisition.

Throughout the sourcing process, there is a strong emphasis on qualifying and filtering out companies that are unsuitable for us and the business owners themselves. We want to ensure that we focus our efforts on businesses that have the potential to be a good fit for both parties involved. This involves assessing factors such as strategic alignment, growth prospects, and compatibility.

Have you faced any unique or unexpected challenges when evaluating potential target companies?

David: In the search process, I have encountered two main challenges. Firstly, the availability of information is quite limited. Since we focus on small private companies, there is typically little external data available online before conversing with business owners. Even after productive discussions, there can still be missing data and certain analyses that are not tracked due to the smaller teams within these businesses. This raises questions about the quality of the information and requires making judgement calls.

The second challenge is in creating value within the acquired company post-acquisition. While it is easy to state growth assumptions, it is much harder to execute them without a deep understanding of the business, its customer base, industry opportunities, and the capabilities of the people involved. In the early stages of the search, it is common for many searchers, including myself, to input growth rates into Excel without a detailed plan to support those projections. This can be particularly challenging, given the uncertainties that exist in this market.

To summarize, the challenges in the search process include working with limited information and evaluating its reliability, as well as developing and implementing a solid plan to create value within the acquired company. Overcoming these challenges requires careful analysis, strategic thinking, and adaptability in an uncertain environment.

When you first started to now, how has your priorities or focus shifted at White Cedar?

David: Reflecting on our journey, I can confidently say our day-to-day operations have considerably matured. We’ve honed our ability to discern what works from what doesn’t, resulting in enhanced team efficiency. Consequently, we now dedicate more time to engaging with business owners and appraising potential opportunities.

The search process has deepened my understanding of the intricacies of good businesses, particularly within the SaaS business model. While the ability to evaluate potential acquisitions is a skill that develops over time and varies for each individual, my capacity to assess a company’s suitability for investment has improved. The process of deciding if an acquisition is worth pursuing has become more streamlined, and my conviction speed has indeed quickened.

How do you see the future of search funds and their role in the entrepreneurial ecosystem?

David: The search model’s longevity, around the eighties, can be attributed to its precision in targeting the right business models and industries. Typically, these are B2B service businesses with high recurring revenue streams, solving mission-critical problems for their customers and maintaining a competitive edge in the market. I foresee this trend persisting into the future.

Technology’s role in the future of search funds will undoubtedly grow, permeating all stages, from fundraising to operations, if it isn’t already central. The profound influence of technology in facilitating services via the SaaS business model or tech-enabled services is already apparent. I predict that searchers will acquire more businesses in these sectors in the years to come.

The landscape is ripe with opportunities for entrepreneurial individuals to acquire businesses. Innovative models are emerging within the ETA community, such as long-term holding companies, catering to those seeking to retain ownership over extended periods beyond the conventional 5 to 10-year timeframe. 

Further, growth-focused acquisitions, less dependent on debt for transactions, are on the rise, outpacing historical trends. This acceleration fuels greater creativity and diversity in deal structures, enriching the ETA ecosystem.

While I anticipate potential shifts towards B2C businesses as the investment space becomes more competitive and knowledge broadens, such a transition will undoubtedly carry a significant risk. I foresee the emergence of more models designed to support entrepreneurs keen on acquiring and growing businesses, as we’re already observing this trend, particularly in the franchising sector.

As a result of increased interest from entrepreneurial individuals and new investment funds to support acquisition entrepreneurs, we may see a compression in returns in the long run to more closely align with traditional private equity.