The search fund model presents a unique and compelling proposition within the alternative investment landscape. However, this potential reward doesn’t come without considerable risk.
Understanding the Core Risks
Before diving into mitigation strategies, it’s crucial to understand the inherent risks in the search fund ecosystem:
Searcher Risk
The entrepreneur (searcher) is often a first-time CEO. While typically bright, driven, and well-educated, they lack a proven track record of running a company end-to-end. Their ability to source a quality deal, negotiate effectively, lead a team, and navigate operational challenges is tested in real-time.
Small Business Risk
SMBs are generally more vulnerable than larger corporations. They may have customer concentration issues, less sophisticated systems, key person dependencies, and greater sensitivity to economic downturns or industry shifts.
Search Failure Risk
A significant percentage of searches fail to identify and acquire a suitable target company within the typical search timeframe. Investors risk losing their initial search capital.
Operational Risk Post-Acquisition
Integrating into the acquired company, retaining key employees, implementing growth strategies, and managing day-to-day operations can present numerous unforeseen challenges.
Exit Risk
Realizing the investment depends on a successful future sale or recapitalization of the business, which is subject to market conditions and the company’s performance.
Despite these risks, the potential for generating strong search fund returns keeps investors engaged. The key lies in how they actively manage these challenges.
Key Risk Mitigation Strategies Employed by Investors
Search fund investors don’t passively allocate capital; they are actively involved in de-risking the investment at multiple stages.
1. Rigorous Searcher Selection: Betting on the Jockey
Perhaps the most critical risk mitigation tool is selecting the right searcher. Investors spend considerable time vetting potential entrepreneurs. They look beyond impressive resumes and academic credentials for traits essential to success:
• Grit and Resilience: The ability to handle rejection during the search and navigate challenges post-acquisition.
• Sales Acumen: Crucial for sourcing off-market deals and later, driving business growth.
• Humility and Coachability: Willingness to listen to advice from experienced investors and board members.
• Leadership Potential: The capacity to inspire and manage the acquired company’s team.
• Financial Literacy: Understanding the numbers and key drivers of business value.
By backing individuals with these characteristics, investors mitigate the inherent “inexperienced CEO” risk.
2. Staged Capital Deployment: Limiting Initial Exposure
The search fund model inherently manages risk through its two-stage funding process:
• Search Capital
• Acquisition Capital
This structure prevents large capital commitments based solely on the searcher’s potential without a concrete target.
3. Active Investor Involvement and Board Governance
Search fund investors are typically not passive. They form the board of directors of the acquired company and play an active role in guiding the searcher-CEO. This includes:
• Strategic Oversight
• Mentorship
• Network Access
• Accountability
This hands-on approach helps the often first-time CEO avoid common pitfalls and accelerates their learning curve, directly mitigating operational risk and enhancing the probability of achieving target search fund returns.
4. Diversification: Spreading the Bets
As this resource shows, search fund returns have been strongin the last year, but experienced search fund investors rarely put all their eggs in one basket. They understand that any single search fund can fail, either during the search phase or post-acquisition. By investing across a portfolio of search funds – different searchers, industries, and geographies – they diversify their risk. The success of a few investments can more than compensate for the losses from others, leading to strong overall portfolio search fund returns even if individual outcomes vary widely.
5. Thorough Due Diligence (Searcher, Industry, and Target)
Due diligence extends beyond just the target company’s financials. Investors scrutinize:
• The Searcher
• The Industry: Assessing market size, growth trends, competitive landscape, and resilience. Stable, fragmented industries with favorable dynamics are often preferred.
• The Target Company: Deep dives into financial health, customer quality, operational efficiency, management team strength (beyond the owner), and growth potential.
This multi-faceted diligence aims to uncover potential red flags before significant capital is deployed.
Maximizing Returns
While risk management is crucial, investors are ultimately focused on maximizing search fund returns. This involves:
• Identifying High-Potential Opportunities: Backing searchers targeting industries and business models with clear avenues for growth and operational improvement.
• Structuring Favorable Deals: Negotiating purchase prices and terms (like seller financing or earn-outs) that provide downside protection and upside potential.
• Driving Value Creation Post-Acquisition: Leveraging their board roles to push for strategic initiatives, professionalization, add-on acquisitions, and operational efficiencies that accelerate growth and profitability.
• Optimizing the Exit: Guiding the CEO towards a well-timed and strategically executed sale or recapitalization to maximize the return multiple.
The search fund model offers a pathway to potentially exceptional investment outcomes. However, achieving consistently strong search fund returns is not a matter of luck. It requires investors to be diligent, disciplined, and actively engaged.
By rigorously selecting searchers, deploying capital in stages, providing hands-on guidance, diversifying investments, and conducting thorough due diligence, investors effectively manage the inherent risks.
This calculated approach to risk mitigation doesn’t just preserve capital; it creates the foundation upon which the significant potential of the search fund model can be realized, turning entrepreneurial ambition into tangible financial success for both the searcher and their backers.
