Is a Search Fund a Good Investment? Key Metrics and Benchmarks

The world of alternative investments offers diverse avenues beyond traditional stocks and bonds. Among these, the search fund model presents a unique proposition: backing an aspiring entrepreneur to find, acquire, and operate an existing small-to-medium-sized business (SMB). But does this relatively niche asset class represent a sound investment?

Evaluating its potential requires a deep dive into its structure, risks, rewards, and crucially, the key metrics and benchmarks used to gauge success.

Why Invest in Search Funds?

Search funds attract investors for several compelling reasons:

Potentially High Returns

Successful search funds can generate significant returns, often exceeding those of traditional private equity or public markets. This stems from acquiring businesses at reasonable valuations, implementing operational improvements, achieving growth, and benefiting from potential multiple expansion upon exit.

Diversification

Investing in a search fund provides exposure to the lower middle market, a segment often inaccessible through public markets or larger private equity funds. It diversifies an investor’s portfolio by adding exposure to a specific operating company in a potentially non-correlated industry.

Backing Entrepreneurial Talent

Investors get the opportunity to back driven, often MBA-educated individuals embarking on their entrepreneurial journey. Many investors enjoy mentoring these searchers, leveraging their own experience to guide the process.

Direct Involvement (Optional)

Unlike large funds, search fund investors often have closer relationships with the searcher and potentially the acquired company, sometimes taking board seats and offering strategic guidance.

Assessing the Risks

Despite the potential rewards, search fund investing carries significant risks:

Searcher Risk

The entire venture hinges heavily on the capability, resilience, and judgment of a single individual or small team. An inexperienced or ill-suited searcher can doom the fund before an acquisition even occurs.

Execution Risk

Finding a suitable company at a fair price is challenging. Even if found, successfully negotiating, financing, and closing the deal requires skill. Post-acquisition, the searcher must prove capable of operating and growing the business, which is a different skill set than searching.

Market & Business Risk

The acquired company is subject to industry downturns, competitive pressures, and operational challenges inherent in any business.

Illiquidity

Search fund investments are highly illiquid, typically locked up for 5-10 years or more until an exit event occurs.

Failure to Acquire

A significant percentage of searchers fail to find and acquire a suitable business within the allotted timeframe, potentially resulting in a loss of the initial search capital.

Key Metrics for Evaluating Search Fund Performance

Investors rely on several quantitative and qualitative metrics to assess search fund opportunities and performance:

Internal Rate of Return (IRR)

This is the most common metric used to measure the profitability of potential investments. It represents the annualized effective compounded rate of return. For search funds, investors look at the aggregate IRR across a portfolio of search fund investments.

Multiple on Invested Capital (MOIC)

This measures the total value returned to investors relative to the total capital invested. A MOIC of 3.0x means investors received three times their initial investment back. It provides a simple measure of overall capital gain but doesn’t account for the time value of money like IRR does.

Searcher Quality

While harder to quantify, assessing the searcher’s background, relevant experience, industry knowledge, tenacity, coachability, and integrity is paramount. Due diligence on the individual is as critical as on the potential deal.

Deal Metrics (Post-LOI)

Once a target is identified, investors scrutinize the company’s financial health, market position, industry stability, valuation multiples, and the quality of its management team and systems.

Capital Efficiency

How effectively did the searcher utilize the initial search capital? Was the search process focused and cost-effective?

Benchmarks and Search Fund Statistics

As Smash VC shows in their detailed search fund statistics, understanding historical performance provides context. Key takeaways from historical studies include:

• Aggregate Returns: Historically, the search fund asset class, in aggregate, has generated strong returns.
• Distribution of Returns: It’s crucial to note that these are aggregate figures. Search fund statistics show a wide dispersion of outcomes. While some funds generate exceptional returns (10x+ MOIC), a significant portion produce modest returns, and some result in partial or total loss of capital. Not every search fund is a home run.
• Success Rates: Roughly two-thirds of searchers historically succeed in acquiring a company. Of those who acquire, the vast majority generate positive returns for investors, although the magnitude varies greatly.
• Failure Rates: Approximately one-third of search funds fail to acquire a company, typically resulting in the loss of the initial search capital. A smaller percentage fail post-acquisition, leading to more significant capital loss.

These search fund statistics highlight that while the potential for high returns exists and the asset class has performed well historically on average, individual outcomes vary significantly. Past performance is not indicative of future results.

So, is a search fund a good investment? It can be, but it’s not suitable for everyone.