With global markets reeling in the aftermath of the COVID-19 pandemic, business owners and investors alike are looking for the next opportunity. Jason Colodne, managing partner at Colbeck Capital Management, recently sat down with Jan Simon, managing partner of Vonzeo Capital, to discuss search funds, often-overlooked investment vehicles that are gaining momentum. Learn about the history of search funds, where they stand today, and where Simon sees search funds in the future.
The Past: The History of Search Funds
A search fund is a type of investment whereby entrepreneurs raise money from investors in order to buy a business. In his interview with Jason Colodne, Simon shared that search funds are a compelling asset class because they’re far from traditional. “You’re investing in younger people who need a lot of mentorship,” Simon explained.
First created in 1984, there are now over 500 search funds available globally — with 50% appearing over the past five years. “Most people had never heard about search funds until they went to business school,” Simon said. Although search funds have been around for decades, it wasn’t until recent years that they caught the attention of investment funds, entrepreneurs, and business owners.
The Present: The Great Wealth Transfer
So, why did it take so long for search funds to catch on? According to Simon, search funds have three phases. In Phase 1, searchers raise capital. There’s no proof of concept, so it’s difficult to find investors. In Phase 2, the company goes through an acquisition. And in Phase 3, the acquirers successfully exit the business.
The issue is that it can take seven years to make it from Phase 1 to Phase 3. This explains, in part, why search funds didn’t gain global traction until 2013.
Jason Colodne added that the Great Wealth Transfer also led to the search fund renaissance. As baby boomers retire, they’re looking to cash out and sell their companies. In many cases, searchers are acquiring businesses from retiring business owners.
Assessing Risk
Although search funds come with the potential for bigger payoffs, they aren’t without their risks. “[In terms of risks], see which ones you can mitigate and which ones you can’t. Only then [should you] discuss if the expected return justifies the risk,” Simon said.
There’s an inherent risk in putting inexperienced 32-year-olds at the helm of a company, so Simon told Jason Colodne that he recommends reducing risks in other areas. “We try to severely limit allover types of risk at the industry and company level, “ the Vonzeo Capital co-founder said to Colodne.
- Simon recommended avoiding risks like cyclical or complex businesses, sector disruptors, expensive acquisition deals, capital-intensive businesses, and businesses that rely on government decisions.
“In short, buy a good business in a great sector, and do not overpay,” said Simon.
Good Versus Bad Acquisitions
Search funds are nontraditional investment vehicles, which means there’s always the potential for an acquisition to go sideways. “Sometimes investing is about avoiding the bad deals, and I think that’s a very important thing for a searcher to understand,” Simon shared. “The risk actually lies in when you buy a company and then you destroy it.”
To avoid bad deals, Simon told Jason Colodne that it’s best to choose businesses in thriving industries and have a defensible moat around the company. Aim to select bigger and more competitive businesses and put a solid CEO into a leadership role and allow them to gain experience over the course of a year without making considerable changes. Additionally, hire an experienced board that orients the business to tackle big issues.
Simon also recommended that once you acquire a business, you should add value to it so you increase the chances of a successful exit. He shared with Colodne that searchers can add value to acquired companies in four ways:
- A strong CEO: “You put in an ambitious person at the helm who finds low-hanging fruit in setting up a sales force with proper incentives,” Simon said.
- A better culture: The top-down corporate hierarchies of the past don’t hold water in today’s market. Simon explained to Jason Colodne that a new cultural model of shared responsibility can improve corporate performance.
- New business models: Whether it’s software as a service, leasing, or maintenance options, new business models invigorate acquired businesses.
- Digitization: As Simon put it, retiring company owners are generally “pale, male, and stale” and fail to embrace digitization. This is low-hanging fruit for ROI-minded searchers.
The ultimate goal is acquisition, but for that to go through, a business needs to experience significant growth. While nothing is guaranteed, searchers can improve the quality of an acquisition — and a subsequent exit — by becoming good stewards of the business.
The Future: Untapped Opportunities Abound
In his interview with Jason Colodne, Simon shared that there are untapped opportunities in search funds. He predicted that businesses in larger countries, like the United States or Japan, will likely experience more success with search funds. The market in Asia, in particular, holds promise because of its rapidly aging population that needs fresh blood to bolster the economy.
However, Simon admitted that search funds have their limitations. “We solved the problem of succession for smaller businesses by putting inexperienced yet smart and ambitious people at the helm,” he said.
But it’s a labor of love: Many investors aren’t willing to put in the sweat equity and time. While search funds dazzle investors with 30% returns, they require a lot of effort. Search funds very well may be the future of acquisition, but they need a strong team and committed investors to get acquired companies across the finish line.
About Jason Colodne
Jason Colodne is the senior transaction partner at Colbeck Capital Management and oversees all aspects of investment execution and portfolio management. Colodne co-founded Colbeck Capital Management as a managing partner in 2009. Colodne’s investment experience spans over two decades.
About Colbeck Capital Management
Colbeck Capital Management (colbeck.com) is a leading, middle-market private credit manager focused on strategic lending. Colbeck partners with companies during periods of transition, providing creative capital solutions. Colbeck sponsors its portfolio companies through consistent engagement with management teams in areas such as finance, capital markets and growth strategies, distinguishing itself from traditional lenders. The firm was founded in 2009 by Jason Colodne and Jason Beckman; the principals have extensive experience investing through different market cycles at leading institutions, including Goldman Sachs and Morgan Stanley.
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