Earlier this year the Wall Street Journal published an article in the career section entitled “M.B.A.s’ Latest Pitch to Investors: Skip the Startup, Invest in Me.” The article compares search funds to SPACs (Special Purpose Acquisition Companies) in that there is an investment in a person before there is a company with a promise of cash flows.  The article was intended to get clicks based on business news readers’ interest in the cooling of a SPAC speculative bubble and does not accurately portray search funds, an investment vehicle that has had 38 years of spectacular returns.

The term “search fund” originated at Harvard Business School in 1984, and was popularized at Stanford Graduate School of Business.  Over the past few decades, a curriculum to teach entrepreneurship through acquisition has been steadily adopted by top business schools in the United State and Europe, mostly Harvard, MIT, Kellogg, Booth, and Yale.  Since 1984, over 500 search funds have been launched, and dozens of investment funds, family offices, and wealthy individuals have begun investing in searches.  Search funds have become so popular now more business schools such as Duke, Dartmouth, and Columbia have recently launched courses on the model.  New ETA clubs for learning about search and leadership strategies attracted hundreds of MBA students, and there are a dozen conferences around the world.

A search fund is an investment vehicle that brings together a searcher, investors, and one private company.  The searcher is typically a recent MBA graduate who is interested in running a small to medium-sized business (SMBs). The investors would like access to investments in smaller private companies with fair valuations, and the business owners typically run a great company but don’t have a succession plan for after retirement, and selling the company would need new management.  Search funds are technically a form of private equity because they are in the business of acquiring and operating private companies.

The search fund model solves a problem for all three parties involved. The searcher is a talented and driven entrepreneur with a desire to run a small business but often lacks the resources and experience to acquire an existing company. The investors would like access to the lower middle market firm that typically has lower valuation multiples, but these deals are typically off-market and take a lot of work to source.  The business usually requires a new CEO to step in and run the firm when the business is acquired from an owner that would like to retire.

The companies that searchers target are typically service businesses, such as insurance sales, IT services, pest abatement, and healthcare billing, with low cyclicality, high recurring revenues, and low capital expenditure requirements.  The searchers typically hold the businesses for 5 to 7 years before exiting, sometimes selling to private equity.  According to the most recent Stanford Search Fund Study, the investment returns for search funds have remained consistently high for years. The Internal Rate of Return (IRR) is on average above 30%, and steadily increasing for the average funds excluding the top 5 performing search fund investments, also over 30%. The Return on Investment (ROI) is on average over 5x, and for search funds excluding the top 5, is above 3x.  Search funds are a fantastic method for attracting talented entrepreneurs into SMBs that become a platform for expansion and innovation.  The growth in the model is exciting and a good thing for our economy since small businesses make up half of all employment and most of the employment growth.