Enabling entrepreneurs: the rise of search funds in Canada - EY

Enabling entrepreneurs: the rise of search funds in Canada By Chris Hutchinson, Lead Advisory Vice President, Private MidMarket Practice, EY

Search fund: a search fund is an investment vehicle in which investors provide capital to an entrepreneur, typically one individual or two, while they seek to identify and acquire a privately-held company. A second round of funding is required to provide the equity to acquire the company, with the original investors having the option to participate or not. Following the acquisition, the searchers will operate the business with a board of directors that will include a small number of the investors. Search funds have become an increasingly popular investment vehicle over the past few years in Canada. Young entrepreneurs have been looking for a financially rewarding career path, and have become intrigued by the opportunity that exists in running an established business. For those who are motivated by the desire to build and manage their own business, but who do not have the opportunity / idea to start a company from scratch, acquiring a small, privately-held business may be an excellent option. In working with the majority of Canada’s most successful search fund entrepreneurs and investors, we have found unique considerations that should be looked at from both the search-fund principal and investor’s perspectives. Here are some key concepts that searchers and investors should consider when embarking on the search fund journey:

Considerations for principals Establishing credibility Running a small business, the challenge of growing an existing private company and the potential financial rewards that a search fund provides, draw

young entrepreneurs to search funds. One of the most significant obstacles that a search fund principal will be faced with early on is establishing credibility with their potential investors to secure funding for the search. There isn't a clear path to earning credibility. Getting introduced to an investor by someone he or she trusts, can help lay a solid foundation for credibility with investors. Investors are looking for searchers who they believe can find deals, use good judgment in selecting a deal to move forward with, and successfully manage the business that is ultimately acquired – this involves a unique blend intelligence, people skills, analytical skills, and experience / knowledge in management. While many investors that we’ve seen have already invested in search funds, we’ve seen that some of the search funds starting in Canada are reaching out to new groups of investors who they may need to sell on the search fund model. As more and more potential investors become familiar with the model, this barrier is removed. An additional obstacle that a search fund principal will need to overcome is meeting with company owners who may be skeptical or unaware of search funds. Business owners may be uncertain as to how a young and relatively inexperienced entrepreneur could secure the financial backing and have the competence to take over the company and lead it successfully. Search fund principals need to possess the ability to convince a potential seller to work with them, and be able to demonstrate their suitability and drive to take over the business and continue to manage the business successfully into the future. A business sale to a search fund does present a unique opportunity to potential vendors compared with strategic or private equity buyers.

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Flexibility is key Search fund principals need to be flexible. During the initial fundraising process, the principal will establish industries of interest and criteria for potential acquisitions. However, the chance of finding the business that meets all of the principal’s criteria is challenging. They will need to manage their expectations, and look at potential businesses that may not fall into the specific categories and industries that they were hoping for. Finding the right business that meets acceptable criteria, and is available for the right price, will be the cornerstone to their search process.

Account for growing pains Once a target has been identified and an acquisition is moving towards closing, a search fund principal should set up financing to allow for enough room for all of the growing pains that may occur in the first year of running the newly acquired business. Principals need to be aware that running the new business may present costs and expenses that were not initially accounted for. Whenever you buy an existing business and look at its records, you're looking at the past. There's no guarantee things won't change going forward from taking over someone else’s business. While completing proper due diligence is critical in understanding the financial viability of a business, there can be challenges when a principal wants to implement cultural or process changes within an established business. Working closely with existing management is key to understanding the culture of the business and deciding the best path for the business to take into the future.

Work with the right lenders Search-fund principals are driven by the potential to own, manage and build a company. They possess the passion to lead a company in which they have a meaningful economic stake, and that passion is stronger than the need to start the company from scratch. This can be a fundamental change in ideology that may be difficult for many lenders to accept. It is important that when principals are seeking funding that they work with a lender who is familiar with the search fund model. This will ensure that the lender is already versed on the process, and will have an understanding of what is required and the structure for typical transactions.

Considerations for investors Weighing the risks with potential rewards Search funds can provide a great opportunity for investors to diversify their portfolio mix and invest in businesses that can grow and yield a high return when ultimately sold. However, as with any investment strategy, there are risks associated with search funds. There is no guarantee that a principal will locate and secure a business to acquire in the timeframe that is financed by the investors’ initial round of capital. If an investor is only looking to work with one principal, they must be comfortable with taking on the risk that the searcher may not find a target business. Investing in more than one search-fund principal yields higher chances of success in finding the right business, however, it requires more capital and risk. Investors should weigh their options and understand their investment limits carefully prior to undertaking the search fund

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process. They must have faith in the principals that they are choosing to invest in.

Leading the future Beyond providing the capital to fund the search process and acquisition, investors may be able to act as a high-quality advisor in the business relationship. Investors can provide valuable guidance through the initial search for a business by introducing principals to key contacts and networks. Often, investors may have key contacts in the banking and legal sectors and can help principals get introduced to the right people within their targeted industries. After the business acquisition, investors may also serve as knowledgeable resources to the principal as a key stakeholder in the business or be on the Board of Directors of the acquired business. Ultimately, it will be up to the principal to determine the level of involvement of the investor in running the business as not all investors can have a seat on the Board. Investors need to be comfortable with the notion that they will not have the full say in the business and they need to have confidence in the principal and the Board to do what is best for the business.

Investors need to be flexible too When a search-fund principal ultimately finds the right business fit for them it may not fit the business model that the investor is looking for. There is a high degree of flexibility that is required on the investor’s end, as they will need to be open to different potential types of businesses to invest in, or risk diluting their share of the fund by not investing additional capital in the acquisition. The typical acquisition target for all search funds will

have similar criteria, such as growing and recurring revenues, a minimum threshold for EBITDA margins, low technological risk and low inventory and capital expenditure requirements. However, keeping a broad list of other criteria such as industry focus will increase the likelihood of a potential acquisition business meeting an investor’s criteria. Having worked with many successful Canadian search-fund principals and investors, the process can be both a challenging yet rewarding experience for all parties involved. Search funds are a good vehicle for investing in small private businesses, which are often smaller than typical private equity targets. For investors, they can provide an excellent alternative for portfolio diversification and are a great option for high net worth individuals who are looking to invest in the private business sector. For search-fund principals, the process provides a great opportunity to gain business experience, build a high calibre network of associates, and presents the opportunity to run and grow a successful business and profit on the eventual sale. While search funds are a newer investment vehicle in the Canadian business landscape, judging by the number of successful acquisitions and new search funds being formed they appear to be here to stay. It will be exciting to see this newer entrepreneurial model grow in Canada, and to see who will be the next one to “make it big.”

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Chris Hutchinson is a Lead Advisory Vice President, Private Mid-Market Practice, EY. He has over eight years of experience in advising clients of various sizes and backgrounds on due diligence matters, search funds, mergers and acquisitions, financing, and valuation matters. Follow us on Twitter @EY_CAPrivateCo.

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