So, you’re about to complete your MBA and looking for a great job. You want to run a company but have neither the experience to get hired as CEO nor a brilliant startup idea to launch your own. How about buying up a promising small company and becoming the CEO right away?
It’s not a pipe dream. It’s the core idea behind “search funds,” a fast-growing niche of the private equity market.
In a search fund, entrepreneurs–often newly minted MBAs–find investors to finance and mentor them. In the search phase, investors essentially pay the entrepreneur to scour the country for a company with potential. In the acquisition phase, the investors back the entrepreneur with capital to buy the company, and some of them provide guidance to build it into something bigger.
More often than not, it works. A new report led by Peter Kelly, a search fund veteran who has taught a course on the subject at Stanford Graduate School of Business since 2009, shows that the funds are racking up real profits and growth. The funds are also becoming more professional, using lessons learned from earlier successes and failures, and recently a growing number have been started by executives who are already in mid-career.
Overall, the returns are impressive. Of 325 funds started since 1984, the study calculates that the average annual return to investors has been 33.7%. On average, investors have recouped almost 7 times their original capital. All told, Kelly estimates, search funds have created about $6 billion in additional equity.
Last year, the number of currently active search funds hit an all-time high of 86, and the number of acquisitions in one year hit a record high of 17. Last year also saw the most expensive acquisition yet by a search fund, with a purchase price of $117 million.
“There has been tremendous growth in the past 10 years, and it’s been driven by entrepreneurs who want to become owner-managers without starting their own companies from scratch,” Kelly says. “These are solid companies in very attractive industries, and the entrepreneurs buying them are on their way to becoming excellent CEOs. They’re just inexperienced and need mentoring to be successful.”
The biggest and most legendary search fund successes have been Kevin Taweel and Jim Ellis, two Stanford MBA graduates who in 1995 acquired a small Texas company that provided roadside assistance. The two soon steered their company into the nascent market for cell phone insurance and built it into a company called Asurion LLC that employs 17,000 employees and has revenues approaching $9 billion.
As in venture capital, superstars of that magnitude are extremely rare. Almost one-third of the acquired companies end up losing money for investors. In fact, Kelly excludes Asurion and two other mega-hits in some calculations of average search fund returns, because those outliers would distort the overall picture.
What’s encouraging, however, is that annual returns have averaged between 32% and 38% ever since 2001. That kind of performance is competitive with larger private equity funds and hedge funds. More than two-thirds of the search funds were able to complete an acquisition, and 71% of those funds were profitable.
“It’s encouraging and a little surprising that the returns have stayed high even with that much growth in the number of search funds,” Kelly says. “I think it means that the model has a lot of power.”
Search funds acquire companies in a wide range of industries, from oil exploration to health care services, and in most parts of the United States. Indeed, a growing number of search funds are based in Europe and Latin America.
But there has been a shift in emphasis. Where manufacturing firms were popular in the ’80s and ’90s, technology and services have become more dominant. Over the past seven years, more than a third of the acquired companies have been in tech sectors. Another 28% were in service industries, including retail, and about 12% were in health care.
The average purchase price in 2017 was $13.1 million. As with traditional private equity funds, investors provide equity capital for a substantial part of the purchase price and borrow the remaining amount.
What drives young MBAs or mid-career executives to launch search funds? The most common trait, Kelly says, is the desire to own and lead a company. For people right out of graduate school, who usually don’t have the track record to run a large enterprise or the money to buy a company on their own, search funds offer a way to become owner-managers without having to build a business from the ground up.
And while many search fund entrepreneurs stay with their companies for years–Kelly ran his company, Pacific Pulmonary Services, for 17 years–the accomplishment of running a company can make them highly attractive as “CEOs in waiting” for much larger firms. Indeed, large private equity firms now look at search fund entrepreneurs as candidates to run their own portfolio companies.
“With the right mentoring and the experience you get owning and running a company, you could be a very good chief executive in four years,” Kelly says.
This article was originally published on Stanford Business and is republished here with permission.