Copyright 2012, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Business Law/Private Equity, February 2012
Search funds, the lesser-known sibling of pledge, buyout and venture funds, are gaining momentum in the Canadian private equity marketplace. This model, which has been in use in the U.S. for several decades, might not be familiar to many Canadians despite its potential benefits for raising capital in a unique market such as Canada, as well as for succession planning for Canadian business owners.
What is a Search Fund?
A search fund is a specialized form of private equity fund best characterized by its multiple-stage capital-raising activities and evolving role of the founders over time.
The life cycle of a typical search fund consists of several phases: (i) initial capital raising to fund the search for a target; (ii) searching for a target; (iii) acquisition capital raising; (iv) acquisition; (vi) ongoing management of the acquired target by the founders of the search fund; and (v) the search fund's exit or sale of the target.
A unique feature of a search fund, as compared to other private equity funds, is the two-stage capital-raising process. A search fund establishes itself by raising an initial capital pool with the aim of financing a "search" for a business to acquire. This first stage seeks to raise anywhere from $250,000 to $750,000 for the search phase, which can, depending on the success of the principals in finding a suitable investment, range from a period of several months to several years. The initial capital raised is used by the search fund to pay organizational and due diligence expenses, as well as a salary for the founders. Often, in exchange for the search capital, initial investors are guaranteed a pro rata right, but do not have an obligation to invest in the acquisition of the proposed target once it is identified.
The second stage of capital raising occurs once a target is identified. The founders of the search fund will canvass their initial investors for acquisition funds and may also look to new equity investors, lenders or the seller of the target as additional sources if the initial investors do not provide the full amount of the acquisition funds. In Canada, search funds typically look for targets with an acquisition cost in the range of $5-million to $30-million, but there are no legal limitations on the acquisition size.
Post-acquisition, the search fund founders will typically operate the target for three to seven years, implementing rationalization strategies, increasing sales and decreasing expenses, much like any other private equity fund sets out to do. The "operating period" is then followed by a public offering, sale of the target or some other liquidity or exit event.
The structure of a search fund can vary depending on the jurisdiction of its investors and tax planning considerations, but a typical structure, for a Canadian deal with Canadian founders, involves the creation of a limited partnership, the general partners of which are the founders of the search fund, and the limited partners of which are the investors in the search fund. Unlike in a traditional private equity fund model, management fees are minimal, if they exist at all, and instead founders receive a market rate salary in their post-acquisition managerial role, often with the ability to earn equity throughout the term.
Motivations of the Players
Founders. Founders of search funds are typically business-oriented individuals who are looking to satisfy their entrepreneurial spirit without having to build a company from the ground up, and who want to work as an operator, while being compensated with equity. Founders typically take an equity stake in the target, often in the form of stock options in the acquisition company or carry in the upstream limited partnership to incentivize the founder to perform.
Investors. Upon contributing initial search capital, investors receive a pro rata right-of-first-refusal to invest additional funds in connection with acquisition financing and the right to convert the investor's initial search capital into equity at an increased value, often 150%, of the initial amount. This conversion rate is meant to compensate investors for contributing capital at the riskiest stage of the investment. The right-of-first-refusal provides comfort to investors in that if they disagree with or lose confidence in the fund, they can bow out. This differs from a typical private equity fund which has firm capital commitments and a limited ability for investors to withdraw investments. A search fund investor base is rarely dominated by any one investor and is usually comprised of sophisticated investors who themselves act as advisers to the business. The founders, seeking to ensure investment in the acquisition phase, will often involve the investors in the acquisition diligence, allowing the founders to capitalize on each investor's knowledge, expertise and contacts. The expertise of the investors is often also called upon post-acquisition.
Canada's lower middle-market capital sector provides a target-rich environment for search funds to operate. However, regardless of deal size, a search fund, like any other fund, will have to consider structuring, commercial and other legal issues prior to its formation and through to the exit stage. Ensuring adequate consideration is given to relevant legal issues is of particular importance to search funds with many first-time founders staking their reputation on a smooth and successful acquisition and exit.
Fundraising Considerations. Search funds must comply with provincial securities laws applicable to private offerings at both the initial funding stage and the acquisition funding stage. Most search funds will want to prepare an offering memorandum for investors to provide more information on their search fund. At the acquisition phase, the offering memorandum will help lend credibility to the search fund and show that the founders understand key risks of the target. Such offering memoranda will require the guidance of experienced legal counsel. Depending on where investors are located, compliance with securities laws of multiple provinces may be required.
Structuring and Governance Considerations. In addition to securities compliance, the structuring of search funds typically involves sophisticated fund agreements which specify governance, distribution, follow-on financing and allocation terms. These documents must balance certainty for investors with flexibility for the founders as the details and structure of the acquisition are not known at the time of fund formation. A key consideration in the structuring of a search fund will be the location of investors. As a result, tax planning should be taken into account at this stage. These preliminary planning steps are vital in ensuring that when the search fund is ready to make an investment, it is in a position to do so without having to revisit key legal points with its investors.
Diligence Considerations. Once the search fund is established and the founders begin diligence on potential targets, legal counsel can assist the founders in a variety of ways including investigating and reviewing potential target investments, drafting letters of intent, non-disclosure agreements and term sheets and assisting with legal due diligence. For many founders, the acquisition may be their first solo experience and legal counsel can help prepare founders for the inevitable questions from investors and educate them in the acquisition process.
Acquisition Considerations. Once a target is selected, negotiations begin and founders often find themselves negotiating on multiple fronts including with sellers, investors and third-party financing sources and managing these relationships in tandem is critical to success. From a legal perspective, different stakeholders have different issues that need to be considered with a co-ordinated strategy. In addition, ensuring that the initial search fund structure remains an appropriate structure for the post-investment time period (from a legal, commercial and tax perspective, among others) will require consideration. Experienced legal and financing advisers can be invaluable in assisting with these considerations.
If you are considering forming or investing in a search fund or are already in an existing relationship, we welcome consultation on deal terms, the search fund model or legal matters associated with the search fund to help this entrepreneurial model grow in Canada.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.