Popular in the U.S. since the 1980s, search funds are a new breed of private equity investment vehicles that have started to pop up in Canada.
We recently spoke with a pair of Canadian search fund entrepreneurs. Zack Newton and Gavin Cheung are the co-founders of Quinzhee Capital (QuinCap), a Toronto-based search fund formed in late 2013. Along with telling us about QuinCap, Newton and Cheung shared their ideas about this new niche market and the unique opportunity it offers to prospective investors.
What are search funds?
Search funds originated in the U.S. as a vehicle to invest in a single, small, privately-held business that is subsequently managed by the fund principals. Since 1984, there have been over 150 documented search funds, which have generally raised between $300,000 and $750,000 of initial capital for a dedicated two-year search period.
In Canada, there have been approximately half a dozen funds that have closed since 2010, with many more principals currently trying to start a new fund.
Search funds normally raise capital from an investor group that can comprise upwards of 20 investors, with all of them – usually including the principals – committing an initial $25,000 to $50,000.
Investment in the fund follows a two-stage approach – the first of which sees the initial outlay to the fund used by the principals' search initiatives for a suitable business. A second investment, which the initial investors are not committed to make, follows to finance the acquisition once the principals have identified a company that meets their investment criteria. Following the transaction, the principals will step in at the senior management level to run and grow the business.
The initial capital raised by the fund will cover administrative expenses associated with the company search, including salaries for the principals, office rent, business development, other overhead, and travel costs (there are no conventional private equity fees paid to the founders).
The principals use their time to find the right business to take back to their initial investors – typically with an enterprise value of between $4 million to $12 million. Once a target company has been identified, the initial investors have the option to participate in a second round of financing to secure it. However, regardless of whether investors choose to participate in the second round, they maintain their initial fund investment and benefit from a gross up to a preset multiple (usually 150%) of their initial investment.
The unique risk for search fund investors is the loss of their initial outlay if the funds dry up before an acquisition is completed. This risk is counterbalanced by the potentially significant returns on their equity stake at the exit phase. Exits can take the form of a private sale or IPO of the acquired business.
Of course, the investors also face risks commonly associated with the purchase of private companies, including whether the investment is able to generate adequate risk-adjusted returns upon its eventual sale.
From the principals' perspective, the investor pool is an invaluable resource in their search efforts. Investors often include sophisticated and experienced financial and business professionals. They can offer useful introductions and access to business networks, and provide guidance during the fund-raising, business growth and exit stages. Their expertise can be leveraged in other ways too. For example they may be suited to take seats on the board of the acquired company or provide insight during the pre-acquisition diligence process and in the post-acquisition operational phase.
Much like conventional PE funds, Canadian search funds are most often structured as limited partnerships, with the principals acting as GPs and the investors holding LP interests.
While structures may vary, a business acquisition is often financed with a combination of bank debt, subordinated debt, preferred shares and common shares. The principals typically receive a portion of the common equity, contingent on the achievement of milestones, which are negotiated between the principals and the initial investors in the first-round financing.
Prospective growth opportunities and cash flow generation are among the factors that will guide the fund principals in selecting a business to purchase. Search funds often focus on established companies, as opposed to startups or turnaround situations.
QuinCap was formed to find, invest in and manage a Canadian business. Prior to co-founding the firm, Newton was an associate at Torys, with a practice that focused on advising business operators as well as private equity and venture capital funds on their investment activity. Cheung was an investment banker at National Bank of Canada, raising capital and providing financial advice for public and private companies in diversified industries.
Newton and Cheung have been close friends since high school, and in mid-2013, they decided that they wanted to collaborate on something more entrepreneurial.
We asked Newton why they chose the search fund opportunity over others.
Newton: From a market perspective, there are many retiring baby-boomers searching for a transition partner whose businesses are too small for conventional financial purchasers. Professionally, we were excited by the prospect of rolling up our sleeves and using our skill sets to take an operational role in a single business. On a personal note, it is gratifying to address a specialized need in the Canadian business community and know we can continue someone's legacy by working with an established company and ensuring it thrives in the future – especially if that company currently has no obvious succession plan.
Following its launch in mid-2013, QuinCap closed its fund in December with an all-Canadian investor base. Its principals' search efforts are now in full swing. We asked Cheung what types of selling companies are preferred.
Cheung: There is a wide range of seller profiles that are attracted to search funds, but two stand out in particular –retiring owner-operators that lack a clear internal transition plan, and entrepreneur-founders looking for liquidity. Every week we meet business owners who have built impressive organizations, and they want to know they are handing over the keys to someone who cares about the business and its employees. We provide that because we focus on a single business with growth potential that we can operate and add value to – as opposed to other strategies, such as product or employee rationalization.
From the investors' perspective, committing to a search fund can present an attractive business opportunity. In return for their up-front commitment, they can invest in opportunities that may otherwise be difficult to tap. We asked Newton to comment.
Newton: Traditionally, most search funds have been financed by a close-knit group of U.S. investors who co-invest in a portfolio of funds, including several recently closed funds in Canada. Our all-Canadian investor group consists of first-time (albeit extremely experienced and sophisticated) search fund investors who were excited by the number of compelling investment opportunities in our targeted size range. Outside of search funds, it can be difficult to cost-effectively find, acquire, operate and grow a company of the size we're looking at.
We also asked Newton and Cheung why they named their firm Quinzhee Capital.
Newton & Cheung: What is a Quinzhee? It's a shelter used in winter camping that's similar to an igloo but made of snow instead of ice. We are both camping enthusiasts who are proudly Canadian, and consequently wanted a quintessential Canadian name. Unfortunately we've had to consistently explain the name as we reach out to business owners!
While quinzhees may still require explanation (even among proud Canadians), the search fund model is attracting increased attention in the domestic market. With its growing prevalence, it's only a matter of time before the model will be better known to businesses and investors across the country.
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