United States: Just What You Are Looking For?—Family Office Direct Investing In Search Funds

Family offices are increasingly taking note of "search funds" as a private equity investment alternative within the broader private equity investment class. Over the past five years, family offices have allocated more and more investment dollars to private equity. Within private equity, though, some family offices have been looking to take a more active role in their private equity investments. As a result, some family offices have implemented direct investing strategies where the family invests directly in an operating company. A search fund, however, offers family office investors a unique bridge between investing in a traditional private equity fund and a direct investing strategy.     

A search fund is a specialized private equity fund that is formed by an individual or a pair of individuals for the specific purpose of acquiring one target company; the principal(s) of the search fund then step in and operate the target company. Search funds are distinct from traditional private equity funds in that (i) the search fund principals take active operating roles following the acquisition, and (ii) the search fund only acquires one target company and not a portfolio of companies.

In the traditional model, the search fund team initially raises "search capital" of approximately $400,000 to $600,000 from approximately 12 to 16 investors. This search capital provides the search fund team resources to search for an acquisition target, conduct their own due diligence, engage third-party diligence providers as needed, and negotiate terms of and finance the acquisition. The search typically takes 18 to 24 months, and search fund principals each draw a salary of approximately $100,000 to $125,000 per year during the search phase. In exchange for the search capital, search fund investors receive a right of first refusal to invest in the acquisition opportunity that the search fund team finds, and they typically receive a 50 percent step-up on the search capital investment dollars.   

The recent trend toward family offices directly investing in search funds is occurring in two primary ways. First, family offices are funding the search—either partially or entirely. This technique brings captive deal-sourcing opportunities into a family office. By funding the entire search, the family office will have the first look at the acquisition target and have the right of first refusal to invest in the deal. This approach would be particularly important for family offices that find deal flow a challenge to their direct investing efforts, or may otherwise lack the investment staff to review potential deals.  

The family may also want to have more significant input in setting the investment parameters for the search fund's target company. If a family office funds the entire search capital, the family will have a say in setting the search parameters— which is important if the family office wants to make an investment in a particular area or industry. For example, the family may have industry-specific knowledge and experience it hopes to utilize in connection with the investment, or they may be looking to make investments in an area of particular interest to one or more of the family members. Search fund principals may also value collaborating with the family and not having to worry about finding and managing multiple investors. While there is a lack of diversification in a search fund when compared to the traditional private equity fund, the family may achieve other goals with having input in setting the search parameters. Also, given the smaller transaction sizes, search fund investments will likely only be a portion of a family's broader, diversified private equity portfolio.   

If family offices decide not to invest at the search phase, a second investment opportunity arises with search funds at the acquisition stage, after a target company has been found. If the search-phase investors do not exercise their right of first refusal and do fully fund the target investment, search funds will need additional outside capital. By investing only at the acquisition stage, the family office does risk the search fund team failing to find a transaction. Also, the family office can assess each investment on a one-off basis. However, if it does not invest at the search phase, family offices may not even get the chance to invest in the target company if the search phase investors fully fund the proposed acquisition. 

As mentioned above, another key difference from a typical private equity fund investment is that, following the investment, the search fund team becomes the management and operates the target company. The collaboration and relationship built between the family office and the search fund team in the search phase can grow even further when the search fund team steps into managing the operating company. The family benefits from having an identified management team to handle the investment. For the search fund team and the investment operating company, the family may bring unique industry expertise and connections to the table.  

Because of the flexible nature of the investment model and collaborative relationships built through the investment process, search funds may be just the investment family office investors are seeking.

Just What You Are Looking For?—Family Office Direct Investing In Search Funds

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.

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