Search Funds In Canada: Navigating Cross-border Challenges

Key takeaways

• Search funds are increasingly popular in Canada but can face structural and tax inefficiencies when formed as U.S. LLCs.
• The traditional search fund operates in two main phases: the search portion which usually lasts between 18-24 months, followed by the acquisition and operation phase.
• For Canadian searchers, planning ahead and considering Canadian LP structures can provide an attractive structure.

Search funds are becoming an increasingly popular investment vehicle in Canada, particularly among aspiring entrepreneurs seeking to acquire and operate small to medium-sized businesses. Originating in the United States in the 1980s, search funds have gained traction globally as an alternative to traditional mid-market private equity or independent sponsor models. While this model has proven successful in many cases, its growing adoption in Canada has revealed certain structural and tax inefficiencies, particularly when search funds are formed using U.S.-centric “boilerplate” legal documents.

Sponsors, entrepreneurs and other proponents need to take into account a variety of issues when considering the establishment and operation of a search fund.

Search fund structuring and overview

A “traditional” search fund typically operates in two distinct phases: the search phase and the acquisition and operation phase. During the search phase, a searcher initially raises capital from a group of investors to fund costs for a search. These costs can include legal and accounting advisor fees, rent, modest salary for the searchers and travel. With these costs funded, the search for an acquisition target commences. In most instances, searchers seek targets that are well-established businesses with positive cash flows and growth potential, but that may lack a clear succession plan for the existing ownership and management team. The search phase usually lasts up to 24 months, but can be extended in some circumstances, subject to investor approval.

Once a suitable target has been identified, the searcher raises additional capital to fund the acquisition. Capital often comes from the same initial investor group. These initial investors benefit from a priority right to invest on a pro rata basis in the acquisition phase and typically receive a 1.5 times “step up” on their initial search capital at time of closing of the acquisition.

Following completion of the acquisition, the searcher transitions into an operational role, typically as the chief executive officer, to manage and grow the acquired business. Investors benefit from actively participating in the support and mentoring of an entrepreneur while having the opportunity to achieve attractive financial returns. Searchers are also granted equity at time of completion of the acquisition. There may also be an ability to earn incremental equity subject to generally agreed-upon time- and milestone-based conditions.

The dominance of U.S. LLCs in search fund structures

The search fund model has been heavily influenced by its U.S. origins, where the vast majority of search funds are structured as limited liability companies (LLCs). This structure has gained prominence in the United States due to its flexibility, pass-through tax treatment and well-established use. Additionally, the search fund ecosystem in the U.S. has developed standardized templates for LLC formation, subscription agreements and operating agreements, which many searchers adopt to streamline their fundraising and operational processes.

However, the use of LLCs in the Canadian context can introduce significant challenges, particularly from a tax and structural perspective.

U.S. LLCs for Canadian search funds create tax inefficiencies

For Canadian investors, the use of a U.S. LLC as the search fund vehicle creates substantial inefficiencies. The crux of the issue lies in the hybrid nature of U.S. LLCs. An LLC is generally treated as a pass-through entity for U.S. tax purposes, but as a corporation for Canadian tax purposes. This mismatch in tax treatment leads to several complications.

First,Canadian investors in a U.S. LLC may be subject to both Canadian and U.S. tax implications in respect of their investment in a U.S. LLC. While the LLC's income is considered earned at the entity level from a Canadian perspective, given its treatment as a corporation, the same income may also be taxed at the investor level in the U.S. through its treatment as pass-through income. The result may be double taxation of the same income in Canada and the U.S. This mismatch significantly diminishes the attractiveness of the investment for Canadian investors.

Holding an interest in a U.S. LLC may create additional Canadian tax compliance burdens, particularly if the U.S. LLC is treated as a “foreign affiliate.” Depending on the operations of the U.S. LLC, Canadian investors may also need to navigate the complexities of filing U.S. tax returns and claiming foreign tax credits in Canada, further increasing compliance costs and administrative burdens.

Given these inefficiencies, the U.S. LLC structure is not optimal for most Canadian search funds, particularly if the target is ultimately a Canadian company.

Using a limited partnership structure is more favourable

To avoid issues arising from the use of a U.S. LLC, searchers may wish to form Canadian search funds as Canadian limited partnerships from the outset. This proactive approach offers several advantages to searchers and investors.

First, a Canadian limited partnership is governed by Canadian provincial partnership laws, which are generally well-suited to the needs of search funds. The structure provides an opportunity for investment on a flow-though basis. At the same time, it generally affords limited liability protection to the limited partner investors that is akin to the limited liability afforded to investors in a U.S. LLC. Similar to LLCs, limited partnerships offer flexibility to provide for profit-sharing arrangements and separate management structures, making them a suitable alternative structure for search funds.

A Canadian limited partnership is generally tax-neutral for investors from many jurisdictions. For example, for investors in both Canada and the U.S., Canadian limited partnerships are generally treated as pass-through entities, allowing income to flow through the partnership without entity-level taxation. Consequently, for non-Canadian investors, investing in a Canadian limited partnership will generally not, in and of itself, create any material incremental Canadian tax exposure or compliance obligations. Given the flexible nature of Canadian limited partnerships, many Canadian private equity and venture capital funds are structured in this manner. Further, by eliminating certain tax inefficiencies associated with U.S. LLCs, a Canadian limited partnership structure can make Canadian search funds more attractive and approachable to Canadian and non-Canadian investors alike, thereby expanding the pool of potential capital.

In some cases, it may be possible to convert a U.S. LLC structure into a Canadian limited partnership at the time of completion of an acquisition. While converting to a Canadian limited partnership in anticipation of an acquisition can address the tax inefficiencies of the U.S. LLC structure on a going forward basis, it also introduces unnecessary complexity and cost compared to setting up the search fund as a Canadian limited partnership from the outset. The conversion process involves legal, tax and regulatory hurdles, including the need to draft new agreements and potentially restructure the investor group. Furthermore, there is no straightforward mechanism to “convert” a U.S. LLC into a Canadian limited partnership. Depending on the circumstances, the conversion may be a taxable event for investors. These challenges can delay completion of an acquisition and increase transaction costs and deal friction, undermining the efficiency of the search fund model.

Planning ahead with a Canadian-oriented approach

As search funds continue to gain popularity in Canada, it is crucial for searchers and their advisors to consider and plan for structures that align with the unique legal and tax landscape of the Canadian market. While the U.S. LLC model has served as a useful template, its potential inefficiencies for Canadian investors and acquisitions of Canadian companies may well mean it is not the ideal structure for search funds established and operating north of the border.

For Canadian searchers seeking efficient models for potential Canadian acquisitions, the Canadian limited partnership provides a tax efficient, simplified structure that can appeal to and attract a broader base of investors. Taking the appropriate time to consider and implement an appropriate search fund structure can position Canadian searchers for long-term success in an increasingly competitive market. As the search fund model continues to evolve, embracing a Canadian-centric approach will be key to unlocking its full potential in the Canadian market.

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