Search Funds are Growing In Popularity As a Way to Raise the Odds of Building a Successful Business

"While most people have never heard of them, search funds are attracting increasing attention as a way for small businesses to beat the usual odds of success, even in the midst of a deepening recession," according to an article in The New York Times ("Paying Entrepreneurs to Find the Right Business," March 12, 2009), from which this posting is abstracted.

"This is the way a search fund typically works: One or two ambitious graduates of a top-tier business school, who want to run their own business but recognize they lack practical experience, offer themselves as fledgling entrepreneurs who can make some tough-minded investors a lot of money.

"These investors put up about half a million dollars for the pair to spend up to two years scouring the marketplace for a promising business with $10 million to $30 million in revenue. If satisfied with the choice, the investors help finance the acquisition of the business, join its board and give their young partners a crash course in hands-on management. If all works out, the venture grows and makes everybody richer.

"H. Irving Grousbeck, co-founder of Continental Cablevision (later Media One) and now a consulting professor of business at Stanford University, helped originate the business model a quarter of a century ago and has been studying it ever since.

"Grousbeck says studies by the Center for Entrepreneurial Studies at Stanford, which he co-directs, show average annual returns by search funds to their original investors of well over 30 percent.

"The results are skewed by the big winners, which constitute about a fourth of the total. Another fourth fold without making a purchase, a fourth lose money for their investors and a fourth provide a middling return, according to Mr. Southern, the Boston investor. Still, taken as a whole, search funds can be a winning proposition.

"The funds do have drawbacks, of course. The same recession that has attracted search fund buyers has scared off sellers, for example, Mr. Grousbeck said.

Moreover, major successes are rare. However, one major success is Asurion, which was built from a $6 million roadside assistance company with 45 employees into the nation’s largest provider of insurance products to cellphone companies.

"Asurion provides a case study of the power of the search fund model in the right circumstances.
The founders, who had studied under Mr. Grousbeck at Stanford, said they liked Roadside Rescue (the predecessor company) because it was not a towing company. Instead, it sold roadside assistance insurance through local wireless carriers to their users. The venture grew by 50 to 100 percent a year in its first four years.

"Then the two men had an epiphany: they were not in the roadside-assistance business; they were in the cellphone services business. In 1999 they expanded into insurance for loss or damage to cellphones. After making three major acquisitions in recent years, Asurion, based in San Mateo, Calif., has grown into a $2.5 billion company with 10,000 employees, more than 70 million wireless customers and a growing presence in Asia.

Jim Southern, a Boston investor, said his search funds had generated 14 times the capital he placed in 20 companies over an average holding period of eight years

He says that "more business school graduates are being drawn to search funds, in part because of Asurion’s success and in part because the recession has diminished prospects on Wall Street and in corporate America. Nearly 25 would-be search fund entrepreneurs have approached him since November alone, he said, compared with fewer than 10 in a full year in the past. He plans to back nine funds this year, the same as in 2008 and 2007 but significantly more than the one or two a year he helped finance before that.

"Mr. Grousbeck, the Stanford professor who nurtured the first fund in 1984 when he was teaching at Harvard, says the business model has spread to Europe, Latin America, Asia and even South Africa, if only by a trickle.

"Still, search funds occupy a tiny niche of the investment world. Mr. Southern estimates that only 160 or so have been created, all looking for companies with less than $50 million in revenue. He estimated that about 60 search fund companies were active today.

"Even so, Mr. Grousbeck said, investors who back a portfolio of search funds stand a good chance of beating the returns in other markets. “I can’t tell you how many investors have asked me, ‘Why should I pay somebody to hunt for a company when entrepreneurs are knocking on my door all the time to invest in theirs?’ ” he said. “I tell them, ‘You’d be taking a very small risk for the chance to ride the coattails of some very bright and talented people.’ ”