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What is a Search Fund?

A Search Fund is an investment vehicle through which one or two entrepreneurs (the “Searcher(s)“) raise funds from investors in order to search for, acquire, and lead a privately held company for the medium to long term, normally in anticipation of an exit down the line, by way of a sale, IPO, or alternative liquidity event. The typical target company is a legacy business which has owners wishing to retire.

• How is it different from a publicly traded SPAC? The equity capital raised by a Search Fund is private versus publicly traded in a SPAC.
• How is it different from private equity? Unlike private equity, Search Funds look for companies in which the Searcher(s) will also take an active role in operating the business post-acquisition. Additionally, Search Funds typically have an involved investor base, with major investors taking up board seats of the target company, which helps guide the Searcher(s) through the search, acquisition, and operation of the business.

This model has been a popular alternative investment vehicle in the United States for many years, however, it is quickly becoming an attractive alternative for entrepreneurs or Searcher(s) in Canada who may want to avoid the growing pains of starting and scaling a business, but still have a strong entrepreneurial drive to run an already existing company, increase the companies valuation, and exit with significant financial upside.

Life Cycle of a Search Fund:

The life cycle of a Search Fund is typically as follows:

1. Initial capital raising to fund the search for a target company (2-6 months);
2. Searching for a target company (1-2 years);
3. Additional acquisition capital raising to fund the target company purchase (1-2 months);
4. Acquisition of the target (60-90 days);
5. Ongoing management of the acquired target company by the Searcher(s) (3-7 years); and
6. Sale of the acquired target company (60-90 days).

Legal Considerations:

Raising Capital:

• For initial capital fundraising, a private placement memorandum (a “PPM“) is normally prepared by Searcher(s) and given to investors in order to provide the following information: (i) Searcher(s) background and experience, (ii) plans for searching for a business and plans post-acquisition, (iii) targeted industries/businesses and thesis and (iv) illustrative economics. The PPM can often make or break a fundraising initiative. The PPM is a key way for the Searcher(s) to demonstrate to investors that they understand the key risks and obstacles of the acquisition, and have a clear plan to add value to the target company and a path to increasing valuation. It is important to have experienced legal counsel to guide Searcher(s) through this process, such that they can present an appealing, yet legally compliant PPM to investors.
• Additionally, Search Funds must comply with provincial securities laws applicable to private offerings when raising funds from investors. If investors are located in different jurisdictions, this will require further legal analysis for raising funds.

Formation & Structure:

• In the United States, Search Funds are typically structured through LLC’s, however, in Canada, the typical structure involves the creation of a limited partnership, whereby: (i) the general partners of which are the founders of the search fund, and (ii) the limited partners of which are the investors in the Search Fund. The Searcher(s) normally receive a market rate salary during the search phase and in their post-acquisition managerial role, with upfront equity and the ability to earn equity throughout the term (up to 25-30% of the total equity). A portion of the Searcher’s equity typically vests over time and a portion is contingent on IRR. Each investor takes a portion of the remaining equity in the fund, based on capital contributed, and typically has a pro rata follow-on right, allowing it to invest its pro rata share of the equity tranche required to close a future acquisition. As compensation for the risk they take in the initial capital raise, the investor’s initial equity is usually stepped up by certain percentage.
• The formation of a Search Fund will require preparation and negotiation of various documentation which will specify structure, governance, preferred share rights, distributions, future financing and allocation terms. These documents must provide certainty for investors together with flexibility for the founders as the details and structure of the acquisition are not known at the time of fund formation. Tax planning considerations are imperative upon fund creation, especially if investors are in different jurisdictions.
• Having a well thought out and legally compliant fund structure from the beginning is vital to ensure that when the Search Fund is ready to go forward with an acquisition, it is able to do so without having to revisit key legal points with its investors.

Due Diligence:

• Once the Searcher(s) have found a potential target, legal counsel can assist by preparing letters of intent, due diligence checklists and non-disclosure agreements which will assist the Searcher(s) in conducting their operational/business diligence. Legal counsel will also perform legal due diligence, including lien searching and contract review.
• As many Searcher(s) may be experiencing their first M&A transaction, legal counsel can also guide them through the bidding process, negotiating the letter of intent and provide other valuable insight. If legal counsel is experienced in Search Funds, they may also be familiar with certain target industries or financial metrics which may be a green flag or a red flag to the Searcher(s).

Acquisition:

• Once an acquisition target is selected, legal counsel will assist in managing and coordinating the steps of the acquisition, including preparing the purchase agreement, negotiating with investors, the seller and third-party creditors and closing the transaction.
• Searcher(s) and their legal counsel should be cognizant of the intricacies of a Search Fund acquisition vs a regular M&A acquisition, including giving consideration to the initial fund structure, and whether amendments to the fund structure are required due to different investors being present for the search phase vs the acquisition phase (the investors who contribute capital at the search phase are not necessarily the same investors that contribute capital at the acquisition phase).

Why are Search Funds Gaining Momentum? What are the Advantages?

• Advantageous to Investors: Search Funds have historically outpaced traditional private equity in terms of returns to investors. Investor returns have been in excess of 30%. Compared with other similar asset classes in private equity, Search Fund returns are often superior by 10-15%. Search Funds also allow investors to take a more active role in their investment. Finally, they offer downside risk protection because investors have two stages to invest and can identify investment failures during due diligence, prior to the acquisition.
• Advantageous to Searcher(s): The Search Fund model is attractive to potential Searcher(s) because it allows them to jump into an existing operating company with an established customer base and brand, providing an easier base to scale a business, with minimal personal or financial risk. It also provides a structure where Searcher(s) can heed advice and expertise from their investors. Finally, it provides the potential for sizeable returns through equity in the fund upon a liquidation event.

The above only provides a brief summary of the Search Fund landscape. If you are interested in forming a Search Fund, investing in a Search Fund or have general inquires in respect of Search Funds, please reach out to any member of the Business Law Group at Fogler, Rubinoff LLP.