Podcast Summary: E145 - Is a 35% IRR Really Achievable? Exploring Search Fund Returns

Podcast Information:

• Title: How I Invest with David Weisburd
• Host: David Weisburd
• Episode: E145: Is a 35% IRR Really Achievable? Exploring Search Fund Returns
• Release Date: March 11, 2025
• Description: This episode delves into the world of search funds, examining their potential returns, operational dynamics, and the experiences of leading investors in this niche asset class. Featuring insights from Rob, a seasoned search fund entrepreneur and investor, the discussion offers a comprehensive look into whether a 35% Internal Rate of Return (IRR) is attainable through search funds.

1. Understanding Search Funds

Definition and Model

• Rob (00:54): "So it's a model for acquiring a small established business where a group of investors would provide funding to an entrepreneur, or we like to call them a searcher, to go out and find a business to acquire, manage and grow."
• Explanation: A search fund involves investors backing an entrepreneur (searcher) who spends up to two years locating a suitable small business to purchase and lead as CEO or president. The objective is to enhance the business through operational improvements, market expansion, and strategic initiatives.

2. Historical Returns of Search Funds

Performance Metrics

• Rob (01:23): "Based on a 2024 search fund study by Stanford, we're still tracking to 35% net IRRs and a 4.5 times ROI."
• Overview: Since inception in 1984, over 681 search funds in the US and Canada have demonstrated strong returns, with an average net IRR of 35% and a Return on Investment (ROI) of 4.5x, highlighting the financial viability of this model.

3. Limited Institutional Investment in Search Funds

Challenges in Scaling

• Rob (01:49): "You're dealing with a micro caps small cap space where you can't put real dollars to work... typically been an asset class for high net worth individuals."
• Insight: The small scale of search fund acquisitions (ranging from $5M to $30M) makes it unattractive for large institutional investors who prefer deploying larger capital amounts, thereby limiting the growth of search funds to high-net-worth individuals.

4. Capitalization Lifecycle of a Search Fund

Funding Stages

• Rob (02:16): "Typically the searcher would raise, you know, call it 500,000 to a million to find the business... each Investor would have their pro rata rights for 500,000 in that example."
• Process: Initial funding of $500K to $1M is raised from about 10 investors to support the search phase. Once a target business is identified, further investments are made proportionally by existing investors to finance the acquisition.

5. Portfolio Construction Strategy

Building a Diverse Portfolio

• Rob (03:01): "I'm investing in the entrepreneur to then look for the business and then I'm investing in the businesses that the entrepreneur buys."
• Strategy: The fund maintains a portfolio of 10 to 20 active searchers annually, selecting specific businesses to invest in. The typical allocation is 70% in acquisitions, 15% in follow-on capital, and 15% in management fees, ensuring a balanced and diversified investment approach.

6. Total Addressable Market (TAM) for Search Funds

Market Growth and Potential

• Rob (04:02): "The reason being is I think the returns speak for themselves... it's become more institutionalized."
• Assessment: The TAM for search funds has expanded significantly over the past 15 years, with increased institutional interest and a more defined playbook contributing to the growth and maturation of the asset class.

7. Evolution of Searcher Profiles

Changing Dynamics

• Rob (04:10): "There's a lot more... there's also a lot more, call it sales CEOs or technology CEOs or strategic type personalities..."
• Trend: The searcher demographic has diversified from primarily individuals with traditional business backgrounds to include those with technology, sales, and strategic expertise, reflecting the evolving nature of the search fund model.

8. Personal Journey: Rob's Search Fund Experience

Case Study: UCIT Online Security

• Initiation (07:46 - 08:35): Rob and his partner Eric launched their search fund in 2010, eventually acquiring UCIT Online Security in Toronto.
• Performance (08:37 - 09:09): The acquisition exceeded expectations, achieving 20-30% annual organic growth over 12 years and culminating in the sale to a strategic buyer as a $150M ARR business with a significant international footprint.

9. Economics of the UCIT Deal

Financial Structure and Returns

• Rob (09:13): "We bought the business with investor capital... each had 15% of the upside of the business."
• Outcome (09:42 - 10:22): Investors experienced a 35% net IRR initially, followed by a 32% IRR after a subsequent acquisition, and a 30% IRR upon final sale to Garda in 2024, demonstrating robust financial returns.

10. Notable Success Story: Asurion

High-Performing Search Fund Example

• Rob (10:26): "Asurion... returns to the original search funders investors was over 100x and some of them who stuck around would be over a thousand x."
• Details: Founded in 1994 by Stanford graduates, Asurion evolved from a roadside assistance carrier to the largest mobile insurance provider globally, illustrating the exceptional upside potential of successful search funds.

11. Fundial Partners: Investment Strategy

Supporting Searchers and Their Companies

• Rob (11:20): "It's a way for me to pay it forward in the community by investing in intellectual horsepower and search fund entrepreneurs..."
• Approach: The fund invests in search fund entrepreneurs and the businesses they acquire, providing governance, board support, and operational assistance to foster growth and value creation.

12. Criteria for Selecting Search Fund Entrepreneurs

Key Attributes

• Rob (11:55): "Educational and professional background, skill set, personal qualities, operational expertise, and commitment."
• Essential Traits:
  • Academic and Professional Excellence: Top decile performance in education and career.
  • Analytical Skills: Strong numerical and analytical capabilities.
  • Interpersonal Skills: Likability and effective negotiation skills.
  • Resilience and Integrity: Ability to handle challenges with ethical standards.
  • Strategic Vision and Operational Expertise: Capability to transform and grow businesses.
  • Commitment: Dedication to the long-term success of the acquired business.

13. CEO Dynamics in Search Funds

Co-CEO Structures and Best Practices

• Rob (14:16): "Returns are stated to be better with co CEOs than single entrepreneurs."
• Benefits of Co-CEOs:
  • Complementary Skill Sets: Dividing responsibilities between internal operations and business development.
  • Accountability: Mutual support and oversight enhance decision-making.
  • Conflict Resolution: Emphasis on respect and radical transparency to manage disagreements.

14. Governance and Decision-Making

Balancing Control and Oversight

• Rob (17:51): "Investors control the board... performance-based incentives... align interests."
• Mechanisms:
  • Board Composition: Investor-controlled boards oversee strategic decisions.
  • Incentive Structures: CEO compensation tied to performance targets.
  • Decision-Making Protocols: Structured processes for resolving strategic disagreements, including third-party consultations.

15. Misconceptions About Search Funds

Challenging Stereotypes

• Rob (20:30): "People think that the young entrepreneur has no right to running a business..."
• Clarifications:
  • Entrepreneurial Capability: Young searchers can effectively lead and transform businesses with the right support.
  • Operational Focus: Emphasizes hands-on management and cultural alignment over financial engineering typical of private equity.

16. Key Takeaways and Insights

Rob's Reflections and Advice

• Resilience and Optimism (19:28): "The resilience that you're going to need in this role is insurmountable, but the meaning that you'll get is way greater."
• Talent Management (20:11): Importance of integrating existing talent and fostering buy-in from long-standing employees.
• Meaningful Entrepreneurship: Search funds offer a path for intellectually capable individuals to make significant impacts on established businesses.

Conclusion

Rob's extensive experience with search funds underscores their potential for high financial returns and meaningful entrepreneurial engagement. While the model remains niche due to capital constraints, its structured approach to acquiring and growing small businesses continues to attract talented individuals seeking alternative pathways to entrepreneurship. The success stories and robust performance metrics discussed in this episode affirm that achieving a 35% IRR is not only possible but has been consistently realized by seasoned search fund operators.

Notable Quotes:

• Rob (00:54): "It's a model for acquiring a small established business where a group of investors would provide funding to an entrepreneur..."
• Rob (01:23): "We're still tracking to 35% net IRRs and a 4.5 times ROI."
• Rob (10:26): "Asurion... returns to the original search funders investors was over 100x and some of them who stuck around would be over a thousand x."
• Rob (20:30): "People think that the young entrepreneur has no right to running a business..."

This comprehensive summary encapsulates the key discussions, insights, and conclusions from the podcast episode, providing a valuable resource for those interested in understanding the intricacies and potential of search funds.