By Bradley Smith, ATP, CM&AA 

Volume 3 Issue 10 May 10, 2016

Search funds, originally conceived in 1984, are investment vehicles through which investors financially support an entrepreneur’s efforts to locate, acquire, manage, and grow a privately held company. A 2013 study by the Stanford Graduate School of Business tracked nearly 200 search funds with investments in the US, Canada, Latin America, and Europe and found that the aggregate pre-tax internal rate of return was 34.9% for these funds. The aggregate pre-tax return on invested capital was 10x. With these results, search funds have become an attractive alternative to classic Private Equity Group (PEG) investment in healthcare. Some search funds are led by experienced operators, but the preponderance are now managed by executives under the age of 40, which may be seen as part of a generational shift in fund management.

So why are we seeing more search funds in healthcare? Very simply, there are unique opportunities in smaller healthcare companies (annual revenue below $25 million) that PEGs and other larger investors shy away from, especially in companies where the founder is seeking an operational exit. Traditional PEGs typically want the current management to continue as part of their investment strategy; search funds provide additional options in this regard. Search funds also tend to be capitalized by a relatively small number of investors, leading to greater management agility in responding to the specific dynamics of the healthcare vertical.

If you are entertaining an exit or recapitalization offer from a search fund, you should consider the following:

• The investment process may take longer for your business than it would in a classic strategic or PEG buyer scenario and they may ask you to “roll over” more equity than would normally be the case.

• The search fund manager who steps into your business post-transaction will likely not be as experienced as you. This possibility should be addressed in planning, including your compensation if you stay on in a mentoring role.

• There may be a schedule of investment in the company based on the goals and cash flow of the business, something that would not be the case with a strategic buyer. This schedule merits considerable study pre-transaction because the investor may not adequately address the cash flow needs of a rapidly scaling healthcare business.

• Make sure to walk through scenarios for your eventual exit strategy, including any dividends and other incentives that should come your way if the search fund manager provides good leadership.

One of the more interesting aspects of search funds is that they tend to be led by entrepreneurs who are the same age as your adult children. We believe this inter-generational flavor adds significantly to the potential for a very dynamic handoff of healthcare leadership to the next generation.