Fundless Sponsors and Search Funds:  Attractive to Funding Sources, Not So Much for the Sponsor

"Search Fund" is another of the numerous misnamed financial terms. "Fundless Sponsors", a term that is a close relative, is clear by comparison. The person who is actually doing the search but doesn't have any money is what I will call the direct sponsor. His or her funding sources are the ones with the money, which I'll call the indirect sponsor.  These funding sources could be other PE funds, their principals, or other high net worth investors. 

The direct sponsor does all the leg work, doing the tedious task of sorting wheat from chaff. Statistics I’ve seen suggest that something like 2 out of 3,000 deals that a funded sponsor looks at will be funded. I don’t have numbers on fundless sponsors, but it has to be worse.  That’s a lot of chaff.  And word on the street is that there is an ever increasing amount of chaff to sort through to get to that grain of wheat.  After all, the lowest hanging fruit is constantly being picked, and after 35 years of buyouts, all the fruit is now at the  very top of the tree, or in reality, the lower part of the lower middle market, and getting lower and smaller all the time.  High quality companies are getting harder to come by.

Indirect sponsors effectively use fundless sponsors as their unpaid business development people.  I could pretty that up, but that’s it in a nutshell.  The fundless sponsor wants a crack at running their own show and having their own nest egg.  So, their task is to identify a company that is not being effectively marketed by an intermediary, or that is off-market.  Any company that is well marketed will be acquired at a price out of the reach of a fundless sponsor. Why? It all comes down to the benefits of diversification of non-systematic risk in a portfolio.

The risk that is specific to an individual company, referred to variously as non-systematic risk, company-specific risk or secular risk – can be diversified away in a well-selected portfolio of a minimum of 10 companies.  Entrepreneurs are well known for having all their eggs in one basket.  Their salary and their wealth are completely at risk and undiversified.  One big slip and it’s all she wrote. This is the life of the direct sponsors.  That's why they can't pay full price. They can't diversify their risk.  To get their risk/reward ratio in line, they have to get a higher reward to compensate for absorbing company-specific risk.  This means that have to buy cheaper.  That's the math.

The indirect sponsor - the money behind the scenes - does not share this problem.  They have diversified their portfolio and risk.  So have PE firms, family offices and other investors groups.  Only the poor business founder and direct sponsor are completely exposed to the risks specific to that business.  The direct sponsor runs the very real risk that she will work her tail off and end up impoverished.  They could spend years living off their own money before they find a company, and once they do find and buy a company, if they lose a major customer, the next thing you know the company is insolvent.

As a result, the direct sponsor’s only recourse is to emulate the work of the investment banker.  They must create a marketing machine that identifies companies, and a sorting machine to sort through all the chaff.  Then they have to court the business owner and keep them from talking to investment bankers who are sure to tell the business owner that if they run a structured process they will get a higher price.  This is a daunting task for the direct sponsor.  The life of the Maytag repairman looks good by comparison.

But here is the play. Most Fundless Sponsors and Search Funds are generalists. To compete, they need a real strategy. Paying 5x EBITDA is not a strategy.  

Generalists don’t see expertise like experts do. Generalist PE firms simply do not have sufficient time to research a narrow niche and see value where it exists.  They simply miss the value proposition.  An expert in the niche sees it quickly and can see how to monetize it.

My advice to direct sponsors is to become an expert in a very narrow field and get funding sources that are experts in that field.  By becoming an expert, the direct sponsor knows real competitive advantages when they see them.  A Chem E, EE, etc. with an MBA and some hands-on-experience at both a large well-run company (3M, DuPont, Monsanto, etc.) and an investment bank is a great start. 

Becoming an expert in a very narrow niche vastly reduces the amount of chaff that a direct sponsor will need to sort through. By narrow I'm talking 3 or more digit NAICS code. Getting funding sources equally as expert in that narrow niche gives the direct sponsor a mentor that can coach them and also understand what they are really looking at when the direct sponsor finds a gem. Lastly, being an expert in a narrow field gives a direct sponsor a chance to really run the company better, and in so doing help move the risk/reward equation a little bit back their way.

While this solves the big problem of finding value at a reasonable cost, it still leaves the problem of the undiversified portfolio.  So, if you want to partially own and solely run a company just for the money, don’t. Do it because you are compelled to, like a moth to flame. Being crazy helps, like someone that starts their own lower middle market investment bank.