Traditional and crypto investors seeking to diversify their portfolios should consider sponsoring search funds. These vehicles generate relatively-consistent, outsized returns on the appreciating value of a successful small business. The traditional challenge with investing in small businesses is twofold:
- returns are often too small relative to potential risk
- taking a meaningful stake in a small business, conducting extensive diligence and operating that business, both of which can be expensive, time-consuming, and unattractive
The most common investment vehicles for small business investing fall flat from a risk-reward perspective. Crowdfunding sites like Mainvest offer often limited returns for investments in high risk businesses. Small business bond offerings are safer, but also offer middling returns relative to opportunities in other parts of the market. Small cap indices like the Russell2000 can offer diversification. But are still composed of companies worth between $300M and $2B, which is much larger than the “traditional” family-owned small business.
Alternatively, search funds offer the ideal scenario for small business investors. Search fund investors sponsor a talented CEO, who finds, performs diligence on, acquires and operates a successful small business. A typical search fund business has ample and consistent cash flow, a long operating history, and is being purchased by a new and ambitious owner looking to modernize and expand its operations, creating both consistency and substantial upside. We believe that people who hold stocks, make angel investments in high growth, high volatility startups, and people who hold crypto could all benefit from investing in cash-flowing small businesses acquired through search funds.
Small Business Market Opportunity
Small businesses account for nearly 44% of the gross domestic product in the United States. That’s a significant slice of the economy. There are around 32M small businesses out there, and 40% of them are due to change ownership in the next 15 years. That’s a huge opportunity for growth and return, as well as supporting this transition of assets from one generation to the next. With this coming increase in supply, investors have an opportunity to invest in talented entrepreneurs. They can own a meaningful share of businesses that are both enduringly profitable and carry upside as new owners implement modern technology and marketing techniques.
US government-backed Financing Facilities for Search Funds
It’s now easier than ever to search and acquire a business, as a buyer, thanks to programs like the Small Business Administration (SBA) loan program. With this program, capital up to $5M can be put towards acquiring a profitable business, under certain conditions.
Additionally, the SBA, through the Small Business Investment Company (SBIC) program, licenses privately and publicly managed investment funds that raise capital from private investors. It then combines it with capital obtained through the SBIC’s issuance of a taxpayer-backed debenture guaranteed by the SBA. The SBIC invests this combined capital in qualifying small businesses through terms established between the SBIC and small businesses within the parameters of the SBIC program regulations and SBA oversight.
Attractive risk-return relationship for Search Funds
A 2020 CES analysis of 401 qualifying search funds found the aggregate pre-tax internal rate of return to be 32.6%, and the aggregate pre-tax return on invested capital to be 5.5x. The main attraction of a search fund lies in the potential returns they can hope to net, with expected internal rates of return (IRR) for some funds climbing as high as 30 percent in their first years.
Usually, search fund investors, as well as searchers themselves, look for companies with strong recurring revenues, high EBITDA margins (generally north of 20%), and a stable cash flow history. After the company has been acquired and managed for up to seven years, the search fund enters the exit phase and looks to be acquired by an industrial player or a financial investor, often a mid-market private equity firm.
While investing in search funds remains riskier than bonds or diversified indexes, this strategy carries the potential of substantial returns and outperforms venture capital as a segment despite a lower risk portfolio. According to a study from Stanford University, which analyzed a total of 79 funds, 38 percent were profitable for their investors, with an average IRR of 37 percent. When compared with venture capital’s average 25 percent IRR and 25 percent success rate for venture-backed startups, the risk-reward calculus for search funds appears attractive.
The main challenge is the manual nature of the search fund process, which can also contribute to a lack of short-term liquidity. Investors only are able to put money to work after they identify a promising operator and support their search for an interesting business to buy. Under the current process, the entire cycle from the time an investor sponsors a searcher to the time the business is ready to sell can take close to 10 years, locking up liquidity for a substantial period. At Private Market Labs, we’re looking to improve this process to make investing in small businesses more efficient and predictable.
Investing Crypto Profits into Small Business
The search fund investment market is still fairly nascent, with only $1.5B in total being invested to date from 1984 to today. As more and more people consider searching as a next step in their careers, there is a growing opportunity for more investors to come into the space. From a risk perspective, this asset class can be a good diversification tool for people who have made their fortunes in cryptocurrencies and blockchain technology.
At Private Market Labs, we understand the importance of enabling access to new asset classes for crypto investors and traditional investors alike, and we are building products and features to connect them with the right buyers, as well as easily and safely invest their capital.
We believe in a future where diverse entrepreneurs backed by non-traditional investors can play a significant role in the small business acquisition ecosystem. We are optimistic about the potential for this kind of investment and we’re working towards opening up diverse opportunities to own a piece of the heart of the American economy.