The Sons You Didn’t Know You Had

POSTED ON May 07, 2014 BY Tim Ropchan
CATEGORY Finance, Stories,

Search Funds finance young professionals to acquire companies from retiring business owners

Neil Cuggy and Jonathan Ferrari, co-founders at MTL Capital, Montreal’s first Search Fund.

There are 1.38 million small-to-medium sized businesses in Canada with owners over the age of 50, according to data compiled by Deloitte.

Many of those entrepreneurs will look to exit their businesses over the coming years.

A creative financial model called Search Funds provides capital to young entrepreneurs looking to identify and take over some of these businesses.

Today we will take a closer look at the practice of Search Funds, and meet two of its youngest practitioners.

Paid to look

The idea for Search Funds was developed by H. Irving Grousbeck, a professor at Stanford’s University Graduate School of Business.

While raising money to acquire a business is not a new practice by any means, Search Funds are unique in that they finance the period of identifying and closing the acquisition.

The belief is that finding a great opportunity takes time, a lot of time, typically 1-3 years.

Search Funds are started by entrepreneurs who are looking to buy only one company and transition into being CEO.

It involves the raising of a “search” round of capital, which is used solely to seek and close a deal.

A typical search round is $500,000 for these purposes, and investors are able to convert the capital at a 150% equity value when the acquisition occurs.

Subject to conditions, the investors then finance the acquisition, usually in the $5-$15 million range.

The entrepreneurs typically earn equity as the company grows.

The deal that put Search Funds on the map

Search Fund partners Jim Ellis and Kevin Taweel bought a roadside assistance company called Road Rescue Inc for $8 million dollars in 1995, hoping to capitalize on the rapid growth of personal cell phones. The company, later renamed Asurion Inc, grew from $6 million dollars in revenue and 45 employees to $2.5 billion in revenue and 10,000 employees just 13 years later, after pivoting towards a cell phone insurance business model. Investors saw a greater than 100x return on their investment, making it likely the most successful Search Fund ever.

Over 150 funded searches have returned an average IRR of 34.5%, according to Search Fund data tracked by Stanford, which supports the rapid growth of new Search Funds (10 Search Funds with Harvard MBA graduates have set up shop in Toronto within the last year alone).

Although the average returns are skewed by home run deals, the model remains proven even adjusting for the largest 5 exists; investors have still realized an IRR of 20% or an ROI of 2.0x.

However, investing in small companies does carry significant risk with 59% of investments in the red, which signifies the importance of diversity.

Joel Peterson, Founder of the ultra successful growth investment firm, Peterson Ventures, discussed investing in search funds over at Techcrunch: “From my experience observing search results, they are somewhere between venture investing and private equity investing. Generally, it takes investor patience and some willingness to work on boards, to mentor and to work with entrepreneurs in order to see the best results. It’s not for every investor, but for those who like building companies from a foundation of existing products/services and existing customers — and who can work with young entrepreneurs — it can be rewarding financially and psychically.”

MTL Capital

Neil Cuggy and Jonathan Ferrari, the two soon to be 26 year olds, left the corporate world to start Quebec’s first Search Fund, called MTL Capital, raising nearly $500,000 in late 2013 to seek and acquire a business with $5-$30 million in revenues.

The duo met while working together in the Global Investment Banking Group at RBC Capital Markets, where they led their respective teams to help organizations gain a competitive advantage, enter new markets and execute growth strategies.

The group has created the majority of their deal flow by identifying and starting conversations with unique businesses across Canada. They also leverage relationships with business brokers, investment banks, and the networks of MTL’s founders.

So far, they have not done a deal yet...

Their capital should last 2-3 years, with the majority going towards closing costs.

Neil candidly says, “Search Funds are truly unique, from an investment perspective, you are constantly balancing personal passion for a business and a great investment thesis. Once you combine those two things, the sky's the limit.”

Search Funds provide an interesting value proposition. Entrepreneurs are able to finance their equity, investors gain opportunities for outsized returns, and business owners get to transition out of their companies with a big fat nest egg.

As this corner of investing grows, we will see how Canadian Search Funds perform and meet the demand from retiring business owners.

Search Fund practitioners may just be the sons they never had.

For more information on MTL Capital visit www.mtlcapital.com.

Tim Ropchan, BA - Honours in Urban Development, is a recent graduate of the University of Western Ontario. He is currently an Associate at MTL Capital where he sources private market deals across a range of sectors.

Tim Ropchan

tim.ropchan@mtlcapital.com

Tim Ropchan

tim.ropchan@mtlcapital.com

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