Search funds have become a popular model for young entrepreneurs seeking to become equity-owning managers and run their own business. They have also become an interesting investment class for experienced private equity investors and other individual investors.
It’s an appealing collaborative model: an ambitious and dynamic yet inexperienced entrepreneur partners with experienced hands-on investors to search, find and operate an attractive company.
Returns have been attractive as well. Recent studies by both Stanford and IESE show internal rates of return for investors in the high 30s; the Stanford study also pegs the searchers’ average financial gain upon exit at $9.1 million.
Despite the returns, it’s worth taking a look at the incentive structure, which runs as a motivational thread through the entire process, and asking whether there might be a better way to align the interests of investors and searchers.
Are All Interests Aligned?
Typically, the acquisition financing terms contain a preferred return on the funds from investors, i.e. investors receive their capital back, plus a fixed return on that capital before anything is shared with the entrepreneur(s). Another generally agreed term involves the earned equity of the entrepreneur once an acquisition has been made. Traditionally, a single searcher can earn up to 25% ownership, while a team of two searchers usually can earn up to 30% between them. That earned equity is usually split into three equal tranches, the first of which vests (i.e. becomes fully owned) upon closing of the acquisition. The second vests over a four-to-five year period, and the final third vests based on achieving specified IRR targets upon exit. This last one most often is based on a scale running from 20% to 35% IRR.
And yet there are reasons to question whether these terms – the preferred return, the earned equity structure, and the IRR hurdles – actually achieve the best possible alignment between investors and searchers and whether there might be a better way to achieve such alignment.
Since the incentive structure works both as a reward and as a behavioral tool, the question could also be formulated as a quest to improve the returns at the bottom end of the scale. The Stanford and IESE studies show that over 30% of acquisitions done by searchers don’t create shareholder value. Is there an improved incentive structure that reduces the left tail while largely leaving the right tail intact?
Imagining a New Incentives Framework
In a recent article, my colleague Rob Johnson and I provide a framework meant to promote further discussion of incentives in the search fund community.
We consider the possibility of dropping the preferred return. We believe that at the lower end, the preferred return, in combination with the performance part of the earned equity, demotivates the entrepreneur at a crucial time, while at the high end it barely matters. Additionally, since the performance part of the earned equity allows investors to keep more in case the expected hurdle rates are not met, we think the preferred return could be dropped.
In isolation this might negatively affect performance, as it decreases pressure to focus on cash flow and ultimately on creating value for both entrepreneurs and investors. Combining the abolition of the preferred return with a higher weight of performance-based equity might address this. Since we don’t see any good reason for the time-based earned equity, the earned equity could be reduced from three parts to two. Having, for example, 12.5% at time of acquisition and 12.5% based on performance, would allow focusing on value-generating activities without the burden of the preferred return.
Our article also addresses a long-running debate within the search fund community about whether IRR or MOIC is a better benchmark for performance. Basing performance on IRR could incentivize searchers to sell the company too early, as they might doubt that the high IRRs can be maintained. MOIC could have the opposite effect; where time is of no relevance, searchers feel less urgency and might be affected by wishful thinking. Investors have debated different solutions to this dilemma. Some have suggested a combination of IRR and MOIC while others a sliding scale of multiples or IRRs over time. One such proposal from Tom Matlack is currently being widely discussed.
As we tried to come up with an improved model, we realized how easily inconsistencies creep in. Examples included performance proceeds to searchers being higher in later years while the exit price was the same, or performance proceeds being lower although value had been added. Solutions based on changes in performance measurements, such as switching from MOIC to IRR, can weaken the behavioral effect that these “motivators” are intended to have as it might induce “gaming” or lead to ambivalent behavior, especially around the regime change. This is not in the best interests of all shareholders.
In the end, there may not be a perfect performance measure. A better recipe for success may be found in the combination of a searcher with integrity and a board that understands the role the searcher plays in value-creation. There have been cases where knowledgeable boards have initiated early changes in the vesting provisions for the search-CEO, rewarding excellent managerial performance. By staying true to the collaborative partnership model, the board can offer solutions where formulaic processes fall short.
For further reading on search funds, see:
Search Funds – What Has Made Them Work?, IESE, 2014