Search Funds for Transformative Impact

Impact investing continues to grow in scale and sophistication, but investors still face a relatively limited number of investment strategies. Resonance is now exploring potential applications of search funds as a means for investors to achieve financial goals while delivering lasting impact in industries that have poor track records of environmental and social performance. Search funds are an investment vehicle through which investors support an entrepreneur’s efforts to identify, acquire, and manage small and medium-sized companies. We have found that search funds offer impact investors another channel to empower mature businesses. This channel leverages a company’s existing assets to achieve transformative social and environmental impacts in ways that go beyond current approaches.

The Search Fund Model

The search fund concept originated at Stanford University in the 1980s as a way for graduating MBA students to acquire and grow promising small to medium-sized businesses. The concept’s attractiveness to entrepreneurs is clear: the search fund provides graduates with the opportunity to manage and grow an established company without the risks associated with starting a new business from scratch. The investors backing these entrepreneurs, meanwhile, get to invest in companies that are often too small to be seriously considered by traditional private equity players.

Unique to search funds, entrepreneurs raise a first round of “search capital” to finance the search process for appropriate investments. In many cases, the ideal target for a search fund acquisition is a family-owned business undergoing a generational transition. When the search fund entrepreneur identifies an acquisition target, s/he raises a second round of capital to finance the acquisition. Once the business is acquired, the search entrepreneur becomes the CEO, operating and creating value in his/her new company. Value can be created in many ways, including improving operations, enhancing scale, and optimizing other aspects of the business to improve financial performance. An eventual exit is usually reached after 4 to 6 years of ownership.

The Search Fund as an Impact Investment Vehicle

Although the field of impact investing continues to grow rapidly, a 2017 survey of impact investors highlighted the lack of high-quality investment opportunities, suitable exit options, and innovative fund structures as among their primary concerns. They also suggested that management capacity and business model execution are the top risk contributors to their portfolios, with liquidity and exit risk following closely behind. Resonance’s analysis suggests that the search fund model has the potential to address some of these concerns, including:

  • Limited Management Risk: Search fund acquisitions enable investors to select, mentor, and support talented managers at the outset.
  • Proven Business Models: Search funds concentrate on mature businesses that have a demonstrated track record of profitability.
  • Limited Pipeline: Search funds use a comprehensive deal identification process to identify and acquire a single firm, limiting common deal flow challenges.
  • Uncorrelated Risk/Return Profile: Search funds provide investors with a diversified investment vehicle with a track record of strong returns.
  • Increased Liquidity: Search funds provide owners of small businesses an opportunity for liquidity in a segment of the market where such opportunities are particularly rare.

While the search fund model clearly addresses some key investor concerns, what makes it uniquely interesting for impact investors looking for social and environmental impact?

Moving the Impact Needle

It is important to understand how impact investors typically operate. Like most fund managers, they must identify companies based on their return potential, considering both social and environmental returns in addition to financial ones. Investors must evaluate the likelihood that the company and its existing management team will achieve its potential for triple bottom line impact. Once money is invested, investors often have limited direct control over the company’s performance or trajectory. Therefore, impact investors focus on backing companies that are already delivering or aspiring to deliver social and environmental returns.

In a search fund model, impact investors can take a very different approach, since investors and their owner-operators actively manage acquired companies. Instead of utilizing a passive tactic, impact-oriented search funds take over an existing business that is clearly impact negative and transform it so that it has a positive impact. This model offers potential for impact at scale, particularly in sectors with notorious social or environmental problems where greenfield startups have difficulty penetrating. With complete management control, an impact-oriented search fund could implement changes to the business that pioneer alternative, positive ways of doing business, paving the way for replication throughout the target industry.

These opportunities may not be viable for other investment vehicles that do not involve an acquisition nor provide the active management control needed to propose and implement these changes. These unique attributes make the impact-oriented search fund a promising approach in sectors that are less mature, highly fragmented, or do not offer strong transparency to outsiders. In these sectors, building an impact-focused enterprise from an existing foothold would be more attractive than starting a new business from scratch. Resonance is currently exploring such an approach through its support for an impact-oriented search fund focused on the aquaculture industry in Thailand.

For more information on search funds, please follow this link to Stanford’s search fund primer. For more information on the Thai Aquaculture Impact Search Fund, please follow this link to the initial investment concept note.