Defining Industry Boundaries for a Search Fund

Note that this is an old article I had taken down as I tried to diminish my electronic footprint. Still, to my astonishment, this one is listed in several places as something aspiring searchers should read before getting started, and, as a result, I keep getting requests to put it back up...so here it is.

I’ve worked with search fund entrepreneurs* who came straight from banking, private equity, business school, and law school. Some have an operating background, some are consulting, and some are more transaction-oriented.

Whenever I meet with a search fund founder, I listen to their background and then ask them to articulate what industries they will focus on and why. I’m not evaluating the attractiveness of the sectors themselves. In fact, by investing in search funds, I have found myself ultimately betting on highly diverse industries such as specialty finance in Mexico, point-of-sale software for multi-unit hair salon owners, and billing/collections for chiropractors. That’s the fun (and portfolio diversification impact) of search funds to me.

I’m listening to how the search funder thinks about the industry. What sectors do they find attractive and why? How are those sectors related to their experience, network, and what they have already done? How do they think about generating deal flow in these sectors? What are they planning on doing to start the process that they hope will end up with them buying a company and becoming CEO?

Indeed, some investors favor their searchers being broad and opportunistic instead of narrowly locked into one industry segment. But I’ve been through the process enough times now to begin to see patterns in what works. I also want to give a little advice to potential searchers just putting their deck together.

In the end, the focus is hugely important. I think of it like looking for a vein of gold. You may have several ideas of where to dig, but it takes much spadework to figure out precisely what narrowly defined industry sector will be THE ONE. Just so you know, I did not say the spadework is what leads you directly to the closed transaction. An unexpected but recurring theme in my search fund investments is that good searchers ultimately find a very specific market. They have a river guide or two in that market, made inroads in the ecosystem around it, and generated solid deal flow. They sign an LOI on a transaction, do exhaustive diligence, and are about to close … when something goes wrong. The seller gets cold feet, a strategic swoops in with a stupidly high offer, and a critical customer reference returns horribly.

Here’s the exciting part. The lost deal is like the writer getting that first shitty novel out of the way before writing the masterpiece. When the first deal dies, all the spadework about the micro-sector is immediately transferrable. And a new, better deal emerges in months, if not weeks. And this one closes.

Having said all the above, knowing the micro-industry focus ahead of time is generally impossible. That’s what the first 6-12 months of a good search are all about testing your hypothesis, doing basic research, looking at tons of deals, talking to industry experts, and going to industry conferences, in a word digging your ass off.

My general advice is to search with four industries you have thought through enough to impress some smock like me. Be able to rank order those four in your mind. And have a very clear plan of attack regarding how you will start digging for industry knowledge and deals.

Within the first three months, the goal is to narrow the field from 4 industries to two: what I would call 1 and 1A. As quickly as it makes sense, you want to focus on the one of the four that seems to have the most promise and go deep. But make sure to identify a backup and keep it warm in case you hit a dead end with the first one.

Don’t be afraid if your research leads you to places not part of the plan. My best search fund to date turned out not to be a search fund regarding the buyout aspect. Two brilliant entrepreneurs did a massive amount of basic research about the specialty finance industry in Mexico. They looked and looked for the right company to buy but ultimately realized that the company they were looking for didn’t exist. That was both a good and bad thing. It was good in that it presented a huge opportunity. Bad in that they would have to convince their investors to pony up $10 million not in an existing company with ongoing profits and asset value, but a green field starts up. They did just that, and the company now has over 600 employees and well over $100 million in assets.

I’ll try to summarize:

1) Start with 3 or 4 attractive industries, and you have unique insight or network into why.

2) Use the Scientific Method to attack these industries to test their relative attractiveness once you are on the ground.

a. Build a deal flow machine (former associates from PE firms do this instinctively, and if you are not one, find one to talk to)

b. Find River Guides

c. Go to industry conferences

d. Do your basic research (the Mexico guys had a management consulting background, which helped here)

e. Repeat

3) Narrow from 4 down to a primary and secondary industry you are pursuing. Continue to look for the particular parts of the industry that are most attractive. Narrow down the search even inside that industry until you hit a dead end, and then broaden back out until you find another niche.

4) The first deal you find is like your first love. Great, necessary…but unlikely to be your long-term spouse. In some cases, that first deal is the one, but it’s the minority of successful search funds.

5) Stick to your guns once you have found the micro-market you believe in. You will find the correct transaction.

* A search fund is an investment vehicle conceived in 1984 at Stanford Business School. Investors financially support an entrepreneur's efforts to locate, acquire, manage, and grow a privately held company.