Pick a Winner: Industry and Business Selection for Search Funds
Notes cribbed from a recent webinar.
This month I attended a webinar on “Best Practices for Industry and Search Selection,” organized by the Black Search Network. Keith Burns and Michael Curry led a Q&A style session with Will Thorndike of Housatonic Partners and Jeff Stevens of Anacapa Partners.
I jotted down notes and posted them on Searchfunder. My headphones aren’t great and my handwriting is outrageous, so any inaccuracies below should be blamed on my mishearing or misreading, not the panelists.
Top 3 Characteristics of a Good Business
WT’s opening comments established the framework for most of the discussion that followed. Based on his analysis of factors that had the strongest positive correlation with top decile search fund returns, and that lacked correlation with bottom decile returns, three characteristics of the target businesses stood out.
The effect of these is significant: “If you have these 3 things, you have a ‘dramatically’ better chance of achieving the target return (25% or more): 4x more likely”
Recurring Revenue
Defined as “consistent business from repeat customers”
Good would be 60%-80% of revenue is recurring, <20% single customer concentration
Organic Revenue Growth
At least 2x GDP growth, ideally in double digits annually
Capital Efficiency
ROTC (return on tangible capital) was cited as the key metric, but on a basic level what you’re looking at is how much of EBITDA converts to free cash flow. This is affected by working capital requirements and capex requirements.
Other characteristics:
Low or manageable operational complexity
To make this more concrete, “low/manageable complexity” is the difference between taking several months to understand business’ operations vs. a year or more
The number of employees is one correlate of complexity. Simple but true.
Recurring revenue is a negative correlate of complexity: “Recurring revenue means doing the same thing for the same customers over time.”
Limited exposure to exogenous risk
Weather mentioned as one example.
Customer concentration or payer risk (for insurance and healthcare related fields) could be considered others
WT on the “long laundry list” of criteria being overkill: “If you find a business with the top three characteristics, you’ll often get many of the others on your list ‘for free.” That is, businesses that exhibit strong organic revenue growth, a high portion of recurring revenue, and that are capital efficient generally satisfy other meaningful criteria.
On the opposite: cautionary signs and characteristics of businesses that had subpar returns
WT: “Really, the inverse of the top 3 desirable characteristics: low organic growth, low recurring revenue, low capital efficiency”
Lack of predictability.
Low amount of recurring revenue (< 40% cited)
Cyclicality
Seasonality - “Less time to correct if something goes wrong”
Exposure to exogenous risk / things outside of the searcher’s control
Labor related challenges
Difficulty recruiting
Large size that suggests more complexity than can be handled at outset
Recommends looking at Revenue / Employee ratio as an indication of whether the business can grow and produce returns without needing to achieve unwieldy scale.
Customer concentration
Key person risk and seller-related risk
Business too dependent on seller or employees who might leave, and/or
Seller misrepresents business during DD and/or competes with business post-close
Factors Affecting Searcher Outcomes
Jeff Stevens discussed his analysis of search funds’ early performance (years 0 through 3) and final outcome. The takeaway here relates to the importance of beginning with a growing business.
You can also see the value of growth by looking at how businesses purchased for multiples at the high end of the distribution ultimately produced larger returns on both an IRR and MOIC basis than those purchased for multiples on the low end.
The difference is explained by the fact that the higher multiple businesses exhibited much better organic revenue growth rates at purchase. (Note - Though these factors weren’t mentioned specifically, you would also expect these higher multiple businesses to have more recurring revenue and/or lower capital intensity). While a searcher’s instinct might be to look for value creation opportunities with a “cheap” but stagnant business, relatively more top outcomes were achieved by paying higher prices for higher quality.
JS made some caveats during the discussion of growth by listing examples of “growth that doesn’t pay”
Growth that comes at expense of profitability / customers that have too high a cost to serve
Growth that increases customer concentration (e.g. growth in an account takes a single customer from 50% to 70% of revenue)
Inorganic growth that comes too soon, before searcher has handle on the first acquisition
Also mentioned were some potential problems that could arise from a value creation strategy based too narrowly on revenue growth. For instance, JS cited examples of deals priced on ARR multiples that could only pencil with some heroic assumptions about continued growth (e.g. 7x revenue in the first five years). High growth industries also attract well funded competition, which increases the need for reinvestment - and the risk of obsolescence.
Other Notes
Given the background of the panelists, the discussion was implicitly centered on businesses that might be suitable for a traditional, funded searcher with meaningful equity backing. Software and healthcare were two frequently mentioned industries. The size, level of professionalism, and according valuations attached to these businesses is generally higher than what a self funded searcher contemplating an acquisition with SBA debt might see.
WT suggested the “Rule of 10” as an informal (and somewhat speculative) check on whether a business’ valuation is justified by its revenue quality. That is, the Logo Churn % + EBITDA Purchase Price Multiple should be less than 10.
An analogous check related to revenue growth and valuation would be the Power Ratio, or Organic Revenue Growth / EBITDA Purchase Price Multiple. A value above two or three would be ideal, though there’s variation by industry, size, etc.
Finally, in the context of a discussion about the need to manage time efficiently (specifically, not spending too much time researching an industry before seeking feedback from investors), JS cited a statistic that in the past 10 years, the acquisition completion rate for searchers had fallen from 80% to 60%. This was a useful reminder that in the real world, businesses meeting all the ideal criteria are difficult to find.