Belated and Belabored Reflections on the Self-Funded Search Conference, 2023

A cross post from Searchfunder.com.

I jotted down some notes earlier this month at the Self-Funded Search Conference in Dallas. The plan was to share them here in case people who didn’t attend were interested in reading them - or better yet, people who did attend wanted to clarify, correct, or otherwise expand upon them.

Turns out my notes were illegible, and what scribbles I could make sense of struck me as fairly trite. That’s no fault of the conference, which I thought was excellent throughout. The panels featured a nice balance of searchers, business operators, investors, lenders, and transaction experts (lawyers, QoE providers, etc.); each discussion tossed off a lot of practical advice that will reduce the number of mistakes I’m likely to make in the future. 

I especially appreciated the panelists’ willingness to discuss the less fun parts of acquiring a business, and judging by the audience Q&A, other attendees did too. Whenever someone stood up to ask a question, there was a decent chance that it would be about broken deals, delinquent loans, or lawsuits. This was strangely comforting, to be surrounded by a room full of intelligent people and collectively try to imagine the worst possible outcomes we may bring upon ourselves. 

I suppose the reason that memory has stuck with me weeks later, and why I’m writing a long post inspired by it now, is that it seemed to capture something of the very particular personality that’s characteristic of people who are attracted to ETA. 

It’s an optimistic type of person who wakes up one day and says to themselves, “I don’t know anything about the ___ industry, but I bet if I personally guaranteed several million dollars in debt to take over a small business, I could learn pretty quickly.” You can choose which adverb to insert before “optimistic": “admirably” or “dangerously” seem equally appropriate to me. 

But we’re also talking about someone who’s guiding principle is realism. Who sees a shooting star in the night sky and doesn’t make a wish, but instead ruminates about how >99.9999% of the universe is a cold and dark void where no humans can survive, let alone create an enduringly profitable business. Who accepts they’re not such a big deal, cosmically speaking, and comes to find joy in the small things - a flower in bloom, a child at play, a landscaping company with impressive route density and lots of fixed assets that can be depreciated on a stepped up basis.

They pride themselves on seeing through hype and appreciating what really matters. When a friend raves about some AI model that’s being trained on acres of GPUs and will be advanced enough to cure every disease known to man, a searcher’s first thought will naturally be of how much recurring revenue some lucky HVAC contractor will earn from servicing all those data centers.

I’m joking, mostly. What I’m really trying to do is describe as best I can the cognitive dissonance that arises when you find yourself both encouraged and concerned, the slightly dizzying effect that happens when you’ve been heads down focused on a particular task, then get the chance to step back and see things from a wider perspective.

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Two interconnected factors seemed to come up most often when discussing the current state of the self-funded search market: interest rates and competition for deals. Both could be described as “high,” which, many frustrated searchers have had occasion to remember recently, is a four letter word. 

Interest rates are obviously higher than they’ve been in many years. One way of making this fact more concrete is to note that the last time the prime rate was at 8.5%, Shaggy’s “It Wasn’t Me” was atop the Billboard Hot 100. Another, more useful way would be - as a panelist from Live Oak Bank did in an early session - to sketch out a SBA 7a financing scenario in a 2023 rate environment vs. 2021. Holding the target’s EBITA and the bank’s minimum debt service coverage ratio constant, a deal could require roughly $1 million of price adjustments, additional equity contributions, or seller financing today compared to two years ago. 

For now at least, price adjustment is not the primary lever that’s being pulled to close the gap. More specifically, price multiple adjustment is not. Purchase price can also come down because of a revision to the underlying EBITDA figure that’s used in the calculation. This may become relevant for currently-listed businesses that had strong post-Covid rebounds but went on to see weaker demand in the back half of 2023 than would have been expected based on trailing twelve month figures: one QoE consultant mentioned that he has recently been seeing true earnings come up 15-20% below the listed number.

Of course, there’s a difference between explaining the reasons for a lower earnings estimate to a seller and having him accept it as the basis for a reduced purchase price. As one panelist observed, getting to close is harder than ever. 

Seller financing is being called on to move stalled deals forward. The elevated rate environment can actually help here: collecting a 7%+ coupon might be compelling to a seller in a way that the low rates of years past would not have been. The flip side is that with 10 year Treasuries near 5%, that same seller might conclude there are a lot simpler ways to earn some yield than by making a subordinated loan to a small business undergoing an ownership transition. 

Perhaps this is academic. A deal whose underwriting doesn’t pencil because of an extra thousand dollars of monthly interest expenses on a seller note was never a deal worth risking it all on. Moreover, the interest rate paid on seller financing ultimately matters less than other factors (e.g. amortization schedule, or whether the ongoing financial commitment is significant enough to motivate the seller to care about the business’ health post close).

You could make the same point more broadly: deals that suddenly look unviable in the current rate environment are also the ones that were most likely to be challenging even if financing were cheaper. Rates have changed a lot, the fundamental determinants of whether an acquisition makes sense or not, less so.  

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In some ways the self-funded search model has always been premised on insulating yourself from as many macro risks as you can and zeroing in on select areas of value creation that are more plausibly within your control. This influences industry selection (cyclical exposure bad; recurring revenue great; growth good, but not required at the same level as it might it be for, say, a traditionally funded searcher needing to make the ROI math work while paying 7x EBITDA for a software business), holding periods (indefinite, rather than set by a finite fund life), and capital structure (which is highly/frighteningly leveraged, but with SBA backed debt that has a ten year repayment term and that offers comparatively generous rates - provided the deal conforms to stringent criteria).

The foundational method of de-risking is being disciplined on the acquisition price. The last session of the weekend drove this point home. The conference organizers from Search Investment Group were presenting a hypothetical transaction as a way of comparing their investment model vis a vis others that people might be considering (raising a traditional fund, acting as an independent sponsor, etc.). For what it’s worth, I think SIG and other groups have done a great job of demystifying the equity raise process by promoting a set of standardized and transparent terms. But the main takeaway for me wasn’t that there’s one specific structure that’s better than all the others. Rather, it was the reminder that outsized returns that attract both investors and entrepreneurs to this space are in fact attainable even with conservative assumptions about growth, capex requirements, and capital costs - provided that the acquisition is done at the sort of multiple (<4x EBITDA in the example transaction discussed) that really only exists in the world of small business.

Finding quality businesses at that price is easier said than done. There’s no law that stipulates a business under a certain size has to be priced under a certain multiple; the correlation between these two numbers can in large part be attributed to market illiquidity: transaction costs (including the mental ones!) are high relative to deal size, capital can only be employed in small chunks, the people who are willing to operate the business are not necessarily the ones who are able to pay for it. 

The good news is that things might be changing. The bad news is also that things might be changing? 

Institutional investors have dipped deeper than ever into the lower middle market and remain the natural high bidder in many scenarios. In the span of 30 minutes I had two illustrative conversations. One was with a searcher who had an LOI rejected for a >$2.5 million EBITDA home services business that was ultimately acquired by a family office and used as a platform for future acquisitions in the area. The other was with a searcher who had an LOI rejected on a <$500k EBITDA home services business that was - you guessed it! - acquired as a bolt on to a family office-backed platform already operating in the area.

Complaining about competition from private equity is basically a form of polite small talk when a group of searchers gets together. But when you notice that in the case of a conference like this, the group of searchers who were getting together numbered several hundred (with more turned away), it’s hard not to conclude that increasingly, the competition for deals also comes from other searchers.

Other searchers who have the temerity to be looking for the exact same sort of business as you! And who are rude enough to have gone to the same schools and read the same books and otherwise be indistinguishable from you, except for the fact that they are a) more attractive and b) seemingly less caught up in the sort of zero-sum thinking that would frame supportive and knowledgeable peers as competitors rather than assets. Spending a weekend with such a group produces the same thought as reading the amazingly thoughtful and informative comments Searchfunder: you’re all a bunch of super helpful weirdos who I’m very grateful for.   

All that to say, I think it would be a mistake to look at the huge increase in interest in ETA and conclude that there must be too few opportunities to go around. For one, the share of business owners working past the standard retirement age is higher than ever, stretching out the Baby Boomer transition longer than you might expect if you just glanced at a Census Bureau population pyramid. But it’s also worth noting that the greater awareness of ETA applies to potential sellers and intermediaries too, and this is a good thing: you’re more likely to be taken seriously as a potential acquirer if the people on the other side of the table know of other examples where a relatively young and inexperienced person proved to a competent partner during an ownership transition. 

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This post is too long already, so I’ll cut it off here. If you made it all the way to the end, clearly you have too much time on your hands. I wouldn’t hate it if you wasted some more of it by reaching out to say hi.