Are Search Funds Moving Up Market?

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Over the past few months, I’ve been presented with five separate opportunities that contemplated the acquisition of a company with $7M or more of EBITDA (this compares to the Search Fund average of $2.2M for the 2022-2023 cohort of Searchers).

While I acknowledge that five data points don’t constitute a trend, at the very least this has piqued my curiosity. While the Search Fund ecosystem has worried – seemingly for over a decade now – about the possibility of middle-market Private Equity firms moving down market, it’s interesting to ask whether the inverse may now be happening, at least to a certain extent: Are Search Funds moving up market?

I’ll flag up front that the most recent data does not seem to agree with my recent experience: According to the 2024 Stanford Search Fund study, the EBITDA of acquired companies has remained relatively consistent over the past 10 years, bumping around between ~$1.7M (2021) and $2.5M (2015) during that period. That said, the data does end in 2023, so if this is indeed becoming a trend (even an isolated one), it may not yet be reflected in the data.  

On one hand, one could make a reasonable argument that larger companies present several merits not applicable to (or at least less applicable to) smaller companies. These could include advantages like:

• A larger and deeper bench of middle management
• A larger dollar amount of EBITDA, both to fund growth investments and to provide a “cushion” against the first-time CEO mistakes that investors reasonably expect new operators to make
• A broader array of lenders who may be willing & able to lend against the transaction
• (Possibly, but not necessarily) A larger and more diverse set of customers
• (Possibly, but not necessarily) Less key-person risk residing within the outgoing Founder/CEO
• (Possibly, but not necessarily) Better ability to recruit talent at executive levels
• (Likely, but not necessarily) Better internal systems and controls across finance, accounting, and other flavors of internal infrastructure
• A larger universe of potential acquirors upon exit
• A larger dollar amount of carry for the entrepreneur (all else being equal, when compared against the same magnitude of value creation in a smaller business with a lower quantum of dollars involved)

That said, there also appear to be several notable risks of moving up market. Perhaps the most notable risk of all is simply that acquiring companies of this size is less familiar territory for the Search Fund ecosystem: While we have four decades of data, going back to 1982, supporting the idea that first-time CEOs can indeed successfully acquire, grow, and sell companies averaging ~$2M in EBITDA, we just have much less data supporting the idea that they can do the same thing for companies generating ~$7M or more (though not to say that this isn’t possible). Acquiring these larger companies presents several other risks, including some of the following:

• Higher day-to-day operational complexity
• (Presumably, but not necessarily) A more competitive acquisition process
• Higher entry multiples: The Search Fund ecosystem has historically benefited from a structural mismatch between the supply and demand for small companies, which partially explains the multiples at which these companies tend to trade. This supply/demand mismatch is presumably less pronounced at ~$7M+ of EBITDA
• Difficulty & complexity simply raising the dollars (and managing the cap table) required to consummate the transaction in the first place
• (Possibly, but not necessarily) Fewer “low hanging fruit” operational changes that can be quick and low-friction ways to create equity value (pricing, sales & marketing build-out, etc.)
• (Possibly, but not necessarily) Are capital providers as tolerant of the inevitable first-time CEO mistakes when they make a $5M investment as opposed to a $500K investment?
• While acquiring smaller companies certainly has its share of imperfections (concentration, key-person risk, limited data, etc.), at least the ETA community has a lot of clarity and experience in dealing with these specific imperfections.

To help me understand whether Search Funds are indeed moving up market, I recently commissioned a survey of current, former and prospective searchers across several different models of ETA (funded, self-funded, independent sponsor, committed capital vehicle, etc.). Though we were constrained by a somewhat limited sample size (n=50), I did find certain of the results (presented below) to be quite interesting:

Survey Results

That said, you’ll notice that 40% of all respondents are explicitly seeking to acquire a business with $3M of EBITDA or more, so at least some amount of bias towards size does seem evident (note that we didn’t differentiate between solo and partnered searches, so some skewness within the data is certainly possible).

Further segmenting the data revealed a few additional points of interest, namely:

• The upward movement appears to be driven not by those currently searching, but by those planning to search in the near-term: Only 34% of current searchers said that they’re looking to acquire a company with $3M+ or more of EBITDA compared to 64% of those planning to search within the next 12 months
  
  
• Perhaps unsurprisingly, the bias towards size also appears to be driven by those pursuing “traditional” (or “funded”) searches: 53% of funded searchers are seeking to acquire a company with at least $3M of EBITDA, in comparison to only 14% of entrepreneurs operating within a self-funded search, an independent sponsor model, or a committed capital vehicle.

The results across all respondents (presented in the adjacent chart) seem to suggest that preferences haven’t really changed all that much, with ~57% of respondents claiming that they continue to look for roughly the same size of company compared to 6-12 months ago.

The most notable insight that came from further segmenting the data concerned which of the ETA models are primarily moving up-market:

• Only 8% of those pursuing a funded search said that they’re now pursuing larger companies than they were 6-12 months ago, in comparison to 60% of searchers from other models of ETA

Taken together, our survey seems to suggest the following (though, again, all conclusions are subject to the limitations of our modest sample size):

1. Funded searchers aren’t moving upmarket as much as they’re continuing to lean towards the larger end of the range of what has been purchased historically
   
   
2. Prospective searchers seem to be particularly interested in acquiring larger targets, which provides at least one reason to believe that a bias towards size may become more pronounced in the years to come
   
   
3.  Those pursuing non-traditional forms of search seem to be demonstrating the most “upward mobility”, albeit off of a smaller base

Why Pursue Larger Targets?

Given that the median has remained relatively consistent over the past 10 years (at ~$1.7M – $2.5M of EBITDA at acquisition), we asked those searchers who were targeting a larger business why they were doing so.

Stripping out the “long tail” of responses that we received less than a handful of times, below are the four major themes that emerged (ranked in order from most frequently mentioned to least frequently mentioned):

1. Better Personal Economics / Equity Outcomes: By far the most common response we received discussed the fact that, all else being equal, a larger company can produce a better economic outcome for the searcher (i.e. a larger dollar amount of carry) when compared against the same magnitude of value creation in a smaller business with a lower quantum of dollars involved
   
   
2. Operational Depth, Infrastructure & Platform Potential: Respondents also seemed to believe quite strongly that larger businesses have deeper management teams, more diversified revenue streams, greater operational maturity, and stronger infrastructure. Several responses also mentioned that larger companies present a more appropriate foundation upon which to pursue an acquisitive growth strategy, something that seems to be growing in popularity of late as we see more committed capital vehicles being raised.
   
   
3. Lower Perceived Risk / Greater Resilience: Related to the above, respondents also believe that larger businesses are inherently less risky due to scale, resilience to macroeconomic shocks, more diversified revenue streams, and more exit pathways, among other considerations.
   
   
4. Investor Influence: Finally, several searchers said that they are being actively encouraged  to pursue larger deals due to investor minimum check sizes, the size of the funds being managed by their LPs, general investor preferences, and other dynamics specific to the composition of their cap tables.

So, what does it all mean?

It would be irresponsible of me to draw sweeping conclusions from such a modest sample size. That said, it would be equally incomplete to ignore the directional signals, both from the data and from my own first-hand experience. While historical data shows stability in deal size, our small survey seems to indicate that preferences — particularly among prospective and non-traditional searchers — may be shifting upward.

I’m not sure that this can be classified as necessarily “good” or “bad”, but if that trend continues for long enough, the ETA ecosystem may gradually find itself operating in a different segment of the market than the one that produced its historical track record. Again, that does not necessarily imply deterioration — but it does suggest that all participants within the ETA ecosystem should be explicit about what assumptions and incentives are being carried forward.

Evolution is not inherently destabilizing, though I suppose unexamined evolution could be.

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