Issue #31: Rolling Funds for Search?

I apologize for the belated issue. I’ll be getting married next Saturday and decided to stagger the newsletter’s release such that I have next week to get our wedding plans squared away without needing to worry about writing the next newsletter. Release will resume on our normal every-other-week cadence on September 5th.

Since AngelList came out with rolling funds, they’ve been a popular topic of discussion on Twitter. Jerry Neumann started a fantastic conversation on Twitter about rolling funds and some of their dynamics I highly recommend reading through. A prominent example today of a rolling fund in practice is Sahil Lavingia’s recently created rolling VC fund. If you’re curious, here’s his fund memo describing the fund’s mission and how he’ll use the rolling fund functionality. He also did a podcast talking about the concept with Anthony Pompliano, which I also highly recommend. (credit to Will Schoeberlein for sending these links over and spurring discussion)

The last two weeks I’ve been thinking if the rolling fund concept, currently applied to venture capital, could also be applied to investing in search funds. I think it can, but there are a number of challenges to address.

In a recent medium article about rolling funds, Ali Hamed brought up a few challenges he sees in the model. One challenge Ali brings up is reporting. Every LP in the fund, by virtue of contributing different amounts of capital over different periods of time, is going to have their own unique mix of investments in the fund.

The same is true in a rolling fund for search as every investor is going to have a different mix of searchers due to the timing differences in capital contributions. I may want to write an annual letter detailing all the searchers we invested in, but many LPs will not have interests in each one of them. How do you share news about your portfolio to investors with different asset mixes? If the fund is 2 years old and has had 8 quarters of capital contributions, do I write 8 different versions of their 2nd annual letter for the 8 different combinations of investments? Perhaps I write a short blurb about each searcher and a software tool, based on an LP’s investment mix, pulls the blurbs about searchers the LP has invested in together in one document? A summary of the year can be written for all investors and the portfolio commentary is pulled together based on asset mix. I think reporting is something that can be resolved, but it will be more complex than a normal fund.

With rolling funds taking investor capital over time, this means I’d always be in fundraising mode, something many managers aren’t fans of, preferring to raise once and invest from a fixed pool of assets. On the other hand when the fund has momentum, LP demand doesn’t need to wait until the next fund to contribute capital to the strategy. Of course this also means investors can pull their future commitments whenever momentum is lost and cease contributions. I’ll be curious to hear about capital contribution volatility from Sahil’s fund here in a few years.

Another challenge with a rolling fund for making investments in traditional search funds is the timing capital inflows. An advertised benefit of a rolling fund is the ability for investors to contribute smaller amounts of capital on a subscription-like basis over a period time. This dynamic especially benefits smaller LPs who can contribute as they raise cash personally, rather than needing a large amount at one time. On the fund side, this works for investing in the search phase of a traditional searcher and filling relatively small equity gaps in search acquisitions.

But what happens when a traditional search I invest in finds an acquisition and needs $500k-1m within a few days or weeks? Unless I allowed capital to build up for a few contribution cycles in the fund, potentially upsetting my investors for doing “nothing” with their capital in the meantime, there won’t be capital available to take advantage of the fund’s investment in the search phase by contributing more capital at a stepped up basis. My imbedded assumption here is the rolling fund initially wouldn’t have meaningfully large capital contributions from investors until I proved the model and investing strategy was successful, thereby granting the fund more investing freedom.

Could a hybrid approach fix this? Use a rolling fund to invest in the search phase and syndicate the acquisition. But not all traditional searchers will find a deal and many of those investments will expire worthless. In funds that invest in traditional searchers, this isn’t a problem because the fund manager can drive returns by investing more capital in searchers who found acquisitions, minimizing the return effect of searchers who came up empty-handed. A rolling fund that only invests in the search phase won’t have this ability. For investors in the rolling fund to get similar returns as a normal fund, they would have to co-invest in the syndicated deals of successful traditional searchers to take advantage of the “call option” of the search phase investment. But not all investors in the rolling fund will have the capital to make meaningful investments in the syndicated deals in addition to their rolling fund contributions. The return disparity between large and small investors could become wide.

Another potential driver of return disparity between small and large LPs is investors in one capital contribution period won’t benefit from investments made prior to their contribution or after their funds are invested. In contrast, when a small LP invests in a normal fund, they have an interest in all prior and future investments from that fund. If a small LP is only able to contribute for 2-3 capital contribution periods, they are going to have a more limited mix of investments than LPs who are able to make consistent contributions over many years. Of course, what a small LP could do is simply stagger their investment over the course of 2-4 years, rather than pouring it all in during a few contribution periods, thereby capturing a wider mix of investments.

Back to investing in traditional searchers though, one way it could work is if the rolling fund grows in popularity, attracting more investors and making each quarter of capital contributions larger than the last. Assuming growing capital contributions from investors over time, a timeline of investments out of a rolling fund might look like this:

  • Years 1-2, low capital contributions: Only invest in acquisition phase deals, no traditional searches.

  • Years 3-4, medium capital contributions: Continue acquisition phase deals, invest into a handful of traditional searches.

  • Years 5+, high capital contributions: Invest with minimal restriction in traditional searchers and acquisitions.

Part of me still feels a rolling fund is just a prerequisite to raising a normal fund, but perhaps if the fund is successful in the early years, it might work for an aspiring fund manager as a permanent vehicle. There are some kinks to iron out, but I think it’s possible to build a rolling fund to invest in searchers.

I want feedback and comments on this concept and what I’ve been thinking through above. There are certainly dynamics and areas of concern around rolling funds I overlooked, or may have addressed improperly. If you have any thoughts around rolling funds for search, hit reply and let’s chat. I’d love to talk more with anyone who’s interested.


Think Like an Owner Sponsors

Live Oak Bank – Live Oak Bank is a seasoned SBA lender focused on search funds, independent sponsors, private equity firms, and individuals looking to acquire small companies. Live Oak has closed billions of dollars in SBA financing and is actively looking to help more small company investors across the country. If you are in the process of acquiring a company or thinking about starting a search, contact Live Oak directly to start a conversation at liveoakbank.com/contactus.

Hood & Strong, LLP – Hood & Strong is a CPA firm with a long history of working with search funds and private equity firms on diligence, assurance, tax services, and more. Hood & Strong is highly skilled in working with search funds, providing quality of earnings and due diligence services during the search, along with assurance and tax services post-acquisition. They offer a unique way to approach acquisition diligence and manage costs effectively. To learn more about how Hood & Strong can help your search, acquisition, and beyond, please email one of their partners Jerry Zhou at jzhou@hoodstrong.com

Traction Capital Partners – Traction acquires companies in the Pacific Northwest with between $1-5m in EBITDA and has acquired two companies to date. Visit their website or contact one of the partners, Justin Turner, directly to learn more.


Capital Notes

Search Fund Survey

I’m putting together a search fund survey very similar to what Post-Close has done for acquisition transactions, which I highly recommend subscribing to. (Here’s Post-Close’s Twitter) Many searchers have mentioned hearing from prospective searchers wanting to learn more about their search. During these calls, many of the same questions and topics are brought up and rehashed. This survey can provide a searcher a place to answer the FAQs about their search and share it ahead of time. That way, whenever a searcher wants to speak with them, the searcher can pass along their survey and give the prospect some background information, making their eventual conversation more valuable and productive. Furthermore by posting these surveys on my website, prospective searchers can read through the accounts of dozens of searchers in a time efficient manner.

If you’re interested in receiving the survey, or know a searcher who would, let me know and I’ll send a link when it’s ready!

Podcast Guests

I’m looking to interview more business owners on the podcast and would appreciate your help in making introductions to owners you think would be great potential guests. I’m most interested in owners of business and home services companies, family owned businesses, and owners who have recently sold to a search fund or private equity buyer. I still want plenty of great investors on the podcast, but I want to include owners in the discussions as well. Some of the best guests I’ve had on the podcast came from referrals and warm introductions and I am very thankful to those of you who’ve helped connect me with so many smart and thoughtful people. If you can think of any great owners for the show, I would love an intro!

Stanford 2020 Search Fund Study

Last but not least, Stanford released their 2020 Search Fund Study. Search funds continue to skyrocket in popularity, as evidenced by the search fund activity chart seen below I pulled from the study. For some good cliff notes on the study, Justin Vogt made a great Twitter thread pointing out the most interesting findings and numbers.

If you found an interesting article, podcast, or interview that I missed, please let me know, I’m always looking for interesting stuff.

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I’m always looking to connect with folks interested in this space, don’t hesitate to reach out.