SMEs are critical to the global economy, but are facing a crisis
SMEs are the lifeblood of the global economy. According to the World Bank they represent a staggering 90% of all businesses and account for around 50% of employment globally. It is not an exaggeration to say that the speed of the global bounce back from the Covid shutdown will depend on their prowess over the next few years.
Yet SMEs are facing their own crisis. A crisis of succession. In Asia alone, Bloomberg reports the value of family businesses without a succession plan is $22trn. While in the US, Project Equity suggests 85% of SMEs do not have a succession plan. And for those that have tried, they note that around a third of business owners over the age of 50 report having a hard time finding a buyer.
Finding a successor is tough. SMEs are personal. They typically owe their success to the toil and dedication of their founder. Finding the right person to pass this legacy on to, is so much more than a business transaction. At the same time, the business tends to be founder’s greatest financial asset, which means it needs to continue being a success if the founder is to have a successful retirement. With such a lot at stake, it is no surprise that so many founders continue to kick the succession can down the road, especially as they still have to do their day job of running a successful company.
Traditional Search Funds offer hope for a limited few
Search Funds offer a solution for succession issues. Search funds grew out of Stanford’s Business School in the mid 1980s thanks to the vision of (now professor) Irw Grousbeck. Traditionally, an individual known as the searcher, raises a small amount of capital to fund their search for a company. Once founded, they raise a second round of equity from the original investors to buy and grow the company. Since 1984, Stanford research suggest that at least $1.4bn has been invested this way, with $6.9bn of equity value generated for investors and $1.8bn for entrepreneurs alike.
However, the traditional search fund model has a number of challenges. First, it can be lengthy. According to Stanford’s latest research, the average search takes 23 months, while the time between acquisition and exit is 6-10 years. That’s a long wait to realise a return on investment. Second, 33% of searches fail. This means that one time out of three, investors are left modestly out of pocket after a two year wait.
Most importantly, opportunities to utilise traditional search funds in succession are minimal. Since 1984 there have been just 401 first time search funds launched in the US and Canada. Internationally their prevalence is even more sparse, with the 2020 IESE search fund study identifying just 132 funds of which 50 were actively seeking to acquire a company. At such a run rate, traditional one-off search funds, will struggle to move the needle on SME succession.
Traditional search funds are not available as an option for most investors
For investors, the limited and sporadic deal flow in the traditional search model means that most are locked out of this asset class – preventing them from benefiting from an IRR of almost 30%. Even for those that do participate, there’s frustration as their minimal access to deals makes attempts to manage risk by diversifying across deals and sectors challenging.
A new approach offers more opportunities with no compromise on the return
The “Entrepreneurship through Acquisition (ETA)” programme from Novastone Capital Advisors is the next generation in Search Funds. According to Founder and CEO, Christian Malek, “as a family office we have invested in private equity for over 10 years. But finding deals was time consuming and costly. We set this up to ensure deal flow and the programme has already launched and filled 4 funds since the end of 2020. We expect to launch another 20 this year alone. We have and will continue to co-invest in each one.”
Part of Christian’s confidence comes from the quality of the searchers. Unlike the traditional model, the ETA programme recruits the searchers, requiring them to have exceptional academic records (often with an MBA) as well as substantial professional experience. “We believe the quality of our candidates and the co-investment community we are building through our programme, means the time to search, the likelihood of no acquisition and the time to exit will all be much lower than in the traditional model, while our incentive structure ensures no compromise in the rate of return.
For more information on how NCA’s ETA programme may be used to solve a succession challenge click here.