Author: Melissa Dainelli

Further to our recent article on the role of search funds as an alternative buyer group and the completion of the sale of the PCB fabrication and assembly business Garner Osborne, today we focus on this buyer class from a lending / debt funding perspective.

To recap, search funds are investment vehicles formed by a group of investors, lead by an experienced business operator (the “searcher”) to acquire a business.  The process involves the searcher securing capital from investors to fund the initial phase of identifying and acquiring a business and the searcher being operationally involved in the running of the target business post transaction / buyout, often alongside the existing management teams, to drive growth.

Like a traditional LBO, searchers often use debt to enhance overall shareholder returns at the point of exit. However, search fund transactions present a distinct set of considerations for lenders. For example, searchers typically focus specifically on acquiring and actively managing a single business rather than investing in a portfolio of companies and whilst they may have run and operated similar businesses in the past, they are not part of the existing management team within the target.

Here, we’ll explore the key areas lenders scrutinise and what searchers can do to position themselves for success in securing debt for these types of transactions.

The importance of follow-on capital and aligned interests

One of the first things lenders will assess is whether there’s adequate follow-on capital to safeguard against underperformance post-acquisition. Covenant breaches, which can trigger a default, are always a concern. However, in search fund transactions, the situation can be further complicated by investors who might not be willing or able to put in additional equity to cure a covenant breach. This potential discord makes demonstrating a clear path to new equity critical.

Moreover, alignment of interests between the searcher and investors plays a pivotal role. Lenders want assurance that the searcher has “skin in the game” — typically in the form of a meaningful equity contribution. This shows commitment and mitigates the perception of risk.

Sector knowledge and business acumen

A core challenge for searchers is convincing lenders they have the expertise to successfully grow the acquired business given that they are not part of the incumbent management team. Without an investment track record, the burden of proof shifts to demonstrating deep relevant industry knowledge. Therefore, searchers who bring prior experience in the target sector, or at the very least closely related fields, stand a better chance of gaining lender confidence.

But technical know-how isn’t enough. Searchers must also exhibit the leadership and communication skills necessary to guide the company through its next phase of growth. This, in turn, reassures both lenders and investors that the searcher can serve as a capable bridge between all stakeholders.

A strong management team is the backbone of any search fund transaction

Given the long-term nature of search fund investments, lenders place significant weight on the strength and stability of the existing management team. A strong team, with the right incentives in place, is seen as a buffer against the learning curve that searchers may face. Lenders will scrutinise the experience and track record of each team member, looking for alignment between the searcher’s vision and the management’s commitment to executing that vision. This alignment can be created by putting in an appropriate equity incentive plan or where management have a minority stake in the target pre-transaction getting their commitment to roll that forward alongside the investors.

In cases where new leadership appointments are necessary, lenders will need confidence that these additions bring the right mix of skills and experience to complement the existing team.

Crafting a deal that works for all

Search fund transactions are bespoke rather than cookie cutter, and this means lenders will require a granular understanding of the proposed deal structure. For example, how much equity will the sellers reinvest in the business?

As noted above, a higher level of vendor roll-over equity can reassure lenders, as it aligns the seller’s interests with the future success of the business. Similarly, lenders will want clarity on how much capital will be required upfront versus how much can be deferred or linked to performance.

In cases where follow-on investments are part of the strategy, lenders will need to understand how those will be financed and what impact they might have on the business’ cash flow.

The critical role of cash flows

While stable profit and cash flow generation are a cornerstone of any debt-funded transaction, they become even more critical in search fund transactions where the buyer may be an unknown entity to the lender. Lenders will expect detailed due diligence, confirming that the target business has a solid history of profitability and cash generation. Moreover, the financial projections should be supported by recent financial performance and provide enough headroom for debt service obligations, especially given the added risk of an unproven searcher.

The road ahead for search funds in debt markets

Despite the unique challenges that come with funding search fund transactions, we expect this buyer group to continue its momentum in the lower mid-market space. The reliance on existing management teams provides a level of continuity that is attractive to lenders, and with the right preparation, searchers can position themselves to secure favourable debt terms.

Our recent experience has provided us with valuable insight into how different lenders view these structures and what steps searchers can take to tailor debt processes to meet these expectations. By focusing on the areas outlined above, searchers can not only mitigate lender concerns but also obtain flexible debt terms for long-term success.

In the end, securing debt for a search fund buyout is not just about ticking boxes — it’s about building confidence, demonstrating alignment, and crafting a deal that works for all parties involved.

Further to our recent article on the role of search funds as an alternative buyer group and the completion of the sale of the PCB fabrication and assembly business Garner Osborne, today we focus on this buyer class from a lending / debt funding perspective.

To recap, search funds are investment vehicles formed by a group of investors, lead by an experienced business operator (the “searcher”) to acquire a business.  The process involves the searcher securing capital from investors to fund the initial phase of identifying and acquiring a business and the searcher being operationally involved in the running of the target business post transaction / buyout, often alongside the existing management teams, to drive growth.

Like a traditional LBO, searchers often use debt to enhance overall shareholder returns at the point of exit. However, search fund transactions present a distinct set of considerations for lenders. For example, searchers typically focus specifically on acquiring and actively managing a single business rather than investing in a portfolio of companies and whilst they may have run and operated similar businesses in the past, they are not part of the existing management team within the target.

Here, we’ll explore the key areas lenders scrutinise and what searchers can do to position themselves for success in securing debt for these types of transactions.

The importance of follow-on capital and aligned interests

One of the first things lenders will assess is whether there’s adequate follow-on capital to safeguard against underperformance post-acquisition. Covenant breaches, which can trigger a default, are always a concern. However, in search fund transactions, the situation can be further complicated by investors who might not be willing or able to put in additional equity to cure a covenant breach. This potential discord makes demonstrating a clear path to new equity critical.

Moreover, alignment of interests between the searcher and investors plays a pivotal role. Lenders want assurance that the searcher has “skin in the game” — typically in the form of a meaningful equity contribution. This shows commitment and mitigates the perception of risk.

Sector knowledge and business acumen

A core challenge for searchers is convincing lenders they have the expertise to successfully grow the acquired business given that they are not part of the incumbent management team. Without an investment track record, the burden of proof shifts to demonstrating deep relevant industry knowledge. Therefore, searchers who bring prior experience in the target sector, or at the very least closely related fields, stand a better chance of gaining lender confidence.

But technical know-how isn’t enough. Searchers must also exhibit the leadership and communication skills necessary to guide the company through its next phase of growth. This, in turn, reassures both lenders and investors that the searcher can serve as a capable bridge between all stakeholders.

A strong management team is the backbone of any search fund transaction

Given the long-term nature of search fund investments, lenders place significant weight on the strength and stability of the existing management team. A strong team, with the right incentives in place, is seen as a buffer against the learning curve that searchers may face. Lenders will scrutinise the experience and track record of each team member, looking for alignment between the searcher’s vision and the management’s commitment to executing that vision. This alignment can be created by putting in an appropriate equity incentive plan or where management have a minority stake in the target pre-transaction getting their commitment to roll that forward alongside the investors.

In cases where new leadership appointments are necessary, lenders will need confidence that these additions bring the right mix of skills and experience to complement the existing team.

Crafting a deal that works for all

Search fund transactions are bespoke rather than cookie cutter, and this means lenders will require a granular understanding of the proposed deal structure. For example, how much equity will the sellers reinvest in the business?

As noted above, a higher level of vendor roll-over equity can reassure lenders, as it aligns the seller’s interests with the future success of the business. Similarly, lenders will want clarity on how much capital will be required upfront versus how much can be deferred or linked to performance.

In cases where follow-on investments are part of the strategy, lenders will need to understand how those will be financed and what impact they might have on the business’ cash flow.

The critical role of cash flows

While stable profit and cash flow generation are a cornerstone of any debt-funded transaction, they become even more critical in search fund transactions where the buyer may be an unknown entity to the lender. Lenders will expect detailed due diligence, confirming that the target business has a solid history of profitability and cash generation. Moreover, the financial projections should be supported by recent financial performance and provide enough headroom for debt service obligations, especially given the added risk of an unproven searcher.

The road ahead for search funds in debt markets

Despite the unique challenges that come with funding search fund transactions, we expect this buyer group to continue its momentum in the lower mid-market space. The reliance on existing management teams provides a level of continuity that is attractive to lenders, and with the right preparation, searchers can position themselves to secure favourable debt terms.

Our recent experience has provided us with valuable insight into how different lenders view these structures and what steps searchers can take to tailor debt processes to meet these expectations. By focusing on the areas outlined above, searchers can not only mitigate lender concerns but also obtain flexible debt terms for long-term success.

In the end, securing debt for a search fund buyout is not just about ticking boxes — it’s about building confidence, demonstrating alignment, and crafting a deal that works for all parties involved.

Let me apologise up front because this might not be one of the most upbeat of topics that I could have chosen to write about.

However, when not just one, but three opportunities came across my desk in quick succession recently all facing similar challenges, I thought there might be something worth exploring.

The companies in question were all looking to raise their next round of funding and looking for corporate finance advisers. Great! I’m a corporate finance adviser.

 On the face of it, they were attractive propositions – strong technologies tackling big problems and with some great investors already on board but in each case there was something troubling me. Casting an elephant shaped shadow over the opportunities was that I felt each company’s valuation was already too high.

Whether it was their last round price or this round’s expectation, warning lights were flickering and pointing to me that valuation was set to be a major issue – big enough to ultimately frustrate a process or at the very least necessitate some painful and protracted discussions before being resolved.

Valuations too high?

How can valuations be too high? Surely it is better to raise as much money as possible, at as high a price possible to minimise dilution?

In theory, yes but in practice….hmmm, you may be storing up problems.

A high valuation can have many causes – it might be a hangover from having raised money in a bull market and therefore different market conditions or the company having been too aggressive in fundraising and raising too much money too early. Maybe the company’s valuation today is too high relative to its commercial progress – having failed to deliver on its promise and not adequately commercialised the technology since the last round. In practice it might be a blend of them all.

Whatever the diagnosis, the treatment might be very painful.….

Securing funding at an excessively high valuation early on can introduce significant risks to a business so an awareness of how to mitigate them is essential for founders looking to navigate the venture capital world.

1. Pressure to Perform

Raising capital at a high valuation sets the bar for future performance. Investors will expect growth and returns that justify the valuation creating intense pressure on the founders and management team to achieve ambitious milestones. Failure to meet these expectations will drive intense scrutiny, and the likelihood of a down round increases eroding confidence among investors, employees, and customers.

AI-chip company Graphcore was recently sold to Softbank for a reported $500m, which might have been considered a success in normal times, until you realise that $700m had been raised and at its peak at the end of 2020 was valued at $2.8bn. Graphcore failed to adequately commercialise its technology despite this huge investment and revenues in 2022 were $2.7m!

2. Down Round Dangers

Down rounds are damaging in a number of ways – as well as existing management and smaller shareholders feeling the brunt of dilution, employee morale can also be impacted if share options lose value. A down round can create a negative perception in the market, making it harder to attract future investors or customers who may view the company as unstable or on a downward trajectory.

3. Challenges with Exit Strategies

A high early valuation can limit exit options as acquirers are unwilling to pay a premium that matches the inflated valuation, leading to fewer acquisition offers. Alternatively, if the company eventually decides to go public, it may face significant hurdles in justifying its valuation to public market investors, leading to disappointing IPO performance.

So, what can entrepreneurs do to mitigate these risks and help me as a corporate finance adviser do my job or to quote Jerry Maguire, to “Help me, help you”.

1. Set Realistic Milestones

It’s crucial to set realistic milestones and be transparent with investors about potential risks. By aligning on achievable goals, you can build trust and avoid the shock of unmet expectations. It’s better to under promise and overdeliver than to face the fallout of under-delivery.

2. Raise in Tranches

Consider structuring the funding in tranches, where additional capital is released upon achieving specific milestones. However, if you do this then any milestone need to be objectively defined with no wriggle room for delays or investment being withheld.

3. Focus on Sustainable Growth

Rather than chasing hyper-growth to justify a lofty valuation, concentrate on building a sustainable business with solid fundamentals. This includes having a clear path to profitability and positive cashflow, strong focus on customer retention, and a scalable business model.

Like Graphcore, on-line car marketplace Cazoo raised significant levels of investment, but successfully managed to generate significant revenues of £1.25b. However, rampant spending and widening losses of £700m could only be sustained for so long and a series of painful cost-cutting exercises precipitated its administration.  It has just been sold for £5m, three years since being valued at £6billion.

4. Manage Expectations

Transparent communication with your investors is key. Regular updates, both good and bad, help manage expectations and build a strong relationship with investors based on trust. If you anticipate falling short of projections, communicate this early and work together to adjust the strategy.

So, what happened with these opportunities on my desk? Although not afraid of a challenge, I nonetheless passed flagging that difficult internal conversations needed to be had before we would even contemplate getting involved.

If the company and investors had not already taken off the blindfold to see Nellie was not so much in the room but had also left them a nasty mess to clear up, then that would make for one frustrating process for all concerned.

Remember, a strong, sustainable business is the ultimate goal—not just a high valuation.

Let me apologise up front because this might not be one of the most upbeat of topics that I could have chosen to write about.

However, when not just one, but three opportunities came across my desk in quick succession recently all facing similar challenges, I thought there might be something worth exploring.

The companies in question were all looking to raise their next round of funding and looking for corporate finance advisers. Great! I’m a corporate finance adviser.

 On the face of it, they were attractive propositions – strong technologies tackling big problems and with some great investors already on board but in each case there was something troubling me. Casting an elephant shaped shadow over the opportunities was that I felt each company’s valuation was already too high.

Whether it was their last round price or this round’s expectation, warning lights were flickering and pointing to me that valuation was set to be a major issue – big enough to ultimately frustrate a process or at the very least necessitate some painful and protracted discussions before being resolved.

Valuations too high?

How can valuations be too high? Surely it is better to raise as much money as possible, at as high a price possible to minimise dilution?

In theory, yes but in practice….hmmm, you may be storing up problems.

A high valuation can have many causes – it might be a hangover from having raised money in a bull market and therefore different market conditions or the company having been too aggressive in fundraising and raising too much money too early. Maybe the company’s valuation today is too high relative to its commercial progress – having failed to deliver on its promise and not adequately commercialised the technology since the last round. In practice it might be a blend of them all.

Whatever the diagnosis, the treatment might be very painful.….

Securing funding at an excessively high valuation early on can introduce significant risks to a business so an awareness of how to mitigate them is essential for founders looking to navigate the venture capital world.

1. Pressure to Perform

Raising capital at a high valuation sets the bar for future performance. Investors will expect growth and returns that justify the valuation creating intense pressure on the founders and management team to achieve ambitious milestones. Failure to meet these expectations will drive intense scrutiny, and the likelihood of a down round increases eroding confidence among investors, employees, and customers.

AI-chip company Graphcore was recently sold to Softbank for a reported $500m, which might have been considered a success in normal times, until you realise that $700m had been raised and at its peak at the end of 2020 was valued at $2.8bn. Graphcore failed to adequately commercialise its technology despite this huge investment and revenues in 2022 were $2.7m!

2. Down Round Dangers

Down rounds are damaging in a number of ways – as well as existing management and smaller shareholders feeling the brunt of dilution, employee morale can also be impacted if share options lose value. A down round can create a negative perception in the market, making it harder to attract future investors or customers who may view the company as unstable or on a downward trajectory.

3. Challenges with Exit Strategies

A high early valuation can limit exit options as acquirers are unwilling to pay a premium that matches the inflated valuation, leading to fewer acquisition offers. Alternatively, if the company eventually decides to go public, it may face significant hurdles in justifying its valuation to public market investors, leading to disappointing IPO performance.

So, what can entrepreneurs do to mitigate these risks and help me as a corporate finance adviser do my job or to quote Jerry Maguire, to “Help me, help you”.

1. Set Realistic Milestones

It’s crucial to set realistic milestones and be transparent with investors about potential risks. By aligning on achievable goals, you can build trust and avoid the shock of unmet expectations. It’s better to under promise and overdeliver than to face the fallout of under-delivery.

2. Raise in Tranches

Consider structuring the funding in tranches, where additional capital is released upon achieving specific milestones. However, if you do this then any milestone need to be objectively defined with no wriggle room for delays or investment being withheld.

3. Focus on Sustainable Growth

Rather than chasing hyper-growth to justify a lofty valuation, concentrate on building a sustainable business with solid fundamentals. This includes having a clear path to profitability and positive cashflow, strong focus on customer retention, and a scalable business model.

Like Graphcore, on-line car marketplace Cazoo raised significant levels of investment, but successfully managed to generate significant revenues of £1.25b. However, rampant spending and widening losses of £700m could only be sustained for so long and a series of painful cost-cutting exercises precipitated its administration.  It has just been sold for £5m, three years since being valued at £6billion.

4. Manage Expectations

Transparent communication with your investors is key. Regular updates, both good and bad, help manage expectations and build a strong relationship with investors based on trust. If you anticipate falling short of projections, communicate this early and work together to adjust the strategy.

So, what happened with these opportunities on my desk? Although not afraid of a challenge, I nonetheless passed flagging that difficult internal conversations needed to be had before we would even contemplate getting involved.

If the company and investors had not already taken off the blindfold to see Nellie was not so much in the room but had also left them a nasty mess to clear up, then that would make for one frustrating process for all concerned.

Remember, a strong, sustainable business is the ultimate goal—not just a high valuation.