What does a search fund acquisition's capital structure look like?

The stack, layer by layer

A traditional search fund raises money from a group of investors before it finds a company. Those investors pay for the search and have the right, not the obligation, to fund the acquisition when the searcher signs a letter of intent. The target is usually a profitable, established company with a departing owner, and the financing looks much like a small sponsored buyout with one difference: the person who will run the company has not run it before.

Some searchers raise acquisition equity only once they have signed a deal, without a search fund behind them. At the size where a company is financed conventionally, their stack ends up looking much the same, because conventional lenders want real equity beneath the loan whoever supplies it. SBA 7(a) loans, the other route searchers use, go up to $5 million, so a target large enough to need more senior debt than that is financed with banks and private credit funds. How lenders treat a buyer without a committed fund is set out in financing an acquisition without a sponsor.

Investor equity with a step-up

In a traditional search fund, investors first buy units of search capital, which pay the searcher's salary and the costs of finding a company. When a deal is signed, each investor can choose whether to fund its share of the acquisition equity. Those who do convert their search capital into the deal at a step-up: a premium credited on the money they risked during the search, in return for having funded a search that might have found nothing. The step-up is agreed in the fund's documents; lenders simply see it as part of the equity.

The acquisition equity is usually structured as preferred, with a return owed to investors before common shareholders share in the proceeds. The searcher's reward is common equity, typically earned in three pieces: some at closing, some over time while the searcher runs the company, and some only if investors' returns clear set hurdles. None of this changes the loan directly, but lenders read it for two things. First, the equity is real cash from investors who have backed search deals before. Second, the searcher is paid for staying and performing, which is what a lender to a first-time CEO wants.

Because the investors expect board seats and regular reporting, traditional search deals look to a bank or private credit fund much like a small sponsored buyout. The difference a lender prices is that the investors have no obligation to put in more money later. A private equity fund that owns a company will often support it through a bad year; search investors may, but a lender should not assume it, and the loan's equity cure terms are where that question is settled.

Senior debt for a first-time CEO

Senior cash-flow lenders to lower-middle-market companies commonly lend 2x to 3.5x EBITDA, and conventional bank lenders commonly look for debt service coverage of at least 1.25x. Where a search deal lands in that range depends less on the searcher than on the company: the length and steadiness of its earnings record, how concentrated its customers are, and how much of the business sits in the seller's head.

Lenders then adjust for the handover. They want to know how long the seller will stay and in what role, which employees hold the key customer and supplier relationships and whether they are staying, and what the board, which usually includes experienced operators among the investors, will do in the first year. A searcher who can show a written transition plan and management who have agreed to stay gives a lender reason to lend nearer the middle of its range rather than the bottom of it.

• Banks tend to lend within senior capacity with amortization from the start, and look for a company with a long record and hard assets or steady cash flow.
• Private credit funds and unitranche lenders will lend further into earnings with lighter amortization, at a higher price and usually with call protection. See senior debt vs unitranche.
• SBIC and mezzanine funds sometimes provide a junior layer when the senior lender stops short and the investors would rather not put in more equity. See SBIC funds.

The same company, financed two ways

An illustration in plain numbers. The target earns EBITDA of 1,000, and total project costs, including the price, closing costs and working capital, come to 5,000.

The second structure needs less equity, which raises the investors' return if the company performs, and costs more every year whether it does or not. It also leaves less room for a bad first year, which is the year a new CEO is most likely to have one. How much debt a business can carry walks through both tests, and the blended cost of a capital stack shows how to compare them on price.

More debt raises the investors' return and shrinks the room for the year a new CEO is learning the business.

What the seller can be paid with

The layers beneath the senior loan are where a gap between the seller's price and the lender's loan gets bridged.

• Seller notes. The most common bridge. The senior lender sets the subordination terms and often allows scheduled payments while the company meets its covenants; see seller note terms in conventional deals.
• Earnouts. Possible, subordinated to the senior loan, and counted in the lender's coverage case for any payment they could require. Earnout versus seller note compares the two.
• Rollover equity. A seller who keeps a stake stays invested in the transition. Lenders credit it as equity if it is genuinely junior; see rollover equity.
• A transition agreement. A consulting or employment agreement that keeps the seller involved for a set period. Lenders read it as closely as the price.

Personal guarantees

On a conventional loan the guarantee is negotiated. Lenders to investor-backed search funds usually rely on the company's cash flow, its assets and the investors' equity beneath them, and many do not ask the searcher for a full personal guarantee. Some ask for a limited one, capped in amount or released once the loan has paid down; limited versus unlimited personal guarantees explains the difference. Search investors are rarely asked to guarantee, and it is worth confirming that early with each lender rather than finding it in a term sheet.

What lenders need to see

The lender underwrites the target first and the searcher second. For an acquisition that means the target's latest full year of figures, never an older year, and the letter of intent, alongside the conventional term-loan file:

• P&L / income statement
• Year-to-date P&L through last month-end
• Balance sheet
• Debt schedule
• AP aging

Then the parts particular to a search deal: the sources and uses with the step-up shown, the investor list and the equity commitments, the searcher's background, the transition plan, and a quality of earnings report if one has been done. Once the documents are in, Midas Partners builds the full lender package, with the financing model, lender presentation, blind teaser and underwriting memo, in a day; built by hand, the same package takes at least a week. Of the 1,800+ lenders in the book, 1,148 write term and private credit, and they differ widely in how they view a first-time CEO. The routes are compared in traditional versus self-funded search.