To play in Canada’s fractured private equity market, investors must go head-to-head with huge established funds for big businesses, or battle venture-capital players for small but promising startups.
But there’s an untapped middle ground, one that a different breed of investment fund is designed to access. So-called “search funds” seek out flourishing, small-to-medium-sized enterprises that want to sell but can’t find buyers. And thanks to a growing wave of retirements by baby boomer entrepreneurs, the number of these firms is growing.
These enterprises are too small to attract attention from big players like the Canada Pension Plan Investment Board, and too big to interest venture capitalists, but they can be attractive investments that boast reliable cash flow coupled with lower risk.
“The level of risk, I think, is substantially reduced compared to the venture capital market” because the businesses are established, said Paul Rogers, a former president at CIBC World Markets in New York, who recently invested in one of the newest entrants in the search-fund market, Toronto-based Auxo Management.
Auxo was started this year by Canadians Rob Cherun and Erik Mikkelsen. With a few years of experience in fields such as management consulting and investment banking under their belts, they recognized the gap in the market and came back from the United States to start their fund.
Unlike most private equity and venture capital funds, which invest in several companies, a search fund generally raises capital to invest in just one. And instead of being passive investors, Auxo’s two co-partners plan on actively managing just one acquisition over the next few years. If the value skyrockets, they will move on to a second, and possibly sell the first.
Search funds like these are rare in Canada, but aren’t completely unheard of. George Rossolatos, co-founder of private-equity firm TorQuest Partners Inc., recently launched a Canadian search fund, called Riverdale Capital Corp.
Unlike most mid-market private-equity funds, which look for companies with a minimum of $10-million in earnings before interest, taxes, depreciation and amortization (EBITDA), Auxo is seeking businesses with $2-million to $10-million in annual EBITDA. They also want to see a history of stable cash flow, and loyal customers.
First, though, they had to find investors. Mr. Cherun and Mr. Mikkelsen were selective about who they brought on board. “We didn’t want just very wealthy people,” Mr. Cherun said. “We wanted people who kind of made it from nothing and were just very, very smart and were more willing to advise and mentor us.”
They were lucky to have a notable backer from the beginning. Joel Peterson, founder of private equity firm Peterson Partners and chairman of JetBlue Airways Corp., taught Mr. Cherun during his MBA at Stanford’s Graduate School of Business and was willing to put some money into the fund.
With a big name on board, Mr. Cherun and Mr. Mikkelsen were able to tap Harvard and Stanford’s entrepreneurial networks to find and convince Rogers, and Howard Stevenson, a senior associate dean at Harvard Business School. They have 24 investors in all. About one-quarter are Canadian.
“Things picked up very, very quickly in the U.S., whereas in Canada we really had to network a lot more,” Mr. Mikkelsen said. They found that surprising, considering the fund intends to invest in Canadian companies – which will benefit from Canada’s favourable economic climate, including its low debt-to-GDP ratio and proportionately much less private equity money chasing firms.
Americans are more accustomed to placing big equity bets, Mr. Cherun said of his experience. They “have seen the Googles and the Facebooks, and they’re very close to it all. And they’ve seen young guys pull this off. Not as much has [been accomplished] happened by Canadians our age.”
Plus, the smaller market here lacks the same volume of companies, said Ian Palm, co-leader of the private equity practice at McCarthy Tetrault LLP.
