Building a search fund cap table - A European perspective

There are many aspects of the search fund journey that lie outside the control of the entrepreneur. A mix of both skill and luck dealing with this uncertainty is required to succeed in the job. There are two key decisions, however, that are within the locus of control of the searcher: the industries in which the entrepreneur decides to focus the search and the initial investor group. Here I will focus on the latter.

The importance of having a strong investor group cannot be overstated. Investors play a key mentoring role through all the stages of the search and operation. Experienced investors, with their pattern recognition skills, help the searcher filter industries and avoid doing bad deals. They also assist the entrepreneur during the cumbersome negotiation process leading to the acquisition. During the operation phase, three to four of these investors will join the board and provide critical guidance to the new CEO, while ensuring proper governance of the company. Having a strong investor cap table must be positively correlated with achieving higher returns (I have no data to back this assertion). 

Building a SF cap table, however, can be overwhelming for a prospective searcher. The number of SF investors has increased dramatically over the last years. When my partner Ignacio and I started investing a few years ago, we were no more than 25 serial investors in Europe, including the US serial investors that brought the SF model. Today searchers have a list of more than 100 potential investors to choose from, and this number will continue to increase in the future. With such a young and vibrant investor community, it is not always easy for the entrepreneur to differentiate amongst the different investors and pick the right team.

Putting together a strong SF cap table in Europe presents some additional challenges:

- Local investors play a key role in the SF model. However, with the exception of Germany and Spain, in most countries it is almost impossible for a searcher to gather a strong group of local SF investors that know and trust each other (and that are trusted by the SF investor community). 

- Experienced SF investors from the US also play a key role, bringing the know-how and a successful track record of 20+ years helping entrepreneurs buy and grow businesses. But these US investors often lack sufficient bandwidth to support their European searchers from the distance, especially when it comes to serving in boards, which is the cornerstone of investor support. 

- Given the early stage of development of the asset class, there are still only a handful of recently exited SF CEOs in Europe. Former searchers are a key source of investor (and board) talent in every growing search fund community. 

- The increasing popularity of the SF model has attracted a lot of new investor faces, making it challenging for the investor community to preserve the traditional search fund ethos. Some of these new investors are also more passive and transactional, using the initial search investment as a cheap option while failing to provide the adequate level of support to the entrepreneur. 

A few things to consider when building a cap table

Searchers should think strategically about constructing their cap table. A sound approach consists of evaluating potential investors across different dimensions: investor experience (including SF experience), deep pockets, availability to support (and to respond quickly), operational experience, etc. This often leads to some investor allocation buckets based on level of experience (serial v non-serial) investor type (funds v individuals) or country of origin (local v other European and US).

Similar to VC, some investors -both individuals and funds of search funds- have built a strong brand and reputation throughout the years. Most SF entrepreneurs are eager to take these well-known investors onboard. However, these investors often require that the entrepreneur has previously secured the backing from some other value-adding investors they trust (including local investors). Building the cap table suddenly becomes like assembling a jigsaw puzzle, but without the possibility of starting with the easiest jigsaws from the edges of the puzzle.

At the same time, some (often less experienced) investors use aggressive outbound tactics to try to generate deal flow. These investors reach out directly to the entrepreneurs through Linked-in or and ask them to participate in their search fund early in the process. Since building fundraising momentum is critical for the searcher, it is hard not to say yes to these early commitments.

Below are a few tips that, if I were about to launch a search fund, I would take into account to build a solid investor group.

Do your homework: Searchers should have a clear fundraising strategy and do their own due diligence on investors before taking any commitments. They should try to talk to at least 25 to 30 searchers before starting fundraising and ask them for advice and references about specific investor names. Searchers, and especially CEOs that have worked with investors for a longer period of time, are a key source of input to qualify investors and prioritize them in the cap table.

Spend sufficient time with investors and ask lots of questions: There is an inevitable element of speed-dating in the way that fundraising takes place today in the SF ecosystem. Still, both entrepreneurs and investors should try to resist this inertia and spend some time getting to know each other, since they're building a partnership that could last for many years.

Investor bandwidth and board capacity: Investor bandwidth is the scarcest resource nowadays in the SF investor community, and in particular board capacity. Searchers should think about their cap table as a proxy for the future board composition and try to identify, within their search cap table, at least 6-8 suitable candidates that show both the ability and the willingness to serve as board members of the acquired business.

Lead investors: Lead investors that are trusted by the investor community also play a critical role in the SF model. These lead investors take a particularly active role at the time of the acquisition, helping the entrepreneur accomplish the most critical tasks, such as negotiating LOI and final SPA terms with seller or negotiating the SHA on behalf of investor group. There are only a few investors today in Europe with both the experience and willingness to devote a significant amount of their time (and resources) to help the searcher close a SF transaction. The distributed nature of due diligence in SFs often implies that, if a searcher has the appropriate lead investors, the overall investor group will follow their recommendations, making the life of the entrepreneur much easier.  

Operational experience: Make sure you bring some operational experience to the investor group (and to the board post-acquisition), ideally from former searchers and recently exited CEOs. Operational experience in the SME space is particularly relevant, since the challenges small businesses face are very different compared to those of bigger companies, even within the same industry. 

Active investors v. passive investors: We sometimes hear from searchers that they deliberately intend to allocate a portion of their cap table to some "passive investors", knowing in advance that these investors don't plan to contribute anything to the project besides their investment capital. The reason for taking these passive investors onboard is that allegedly these investors are easier to manage for the searcher. I find this strategy quite risky, especially in Europe. It assumes that the entrepreneur has the ability to determine in advance the level of investor support that he will require at all the stages of the SF journey. It also assumes that there will not be any significant changes in the "active portion" of their cap table at the time of acquisition, which is not always the case. Experienced SF investors know when to take a more passive role and let other investors take the lead, and in fact from time to time we are happy to do so.

Don't commit too early: As already mentioned, there is an increasing number of (often new less experienced) SF investors that, in the absence of inbound deal flow, use aggressive outbound strategies to contact and commit with SF entrepreneurs in order to secure an early spot in their cap tables. This has the advantage for the entrepreneur that it helps him/her build momentum in their fundraising, but it can backfire later in the process. Entrepreneurs should try to resist that pressure respectfully and do their due diligence on the investors before taking any commitments.

Enjoy the ride!: It doesn't happen very often in life that you have a group of smart and experienced individuals willing to listen to your story and provide honest feedback and advice. Beyond the short term fundraising goal, I decided to approach our own fundraising process at Istria as an exercise to meet interesting people and build a network of potential partners for the future. This is something I learned from one of our LPs and it helped me reframe the way I think about fundraising.

How many investments make an ideal SF portfolio?

As an investor managing a fund of search funds, I spend a lot of time reflecting on portfolio construction. A question that I think hard and often about, is portfolio sizing. How many SF acquisitions should we invest in if we want to maximize our chances of beating the 30%IRR benchmark from the Stanford and IESE studies?

Portfolio construction requires weighing the benefits of diversification against the investor's ability to effectively support entrepreneurs and help them find, acquire and operate great businesses. The amount of capital available to invest, investor bandwidth (including board capacity), the opportunity set (having access to quality deal flow), fund mandate restrictions or even tax implications, are also limiting factors that often drive portfolio sizing decisions.

Let's take the example of a fund of SFs like Istria. Fund size inevitably plays an important role in determining the number of portfolio investments. It is almost impossible to run a concentrated portfolio of 10-15 SF investments when you have over €20m in assets, given the small average size of equity tickets, at least in Europe. Running a portfolio of 50 companies is also challenging for a small fund with an investment team of 3-4 people, due to lack of sufficient manpower to support the portfolio companies. Having access to top entrepreneurs and deals is also key, since we know that the top quartile SFs drive the lion's share of the asset class returns. Finally, fund mandate restrictions may also apply, such as having a maximum allocation for a given country or geographic region.

But leaving aside these limiting factors, from a modern portfolio theory approach, what is the optimal number of investments in a SF portfolio to maximize returns? The answer to this question will depend on the investor's view about probability distributions and the distribution of SF returns. 

Probability distributions and private equity (VC and non-VC) returns

For a user-friendly explanation on the math behind probability distributions and the most important concepts applied to investing, I would suggest to read here or here (most of the relevant studies and articles belong to the VC space).

It seems to be widely accepted that early-stage VC returns follow a power law distribution, with many strike outs and a few home runs driving most of the returns (see, for example, here and here). On average, 7 out of 10 investments in a typical VC fund will lose money, 2 will make enough to cover for the losses and the remaining one should provide for all the returns of the fund. According to different academic studies, 4% of VC deals return more than 10x capital and 0,4% of deals return more than 50x capital. As a result, an optimal VC portfolio strategy should aim to assemble 500 investments, with 100 investments being the minimum. If we believe that VC returns are subject to strong power law behavior (what is known in the jargon as having an alpha < 2), then an investor would increase its expected return by investing in almost every possible deal.  

There are fewer studies on the analysis of returns distribution in traditional (non-VC) private equity, partly due to the difficulty of obtaining reliable data on the individualized gross returns of PE portfolio companies. The standard assumption in most studies (see here) is that PE returns are also rightward-skewed (although not as much as VC), forming a lognormal, a Pareto-type or some other related form of distribution. 

Are SFs returns normally distributed? Making an educated guess

The SF asset class is still too young to benefit from the quantification that has revolutionized modern finance. Despite the thorough repository of returns data gathered by Stanford and IESE, the sample size is still too small to draw any statistically relevant conclusions on SF returns distribution.

In the absence of empirical evidence, our job as investors is still to make our best educated guess based on the information that we have available and the inferences we can draw from other areas of PE. This is what I believe:

- The Stanford and IESE data suggest that SF returns do not follow a normal distribution, but some type of right-ward skewed distribution, with the top quartile of SFs driving the lion's share of the asset class returns.

- Although SF investing is not an extreme outlier business like VC (the median SF investment in the Stanford and IESE data generated positive returns), a few outliers have earned a significant part of the SF asset class returns (Asurion being the best-known example), which could be indicative of some power law behavior. 

- It is impossible to determine, with the existing data, which type of right-ward skewed distribution would fit better the SF asset class returns (lognormal, Pareto, power law...). We have seen that a few home runs have generated exceptional returns, but power law distributions are often hard to differentiate from other skewed distributions (according to the studies, you need at least 1,000 data points to confirm a power law distribution).

- My intuition is that, even if the returns of individual SF investments do not follow a power law distribution, it is still possible that overall asset class returns exhibit some power law behavior, due to some outperforming investments having much longer holding periods that end up making the distribution's tails heavier. In this regard, we see that some of the most significant successes in the US had holding periods over 10 years (e.g., Asurion, ServiceSource, Alta Colleges, MedMart).

- The data suggest (yet again, I doubt there is statistical evidence to support it) that there is a positive correlation between returns in the top quartile (and a negative correlation with those in the bottom quartile) and those companies that meet certain economic investment criteria - company growth in an industry with favorable tailwinds, strong free cash flow generation (asset light business models often with negative working capital) and a high degree of recurring revenues.

- My intuition is also that investors may experience different distributions of expected returns when investing in so-called "growth deals" (e.g. niche SaaS software businesses in industries growing at 20% CAGR, often acquired at 6-8x EBITDA although more and more measured in multiples of ARR), compared to more traditional "free cash flow deals" (stable businesses growing at 5-10%, acquired at 4-5x EBITDA).

Some key takeaways for portfolio sizing and portfolio construction

Based on my educated guesses described above, here are some key takeaways for portfolio construction:

- Since I am highly convinced that SFs do not follow a normal distribution, I believe that running a concentrated portfolio of 15-20 SF investments does not make sense (from a portfolio theory perspective). I don't believe investors have the ability to pick winners, neither do I believe that an investor's increased dedication to a smaller portfolio of companies will end up yielding better returns than a more diversified approach.

- Since we cannot know (today) whether SF returns follow a power law or some tamer form of right-ward skewed distribution, I believe that the optimal portfolio size should be anywhere between 35 to 100 investments. A smart question for a SF investor to think about would be: what is the chance of getting a 10x investment or a 50x investment in my portfolio? 

- The diseconomies of scale associated to SF investing makes it hard for most investors to run such a diversified portfolio of investments. Unless you are a passive investor (which most SF investors are not), diversification brings significant operational challenges, mostly due to manpower resource constraints.

- I believe that, for a small fund like Istria, running a portfolio of at least 30-35 investments increases your chances of investing in some of the top performers, while staying reasonable in terms of number of companies given the size of the team. I also believe that your chances of hitting a home run also increase if your holding period is flexible and can be extended up to 10 years, allowing you to ride the winners for a longer period than the regular 6-7 year hold. 

- At Istria, we see other additional advantages in running a bigger portfolio size. It increases our profile as an investor, which helps improve our deal flow. Evaluating and investing in more companies also gives us more data to build our pattern recognition capabilities (improving our investment process), and it helps expanding our network.

- It is important for SF investors to avoid adverse selection and build up a brand/reputation that allows you to have access to the top 25% of the deals. It also makes sense to run a barbell strategy, having a combination of "free cash flow deals" and "growth deals", and always focusing on high quality teams and SF acquisitions that meet the economic investment criteria.

- An individual SF investor should consider whether he or she would be better off investing through a fund of SFs. Although direct investing in SFs is fun and rewarding, unless you are a professional serial SF investor, building a diversified portfolio of direct investments is hard and requires a high level of dedication and human resources (and definitely not the same skill-set you need for fund allocation and fund manager selection). From a pure financial returns perspective, the average individual investor might be better off investing through a fund of SFs, even after accounting for all expenses and fees.


As with other asset classes, the right SF portfolio size is ultimately a judgment call based on risk appetite/risk tolerance, opportunity set and some notion of investor bandwidth. From a portfolio approach, and in the absence of empirical data, I believe that running a highly diversified SF portfolio seems to be a better option, since it increases the chances of capturing some of the outliers falling to the right of the bell shaped curve.

Spain search fund market in 2020

In the last three years Spain has seen a significant growth in the number of search funds, becoming the single most active European country and the third largest search fund market worldwide after the US and Mexico.

In 2020 we finally witnessed the first exit of a search fund acquired company, a key milestone for the SF community. Repli, the plastics packaging company acquired by Spanish pioneer Ariol Capital in 2014, was successfully sold to a strategic buyer, generating a solid outcome for its shareholders. Kudos to Marc Bartomeus and the entire Ariol team!

On the acquisitions front, 2020 saw 3 new search fund deals in the online education (ENEB), plastics manufacturing (Plásticos Arias) and contractor management software markets (CTAIMA, one of our portfolio investments). This makes for a total of 11 acquisitions to date.* In addition, two Spanish entrepreneurs acquired a fleet management software company based in the Netherlands (CarPro Systems, also an Istria portfolio company).

In terms of new funds raised, 5 search funds were launched in 2020 (Istria is an investor in 2 of them), bringing up to 15 the total number of active funds looking for a business to buy. Also, one search fund was terminated without closing an acquisition, the second time this has happened in Spain.

The number of local investors has also continued to grow, with several new faces joining the investor community in 2020. The existence of a strong community of local serial investors is an important factor that continues to make experienced US and international investors more comfortable investing in Spain.

Finally, from an academic perspective, IESE continued to be the reference for so-called "international" search funds (those outside of the US & Canada), with the organization of the international SF conference (this year in a webinar format) and the release of the latest version of its international SF study. 

Still one of the most attractive markets to be a searcher

Prospective searchers often ask us if Spain continues to be an attractive market to launch a search fund. There is some fear that it has somehow become a saturated market now that there are 15 to 20 search funds actively looking for a company at any given time.

When we look at the numbers, however, we can see that there is still plenty of room for growth. There are approximately 1,500 to 2,000 potential targets in Spain that meet the broad search fund investment criteria. That's a lot of companies for (still) a relatively small number of prospective buyers. This is particularly true if we compare it with the traditional private equity market, where a much smaller universe of potential targets is chased by a larger number of PE funds.

There are two important aspects of the Spanish SME market that are often overlooked. First, most companies in the €1-3m EBITDA range are still founder-owned businesses, increasing significantly the proportion of so-called "natural sellers" of high quality niche services businesses. Second, the level of penetration of both professional buyers and intermediaries in this micro-buyout space is much lower than in other European countries. This combination of a higher proportion of suitable targets and less competition from other buyers, together with other factors such as the availability of cheap financing and some favorable macro and fiscal trends, continues to make Spain one of the most attractive markets in Europe, even today under the difficult Covid-19 environment.

There is undoubtedly more competition nowadays than there was some years ago when there were only one or two entrepreneurs searching for companies, but that is an inevitable consequence of the development of the search fund model in Spain. Yet, the chances of two search fund entrepreneurs bumping into each other are still relative low, especially in proprietary sourced deals.

(*) Repli (2014), Lodisna (2015), Cermer (2016), Mapex (2018), Lanaccess (2018), Frenkit (2019) Logiscenter (2019), Vozitel (2019), ENEB (2020), Plásticos Arias (2020), CTAIMA (2020). 

My first post

I am a serial search fund investor. Together with a group of co-investors, I back young talented entrepreneurs and help them source, acquire and become successful CEOs of small growing businesses. I love what I do.

I believe that the transfer of wealth that is taking place with the retirement of the generation of baby boomers offers one of the investment opportunities of our lifetime. Search funds allow investors to capture this opportunity by investing in profitable businesses in the often-unexplored lower end of the middle market.

I live in Madrid. During the last 3 years Spain has become a hub for search funds in Europe. I am also a husband and a father of three, and I love spending time with my family even more than investing.

In 2018, alongside with my partner Ignacio, I co-founded Istria Capital, the first (and so far only) institutional fund of search funds based in Europe. At Istria we have backed more than 50 searchers worldwide and invested in 12 operating companies. I serve in 3 boards and sit in another one as observer (Tethys, Teclena, Theia and CarPro Systems as observer).

I love reading about investing, decision-making and storytelling. I also love playing soccer – I’ve already played the top ten games of my career - and occasionally playing guitar and golf - I hope I haven’t played yet the top ten golf games of my career. Having three young girls and running a small investment firm, it is always a challenge to keep other interests alive.

I am a generalist. Although I have broad experience as a lawyer, private investor and second-generation family business owner, I am only at the beginning of my SF investing career and still early in the learning curve. There are many folks out there that have a much deeper knowledge and experience investing in search funds and operating companies. I feel lucky that we get co-invest along with them, learn from their incredible experience and be part of the incredibly talented and kind search fund community.

At Istria we like to think of ourselves as fast learners and, although we are relatively new to the search fund ecosystem (as almost everyone is in Europe), we are one of the most active investors. There is no substitute for personal experience when it comes to investing. We (hopefully) have many years ahead of us to fix this. 

I decided to start this blog because writing helps me improve my thinking process. My initial idea is to write here mainly about search funds and search fund investing. However, knowing myself, it’s just a matter of time that I start digressing and writing about other topics that interest me.

Don’t expect to find here the ultimate wisdom of search fund investing. But do expect to find hard work, some good research and sharing my learning journey.