Lack of Capital, Frothy Multiples, and the Growing Pains of Modern Search

Photo Credit: Robert Benson Photography

The search space continues to evolve and become overly crowded, though not everything is up and to the right in the space. I've been helping searchers for the past four years trying to add a more institutional lens to diligence with KPI insights, finding precedent transactions, building investor presentations and more detailed LBO returns models. Having gone through a rigorous two year investment banking program and deploying over $2.1 billion of capital into the lower middle market over the past decade, I try to push searchers in the right direction around interesting opportunities, valuation, structuring deals for optimized alignment with the seller, and ultimately getting to a successful closing. Boy is that hard today. Below are my current thoughts and insights into the search space as 2025 comes to a close (apologies in advance for the bearish but realistic tone).

Overcrowded Space

15 years ago nobody had heard of a search fund. The opportunity was massive. The outsized return potential of buying a $1.0-5.0 million EBITDA business for 3-4x EBITDA and professionalizing a company over 5-8 years was huge. Building a must-have, scaled asset and selling into private equity or a hungry strategic for significant multiple expansion and an outsized return was always (and still is) the goal. The challenge is how 'mainstream' search has become. For the better or worse, hundreds (if not thousands) of post-MBA's are all diving into the space each year to acquire and run a small business. To be transparent, the quality of the average searcher has significantly declined. What may have been the top 10-15 students from an MBA program pursuing search has ballooned into 50-300 students all pursuing the same goal. You may argue this is a good thing - maybe due to the space gaining popularity more investors or lenders are familiar with the model and providing capital to deals. I'd argue the opposite. The challenge is so many searchers dig into poor opportunities or do not receive the resources / attention they need from their investors and the likelihood of closing a deal diminishes. Small investment banks and brokers are beginning to take notice and are hesitant to even allow searchers to bid in their processes. Why would I let a searcher who has no M&A experience sign exclusivity on a business when a $300 million private equity fund with decades of PE experience, COMMITTED CAPITAL (more about this below), existing debt relationships, and significantly more resources can pre-empt a process and close the transaction in 45 days? As the quality of searcher has deteriorated, the perception of the search space has declined in the eyes of others across the finance space and many bankers I talk to no longer want to even include searchers in processes due to so many failed transactions. Searchers often sign LOI's and then do not have the capital to close the deal, thus blowing up the deal and wasting the seller's time (and dollars) all to re-start the management meeting and LOI process to find the right party who actually has capital.

Lack of Capital

"I raised my search fund nine months ago and just signed my first LOI. It's a really high probability opportunity and I'd love to work with you." I hear this all of the time from searchers who just signed an LOI with exclusivity and have a ton of work to complete prior to reaching that desired finish line of acquiring a business. The largest challenge? Capital. Seems odd. When I first started helping searchers I didn't understand - so you have a 'fund' of capital, but ultimately everyone on your cap table can just pass on your deal so you may have no capital? So what good is the capital? Oh by the way, if we pass on the deal, but you close on it we have what's called a 'search step-up' of 1.5x the initial money that vests into the cap table and dilutes the owner (usually unknown to the seller until the final weeks of diligence) or gets paid in cash at closing. What? The biggest hurdle in closing a search deal continues to be capital. How can this be when so many investors, both traditional search investors (former searchers) and family offices are pouring into the space? There are constantly gaps in equity.

Here's an example. You sign up a deal that requires $10 million of equity. Your largest investor is 15% of your cap table and your second largest is 10%. Say your lead investor is in and excited about the opportunity - $1.5 million raised. Great. Your second largest investor waffles on the opportunity, asks you to 'continue to dig in', but has concerns around cyclicality or the recurring nature of the offering and ultimately passes. That's immediately a $1.0 million gap in your equity raise. And 9/10 times your lead investor will not flex up and take on that incremental $1.0 million of equity (we call it a mop-up). The current traditional search model is broken and this significantly differs from institutional private equity and typical co-investment. Usually a PE firm signs up a deal and they may show some select large limited partners 'co-investment' or incremental equity outside of their fund to close the opportunity. Co-investors typically get 3-4 weeks to piggy-back on diligence alongside the lead sponsor and come to a conclusion in short order if they want to participate in the deal or not as the sponsor will otherwise show the deal to other investors. Sometimes a co-investor has one week to decide and the deal is closing by month-end. Many parties have the ability to flex-up or flex-down based on the demand and capital required, thus filling in holes to ensure the required capital is solved for. For a $10 million check within private equity, that's typically solved for by 1-2 investors. A lead could be $7.5 million and a secondary investor being the remaining $2.5 million of equity. If the smaller investor pulls out or does not participate, often the lead investor will just take the full amount and have $10 million of exposure. Case closed. Deal transacts. Closing party gets scheduled and the 100-day value-creation plan begins. In search, the 'larger' investors often take their pre-emptive / pro-rata rights, however, they will not take in excess of their pro-rata. This immediately leads to gap equity needs.

The other challenge is few investors are willing to write larger checks. Search is turning into venture and I personally hate the venture model. The VC model is we'll back 10 companies and know that 8 will go under, 1 may make a slight return, but that last remaining unicorn is a 10-20x MOIC deal and by far returns the fund on its own. You can't miss that unicorn opportunity or your fund's returns significantly suffer and you're out of business. Search investing is turning into throwing darts. The more darts you throw the better odds of participating in that unicorn transaction. I'm not seeing search investors write $5-15 million checks and having a relatively concentrated portfolio like private equity. They're writing $500K-$3 million checks (often $1.5 million or below) and hoping they have exposure to enough deals to hit that unicorn that drives outsized returns. As a result, many searchers are shutting down their funds after two years as they didn't close on deals and the transactions that do have hope of closing are left with significant equity holes. Enter the wild west of search and pinging 100 family offices to write $50K-$250K checks. This model isn't sustainable. I've chatted with more institutional family offices and placement agents and what you'd call 'sophisticated capital and resources' continue to shy away from search. There continues to be a large gap between an independent sponsor and search fund. Search has an equity problem and it will not be solved soon until the space evolves.

Low-Quality Diligence

You now have so many searchers signing up small businesses under LOI from brokered processes and these transactions have a near-zero probability of closing. "I bid a 7x valuation on 2025E EBITDA of $1.0 million, am I overpaying?" I get this question all of the time. I've seen searchers sign up deals without ever seeing LTM P&L and balance sheet financials in excel. How do you have any idea if you are overpaying if you don't know if the $1.0 million of EBITDA is real? You should take what the seller says regarding EBITDA with a grain of salt and always ask for the raw P&L financials (should be your first request). Everyone has access to the highly simplified LBO model from investors which is at least a starting point (though not perfect and often lacks detail) in evaluating what growth expectations need to be hit in order to achieve your return targets.

I'm also seeing searchers sign LOI's without fully understanding the terms. I'll ask "Is the seller note cash or PIK interest?". "What do you mean?". It's important you know what you're signing up for. Are you paying cash interest on the seller note on a quarterly or semi-annual basis or are you having the note 'accrue' or 'PIK' for a number of years before making a balloon payment? Many searchers are just assuming they can then make that seller note balloon payment with cash from operations 2-4 years in. The business is tiny. You're investing into the team. How are you going to pay $4 million in cash just two years in? Options include a revolver or working capital line provided by a lender or equity from your investors (expensive). Evaluating true cash flows of a business is so important to understand what you can or can't afford. I always urge searchers to try to spread out the seller note payment across two years and two separate balloon payments so you can afford it with cash from operations and save the additional equity and capital call from investors until you really need it (i.e. accretive add-on).

The other odd element of search is this artificial target of a 35% net IRR. As I help searchers with post-LOI diligence I get this comment all of the time: "the model looks great and it's really easy to follow, but the base case returns show a 28% IRR and I need to show my investors 35%. Can you tweak the assumptions?" Sure, happy to. Want to show 50% IRR? No problem. Happy to juice the exit multiple by four turns and just assume the business grows at 40%. We've hit it. Private equity firms typically underwrite to a 3.0-3.5x MOIC and high 20%'s IRR base case. I don't think searchers (and frankly a good portion of the investors in the space) truly understand how much has to go right for a deal to achieve a 35% IRR. To me that is a great upside case. But base case? Base cases should be very achievable. If we can complete X, Y, Z growth initiatives and sell for the same exit multiple (or one turn higher max), we can achieve our goals. This 35% figure is completely fake. I've seen investors say they won't dig in unless a base case shows at least a 35% net IRR. The reason? Double fees. Your investors are not only paying your tiered carry up to 25% or 35%, but they're also charging their investors 20% carry (sometimes even premium carry above 20%). You get a double layer of fees. In order to make the cost of capital work, they need such an inflated return so after all of the fees and carried interest paid out the funds can still generate a 17-20% net IRR. Institutional private equity has a different way of handling doubling fees and blending down averages to make lower returning deals work, just a difference in the cost of capital. Search isn't there yet. The model isn't scalable. It's why the largest search funds in the space are $200-300 million in size and viewed as 'massive'. The smallest of small private equity funds are $100-300 million and most are $500 million to $5 billion, excluding the mega funds that can raise $10-25 billion per fund. These are the growing pains of search. You want to show a 35% net IRR in your model? No problem, but be aware of the underlying assumptions that are needed to get there. That is why the mini LBO model is helpful in analyzing how much you can pay for a business. If you're paying 6-7x for a $1 million EBITDA business plus your search salary your assumptions are going to be highly aggressive to hit the required hurdles. Move on and find a better deal.

Finally, a fast 'no' is the best answer you can get from an an investor (outside of a "yes we are in and love the deal" - that rarely happens). No investor wants to be the bad guy and blow-up a deal or pass on an opportunity. So what do they do? They tell the searcher to continue to 'dig in'. Build more slides. Have your free interns Google for more crappy industry articles and stitch together some quotes from public company CEO's that there are in fact industry tailwinds, despite that massive publicly traded conglomerate having really little to no overlap in service offering with the small niche provider you are evaluating. Investor presentations should not be 100 pages. Your investors aren't even reading 20 pages. Investors have backed too many searchers and many of these investors are teams of 2-3 people with no junior resources (not the case for all search investors). On top of that, many of these investors do not have private equity experience and the only business they underwrote before launching their small fund was their own. I continue to urge searchers to push towards quality over quantity during diligence. A 50-70 page investor deck with some supplemental slides is highly effective. You don't need 30 pages showing pictures of a facility or Q&A from investors. Nobody is reading it and it is a waste of time. I continue to be shocked at how people use their valuable post-LOI time, but time is the #1 killer of deals. Push your investors early to lean in or out and start gap equity conversations early - no family office can get caught up to speed fast enough two weeks before closing.

Growing Dead Deals Means More Dead Deal Costs

As a continuation from the diligence point above, dead deal costs are a sore subject in search (and frankly with my own services model catering to searchers). Searchers want to limit dead deal costs as much as they can - totally get it. "I have 10 highly qualified interns helping me". Awesome. One of my favorite sayings is: you get what you pay for. If you want to manage 10 interns who have zero private equity or investment banking experience (many have zero work experience or finance in general and are in undergrad) be my guest. My guess is you're moving slower. I think a team of interns is highly valuable for driving deal flow, sending out cold emails, doing light industry work ahead of an LOI, and tackling the basics of pursuing a theme or sector. They're likely incredibly useless when it comes to building an LBO, running customer retention analysis, digging into messy charges and collections data, or building a customer cohort analysis. But those KPI's and financial analytics are what will really drive post-LOI diligence and are the most meaningful to kill a deal early or move forward via a go / no go decision. Everyone wants to do as much work as possible upfront to gain conviction on an opportunity before launching the QoE to save on dead deal fees. The challenge is the QoE is often the most valuable (despite expensive) to convert financials from cash to accrual and evaluate how real the proposed EBITDA adjustments are. These small businesses have often under-invested into the finance and accounting department and have messy financials. The QoE is going to validate if you are buying the business you think you are and if there is enough scale - this is especially scary when a banker proposes the business is 2025E Adj. EBITDA of $1.0-1.5 million but you know it likely comes down or the company will not hit its projected financials for the year. So searchers spend 4-5 weeks digging into raw financials and trying to work as quickly as possible through an investor memo that few investors take the time to read to feel confident enough to launch a QoE. A quality of earnings is going to take 3-4 weeks minimum, which you're going to wait to get back before kicking off legal which will be another 3-6 weeks depending on how responsive the seller is. How on earth does any searcher close a transaction within 60-90 days of exclusivity? They don't.

The searchers I have worked with who are most successful focus on the top 2-3 areas during the first two weeks of post-LOI diligence that could kill a deal. Maybe it's customer retention, or ARR growth, or physician productivity, along with usual EBITDA adjustments. Make sure the most important elements of diligence check-out before you spend any third-party dollars, but don't wait too long to launch the QoE as you're losing valuable time (and credibility) during the exclusivity period. If you're that worried about dead deal costs it sounds like (i) you haven't done enough of your own work to validate the company's financials pre-LOI, or (ii) you, yourself have concerns around the risks in the deal and lack confidence that it'll get across the finish line. You'd save everyone involved time and money by killing a deal upfront. I've seen way too many searchers get bullied into quick LOI's by pretty unsophisticated brokers or very tiny boutique banks (I call them 'chop shops'). The searcher is then back-peddling and scrambling to catch-up in diligence, but the clock is ticking. I've mentioned this in prior blog posts but don't just submit an LOI to submit one. Do your work and try to keep pace, but it's okay if some opportunities slip through the cracks because of the crazy broker-proposed timeline. My other piece of advice on mitigating dead deal costs is to get 5-6 quotes on pricing from QoE and legal service providers. I'm seeing a lot of searchers utilize very expensive third-party vendors and racking up large transaction expenses (sometimes even in-line or above a typical private equity deal), but selected them "because my investors wanted me to". If you're scared to launch a QoE because of the cost it sounds like you think the deal is already dying or won't have investor appetite and maybe you pass on it early.

I'm also seeing a wave of pretty low-quality service providers enter the search space. Constant spamming of LinkedIn posts, Searchfunder posts, and free 'advice' is suffocating my timeline. There are so many third-party vendors who (i) are not CPA's, (ii) do not have a Quality of Earnings background, (iii) have never worked in investment banking, and (iv) have never worked in private equity, that are pouring into the search space. It's scary to watch from the sidelines. Please be mindful of the third-parties you engage during your search. Given the heightened deal activity, many of these providers do not care if your deal closes, but are after the large search transaction volume. I hate dead deal costs as much as anyone else (one of my sticking points of private equity) and many of these vendors will gladly assist you on a deal that likely will never close to get that upfront fee. Be cautious and ask not only your investors, but searchers who have successfully closed on deals, for their thoughts and advice on third-parties to engage and typical fee constructs as you plan your budget.

Returns are Declining

2010 to 2020 was one of the strongest U.S. bull markets in recent time. Outside of commodity exposure to the oil and gas segment, the stock market ripped and private equity returns across vintage years produced excellent outcomes throughout the decade. Times have changed. Assets purchased during the COVID peaks in 2021 are not performing well. Frothy valuations, overpaying for low-quality assets, growing competition, utilizing too much debt, which is also much more expensive due to heightened interest rates, has significantly impacted the return profile of deals. You always know when a fund isn't performing well when they mask their overall returns and just state realized returns. That's great that you've maybe exited 2-3 deals that were highly successful outcomes and generated an aggregate 3.5x realized MOIC, but the truth is buried in the unrealized returns and longer holds. Private equity has a liquidity problem and search does as well. Middle market PE firms are less active than ever before which is driving down valuations for mid-market assets that produce $20-60 million of EBITDA. A very limited buyer universe has caused all sorts of broken auctions, secondary investments, and the emergence of continuation vehicles to try to get capital back to investors and drive DPI (distributions). The portfolio of unrealized deals continues to grow and many of them are struggling. Everyone always exits their winners early. It's the opposite of the stock market - you hold your winners and sell your losers. Private equity sells their high-flyers early to lock in IRR and return capital to investors to get in the carry and set-up the next fundraise. There are dozens of private equity zombie funds out there with low returns and declining assets that can't be sold. Search is experiencing some of this as well and unrealized deals are not performing overly well. I expect search returns will continue to decline in the coming years (again going back to the artificial 35% net IRR topic) as the lower middle market becomes more competitive and more searchers do not successfully transact, thus creating a J-curve and lost capital for the investors.

Searchers are also paying more frothy multiples today than several years ago. The challenge is many are signing up $1 million businesses and directly competing in auctions vs. private equity firms. There are multiple hot segments right now that dozens of PE firms are pouring into including medspa, roofing, landscaping, car washes, and clinical trials. Many of the searchers do not have any precedent transactions to justify for their valuation. Signing up an asset for 6.0x is not always a bargain and recently I've seen searchers over-pay or sign LOI's with a premium valuation for a non-premium asset. "Do you think I'm overpaying?" Well, based on the past 10 deals I've seen from real PE groups in the segment, the average valuation was 6.2x but the average EBITDA for those deals was $6.5 million. You signed a $1.2 million EBITDA asset up for 6.0x. The other comps I've seen below $2.0 million of EBITDA traded for an average of 5.0x. I think you're over-paying. Increasing valuations will also impact investors' go-forward returns as multiple expansion may come down upon exit.

The Sobering Reality of Success in Search Today

I keep in touch with a lot of searchers. Closed deals. Still searching. Just kicked off their fundraise. Wrapped up their fund without a deal. More and more searchers are closing their funds without successfully acquiring a business. Investors are focused on optionality and deal flow today. A search fund that previously backed 12 searchers in a year, of which 10 went on to close deals and 2 wrapped up their fund unsuccessfully, are now backing 20 searchers. The challenge is the same 8-10 deals are closing, but now 10-12 searchers are unsuccessful in acquiring a business and the rate of success is declining dramatically. There are so many searchers who I've had a continued dialogue with going back to 2022-2023 who are wrapping up their search at year-end and never acquired a business. This also creates an even greater J-curve for the investors as they have expenses and invested capital into searches that never go on to generate a return. Here's a quick comparison - since June, I've helped four independent sponsors on post-LOI deals and three transactions closed. Proven historical track records, existing debt and equity relationships, and disciplined valuations all led to a higher likelihood of closing compared to the typical search deal. I have helped six searchers on post-LOI deals during the same timeframe and none of the opportunities have closed yet. Some are hanging by a thread and may die largely due to being sub-scale, fake EBITDA adjustments, or little interest from investors. I've seen searchers sign up very interesting $6-8 million EBITDA deals on a fully proprietary basis. The painful reality is those deals don't get done (even if highly interesting) as the capital isn't there. My advice is to continue to focus on companies with $2-4 million of EBITDA. Below $1.5 million of EBITDA may be challenging due to EBITDA adjustments, layering in your salary, and having a truly scalable asset. Anything above $4 million of EBITDA likely creates an outsized equity check. Despite what your investors may say, I have rarely seen larger deals have sufficient capital to close. They don't want to write a $6 million check into a single deal - they want to write $1 million checks into six deals and hope that 'unicorn' deal is included to return the fund and save their returns. It's always funny attending the ETA conferences and the speaker happened to be a duo search that closed on an $80 million EV deal. That is not the norm. I often see searchers with a $20 million EV struggle to raise sufficient debt and equity to close.

Conclusion

If it's not apparent based on reading the past 10 minutes, I'm slowly becoming bearish on the search. I've attended the Harvard ETA conference the past 3-4 years, but skipped the conference this November. Private LinkedIn messages, emails, and notes from others in the space are largely agreeing with me that search has growing pains. Too many searchers are entering the space with (i) no prior operating or C-suite experience and (ii) no experience acquiring a business (private equity or growth equity). It's a pretty tough model in today's competitive environment to not only be a first-time CEO, but also be a first-time acquiror and trying to understand what EBITDA adjustments are real, let alone build a fully functional LBO returns model for the first time (in 30 days by the way because your investors need to see that 35% IRR ASAP). On the investor side, returns were amazing the past decade, but 2020-2030 will be much different and returns are coming down with more searchers not finding deals and more deals being write-offs (zero's). The competitive market is pushing valuation multiples higher and what seller wants to rollover 30%, provide a 20% seller note (that is somehow at-risk), on top of working through a delayed diligence period and neither side understanding how to negotiate a net working capital peg? The pockets of capital within search will need to evolve, otherwise I wouldn't be surprised if the traditional search model shrinks dramatically over the next 10 years. You'll have ex-PE searchers shift to an independent sponsor model where they have 2-3 relationships that can each write a $5-10 million check and get a real deal across the finish line. You'll then have a sub-category of traditional searchers just go the SBA route or self-funded route and acquire a sub-scale business with $1 million of EBITDA on their own, rather than with a cap table and all of the bells and whistles that come with it. I'm excited to see where the search space goes in the coming years, but am expecting a somewhat rocky road ahead. I look forward to staying in touch and exchanging industry notes with many of you throughout 2026.