The Gap Equity Problem in Search

Q1 2025 Search Fund Update

The evolution of search will only continue over the next 12 months as the entire investment world works through inflation, tariffs, supply chain, labor challenges, and potential early indications of a recession. RiverStone recently reviewed its ~25 independent sponsor, traditional search, and self-funded search engagements since late 2023, of which 10 deals successfully closed and 15 deals died post-LOI. After a difficult mid-to-late 2024, a handful of deals successfully closed in early 2025. The 40% transaction success rate witnessed internally is consistent with recent search publications stating that 40% of search deals are closing today, which is down from 60% a decade ago. The 10 closed deals over the past 15 months included four self-funded deals, three independent sponsor deals, two traditional search deals, and one HoldCo / traditional search vehicle. What stood out to our team was out of the 15 dead deals, 10 (67%) were related to traditional searchers, three were self-funded search deals, and two were led by independent sponsors. When you attend these search fund conferences, the traditional search path is often pitched as 'less risky' as you have a committed pool of capital to support your search, can draw a salary, and once under LOI, should have investors eagerly waiting to write checks and help you get a deal across the finish line. Through various private conversations with investors, searchers, family offices, third-party providers, and bankers, here's what's actually going on in the search space today:

Lack of Funding

The access to funding in the search space has ballooned over the past decade. There were maybe a handful of firms truly dedicated to backing searchers in 2010 and over the past 15 years, there are now dozens of capital providers who look for proprietary deals, conservative valuations, and alignment of interest with the eventual search CEO. Fund size is an important attribute when ensuring you may have the capital available to pursue a deal, whether larger or smaller. Keep in mind, unlike typical lower middle market private equity funds that are $200-700 million in fund size (usually anything below $1 billion is still considered lower middle market), most search funds are $20-100 million with a few players in the $100-300 million range. Say you're a post-MBA traditional searcher and you just raised a $20 million committed pool of capital. Usually the top investors in your cap table are maybe 10-15% of your equity or can write up to a $3 million check. A recent searcher signed up an interesting business on a fully proprietary basis with high single digit EBITDA. The deal had a reasonable purchase price, strong alignment with the family owner (substantial rollover and seller note), and would utilize conservative leverage at closing. The equity need was about $20-25 million depending on final debt reads and transaction expenses. The opportunity checked many of the boxes that a typical independent sponsor would look for on the more traditional private equity side. The challenge in search? Your largest investor may have a $50-75 million fund and taps out at $3-4 million. Based on the size of the deal, you already need to go out and raise additional capital. 3-4 of your investors may be leaning out on the opportunity, which only adds to the gap equity you need to go out and raise. Investors may participate pro-rata (their % ownership in your cap table), but we are rarely seeing investors flex-up and write larger checks above pro-rata. This puts the searcher in a difficult position because whether the searcher needs $8 million or $30 million to close a deal, their investors view their equity on a pro rata percentage basis and may tap out at a certain check size, leading to an even further gap. More and more searchers continue to partner with family offices or even independent sponsors / co-sponsors to get deals done outside of the typical traditional cap table. I would say 4 in 5 deals in the search space require gap equity today as many investors are pencils down due to macro risks or are capacity-constrained to really dig in, creating a constant need to go outside of your cap table. Search is also becoming more like venture in that many investors will wait for others to step-up and commit capital before they commit to a deal. Once a brand-name lead investor is signed up and committed, other investors may pile in piggy-backing off of their diligence, work, and conviction.

Shifting Out of the Strike Zone

Just because a deal is larger does not mean it is a good fit for search. It is hard to find an attractive opportunity that is $2-5 million of EBITDA and not get outbid by another private equity firm. Proprietarily sourcing deals is incredibly competitive today. I continue to push searchers to stay in their lane and not shift outside of the strike zone in terms of company size / EBITDA and check size. Many traditional searchers target $2-5 million EBITDA companies in their PPM and after 9-12 months of searching begin digging into sub-scale businesses such as <$1 million of EBITDA or a heavily adjusted ~$1.3 million of EBITDA (addbacks most private equity firms wouldn't give credit for). On the flipside, some searchers are digging into large opportunities likely getting excited by putting a significant amount of capital to work and having more economic upside, however, the equity raise is incredibly challenging. There was a duo search I had been in dialogue with that recently signed a business with $10 million of EBITDA under LOI for a double digit multiple. Both searchers had no prior private equity experience, no industry / subsector experience or specialization and continued to justify the purchase price as being 'value-oriented' and 'cheap'. The searchers completely disregarded the fact that the opportunity was sourced in a brokered process and they were clearly the highest bidder, though continued to pitch the the owner loved their offer beyond just the purchase price. Nothing about this situation is compelling and it can be difficult to go raise third-party dollars when typical limited partners that back independent sponsors (non-search deals) look for operational experience, a true private equity track record, and 10+ years of industry experience. Raising $60 million of outside equity is incredibly challenging in this market on top of getting a lender comfortable with the valuation and search dynamics. Many searchers will justify a valuation by saying they weren't the highest bidder, but the owner wanted to partner with them due to (i) cultural alignment / fit or (ii) opposition to the typical private equity model. While these are fair reasons for a fully proprietary deal, ultimately you're being selected in a broad process because your valuation is enticing to the owner (you aren't fooling your investors). I continue to tell searchers to be careful in bidding up in brokered / auction processes and ask yourself 'why is the seller selecting you as the winning bidder'? While you may want to think that you 'hit it off' with the owner and you'll have amazing cultural alignment post-closing, I hate to say it but you probably are being selected because you're overpaying and offering a market-clearing price. Chances are, dozens of lower middle market private equity firms with $100-400 million fund sizes, industry expertise, and already committed pools of capital (less risky buyer vs. search), also saw that same opportunity and either passed or bid less than you. I continue to see searchers accept more one-time adjustments than the typical private equity firm such as adding back a CEO salary to get to 'seller discretionary earnings'. Not only do private equity firms fully-burden EBITDA with C-suite members, they may argue that infrastructure is under-invested and slash EBITDA by a hypothetical $150-200K to add a new CFO / COO (though PE firms often give full credit for run-rate adjustments in high-growth companies or may value businesses on next 12 months of earnings).

For the searchers that source a larger opportunity on a fully proprietary basis and will need incremental equity, I strongly urge you to begin having gap equity conversations even before signing your LOI. Get feelers out upfront and begin networking and building new LP relationships. Many family offices are showing interest in the search space and are open to similar economics as traditional search investors. The model is different from the standard 2% management fee, potential sourcing / transaction fee, and 20% tiered carry that independent sponsors charge for one-off deals. The more time you give a new LP to build a relationship with you and learn about the opportunity / tag along in diligence, the higher likelihood they'll be able to write a check by the closing date. It is not realistic to go out and find $15 million of new equity and still close in 30 days.

One other point on moving goalposts: while some searchers may shift focus to a company size above or below their initial plan (this commonly upsets investors), I've also seen investors re-trade economic terms with searchers once a deal is under LOI. For example, one recent traditional searcher had a very fixed cap table and had negotiated premium economics upfront in their search due to an impressive background and having more experience. That searcher got a deal under LOI, of which ~50% of their cap table showed interest, however, the other half of investors passed on the opportunity creating a need for gap equity. Despite agreeing to economics over 12 months ago when the searcher first launched, the interested investors pushed the searcher's economics down removing certain premium carry potential and increasing tiered carry hurdles given the lack of investor demand. It's unfortunate to see this occur in the space and is something to be aware of. If you are a new searcher raising your initial cap table, I highly encourage you to talk with other active searchers and former searchers to find the most value-add partners. Do not only conduct reference calls with current CEO's / successful searchers, but also try to find searchers who didn't close on a deal during a two year span and ask for feedback and advice on the best investors to work with. They're not all the same and you want investors who communicate, lean in, and will support your search both pre- and post-closing.

Money Talks

There are probably a dozen highly influential backers of the search space who speak at all of the usual conferences and many previously ran their own successful search (internally we call them the 'search influencers'). They offer excellent advice, are instrumental to the growth in the search community, and are highly active participants across many searchers today. Many of these individuals are on dozens of cap tables and continue to back traditional searchers, which is great to see. The challenge is that many times these individuals are <5% of a cap table or write $50-100K equity checks. Post-LOI, many searchers struggle to get their cap table to lean in early in the exclusivity period and often point to or name-drop a prominent figure or search influencer who is interested or digging in as a means for the deal to have 'momentum'. A big problem that searchers are currently experiencing is that their top investors are frugal / judicious with their capital and many are passing on post-LOI opportunities at record rates. A searcher will continue to dig in post-LOI and begin spending third-party dollars on a Quality of Earnings, market or industry research reports, benefits / insurance verification, and potentially even begin spending meaningful dollars on legal. If you need $10 million of equity to close a deal and four of your top five investors on your cap table don't seem to be engaging you're going to have a tough time getting that deal across the finish line. Just because 1-2 search influencers are positive on the deal and want you to continue doing work doesn't mean you necessarily should. Their $50-100K commitment, while generous, is not going to move the needle in your cap table and money talks. Raising that gap equity becomes even more challenging when new investors feel like they're seeing 'leftovers' or deals that sophisticated investors already passed on. My advice is to screen new opportunities early on with your cap table and especially push your top 2-3 investors to lean in and be overly communicative. A quick 'no' is much more helpful than a prolonged diligence process before your investor ultimately says no after you've wasted three months and spent a portion of your budget on diligence. We are seeing many search investors push off being the bad guy and providing that 'no' upfront, which is leading to wasted time and resources and more dead deals in the segment. It's great if you have investors leaning into an opportunity showing interest, but keep in mind their check size and if they have the ability to flex-up if needed. A best case scenario is you need to cutback or cut-out investors from a deal due to too much demand (have yet to see this situation occur across dozens of deals). Begin gap equity conversations early and try to drum up incremental demand in case investors drop out because based on data over the past 15 months it's bound to happen.

Increased Competition & Capacity Constraints

Another challenge the search space is witnessing is increased competition at the searcher-level and portfolio construction issues at the investor-level. More and more post-MBA's continue to flood into the search segment to be their own boss and work for outsized upside compared to the corporate world. Many of the known traditional search investors are highly capacity-constrained. They may write $250-600K equity checks and have dozens of existing search investments that remain unrealized. Liquidity has been prolonged in private equity and the exit drought will only continue / worsen with macroeconomic uncertainty as it becomes even more challenging to exit companies. Traditional investors have a growing pool of unrealized deals that require time and attention and continue to back more and more new searchers. A fund that previously participated in five out of 10 post-LOI deals now seems to be participating in 1-2 out of 10 post-LOI deals as they've backed too many searchers. Keep in mind that many of these firms have a whopping investment team of 1-4 individuals and may not have any junior resources at all. These shops are often formed by prior successful searchers who bring invaluable perspectives as a prior CEO / searcher, but may not have much M&A or diligence experience in private equity or investment banking outside of their own search a handful of years ago. So much is learned in private equity when it comes to lender negotiations, setting covenants, negotiating net working capital, building detailed budgets or projections, integrating add-on acquisitions, and implementing and executing on true value-creation plans and some of this special sauce gets lost in the segment.

To summarize - you have more MBA students entering the search world and being backed by investors and investors have growing portfolio companies with a lack of near-term liquidity and exits. As a result, it can be hard for searchers to get constructive feedback from their cap table when they need it, let alone receive a response. One of our recent search clients sent out their near-final LBO model with return scenarios to its cap table and a larger investor responded with a list of requested sensitivities and scenarios they'd like to have the searcher run in the model - but isn't this the job of a limited partner? You received a dynamic LBO with various projection cases and blue hardcoded assumptions that can be easily toggled. Coming from a large LP setting myself, it is understood that the GP (or in this case a searcher) is responsible for driving diligence and the buildout of materials, but simply sensitizing a model is the responsibility of the LP, which shows just how bootstrapped some of these parties are in the space. Of course, a searcher can walk through the model or assumptions to achieve its 40% IRR threshold and field detailed diligence questions on an opportunity, but I was surprised to see select investors weren't digging into the materials themselves.

We continue to urge searchers to over-communicate with their investors and cap table when nearing an LOI. For the searchers that do successfully close a deal, I'd highly recommend having a diversified set of board members that include your top investors, but also independent advisors and ideally someone with operating / sector-specific experience. Due to the reasons mentioned above, many search investors are stretched thin and may not be as value-additive as you may think post-closing - how can you possibly sit on 40 boards and add value to each one plus manage your near-term pipeline of deals with new searchers? I continue to hear this from searchers who closed deals and would recommend you continue to network to find true independent, value-added board members who can make customer / vendor introductions, assist with add-on acquisition integration, upgrade systems, directly source C-suite hires, refine go-to-market sales strategies, etc.

I continue to tell searchers not to be discouraged by the LinkedIn posts and all of the positive commentary at search conferences - the grass isn't always greener and to be honest, this is a very challenging time for both public and private markets. For instance, a first-time search CEO recently spoke at a conference and actively posts on LinkedIn about the company's growth, but what the audience does not know is that their EBITDA has declined by 75% since closing 18 months ago. Another traditional searcher's company lost its top customer during its first year of ownership - a customer that accounted for 35% of sales and will pose cash flow challenges / potentially breach covenants later this year. Another HoldCo / search team had closed on two business services deals, however, both imploded / went bankrupt over the past year and they've shut down their firm. The reality is this is a challenging M&A environment and the bar is high. Continue to be patient in your search and only submit LOI's in companies you're truly interested in acquiring to be efficient with both you and your investor's time. And remember "a good deal will always find capital" - if your existing cap table isn't stepping up for an opportunity you truly believe in, work efficiently and network like crazy to get in front of new family offices and limited partners that can write larger checks (we are talking 80 new conversations with prospective investors, not just eight). The earlier you can start those gap equity conversations the better as time is the #1 killer of deals. If you have investors who pass on a post-LOI deal, ask them for referrals and introductions to other equity investors given their lack of participation is part of the reason your deal may not close. There is likely further market turbulence ahead and searchers who are patient and scrappy will come out in front. We don't know if and when we may go into a recession, but keep in mind that the fund vintage year coming out of recessions continues to outperform other vintage years (i.e. 2009 was actually a great time to opportunistically buy high-quality companies at a discount if you had access to capital).

Feel free to reach out to our RiverStone Reporting team (Eric@RiverStoneReporting.com) if you may be in need of institutional diligence assistance with investor memos, LBO models, or post-close help with board materials, KPI's, and financial reporting. Our team brings vast private equity experience and has deployed over $2.1 billion into the lower middle market private equity segment over the past 10 years. We remain bullish on the search segment and lower middle market and are excited to watch the space and community continue to professionalize and evolve in the near-future.