Young investors on the takeover trail

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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.

However, Canadian search funds could be poised to grow, given the number of entrepreneurs approaching retirement who, in many cases, have no family members willing to take over.

"The financial crisis was a wakeup call to a number of business owners," said Dennis Fortnum, national leader at KPMG Enterprise, which deals with small businesses. "The values that they thought they had built in their businesses went down significantly," which made them think about the best time to sell.

"In the lower end of the mid-market, that exit strategy can be a little more difficult," he added.

Enter the search funds, which hope to snap up some of these companies. As well as demographics working in their favour, there is also a current scarcity of mezzanine debt products available to mid-sized firms looking to grow. And super-sized pension plans are moving toward direct investing, rather than through funds.

A few years back, the private equity world looked quite different. As late as the turn of the last decade, players such as EdgeStone Capital Partners and Birch Hill Equity Partners were raising capital to pursue mid-market companies. Then the boom hit and the minimum investment requirements edged higher.

"When dollars were flowing in and people were saying private equity's a great asset class, a lot of these firms that started out in the mid-market raised bigger funds," said Sandra Bosela, EdgeStone's president and managing partner.

Her own firm is a prime example. Its first capital raise brought in $180-million in 2000; its latest, in 2006, generated $800-million. Ms. Bosela added that most private equity funds like to hold eight to 10 investments, so the more money they raise, the larger their targets, aligning them more with the pension plans than the venture capitalists. The market has also been in limbo since the financial crisis because no one knew if it would recover.

As Auxo tries to grow, it may have already overcome the biggest hurdle: convincing investors to trust two guys about five years out of undergrad.

If anything, Mr. Rogers said their ages encouraged him. Also, their backgrounds in finance were a plus. "It's almost like these guys have 30 years of experience already," he said. And because their venture is so entrepreneurial, "young guys are well-suited. They have lots of energy, lots of ambition."