Asset managment | Search Funds: Meeting Growing Demand While Avoiding Legal Pitfalls

In a market where creative deal structures are on the rise, search funds have emerged as a compelling investment model, making 2024 a record year for newly formed search funds. A search fund generally involves one or two individuals who raise a modest amount of capital from a small, engaged group of investors to fund the search for, acquisition of, and subsequent growth in a privately held company. In this newsletter, we examine the typical stages of a search fund’s lifecycle and explore how to avoid legal risks—particularly regarding the question of whether a search fund requires authorisation under the Norwegian Alternative Investment Fund (AIF) Act. Are these vehicles truly “alternative investment funds,” and thus subject to regulation (including the need for a marketing authorization), or do they remain outside the AIF regime?

Understanding Search Funds

1. Fundraising

The first phase in any search fund begins with its sponsors—typically one or two entrepreneurs—gathering capital to finance the search for a viable target company. Although a large share of sponsors are under 35, seasoned professionals also view search funds as a way to become owner-operators. Crucially, the funds raised at this stage—often around USD 600,000—are not intended for actual investment in a target but rather for covering expenses such as salaries, legal fees, office rent, and travel. Approximately 12 investors typically participate, creating a tightly connected group that can provide practical guidance as well as capital.

2. Search

Following the signature of a shareholders’ agreement (SHA) among sponsors and investors, the fund launches its search for a suitable acquisition candidate. This target is frequently an established small or medium-sized enterprise with stable cash flow. The nature of the search is rigorous, requiring in-dept due diligence, dialogue with target-company owners, and entering into letters of intent. This phase also carries a notable risk that no acquisition materializes: statistics from the US and Canada show that approximately 37% of search funds never complete a deal, with somewhat lower figures reported in Europe.

3. Acquisition and Growth

If a promising target is identified, the investors are presented with the investment opportunity. Only those who actively decide to contribute to the transaction become shareholders in the target alongside the fund sponsors, who assume managerial roles in the newly acquired business. Deal sizes are often in the lower mid-market, with studies citing median prices of around USD 11.7 million in the US and Canada and approximately USD 14.4 million in Europe and other global markets. Once the deal is closed, the sponsors devote themselves to growing the acquired business, supported by insight or strategic advice from their investors.

4. Exit

The final phase is typically a sale of the acquired company. Historical data suggests search funds can yield notable returns for investors, although outcomes vary across regions. In the US and Canada, average ROI of 4.5x and IRR of 35% have been reported, whereas in Europe and the rest of the world, the figures are closer to 2x and 18%. As with all private equity-style investments, profitability depends on prudent target selection, sponsor expertise, and a robust legal framework.

Avoiding Legal Pitfalls

There is a whole range of legal documents and processes involved in the lifecycle of a search fund, that can cause pitfalls: LOIs, SHA, PPM and due diligence obligations, among others. An integral focus is whether search funds meet licensing or registration requirements under the Norwegian AIF Act. Marketing or managing an AIF without the required licensing in Norway can result in hefty fines or even imprisonment for up to one year. According to the AIF Act and relevant guidance by the Norwegian FSA, an AIF requires that capital is raised for the purpose of investing to generate return for the investors. In addition, according to ESMA guidelines, the manager must have a legally binding obligation towards the investors to follow the investment strategy, including any modifications to it.

BAHR’s Opinion

In our opinion, most search funds should not fall under the AIF Act in their earliest phase and therefore not require marketing authorisation. During phases 1 and 2, the funds raised are directed toward paying expenses for the sponsors rather than being invested to generate returns. This distinction strongly suggests that a search fund in its initial stage is not an AIF. This conclusion is supported by the ESMA guidelines. In search fund arrangements, the investment strategy can remain flexible and subject to each investor’s independent decision whether to participate in the ultimate acquisition or not. In a search fund context, the manager has no discretion to enter into an investment on behalf of the investors.

When phases 3 and 4 arrive, the question of classification as AIF becomes more relevant, as investors typically make a more traditional commitment. Nonetheless, it is possible to structure search funds so as to remain outside AIF status by granting investors a sufficiently high degree of control or influence over day-to-day operations in line with ESMA guidelines. Where investors collectively retain decision-making authority, the search fund may fall outside the definition of an AIF, even at this later stage. However, the specific contractual provisions and ownership arrangements remain critical, making thorough legal analysis prudent. Even if a search fund falls outside the AIF definition, it may still be subject to good business rules, MiFID II, the Securities Trading Act, and potentially even prospectus rules. An alternative is to structure and register the fund as an AIF and to register its sponsor as asset manager. In doing so, the emerging managers typically benefit from a lighter regulatory framework although this limits marketing to professional investors in their own jurisdiction. Marketing in other EEA countries or to non-professional investors is subject to a more comprehensive legal framework, and specific rules may vary from one jurisdiction to another.

Search funds have a proven track record but remain relatively unfamiliar in the broader market. This creates both a promising opportunity and a unique risk that can expose sponsors and investors to legal pitfalls. The search fund’s recent record demand and popularity also attracts the attention of regulators, making it all the more crucial to seek legal guidance at every phase of the lifecycle. Search fund ventures can be bold and risky; yet with a well-conceived legal structure, search funds can meet growing demand while avoiding legal pitfalls and become a remarkable success story.