Florida bank aims for first-mover edge in financing search funds
Professional Holding in Coral Gables, Fla., is taking the road less traveled as it looks to add revenue in the midst of the pandemic.
The $2.1 billion-asset parent of Professional Bank plans to open a loan production office in Bedford, N.H., an hour north of Boston, to target search funds, where an aspiring CEO, often a recent business school graduate, identifies and buys an existing small business.
Professional entered the far-flung Boston market after hiring Zach Duprey, who had worked previously at Provident Bancorp in Amesbury, Mass. The South Florida bank had been looking to enter search fund lending for more than a year.
Duprey’s “track record in the space was a big part of making the move to get into this,” said Daniel Sheehan, Professional’s chairman and CEO, who first learned of search funds from a friend who actively invests in early-stage companies.
“You’ve got to have a team with the reputational capital inside the ecosystem to generate deal flow,” Sheehan said. “I’ve been kicking around the idea of different ways to enter the market, figuring out the right entry point.”
Professional joins a list of banks entering or expanding into narrow niches at a time when traditional businesses have become overcrowded and lending opportunities have become scarcer.
BOK Financial is providing financing to private investors looking to buy senior housing facilities from real estate investment trusts. Homeowners associations are another area growing in popularity.
Live Oak Bancshares in Wilmington, N.C., is constantly evaluating niche industries as part of its Small Business Administration lending platform. The $8.1 billion-asset Live Oak has been involved in search fund lending since 2017.
Those efforts often require hiring the right person to oversee an expansion. Professional brought in Duprey, who spent nearly seven years as director of Provident’s Search Fund Lending Center, where he helped finance $250 million tied to more than 60 acquisitions.
Duprey said he was impressed by Professional’s digital platform, along with Sheehan’s grasp of the business.
“I liked the fact Dan was in tune with the community, so I wasn’t trying to explain what search funds were,” Duprey said. “I found Professional Bank to be a fantastic alignment and Dan to be the CEO I wanted to work with to continue to build this.”
Sheehan, who sees Professional emerging as an “active capital provider” in the search fund community, declined to disclose any lending targets.
Search funds were pioneered in the mid-1980s by Irving Grousbeck, a cable television executive who later taught at the Harvard and Stanford business schools, which became incubators for the industry.
The way traditional search funds work, a recently graduated professional will assemble an investor group — frequently including professors and other academics. The goal is to raise capital, identify and buy a small business where the professional can become CEO. Members of the investor group then join the board to provide counsel and oversight.
Variants of that model have developed in recent years, including some where the prospective CEO largely self-funds a deal, often relying on SBA loans. Deep academic and investor involvement is a common thread.
“Obviously, that gives a young CEO a support system and a better chance of success,” Duprey said.
Search fund lending requires extensive due diligence on the part of the lender to reduce risk.
“These are asset-light transactions,” said Lisa Forrest, a director of sponsor finance at the $8 billion-asset Live Oak.
“There’s not a lot of collateral. … You have to be very comfortable and competent with cash-flow lending,” Forrest added. “It’s important we get to spend some time and actually get to know [a potential CEO] before we have a deal on the table. The investor and director sides are also critical. That oversight is part of what makes the formula work.”
Lenders’ risk is mitigated by the oversight provided by the boards of search fund companies, said Chuck Withee, president and chief lending officer at Provident, which continues to operate in that space. Withee said Provident has built a strong team to evaluate and underwrite deals.
“We have a full team and we built that over time,” Withee said. “We were three years into it when we launched nationally,” he added. “We got our sea legs. … I would advise any peer if they’re exploring [search funds] to take their time, do it right, study, talk to their regulators. If you do it right its great lending.”
A total of 88 traditional search funds were launched in 2018 and 2019, including a record 51 last year, according to an August 2020 study published by Stanford University.
Of deals struck during those two years, the median revenue of targeted businesses was $6.7 million, while the median acquisition price was $10 million. The aggregate pretax internal rate of return on search fund deals has topped 30% over the past three decades, the study found.
“It’s a very interesting niche,” Withee said. “We feel really good about it.”
Most of the capital raised for search fund acquisitions comes from private sources. Only a handful of banks have been involved, including Provident, Live Oak — and now Professional.
“There’s a group of maybe 200 to 300 people that are serial investors” in search fund acquisitions, said Heather Endresen, another director of sponsor finance at Live Oak.
“A traditional bank credit person might perceive this as very high risk,” Endresen added. “You take a smaller bank and say, `'How would you like to lend to these young entrepreneurs in a leveraged buyout deal?’ Most are going to think you’re crazy.”
Counterintuitive moves are commonplace for Professional. The company raised eyebrows in May 2019 when it was revealed that it made a loan to President Trump. In November 2018, Professional opened a digital lab in Cleveland to enhance its virtual banking platform. It acquired crosstown rival Marquis Bank in March.
The company is currently working through a problem with a loan it shares with other banks, including Amerant Bancorp, for Coex Coffee International, which is going through an orderly liquidation. Professional recorded a $7.6 million impairment in the third quarter tied to its share of the loan.
While the search fund sector is a small niche in absolute terms, it is growing. Deal flow has increased over the nearly seven years Provident has been active, Withee said, while Endresen said she expects the growth highlighted in the Stanford study to continue.
“Macroeconomics don’t just suggest, it sort of screams that [search funds are] a great place to be,” Endresen said. “There’s more supply of businesses that need to change hands than there are qualified people to take them over.”