This episode explores a niche investment called 'REALLY private equity'—buying and holding small, boring businesses like a window-washing company or a billing service for ambulances. The professors argue these deals offer huge returns (60%+ on equity) because they're too small for big funds (equity needed is just $1-2 million), so individual investors can get in. Key examples: Systems Design West (a medical billing firm, acquired successfully), Castronics (a pipe-threading business with high margins), and an unnamed mosquito control company (municipal clients, very stable).
Harvard Business School professors Royce Yudkoff and Rick Ruback discussed "REALLY private equity" on the program — an investment model that involves acquiring and operating small businesses through a search fund. The core argument is that while this strategy carries extremely high upfront costs (tr
Harvard Business School professors Royce Yudkoff and Rick Ruback are leading researchers in the field of search funds, co-teaching a course on how MBA graduates acquire and operate small businesses. This episode focuses on an investment model they call "REALLY private equity" — acquiring and holding for the long term small businesses that are "enduringly profitable." The most impactful judgment in the entire episode comes from Royce Yudkoff: "When you buy an enduringly profitable mature small business at 4x EBITDA, you get a 25% return on the total purchase price. If you finance it with about two-thirds debt, your equity return reaches roughly 60%-65% with zero growth." The core tension of this model is that while returns are astonishing, the deal sizes are too small (equity needs typically $1-2 million) to attract institutional capital, making it a unique opportunity for high-net-worth individual investors.
Rick Ruback argues that the fundamental reason for the existence of the search fund model is structural market inefficiency, not an information advantage.
Royce Yudkoff adds three risk-mitigating factors, explaining why a purchase price of 4x EBITDA naturally reduces risk:
1. Extremely Low Multiple Compression Risk: In traditional PE, buying at 7–10x EBITDA and facing industry revaluation is a major risk. But buying at 4x means "there's almost a floor that can't be compressed further."
2. Extremely Low Default Risk: Traditional PE buys at 8x with 4–5x leverage, requiring close monitoring of covenant terms. Here, senior debt is typically only 2x EBITDA. "Day one leverage is just 2x, and it gradually declines, making default very difficult."
3. Manageable CEO Transition Risk: MBA graduates taking on their first CEO role replace retiring founders, but there is usually a 6–12 month management transition period. Additionally, sellers, holding substantial seller notes, have an incentive to cooperate with a smooth handover.
Royce Yudkoff and Rick Ruback jointly proposed core screening criteria for acquiring small businesses, emphasizing that these principles also apply to value investors in public markets.
Royce Yudkoff stressed: "We encourage students to buy businesses with a recurring customer base — customers automatically renew their service or product year after year because it is in their financial interest to do so." Ideally, over 90% of customers return year after year, and at least 80% should do so.
Case Study: Systems Design West (Acquired by Jennifer Brouse)
Case Study: High-Rise Window Cleaning Business
| Criterion | Explanation | Risk Point |
|---|---|---|
| Low Cyclicality | Avoid businesses sensitive to economic cycles, as acquirers typically carry debt | Cyclicality can "wipe out years, not just seasons" |
| Low Seasonality | Seasonality causes significant working capital fluctuations (e.g., landscaping businesses require heavy upfront spending from March to June) | May "make it impossible to finance growth or even serve existing customers" |
| Low Customer Concentration | Many small businesses are built around a single large customer | Supplier concentration is equally dangerous |
| Strong Free Cash Flow Characteristics | Nearly all EBITDA is available for debt repayment or equity distribution | General investment rule |
| Transferability | The business cannot rely on the founder's personal relationships; any qualified person can operate it after reasonable training | Transition risk |
Rick Ruback posed: "The question you need to ask is — why is this business small? Some businesses are small because they are bad businesses, but others are small because they serve a local market in a unique way." For example, a bakery can only deliver bread within 50 miles, and a window cleaning company can only send its trained teams and trucks a certain distance. How this question is answered determines whether the business is worth acquiring.
Rick Ruback cautioned: "This is like asking who the perfect spouse is. Tom Brady looks good, but he probably works too hard and gets beaten up every Sunday. In the real world, you have to compromise. As a searcher or investor, you must decide what is 'good enough' for you." Searchers typically need six months to two years to find a business that is "good enough" and can be acquired at a fair price.
Royce Yudkoff uses mathematics to argue why growth is not the core criterion for small business acquisitions: "When you buy a persistently profitable, mature small business at 4x EBITDA, you achieve a 25% return on the total purchase price. If you finance about two-thirds of the deal (senior debt plus seller debt at single-digit interest rates), your equity return reaches approximately 60%-65% without any growth. Even with moderate growth of 5%-6%, returns become even higher."
1. Growth Erodes Recurring Revenue: Royce Yudkoff notes: "The faster the growth, the lower the proportion of recurring revenue — this is almost definitional. New customers bring new problems, often of a different kind."
2. Growth Comes at a Cost: Rick Ruback adds: "If a non-growing business is priced at 4x, a similar business growing at 25% annually might be priced at 6x. You pay upfront for growth, and then you still have to deliver it."
3. Growth Consumes Capital: If the business is capital-intensive, rapid growth quickly drains funds. Royce Yudkoff warns: "You don't want a business that requires constant working capital injections as it grows."
Rick Ruback concludes: "Every business would be better off with a little growth, but I really prefer 'a little growth' over 'a lot of growth.'"
| Model | Source of Search Capital | Typical Equity Allocation | Investor Target Return |
|---|---|---|---|
| Self-Funded Searcher | Searcher pays out of pocket (prior career savings, wealthy relatives, spousal income) | Investors ~50% common stock, Searcher ~50% | Net return ~25% (first return of all capital, then 7%-10% preferred return, followed by pro-rata distribution of remaining) |
| Sponsored Searcher | Investors provide search capital (hundreds of thousands of dollars) | Investors ~80% common stock | Higher, due to additional risk borne during the search phase |
Royce Yudkoff suggests: "The largest pool of searchers comes from about 10 business schools. These schools frequently host events—Harvard Business School holds a major searcher symposium annually. Interested individuals can attend for a day and meet people at various stages of their search, who in turn introduce others. If you are willing to spend a little time building a network, you can quickly connect with searchers in need of capital."
Rick Ruback adds another approach: "There are also 4-5 small private equity funds that specialize in this space. A low-effort way to get involved is to become an LP in one of these funds, learning the field indirectly." Additionally, many searchers raise capital through "retail placements"—seeking $100,000 to $200,000 investments from friends, family, and their social circles.
Royce Yudkoff (former PE practitioner) highlights the biggest challenge for traditional PE investors: "Massive capital has flooded into PE, driven by low interest rates. The IRR gap between top-tier and poor managers in PE can be as wide as 15 percentage points, but top managers are always oversubscribed. As an LP, it is extremely difficult to allocate capital to top managers. Here, there is no institutional competition because the check sizes are too small for institutions to be interested."
Rick Ruback explicitly states his dislike for tech companies: "Anything with technology risk — where a substitute technology can easily drive you out of the market. I look for businesses with low 'zero-to-zero risk'." He also warns about "stroke of pen risk" — for example, an autism clinic or MRI center: if reimbursement rates drop by 20%, profits could fall by 90%-100% because costs remain unchanged.
Royce Yudkoff summarizes: "They love the idea of being a general manager and entrepreneur, and are fairly agnostic about the product or service itself. They are motivated by the concept of combining labor, capital, strategy, and customers. They do not have Silicon Valley-style new ideas, and they are cautious about risk — the idea of entrepreneurial failure holds absolutely no appeal to them."
| Position | Guest's View | Key Data |
|---|---|---|
| Systems Design West (Acquired by Jennifer Brouse) | Bullish – Classic case | Acquisition price ~4x EBITDA; debt structure: 50% bank loan + 25% seller note + 25% equity |
| Castronics (Pipe threading) | Bullish – High margins, low price sensitivity | Threading fee ~$45 per pipe; pipe itself $2,000 + transportation $1,000; located in Kimball, Nebraska; nearest competitor 500 miles away |
| Red Hen Baking Company (Vermont bakery) | Neutral – Lifestyle business, not an investment target | Margins 20%-30%; price unimportant to customers (students guessed within a $3 range) |
| Mosquito control company (Unnamed) | Bullish – Ideal target | Municipal clients, highly recurring revenue, non-cyclical, price-insensitive |
| Chemical import/distribution company (Unnamed) | Bullish – Counterintuitive pricing power | As a secondary supplier with 10% market share, charges a premium due to clients' fear of single-supplier risk |
| Waste brokerage business (Unnamed) | Bullish – Negative working capital model | Clients prepay fees; operates like "a small bank plus management services" |
1. Rick Ruback: “I call it ‘true private equity’ because it is truly private. No institutional investors are involved; it is face-to-face equity transactions.” — Rationale: The search fund model, due to its small transaction size (equity of $1-2 million), cannot attract institutional capital, keeping valuation multiples at a low 4x EBITDA. This is a structural source of excess returns.
2. Royce Yudkoff: “When you buy a persistently profitable, mature small business at 4x EBITDA, your equity return reaches approximately 60%-65% without any growth.” — Rationale: A 25% EBITDA yield, combined with roughly two-thirds debt financing (at single-digit interest rates), creates leverage that pushes equity returns far beyond traditional PE.
3. Rick Ruback: “Why is this business small? Some are small because they are bad businesses, but others are small because they serve local markets in a unique way.” — Rationale: If the answer is “the market itself is small” (e.g., bread can only be delivered within 50 miles) and the business is the best locally, then small size itself is a moat, not a flaw.
4. Royce Yudkoff: “In traditional PE, buying at 7-10x EBITDA and then facing industry revaluation is a major risk. But buying at 4x, there is almost a floor that cannot be compressed further.” — Rationale: A purchase price of 4x EBITDA naturally eliminates multiple compression risk. Combined with an initial leverage ratio of 2x EBITDA, default risk is extremely low.
5. Rick Ruback: “In small businesses, the barrier is often superior execution. People don’t switch suppliers because you do things so well that you never give them a reason to be upset.” — Rationale: Unlike large companies that rely on patents, brands, or licenses, the moat of a small business comes from consistently delivering high-quality service, leaving customers with no incentive to bear switching costs.
6. Royce Yudkoff: “The faster the growth, the lower the proportion of recurring revenue—this is almost definitional. New customers bring new problems, and often different ones.” — Rationale: Growth erodes the core advantage of the search fund model (predictable cash flow). Growth also requires upfront payment (higher valuations) and may consume working capital.
7. Rick Ruback: “I look for businesses with low ‘zero-risk.’ I don’t like tech companies—alternative technology can easily push you out of the market. I also don’t like businesses with ‘pen-tip risk’—if reimbursement rates drop by 20%, profits could fall by 90%-100%.” — Rationale: Search fund investors should avoid risks of technological disruption and sudden changes in regulatory/reimbursement policies, as these cannot be adequately hedged even at a 4x EBITDA purchase price.
8. Royce Yudkoff: “When most of these CEOs talk about their greatest satisfaction, the first thing they mention is not revenue, not independence, but their ability to impact employees’ lives. They have 45 people whose names they know, and they care about their families.” — Rationale: This sense of responsibility becomes a core driver of CEO focus and prudent management, indirectly reducing investment risk.