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Constellation Software: Acquiring and Empowering
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“You can’t judge the quality of this quarter’s acquisitions by this quarter’s profit, but after 85 acquisitions over a 13 year period, we seem to have developed a knack for acquiring fundamentally sound businesses at fair prices.” This was stated by Founder and President Mark Leonard in his letter to Constellation Software (CSI) shareholders in Q3 2008. Today, soon 30 years after its inception, it is safe to say that CSI has become a true master of strategic acquisitions and long-term value creation. The company had its IPO in 2006, and since then, early investors have seen their initial investments compound at a CAGR of almost 36% annually (dividends reinvested). With a humble beginning in Toronto in 1995, CSI has as of April 2024 acquired over 500 businesses, focusing on niche vertical market software (VMS) companies, and serves over 125,000 customers in over 100 countries. Studying this company provides great lessons whether you’re a founder, manager, investor, or just interested in business yourself, so let’s take a closer look.
Key Insights
Strategic acquisition focus: Constellation Software has perfected a “buy and build” strategy, focusing on acquiring and developing small, profitable software firms within niche vertical markets.
Empowerment and autonomy: A key element of CSI’s success is the empowerment of acquired companies to operate autonomously. This fosters innovation and growth within these firms, aligning with CSI’s long-term value creation philosophy without micromanaging the day-to-day operations.
Decentralized capital allocation: CSI’s unique strategy includes decentralizing capital allocation decisions, allowing lower-level managers and acquired founders to take active roles in scouting and executing on new opportunities. This contrasts with traditional centralized models, contributing significantly to CSI’s scalable growth.
The Core Strategy: Acquire and Empower
CSI’s business model, known as “buy and build,” is grounded on acquiring small, profitable software firms that possess deep customer and industry insights. This not only diversifies CSI’s portfolio across a myriad of sectors – from municipal software to automotive repair shops – but also across various geographies, including the US, Canada, Europe, and Australia.
Key to CSI’s strategy is a focus on VMS companies – those developing software solutions for specific industries. This focus has enabled the company to harness the potential of niche markets that offer high margins and steady revenue streams, ultimately contributing to its diversified and resilient business model.
What does Constellation Software look for?
In the subpage “Being Acquired” on CSI’s website, they state how the companies they buy represent a lifetime of effort and talent, and how these generally share three traits that CSI believe make them exceptional: 1) an outstanding manager, 2) consistent profitability, and 3) above average growth.
What CSI often sees is that, despite various different reasons for selling, the managers of these companies wish to have their businesses continue to operate in accordance with the history and values that made them exceptional in the first place. CSI recognizes how rare this is, and sees the value in empowering them to continue their exceptional operations as they have in the past.
However, just buying one exceptional company after another is hard, even to CSI, which is why they state how they often buy more accessible – good – companies. But what is the difference between these two?
An exceptional business meet the following criteria, as listed by CSI themselves:
A mid- to large-sized vertical market software company (a minimum of $1 million earnings before interest and tax).
Consistent earnings and growth – generally EBITDA-margin + revenue growth of 20 percent or more per year.
Experienced and committed management.
An offering price that has been determined.
And for a good business, they list the following criteria:
Number 1 or Number 2 market-share holder in a niche vertical market.
Revenues of at least $5 million.
Hundreds or thousands (not dozens) of customers.
Unimposing competitors.
An offering price that has been determined.
Post Acquisition
When a good company then is acquired, CSI identifies and addresses the reasons behind why it is not yet exceptional. This includes offering coaching and resources in a number of different areas. To name a few: they help establish values and capital allocation processes, profit-sharing programs, benchmarking against other subsidiary companies, and share best practices they have identified through the years.
Here’s Leonard in his Q1 2007 letter to shareholders, giving us an insight into the value CSI can bring to the acquired companies:
Organic Growth can also be driven or diminished by acquisitions. When we acquire a rapidly growing company we boost Organic Growth. When we acquire an underperforming company that needs to have some of its unpromising lines of business reduced or removed, Organic Growth suffers. History suggests that we generally grow our acquired businesses, frequently providing additional products for them to sell into their installed base, and bringing our increased scale and best practices to bear upon their business. Occasionally however, the reduction of an acquired business to a profitable Core will leave us with a smaller, but usually more profitable business.
CSI emphasizes that they do not take over the day-to-day management of the acquired businesses. They instead rely on the managers and employees of the businesses to run their businesses well. “Don’t hire a dog, then do the barking yourself,” as David Ogilvy once wrote.
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When it comes to incentivising its managers, Leonard writes in his Q3 2007 letter how CSI aligns the compensation with what creates shareholder value – long term ROIC plus Organic Net Revenue Growth:
We believe that long term shareholders will generate a return on their Constellation shares that cannot exceed the sum of long term ROIC plus Organic Net Revenue Growth. We align compensation with this belief, basing our corporate bonus plan upon ROIC and Net Revenue Growth.
As Munger said in his Psychology of Human Misjudgement speech at Harvard – “Show me the inventices, and I’ll show you the outcome.” And here in his Q2 2008 letter, Leonard explains how wrong incentives can backfire, and how it can be cross-checked:
When economic times are tough, and bonuses are tied to financial performance, there’s a strong incentive for the managers of any business to aggressively recognise revenue. I believe that our people are largely inured to such temptations, but there’s a quick way to cross-check. Aggressive revenue recognition nearly always gives rise to an associated increase in accounts receivable and work in process. We should be able to see any such movements in our Tangible Net Assets/Net Revenue metric. In Q2 of 2008, this metric was -58%, down from -45% and -51% in Q2 of 2007 and 2006 respectively. This improvement over prior years suggests that, if anything, our businesses are being conservative about the earnings that they are reporting.
Further reading: Mark Leonard: The Mysterious Brain Behind Constellation Software
Decentralizing Capital Allocation
The overall organization at CSI is heavily decentralized. In his 2012 letter to shareholders, Leonard touches on how the head office is managed, and how they continue to keep the staff slim:
We have a 14 employee head office staff composed primarily of finance, accounting, acquisition, tax and legal personnel. Head office provides the Operating Groups with capital allocation assistance and decisions, and tries to disseminate some best practices, a few clear rules, a bit of coaching, and coughs up the occasional partly trained employee for the Operating Groups. Compliance, investor relations, and handling the finance function round out the head office duties. Whenever we feel stretched at head office, we download more of our work to the Operating Groups.
Probably the most important enabler for CSI being able to continue its growth however, is how they educate and trust lower-level managers in capital allocation decisions. Leonard spoke on this during CSI’s 2023 AGM, and shed light on the potential of acquired founders as sources of new opportunities.
Comparing this strategy to that of Berkshire Hathaway is interesting, where capital allocation decisions were (and are) more centralized at the head office with Buffett and Munger. Think about what could have happened if they had educated and trusted say, Chuck Huggins, longtime CEO of See’s Candies or, Kathrine Graham at The Washington Post, with allocating capital. A completely different strategy of course, but very powerful when it works properly.
Leonard explains in CSI’s Q3 2015 earnings call how the operating managers in the company essentially already are making capital allocation decisions daily, and how they are teached to also apply it in M&A:
Any operating manager inside of a company like Constellation does do capital allocation every day as they do R&D, sales and marketing on initiatives, because those initiatives don't pay off for 5 to 10 years. And so they are, by their very nature, investing now for a payoff many years down the road, and that's the same thing that you do when you do an acquisition. It's just a make-or-buy decision. And so I think we've got people who are naturally predisposed to be capital allocators because they've been in the software business with very long-time horizons, and we're just teaching them some of the nuances that come along with mergers and acquisitions, and that's why we're off site today. About 1/3 of the people here are business unit managers who are trying to figure out how they can deploy their capital, so that they end up running something bigger and hopefully more successful.
– Mark Leonard, Founder & President at Constellation Software, Q3 2015.
And here in the same earnings call he notes how this, once working, makes all M&A problems at the head office go away:
So the best way to answer it is to say you have a culture of not managing and monitoring. What we really want are a collection of small teams that are self-managing, run by trusted individuals with experience and integrity. And gathering together 200 leaders that have those characteristics and getting them to run business units is a nontrivial task, but it's also one that, as that high wheel starts going and working, tends to be a thing of beauty. You have one business unit manager, and if they can buy an equivalent business in the next 3 to 5 years and coach it to perform as well as the one that they're currently running, then all of my M&A problems go away. All of my integration problems go away, and it becomes an organization where you just need the ability to reach into the occasional faltering business unit and provide coaching or sometimes replacement managers. But for the most part, it's self-managing and self-maintaining. And that's what we hope to get to. What it does require is that those operating managers become capital allocators, so a task of teaching capital allocation to people who perhaps have come up through the ranks and that has not been their natural activity.
– Mark Leonard, Founder & President at Constellation Software, Q3 2015.
Wrapping Up
Constellation Software Inc. (CSI), under Mark Leonard’s leadership, has mastered the art of strategic acquisitions in the vertical market software (VMS) sector through its perfected “buy and build” approach. This strategy focuses on acquiring small, profitable software firms with deep industry insights, diversifying CSI’s portfolio across various sectors and geographies. By emphasizing empowerment and autonomous operation of acquired companies, CSI fosters innovation and long-term growth within these firms.
CSI’s unique approach to decentralizing capital allocation decisions further strengthens its acquisition strategy, enabling lower-level managers and acquired founders to actively participate in scouting and executing new opportunities. This strategy, contrasting with traditional centralized models, has been instrumental in CSI’s scalable growth.
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