Disclaimer: This interview is for informational purposes only and should not be relied upon as a basis for investment decisions. In Practise is an independent publisher and all opinions expressed by guests are solely their own opinions and do not reflect the opinion of In Practise.

Today, we are going to discuss a piece titled "Constellation Software, Vitec, Röko, and M&A Sourcing, Proprietary versus Broker Channel. How long have you been thinking about deal sourcing channels for serial acquirers?

Probably too long.

Is there such a thing as too long? Is it possible?

Well, it's interesting because, at a higher level, you can divide it into broker versus direct, but there are many nuances in the way the transaction unfolds. This piece of research really originated from the Redeye conference in Stockholm, where I met the Vitec CEO. During the meeting, I asked him how often he sees a Constellation operating group in a transaction, and he said hardly ever. We never see them, effectively. That might not have been shocking to most people, but it made me step back and think more deeply about how and why that might be.

An obvious reason could be that there are so many businesses transacting, and maybe they're just buying different things. Vitec typically pays up for what you might call higher quality, faster-growing, organically SaaS-type businesses. Constellation is perceived to be buying lower quality, on-premises, slower-growing assets. I then asked the Vitec CEO how they source their transactions, and he said the majority, if not all, are through brokers.

From the work we've done, interviewing around 10 former Constellation BD executives or M&A professionals, the people involved in the day-to-day sourcing and moving target companies through a funnel, their channel is effectively the inverse of Vitec and many other acquirers. Most other acquirers source through brokers, while Constellation seems to do the majority, at least from those we've spoken to, 60% to 80% through a direct channel, typically outside of auctions and nurtured over several years. The average lead time is just over four years for Constellation.

This led to questions about how much a proprietary funnel matters for long-term returns in these types of businesses. How do the multiple and underlying quality of the business differ across broker-led versus proprietary channels? How does the sourcing channel potentially define an acquirer's moat, like Constellation or Vitec? That's the context for this piece. It's been a topic I've been examining for a good number of years now.

Why did you choose these three companies in particular for this piece?

I was mainly looking at VMS, Constellation Software, and Vitec as the obvious listed players with a very defined strategy. It goes back to when Fredrik at Röko made a comment years ago about sourcing transactions, which I love. I can't remember exactly, but it was at one of the early Redeye conferences. There were several acquirer CEOs explaining how they nurture leads for years with coffees and drinks. Then Fredrik got up and said, "We just use brokers because you can't buy a business that's not for sale," or something like that. He effectively uses 100% brokers, with a thousand brokers across Europe, creating an inbound funnel from all these advisors. It's worked for him so far, and Lifco has a similar strategy that has worked for them. It's not about one strategy working over the other; both can work. It's interesting to look in more detail at how these businesses scale and what works at scale, especially with the different amounts of capital being deployed, particularly by Constellation and Vitec.

And that element of what is scalable, I've seen you focus on this for the better part of five years.

If you look at the numbers, Constellation is deploying probably five to six times the amount of capital per year compared to Vitec in small acquisitions. Constellation aims to do $600 to $800 million per year in small acquisitions, around 80 to 100 acquisitions, a couple per week. Vitec is doing 15% to 20% of that, around $100 to $150 million a year. If you look at the incremental return on capital, Constellation is 8% to 10% higher. Vitec will do around 15%, and Constellation is north of 20%, close to 25%. Why is that? I don't know exactly, but there are multiple overlapping moats. One is the sourcing side, but more importantly, the operational side—how you run these assets post-acquisition. I think that's an underappreciated advantage for companies like Constellation and TransDigm.

What makes you say that it's underappreciated?

I don't think the multiple they trade at suggests they're underappreciated. However, if you talk to most people about Constellation, they might not necessarily say they're the best operators of software assets. The same goes for TransDigm to some extent. People often say they just hike prices and focus on how much capital they can deploy, which is indeed a critical factor.

From the transactions I've looked at, I follow many of the small acquisitions Constellation makes, including Topicus and other Constellation groups. Some of these acquisitions have full accounts available, especially if they're in the UK or the Nordics. I've seen businesses where they've carved out assets from publicly listed companies, allowing you to look at the filings and see the financials of what they're acquiring. They're not acquiring 50% EBITDA margin businesses off the bat. These small companies aren't running as efficiently as Constellation does.

It's similar with TransDigm. They recently bought a small publicly listed business at a 300% premium to the last close. If you examine their financials, they have a 20% gross margin, while TransDigm has a 50% EBITDA margin. Clearly, there's an operational playbook here that's critical, and it's not just about pricing. I think that's what I mean by misunderstood. From my experience speaking with other investors, not many people consider how experienced these companies are in running the specific assets they acquire.

I can't quantify how much this experience matters versus other factors, but all these factors are important. You need to deploy capital and have an operational playbook. The more time I spend on this, the more impressed I am by how well they run these assets.

Yes, across operations, I've watched you for several years methodically go through each operating function and core capability, or however you'd categorize the different lines of business activity. You've examined them one by one.

On that point, there's a philosophical stance on how to run these assets. Constellation Software is clearly focused on shareholder returns. Many people I've interviewed, particularly those who left Constellation, felt it didn't align with their philosophy of running software companies. They might want to invest more in R&D and launch new products, but Constellation requires a clear ROI explanation for R&D investments. Some argue that's not the way to innovate. There's a philosophical debate on how companies should be run. The numbers and returns speak for themselves at Constellation, but it doesn't mean it's the only way. Others might prefer a more innovative approach.

Bringing it back to the research piece, having a proprietary funnel isn't the end-all. Other industrial acquirers like Vitec have succeeded by acquiring from brokers. As you scale, if you continue acquiring from brokers, you need an operational playbook to drive value because you'll be paying more as you deploy more capital.

Critics might say that while this approach has worked so far, it could introduce fragility by focusing on a narrow set of variables. That's a discussion for another time. I want to delve into how a piece like this comes to be. You've been thinking about these businesses, whether industrial or serial acquirers, highly acquisitive industrial holding companies, vertical market software, or inorganic compounders. You've been working on these for years, publishing IP research for about three years, and longer synthesis pieces for two years.

For our existing subscribers and new listeners, we publish around 50 to 60 pieces a year. At the start of the year, we don't have a formal plan for what will be finished and published. Regarding this specific piece on deal sourcing, how does it come to be? When do you decide something is ready? What parameters do you use?

I believe you can't force these things, and I've probably been considering this for quite a few years. It just so happened that meeting the Vitec CEO initiated this piece, but it was likely brewing for a long time. It's still an ongoing piece of work. It's not like I'm going to stop looking at this now. I'm always trying to learn more about how these businesses operate and how much it matters if you source only from brokers versus a proprietary funnel.

Typically, I have various questions or lines of inquiry for companies I study and follow over extended periods. Then, I let them come to the surface when I think I've gained an insight or received something interesting from someone. In this case, it was the comment about never seeing Constellation in deals. That pieced together various other information I had about where these companies source deals from.

I've known for several years now that it takes Constellation, on average, four years to transact on something from outbound to LOI. Multiple people I've spoken to over the last couple of years have told me that 60% to 70% of the deals they do at Jonas or Harris are all proprietary. That information was there, but sometimes it takes something to instigate and bring it to life.

What's interesting about Constellation is that when you speak to most BD people who worked there for years, they have a Salesforce instance with 60,000, probably close to 100,000, VMS software assets as potential targets. One person I spoke to, who worked there for around five years, said he added four companies to the funnel. He couldn't find a software company that wasn't already in there. Maybe he wasn't looking hard enough, but that's his job. It's pretty remarkable, right?

They've clearly mapped out what is likely the most complete database of software assets on the planet. They're nurturing these leads constantly. Constellation had this "Keep Your Capital" program they deployed and pushed down to the operating groups a number of years ago. This means the teams within the operating groups have to keep the capital they generate. The free cash they generate has to be redeployed in other assets, or it comes back up to headquarters. This led to a big push by the group to acquire many more BD reps. They now have over 200 business development reps doing M&A globally.

I don't think any private equity firm probably has 200 people solely focusing on software. I'm not sure if Thoma Bravo or Vista has that many, but it's a lot. If you do some simple math on 60,000 leads in Salesforce and 200 BD reps, that's 300 company targets to manage per person. If they're earning $100,000 per year, that's like $300 per lead. It's economies of scale in sourcing these companies like no other. No other company can compete with that now.

There are different schools of thought here. Most people we speak to from Constellation say this is a moat for them. The Salesforce is their moat, the proprietary funnel is their moat. They have fewer auctions, an unparalleled funnel they can nurture, and more control over it. Most acquirers using brokers say the opposite. Fredrik, for example, finds it too expensive to nurture these leads and prefers to buy what's for sale.

I interviewed Magnus in the last interview we did, and he said the same thing. He mentioned that, from his experience, he hasn't seen any advantage in proprietary sourcing. He said it could be more expensive and a hassle because the owner might think their business is worth more than it is without a broker to keep them in check. They would say that if they're sourcing more from brokers, and they don't need to deploy as much capital. There are two schools of thought here around broker versus proprietary sourcing and how much each one really matters.

This highlights the way we've worked and published for years. You've led our research function, and there are these evergreen questions. Some questions are quite hard to get a conclusive answer on. Yet, interesting insights arise by continually engaging with people and comparing how they approach things that appear similar on the surface.

There are nuances, right? Magnus is acquiring 10 million of EBITDA, which is a different level of scale.

To clarify for our listeners, we're discussing Magnus Soderlind at Bergman & Beving.

The beauty is that both approaches can work. Vitec has done well, Lagercrantz has done well, and Lifco has done great. They don't need a proprietary funnel, although they operate at a different scale compared to Constellation. My evergreen question for these businesses is about the law of large numbers and diminishing returns on capital. You're already seeing this in some businesses. For example, Vitec relies on brokers and needs to deploy a lot of capital, which presents a human capital challenge in transacting with many companies annually. If you're deploying more capital, it becomes difficult without an operational playbook. Most of these companies are excellent at running their businesses, but they might not have a proven system like TransDigm or Constellation. It will be fascinating to see how these businesses evolve over time because the law of large numbers is real and challenging.

It is indeed. One of the more obvious questions is how long can these things continue, and what changes as they grow? We've done a series of pieces comparing and contrasting operating practices and models. We've compared Lifco and Halma, looking at their M&A team structure and operating group structure. We've also compared M&A accounting practices across several serial acquirers. Before we wrap up today, could you share a few more of your evergreen questions that you continue to explore for these serial acquirer business models?

An interesting question for major companies like Constellation Software or TransDigm is how they can apply their success in a single vertical to other verticals. At the last AGM of Constellation, it was clear they are exploring other areas to deploy capital, pushing more into hardware and software-related businesses. TransDigm has also explored different acquisitions, not strictly FAA-regulated parts, but also testing businesses and adjacent verticals. They still serve aerospace and defense, but not in manufacturing parts. This is a significant question for larger companies.

Additionally, there's a lot of competition in VMS. Many new businesses are starting and acquiring. I didn't mention much about the proprietary funnel side, like the level of competition that has entered the market over the last five years. They are all looking at brokered processes. Magnus Soderlind, Bergman & Beving, and others have suggested that direct sourcing doesn't necessarily mean a better price. However, at scale, it's hard to believe there's no benefit to not sourcing through brokered processes, especially with hundreds of new competitors in the last five years.

The numbers suggest Constellation is still acquiring small businesses with great returns. They mentioned last week that they are either paying up or operating them better. I believe there are overlapping moats here that create compounding results for Constellation. They have direct sourcing at scale, economies of scale to nurture leads, and an operational edge. Whether they get better prices or better assets, it matters. The interplay of these factors is crucial. Who knows what will happen over time? If they unlock a different vertical, the multiples might increase even more.

We have a Research Roundup available for both subscribers and non-subscribers for free on our site. It's titled "Research Roundup Industrial Hold Cos." We've curated much of the last five years of work, sharing topics we will continue to focus on for the next few years, and likely the rest of our careers. This business model is intriguing if executed correctly. It's also interesting to explore where they go wrong.

I think we understand how they can go wrong, but preempting those issues is crucial.

Yes, there's a piece we've been developing for about two and a half years on serial acquirer failure modes. Stay tuned.

Thank you for listening, as always. This is for informational purposes only and should not be relied upon for investment decisions. Please conduct your own research.

This podcast explores this recent IP research piece: