Interview Transcript

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.

I'm interested to hear how the Constellation acquisition machine works and how sustainable it is, as well as the special things Constellation does and how hard they are to replicate. I want to get into the operating companies as it is not appreciated how well those are run as they're not all 100% focused on acquisitions. To start, could you give us your background and what roles you had at Constellation?

I spent five years at CSI. A lot has changed in five years but, when I joined, the Jonas portfolio was headquartered in Toronto, which it still is. They had bought 10 UK businesses and it was worthwhile to have UK headquarters, which we called Europe. A European CEO was drafted in, who was already in the business running a portfolio in the US. He wanted a local M&A hire of his own rather than having a five-hour time difference, having to go back to Canada every time he wanted to talk to someone, meaning the overlap was four hours per day. I ended up being that hire.

During that journey, I got to understand the M&A process, regardless of sector, the KPIs of vertical market software businesses and how to assess the quality and the value of those. It is easy to value your house because you can look at what was paid for the house next door, but when you try to value things which are not directly comparable, you don't always have information on what other people paid. You need to develop quality metrics to understand what you're looking at and how much to pay for it. I completed 21 acquisitions during my time there but, in the first six to nine months, we didn't close anything because we were trying to do the business development side of things. It was a fantastic M&A and software education and I could not have been educated on those things better elsewhere.

What has changed in five years?

The level of competition. Constellation has strict hurdle rates and buy on an internal rate of return basis rather than on multiples. If you are at 24.8%, you need to find a way for it to be 25 or that deal will not happen. In the private equity world, if you're short, you simply throw in more money to get the deal done. That's the reason for their return and share price performance. They're disinterested in making 15% IRR; if it is not 25%, you hold your nerve and look for other businesses.

Is that a source of frustration for people like yourself?

You can ensure you do your diligence properly. IRR is all about the timing of cash flows. I look at when money comes in or goes out and how it moves the needle. Many people involved in M&A, specifically in private equity, are project managers who outsource the financial and legal diligence. At Constellation, it is all done in-house. It is similar to an accountant who relies on software but doesn't know how to do accounts. You need to understand why things go wrong or are not quite as you expected. Doing proper diligence means you can dive into where you can move the needle on IRR. The first three and a half years weren’t frustrating because we got the bulk of those 21 deals during that time.

I began to notice, in the UK, you're competing with Access Group, Advanced, Iris, ClearCourse and many others who have realized vertical market software businesses are a great investment. The CSI share price makes it suddenly attractive to people, as it started at $18 and is now north of $2,000, which everybody wants a piece of. It is harder to compete against people who are willing to make lower returns. I definitely felt that during my final 18 months. Despite that, CSI always win when a business is distressed because most people buy businesses which are growing quite well. A flat or shrinking, poor quality business, doesn't always translate into a poor-quality investment. At the right price, it could still be a good investment, and in those businesses, they have a free run because they know where they can tuck it in and make it more efficient.

This is linked to your question about low level single digit organic growth. Everybody wants businesses with 10% to 15% organic growth, so you compete against other private equity businesses who are willing to pay way more. On a go forward basis, I don't know what the answer is to their strict hurdle rates and discipline. They will be less competitive but will continue to win in certain areas. The 134 acquisitions they did last year is a lot on the face of it, but what was their average size and how much capital was deployed? There were a few outliers last year because we closed one five times bigger than ever. We were always hoping to buy businesses of four or five million revenue but we ended up buying those with two million revenue and less, because we were competitive there.

They can also win as a result of their slick business development team. Many people repeatedly reach out to businesses and internal competition keeps them on their toes. To avoid competitive bidding scenarios, you need to ensure you are alone at the table when putting a bid in. We always bid on broker-led deals which we knew we would never win. The feedback was always the same; your pitch was the most professional but you were 50% of whoever else out there. It's about knowing where you're stronger and where you can win. Going forwards, at some point, the hurdle rate has to change.

Does CSI being a permanent owner of the business make a difference?

When I first started doing this, I assumed everyone took the biggest check, but there have been concrete examples where that wasn't the case. One specific business knew he wasn't getting the biggest check, but it was big enough for him to be happy and he cared about the team he left behind. Buying SME businesses is different to buying businesses for 100 million, where no one has an emotional attachment to it. These are businesses where the owner knows everybody's husband, wife or kid's names, so they care about what happens to the people and culture post acquisition. You can pull those levers in terms of not changing the culture or name and holding it forever, as opposed to ripping the guts out. That doesn't bridge a £1 million valuation gap but it might bridge 250 grand or a timing of payment issue.

You do what you can but people aren't going to give their businesses away. We're very conscious of the fact that sellers only get to sell once. You have this battle where you are empathetic to what the seller is going through, but we have to stay disciplined with what we do, and hope there is an overlap. That gets harder when seller's valuation expectations go up.

Is that hurdle rate change a step change or not a very large one?

There are three hurdle rates. Less than a million in revenue is 30% IRR; above four million, you can drop to 20%; and 25% is for everything in between. You can go to 20% because those bigger businesses are more competitive, but everything which falls in the middle at 25% is 90% of deals. There is another hurdle rate of 15%, but that is on deals so large they're not in CSI's wheelhouse. Above 50 million, you can go to 15% but they might only do one of those per year. Dropping those thresholds by 2.5% won't have much impact.

I bought a business, in Europe, with a 20% hurdle rate. The whole topic intrigued me because, if you don't reach the hurdle rate, you can't get a deal done. If we did all that work and modeled it out at 19%, the deal won't get done. Playing devil's advocate, would you rather drop it to 18%, which means you've got the deal done but you have a platform in another geography to buy five more businesses, which as a basket, you breach 20%, or do you cut your nose off to spite your face and simply not do it. If we bought a business at 17.5% with four million IRR, and it allowed us to buy more, is that not a better result than doing nothing?

That's where CSI could be slightly more complex in terms of the structure. I'm empathetic to the problem Mark Leonard has, which is always being tasked with deploying free cash. The bigger you get, the more free cash there is, and the only way you can deal with that is by pushing M&A responsibility down to more people. The further you push that responsibility down, the caliber of M&A execution gets worse. If you don't have hard and fast rules, and Mark cannot look at every deal, it's a way for him to ensure nobody does anything silly and things run away. During my time when I started, it was me and the European CEO, then his two portfolio managers joined, as did others running businesses below them. As the tiers get lower, the M&A knowledge gets weaker. I see why he wants to keep to the hurdle rate, because you have people who don't know what they're doing tasked with spending millions. That's probably what goes through his mind, whereas if he was doing it all himself, he would take a different view.

You spoke about figuring out the real KPIs of VMS businesses and how to assess the quality of those; I would be interested in your thoughts on that.

CSI own 900 software businesses which gives them an amazing bank of data to work out what good or rubbish looks like and can share best practices. They know who is the best at professional services so they can teach the rest of the group. Such a spread allows them to have core KPIs for software businesses in all sectors. They can look through the same lens to measure the efficiencies of professional services and support teams, and cost of R&D, G&A and sales and marketing. They can tag every individual and pound spent or made into those five buckets, and know professional services revenue should be this ratio of professional services spend. That's what it should be, which means they can immediately spot weak spots in target businesses.

They could see they have two too many PS heads and need a salesperson, which is a huge advantage over private equity companies who lack that depth of knowledge. They don't know how to run them post-acquisition or which strategies can make them better, such as when and how much to increase prices. The senior people at CSI could tell you, with their eyes closed, that if attrition is less than X, you haven't done it for five years, your software is mission critical and high ticket, if they paid £200,000 to implement it, they will not get rid of it. These are areas where they back themselves because they know, and they know because they have owned many businesses and done it many times.

When they look at a business, although the hurdle rates might be quite high, they would build into their acquisition price if needed, that we can afford to get rid of three heads and put through a 25% price increase, which can move the IRR needle hugely. A private equity firm buying a business wouldn't factor that in unless they knew what they were doing. That's where they often lose because they wouldn't back themselves to make operational changes CSI knows they can successfully make.

Once you leave CSI, do you no longer have access to that data?

The key is those five stable ratios; there's no point reinventing the wheel. Mark Leonard worked out what they were so you don't need to pick them apart. The difficulty you will face is that, unless you leave CSI and go to a place with ex CSI people, trying to change people's habits will be like pushing water uphill; that's human nature. You won't go into a new business and tell them they are measuring everything wrong. In the first year, you might make small changes, and in the second year a few more, but it's like turning an oil tanker, which takes time. Unless somebody was open-minded and on board – which isn't human nature – it’s difficult to go into a business and change everything.

You can point to what Constellation did, but that's not human nature.

Everything is metric-driven and organized, even the business development database. Our portfolio had 5,000 leads which were split into buckets of VIP, high, low and medium, when we last spoke to each one and what percentage we spoke to in the past 12 months. A private equity firm would fire out emails, see how many stick and see what avenues to follow. When you're cheap, it has to be a machine. We need to know who we spoke to and when, and how often we will do it and who is important. Private equity firms pay more and get an LOI signed for every three offers, whereas CSI are closer to every 10th.

Whatever BD activity a private equity firm does, CSI has to do at least three times as much, which means it has to be well-rehearsed and slick. Everyone has to know their piece and what they're doing. We have weekly discussions about it and you're constantly tracking success, capital deployed and money in and out. How many calls and emails did you do this week? How many VIP leads did you engage? You must have had a meaningful conversation which means you received information from them which wasn't publicly available, otherwise you didn't engage with them. Having such high hurdles means everybody is working hard to do the best that can.

Do those 5,000 qualified leads change regularly?

That was one portfolio, the CSI database has 200,000 leads globally between the divisions of Volaris, Vela, Harris, Perseus, Jonas and TSS. If you were at Vela and engaged with a lead, Volaris cannot poach them unless there has been no contact for 12 months. That stops two CSI companies bidding each other up and it also stops complacency. If a business development person's leads are constantly poached, it means they weren't doing a good enough job because they weren't talking to them. It's a way of incentivizing everybody to track how many they lost to another CSI group. There were other metrics around many businesses which got poached internally, and many of those are not the ones that close. Internal competition is at the heart of CSI culture. That is brilliant for business development people who are, effectively, salesmen who you have to keep on their toes.

134 acquisitions doesn't sound like much in the context of 200,000 leads.

They will vary and nothing ever gets deleted. Ticketmaster and Accenture are in there, but you will never buy them. If someone else bought a VIP and we weren't even at the table to bid, that's a sin. High is a bit less and medium and low are either unattractive sectors or small businesses. It could be a four-person business and you wait until they have 15. Everything is super organized.

New businesses come in as you discover them but it's an all-growing thing?

Some get acquired by others and new businesses are spun up all the time, so you have to do your fair share of hunting and farming. You have to find new leads and nurture the ones you have, so that you are alone at the table to get a good rate.

When a company is part of a portfolio, is it the same level of monitoring?

When CSI buys a business, culturally, day one looks the same as before. They very rarely change the name, staff or office, but some reporting would change. Everything is looked at through the same lens, whether it is a software business in the education or asset management space. There are four types of revenue; license, professional services, support and hardware. Your cost of goods and net revenue will be the same. Your opex is split into G&A, R&D, sales and marketing, PS and maintenance. Everybody's cost goes into one of those buckets. Doing that for all the businesses gives you base rates so you know what good or bad looks like. Some sectors will never achieve the PS rate of others, but that might tell you which sectors to avoid and which are more attractive.

Attrition is measured most closely. Most businesses view attrition as customers lost, but customers you keep who pay less is also attrition. Our attrition metric doesn't include up sell or new customers; we are only interested in the combination of lost and down sell customers. If the combination of those two is less than 5%, that business has a good chance of growing. Even in a bad year, not much can go wrong, whereas a business with 20% attrition you have to back fill to stand still. That feeds back into business quality and what they should pay based on the future.

Are other aspects of the playbook value-based pricing and price increases?

Price increases won't work in a business with 15% attrition; they struggle to keep their existing customers even at the current prices. They would say if attrition is less than 5%, and I would say less than 7%, and is mission critical and high ticket, meaning it costs a lot to implement, on-prem is easier to raise prices than SaaS. An interesting one many people don't look at is whose money customers are spending. Whoever makes the decision at a council is not spending their money, whereas an owner operator will look at that money differently. You look at those five metrics and if all of them tick the right boxes, you can put through a price increase. If mission critical, cost 250 grand to put in, was low attrition and had no price increases in five years, you could increase it by 30%. The customers might moan and attrition could spike from 5% to 7% for one year, but what you gained massively outweighs it.

CSI have confidence to do that because by owning 900 businesses, they know exactly what will happen. If you own 20 businesses, you would be nervous about the impact of doing that. They also look at price equalization, because some customers are paying nowhere near as much as they should for the size of business they are. You could aim for a 30% price increase, but some customers only need 15% and others need 50%, so they also look at that. They use Utopia grids which have customers on the side and modules across the top. They look at who has what, and all the blank modules are back to base opportunities. These are all simple but you can move the needle by overlaying even half of them.

Whoever owned the business pre-acquisition did a fantastic job to get the business from nothing to wherever it was on their own steam and with their own ideas, but every decision they made was a best guess where they hoped it was a good one. They would see the outcome then make another decision, but how much easier would it be if every problem you come across, someone else had and knew the outcome. That allows you to make a more informed decision about anything you do. It could be development, price increases, team size or type of individuals you hire. It's a massive advantage to have seen it all in other businesses to help you make better decisions.

I didn't ask you why you left, which ties into the culture of working there.

When I look back on my time there, it's a mix of thoughts. I will always be grateful for the opportunity I was given. People would give their right arm to be in M&A because it's a lucrative place to be. I had a first-class education for five years, not only knowing how to buy a business but the whole process from beginning to end, front and back. The downside is the level of pay, but it was worthwhile because of what I was learning. I always knew my learning curve would flatten out and we would both have got what we wanted from the relationship, and we left on good terms.

Today, I am in an M&A role elsewhere and continue to learn in a different sphere, and I earn considerably more. If you want to learn about M&A and software, I would highly recommend spending time there. The culture is interesting because the business is made up of 900 SMEs, which have their own individual culture and nimble small teams. They have that small business feel about them which is unique because everybody's experience will be related to that business. You cannot say CSI is good, bad or indifferent when it only applies to a small pocket. Your experience at work depends on your specific team and line manager. If somebody has a poor experience in a 15-person business, it doesn't mean CSI is a bad company to work for.

If somebody was offered a position at CSI, I would tell them to take it because you get more out than a paycheck, which you monetize later. Pay is a recurring theme in some of the negatives, but I cannot criticize that from the outside looking in. That comes back to the brilliance of Mark Leonard and understanding a lot of CSI is about efficiencies, which include the efficiency of acquisitions, running the businesses and the P&L, and he won't pay people more than he needs to get someone else to do that job. A listed company cannot suddenly give everybody 20% pay increases.

Is there any broad problem of turnover?

The CSI head office has 15 people; the majority of employees work in the brands. The head office of the portfolio I worked for had less than 10 people. We used to track employee retention, and if it was it's more than 12% a year in any business, we would deem that a problem. People will always leave if they get offered more money. There's no point dancing around the fact that all of us go to work to take money home, so you can't begrudge people who might get a five grand pay rise. There are always new opportunities when you work for a business which is highly inquisitive. They are constantly restructuring, breaking things apart and putting them back together. If you are good at what you do, you have a chance to do more.

Did you have any interactions with Mark Leonard or the team in Toronto?

I remember Mark but I doubt he will remember me because he's a larger than life character. The more M&A responsibility gets pushed down, the harder it is for him to be over everything. A business acquired for less than two million, he won't even know it happened because it's not worth his time, but on the larger deals they would get involved. My very last deal was a large one which meant we were on calls with Mark and Bernie, who would give their opinion. They were good at giving their opinion but still letting you make the decision. They might tell you they hate it, but they would also tell you to do it if you believe in it.

If Mark gives his opinion, you should listen. In life, occasionally, you come across high level individuals, and out of the hundreds of people I've worked with so far, the five or six I've come across are all at CSI. The caliber of Bernie, Mark, Farley Noble and Scott Saklad is light years ahead of others, so when you are around them, you absorb as much as you can, even if you are smart. The annual M&A conference is about knowledge sharing, which is obviously good for CSI but it's also a reflection on what they see as important.

How was the bonus system perceived? I imagine you had to buy shares?

I did, but not in the first few years. I could have, but it was at a level where you could opt to take it all in cash. Towards the end, I did take some shares. Senior staff have to take 25% of their bonus in shares, which goes up the more senior you become. You might have to take 75% of your bonus in shares, a third of which vest after three, four and five years, so you are always on a conveyor belt of doing a third each year. That also means you feel like you're hooked in because, not only is it coming in future, as the share price keeps rising, whatever shares you got three years ago are now worth X and you will get more and you can drive what they are worth. If you are senior enough for your bonus to be a significant number, it's a retention scheme.

I wasn't at that level so the pay increase I got when I moved on was so significant that no bonus would have kept me. Some people there have stock worth seven or eight figures. You also get to a stage where you've made so much there's no incentive to go elsewhere. A lot of personal wealth is tied up in stocks. Mark Miller and Barry, and even people below them, have shares worth hundreds of millions, so leaving will probably have an impact on a share price if you're that senior. There's a lot of loyalty to Mark because many guys came in when the shares were $20 each and they are now worth $2,000. When I joined, the shares were $700 and I thought I'd missed the boat, but when I left, they were $2,200.

Interestingly, the last 12 months has been flat and I assume everybody is asking the same question of what do you do with a billion cash on the balance sheet, because it doesn't do anything in the bank. Do they change hurdle rates to buy more, which comes back to what I said earlier about playing devil's advocate. Would you rather buy one business at 25% or five businesses at 20%? I'm sure Mark has a view on that. The share scheme is brilliant because anybody who gets a significant amount in shares has earned their way and are therefore high caliber individuals.

What does Constellation 2.0 look like?

They could continue doing the same thing at a different hurdle rate, or spin up something else. Are there non-software businesses out there that are maintenance with annual contracts and could be measured and run similarly? Is that another way to deploy capital or should you look for 500 million businesses? They paid a 400 million dividend two years ago because it was embarrassing how much cash they had. I am on the outside, looking in, but the personal feeling I had doing M&A in the last 18 months, was that deals were drying up and the ones we were doing were smaller. It was so competitive that when we would offer two million, which is 1.5 million now and 500,000 in a year, they would say private equity offered me four million up front. There are no levers you can pull which is a challenge, and I'm fascinated to see what they change.

Do you have any thoughts about their spin-offs like TSS and Topicus?

It's as much an experiment as anything because how will the share price of CSI versus Topicus fluctuate? CSI have a controlling share of Topicus so they are intrinsically linked, but is one investment better than the other when buying shares? When that spin out happened, people who had many shares in CSI were given a portion in Topicus, which is Mark and Bernie figuring out what to do with all the cash. That was dipping their toe in to see what impact that would have. There was a venture in Japan which might have failed but I can't remember. These things point to the fact that they are exploring alternatives.

Do they start buying horizontal software businesses which will open many doors, or simply continue? When Covid happened, we thought there would be fire sales and large businesses would sell non-core for cheap rather than it go to nothing, but that didn't happen. A recession is coming, which usually leads to valuations dropping, but the valuation expectations of sellers doesn't change as quickly as it does for buyers. I'm intrigued but it will be tough to keep deploying capital at that level of return.

Do you have a sense as to whether the European market is an opportunity?

Europe is a big opportunity but not all countries are equal. The UK is a small geography with strong competition so everyone is emailing the same leads. The US is huge so they can spend a lot of time there and continue to be successful. Europe is less competitive at the moment. The obvious hurdle with Europe is that it differs to the US which has 50 states where everybody speaks the same language. Europe has loads of different cultures, languages, laws, taxes and governments. Buying something in Spain is different to Sweden or Italy, so it adds complexity. You can't buy a 10-person business in Italy, you first have to buy a 50-person business, then a headquarters, then a 20-person business. Only then can you start building out because the first acquisition in any new geography has to be able to stand up on its own. CSI is a fascinating business for many reasons, it's the greatest example of capital deployment in history.

It is unbelievable.

It's telling that everyone wants a piece of it. Private equity know what they're doing and are trying to copy it and make the returns. Taking price out of the equation, CSI still have significant advantages by owning 900 businesses, which gives them the knowledge of what good and bad looks like. That will not go away but it's been fascinating watching the share price because if that stays flat, they will have to change what they do. I get LinkedIn alerts when they buy something, and they are still breaking things apart, putting things together and spinning up new entities.

Did you keep your shares?

Yes, but my shareholding is small. My first conference was in 2017, where Mark Leonard put up a graph showing how he wanted to get from 300 to 3,000 companies over the next 10 years. He's halfway there, but it gives you a sense of what they want to achieve and they don't feel they are done yet. I’m fascinated to see what happens.