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.

{audio:0:06:36} I run a hedge fund and Constellation Software is our biggest position. We have owned it for a while and hope to own it for many more years, so I'm interested in talking to people who have worked there to dig into the M&A process, how they manage portfolio companies and the culture and what it's like to work there. A good place to start would be to tell us how you got to Constellation and what you did there?

{audio:0:07:19} I am an accountant by training and started at Constellation in 2006 working in the Jonas Group, who had $50 million in revenue, a couple hundred employees and four locations. There is a huge expansion by acquisition methodology at Constellation, so as we grew, we needed people to run them, so there was a lot more promotion and cross-pollination. When I started, we had 15 people in the finance team spread between Philadelphia and Toronto. As we grew, my role expanded. We had been championing a shared services model so as we grew, we incorporated much, if not all, of their accounting into our shared services teams. 

{audio:0:09:40} Sometimes client invoicing would stay in the acquired business, and sometimes we had somebody of an analytical sort who stayed at the business because the owner/manager refused to let them go, as part of their transition. In 2013 that was getting very rinse, wash, repeat, and to be honest, part of what I loved about working at Constellation was the ability to see and touch all these different businesses and help coach them as they grew and expanded, and to see how they fit and share best practices. But the bigger we got, the less of that I was doing. 

{audio:0:12:08} 2018, and since then I've been working as a contractor, typically with a handful of smaller software companies in Toronto, helping them prepare for sale or go through an acquisition and integration process.

{audio:0:12:40} Did you retain your shares in Constellation?

{audio:0:12:44} I have way too much of my net worth wrapped up in Constellation shares, but I will proudly tell you that my average acquired cost is $100 a share, Canadian, maybe $120.

{audio:0:13:06} Wow, that's the power of long-term investing there.

{audio:0:13:11} For sanity, I have divested some shares and tucked them into other investments, and I keep a worksheet of money lost, which is just torture, but it's the cost of risk mitigation.

{audio:0:13:37} That's a good problem to have and what we call a high-class problem. You mentioned shared best practices, how does that work?

{audio:0:13:57} It's the greatest blessing and curse, and the most challenging thing to do in the decentralized management model of Constellation. The pond keeps getting bigger and bigger, and people still need access to the information for 10 or 20 companies, but the true sharing of best practices across the board is shared across a small pond. When I started, they used to do an education initiative every fall, which was across all Constellation GMs and participants. Several years into that, the Jonas initiative did their own form of Constellation University. When I was leaving, we had done several years of a fitness-only initiative, in addition to the Jonas-wide one. Today it only happens at a cross-Jonas level with business unit managers, I believe. 

{audio:0:15:56} Once you go beyond 80 to 100 people, not much is retained, nor is there cross-pollination. They already have 100 GMs, so now they only take people who manage more than one company or portfolio managers, business managers and acquisition teams. There is also an annual Constellation M&A conference which, to the best of my knowledge, still happens, where they share wins and losses. Mark Leonard is a data monster, so there's usually an initiative he presents on, such as the success of pre-acquisition forecasting. For a while he was on the high growth conglomerate reviews to see if we could learn anything from those. Mark is the smartest person I've ever been in the room with, but from a business perspective.

{audio:0:17:27} Yes, he's a fascinating character, but there's not much out on him of course. He doesn't write his letters any more but he must have been something to work with?

{audio:0:17:37} He is brilliant, very smart, humorous, zero EQ; maybe not zero, but lowish EQ. He is driven and has a mind like an encyclopedia, and he was very pragmatic. He had a real gift for turning it into understandable language for the layman. They are very disciplined about consistent acquisition process and strategy. Each division has their own post-acquisition check list, which is the best tool for ensuring the Constellation play book touches every business. It is up to the portfolio managers to ensure they stay on that path or prioritize, post-acquisition.

{audio:0:19:27} Obviously, M&A is an important part of the growth story. How did the M&A process work, how did you find an opportunity and then what happened?

{audio:0:19:50} Constellation is the only company I've worked with who are as acquisitive. Smaller independent software companies are not very aware of their competitors. They are aware of them from a market presence, but they don't go for a beer at the end of the trade show or share war stories about what's going on, so it doesn't seem to be quite as pervasive. Constellation's philosophy is that you should know all the competitors in your space and try to cultivate a positive relationship with them. You should also know folks in adjacent spaces that you might want to meander into, which is the responsibility of GMs and portfolio managers in their space. 

{audio:0:21:11} They have undertaken several initiatives in the last X number of years to ensure they measure how many deals they're not a part of or weren't even aware of, and have taken action to ensure they're at least aware of, with the possibility of being at the table. That has continued to increase but is still below what Mark would want it to be. We are very incented to have profitable growth of any kind, and they've changed the bonus plan over the years to ensure managers stay focused on finding and participating in acquisitions. They have also been more creative with their rules around borrowed capital. In the early days, we didn't care how you did it, but you cannot manage your cash flow by borrowing money in your purchase price and your outgoing cash flow; you have to hit with the whole acquisition on day one. Today, the larger deals have some flexibility around incorporating for finance.

{audio:0:23:24} Would a business manager decide, at the deal, level if they could borrow?

{audio:0:23:33} Not theoretically, but they would account for the outgoing cash flows in their ROI to account for the possibility of borrowing. I don't know enough of the details but my guess with Mark and the board's influence would be that it wouldn't matter how you structured it. You could be limited to factoring in only 50% of the purchase price on borrowing and take the 50% lack up front. It can also go no longer than three to five years and there will be an applied interest rate higher than what we were paying. We would be allowed to use it but not as creatively as a PE firm.

{audio:0:24:45} Does this tie into the reduced hurdle rates or is that a separate thing?

{audio:0:24:50} They may do the reduced hurdle rate to account for borrowing, but you wouldn't do both on the same deal. Mark believed when you tried to get creative, it was shenanigans.

{audio:0:25:28} Were you surprised when they lowered the hurdle rate after you left?

{audio:0:25:35} I am not surprised and continue to believe the management philosophy is good. When you talk about lowering the hurdle rate, it's not going down to 10%.

{audio:0:25:53} That's right, it went from 30 to 25, which is still high.

{audio:0:25:57} Yes exactly, so good luck. It's still the most daunting piece. Mark had done a full analysis of 250 acquisitions where we used Chicago modeling in four scenarios. He calculated the accuracy of forecasts, both revenue, costs and EBIT of acquisitions by size and time frame, and there were definitely some learnings to figure out from that information, but it was also a bit of him calling BS on some of the M&A teams. They thought they could put a price increase in, but that would not happen on day one; it would take six months to put that forward or streamline the team, so we had to be more realistic in our wins and losses.

{audio:0:27:20} How big is the pool of possible acquisition candidates?

{audio:0:27:35} I agree that, in theory, you think this has to stop some time, but unless you're competing against Facebook or Google, there are still a bunch of guys in their mom's garage, trying to write something. I'm still surprised at the number of people who move into a fairly dense market, with a slick, streamlined SaaS offering. They can get funding for it and see if they can make a go of it, which is a very different strategy than an incumbent coming out with a SaaS product with some degree of transition modeling behind the product. In theory, that's a whole new install from scratch, and many people are doing it.

{audio:0:28:41} What competition did you see on these deals and how has that changed over time? How do Constellation and private equity differentiate themselves to sellers?

{audio:0:29:05} That has evolved since the early days and in my time, there was much less competition, particularly in the areas we were shopping. A little software company who sold construction software in the metal cutting space and had 30 employees with $7 million a year, nobody wants that business, no PE firm would walk into that. As Constellation and others rose to prominence, there was more competition in the space of people trying to replicate, without as much done in specific segments. I don't want to say without strategy because that's not the case, but not necessarily as well-rounded a strategy on how they would do it. They still had a PE mindset of, I'm going to own this for three to five years, then I will flip it or re-cap it. 

{audio:0:30:48} We went through a phase of a lot of consolidation in different verticals. For a few years, Amazon and Salesforce would lose money hand over fist but their share price would still go up. They got to the position where they bought anything and everything that tucked into them, so that they could have this robust approach to the market. There were some stragglers who didn't get bought by Salesforce, and more recently, we're seeing consolidation amongst PE firms with a very clear strategy on what they're going to do in a specific market or segment. The PE firms all stratify towards small market, early or mid-growth stages, pre-IPO, and simply trade their cards until they die or go to market. In the last five years, we've seen a handful of companies who say they are Constellation-like. I don't want to say there's very few differentiators because there's always differentiation, but nobody truly does decentralization like Constellation does. I've forgotten what it was like in the early days and compare it to what some of these mini-Constellations are doing.

{audio:0:33:10} That's not so easy to copy.

{audio:0:33:12} Well, it isn't, there's absolutely a little bit of lightning in a bottle there in terms of what's happened, how they were able to grow and acquire and allow enough individuality in the businesses for decentralization, but also adherence to the model. If you are a part owner or manager, it is your decision to stay with the business post-acquisition. Two thirds stay and one third are looking for the, I want to go and fish exit. Of the ones who stay, half don't last past a few years, either because they are not a fit or do not appreciate the difference between truly being on your own and being part of a machine.

{audio:0:34:31} What kind of sellers does Constellation prefer?

{audio:0:34:36} One of Mark's learnings was, if the seller is a pain in the ass during the acquisition, they will be a pain in the ass after the acquisition, that was his only preference. He believes in his methodology that can be taught more easily than taking a Constellation meal fight and teaching them the business they're acquiring. There is nuance and you cannot simply come in with a sledgehammer. Constellation is a metrics-driven company who measure and track all kinds of things and have targets and ranges for the things they measure. They're not saying you have to be within that, but you have to understand where you should be in this range and why you're at that point, and more importantly, measure to ensure you stay at that point as your business evolves, or not, and again, if so, why not?

{audio:0:36:08} What percentage of those sellers were looking for the highest number they could get, over choosing Constellation because they know the people would be there? How much does that play into it, in your experience?

{audio:0:36:31} In the smaller to mid-market it's more important to them to have that over price. In some smaller growing companies, we can be a little creative with earnouts, but not crazy creative because Mark hates them, so there are some rules around that. We can be creative with earnouts for a growing company to get them more money down the path. I worked with somebody who sold their company and couldn’t care less who they were selling it to; they only wanted top dollar. We spoke to an investor who now has a firm and was one of the founding four of what became Pornhub, and when she was selling it was right as they were getting into the scandal about illegal imagery on their platform. She said she wanted to give them a hard time about it, but if they write the biggest check, they write the biggest check.

{audio:0:38:23} Sometimes, Constellation wins that deal depending on how many people are at the table, and they're not afraid of those deals, but some of those are so competitive today. The PE firms who are doing consolidation and flip plays are paying stupid money. She sold her small niche software business for almost five times revenue, which is a great number.

{audio:0:39:16} Once the company is in the portfolio; what focus and monitoring is put on it?

{audio:0:39:26} Oh, dear. Remember that check list I mentioned?

{audio:0:39:30} That immediately gets transferred from M&A to the portfolio manager to manage. It includes the first seven, 30, 60 and 90 days as well as projects like getting them onto the accounting system as quickly as they can, as that's the easiest way to follow the financial metrics you are quoting. We immediately start on some of the core elements of productivity we measure which are non-income statement or financial statement based. We start digging into how we can create that or what they currently have going and how we can tweak that a little to get what we're trying to get out of it. 

{audio:0:40:32} Financial ratios are trailing indicators of things you're doing in your business, so our job in the business is to figure out what the metrics are within the business that are closer to either less of a trailing indicator or even a leading indicator of future success. An obvious one is sales funnel, and if you're tracking the sales funnel, are you also tracking age of leads, days of turnover, days to close, success rate by rep? There's always a different way to slice and dice data and that's where you're not having the success you want. You have to be creative in how you think about it and look at it from a different lens. What do we have on hand because I'm not creating a project in measuring stuff?

{audio:0:42:03} How about the organic growth challenge, I'm sure you know all about that?

{audio:0:42:08} Jonas was always one of the leading groups in terms of internal organic growth, and I get that, at some point, it becomes a challenge, but it's not merely about price increases; it's about expansion of product offering and properly pricing within your business. We provide support but where does that stop and training start? There are many pieces to it, but we are required to visit pricing annually. That doesn't mean you have to put a price increase through but you have to understand where you are in the market versus your competitors. Can you modularize your product and sell your core module? 

{audio:0:43:16} In the SaaS world, you can start for $69 a month which gets you a front seat and a steering wheel. If you would like doors or an engine, you have to pay a little extra for that. There's definitely a perception and understanding in the market that Constellation can be punitive in its price increases. Now that Salesforce is no longer giving away their product and other software providers are equally as punitive, if not more so, it's become a much more accepted business practice. 

{audio:0:44:16} One of the things Constellation does very well in these smaller businesses post-acquisition, is they have no sense of where they are in the marketplace and no conviction of doing monstrous price increases or changes, because they're terrified of losing a big chunk of their customer base. Constellation have done this a million times and know they won't lose that many clients, but even if they do, they will back stop it. It's not a judgment against the prior ownership, it's simply an economic reality of where your courage comes from.

{audio:0:45:05} Did you have to close down, sell or merge a company in the portfolio? How frequently did that happen and how did it go wrong when it did?

{audio:0:45:21} The success of the ROI of investments and acquisitions is measured in perpetuity. There is a focus on those who don't perform as expected, and decisions are made. In the Jonas family, we had a handful of stinker deals. In 2003, they needed a US company for tax planning, not a shell company but an existing company. The original Jonas software company was in the private golf market space, so they bought a company which made public golf course software, which is a very different beast. You wouldn't think so, but it is, and at the time that they did the acquisition, that company had 1,600 clients, and when I left Jonas, they had 65. 

{audio:0:47:19} There were only two people, one of whom was semi-retired and the other worked in another business and simply fiddled with it when needed, to continue maintaining those 65 clients. They knew nobody would buy the product, but they utilized it even though it never changed, and as you can see, there's a market for never going to change. At some point, they wouldn't be able to continue doing that effectively and would sunset it, but it was exceptionally rare. With several companies they said, you could move to our partner product, but they never forced it. 

{audio:0:48:28} In the first example I gave, we didn't have another product but we would offer them the functionality they needed. They would keep it going but at some point, they would give them 18 months to get off. If we bought competing products, you could switch with as little friction as we could create. We ended up with Signature products after we stopped calling them legacy. If you had our Signature products, you could move to the newer version of the product. Forcing a move opens a buying decision possibility, and why would you do that?

{audio:0:49:28} What's your view on the businesses in general, in terms of their longevity because one of the objections with Constellation buying these VMS businesses … 

{audio:0:49:44} Yes, that's no longer as much an objection, but people still wonder.

{audio:0:49:54} There is one division at Constellation who are known to buy dogs.

{audio:0:50:07} HomeBuilder or Dexter's group, but he buys them for 10 cents and gets fantastic returns. There's no dictation of what you can and can't invest in, but the issue is, can you run it profitably and efficiently and potentially expand in that market, and if not, how will you manage it until it goes? Every division has businesses that are not in active growth mode. The question becomes, what is the strategy for that business and ultimately it focuses on retaining clients or potentially expanding product offerings. They still have a dev team with things to do; it cannot all be bug fixes.

{audio:0:51:42} The Allscripts deal happened after you left, but do you have any view on that because, as a business it's not growing, but it's larger than any previous deals?

{audio:0:51:57} Yes, it's a business that's not growing, but why? It will certainly get focus. Have they not had the capital to invest in it or have they simply been inept? These are all too simple but something will happen. They've had a lot of success in merger acquisitions of businesses because there are businesses out there which live on hope and prayer, and will always find somebody to invest in them to keep the machine going. We've never seen something on this scale but they get bought as a tuck-in in some larger group and you carve them out. Somebody comes in and thinks they can do all kinds of things with it.

{audio:0:53:07} You would not believe the number of businesses we purchased which sunk a ton of money into a re-write and simply won't let go of it. Then immediately post-acquisition, forget the sunk costs, where are we going from here? We bought one business where they thought it was going to be three years and $7 million to do the re-write, but seven years and $28 million later and they had fewer than 100 clients on it. The purchase price of that business had been cut in a third. That was a very profitable business and they went in, shelved the new product, but took pieces of it to merge into the existing product, and where it made sense, added to the functionality. There's a reason re-writes have this reputation, it's like doing a house renovation.

{audio:0:54:59} Yes, easy to spend money.

{audio:0:55:01} Yes, between scope creep and does it really cost that much; what do you mean this is more complicated than we thought to build a 57-layer page? You want it to also calculate commissions; you want that car to have windshield wipers? Some of those types of businesses don't take much tinkering to get them back on track and then go from there. I can't imagine a business in the medical space which doesn't have phenomenal potential for growth, so what are they doing wrong? Post-Covid we see it at all sorts of levels, so I simply cannot imagine that technology is not going to continue to drive growth in the medical space.

{audio:0:56:30} The Topicus deal was spun out a year ago; will there will be more of that and were you surprised?

{audio:0:56:41} Part of that was the initial deal structure they did when they acquired Topicus.

{audio:0:56:49} Yes, it was unique; they didn't buy the whole thing.

{audio:0:56:51} Mark has said he regretted structuring the management ownership portion, because it's not the norm and made managing it a different thing. They came up with a way to solve that problem in theory. Most of the Constellation portfolios are larger than Constellation was when they went public, and as long as Mark is around, I would be surprised to see other groups doing it, because other than the cost of having two or three public companies to report on, what is the benefit? Mark loves the shelter of not having to slice and dice results down to the individual level. When they went public, they were asked to segment their markets and they said private and public, and they haven't differentiated since, which is not that helpful.

{audio:0:58:49} What does the future of Constellation look like in 10 years?

{audio:0:59:01} At some point, Mark Leonard is going to get ill and not be as hands on in the day to day of that business. All the portfolio leaders, including John Billowits, are his disciples, so I expect even in Mark's absence, those vertical leaders will continue to execute on the strategy. Each of those leaders has their own layer of disciples, but the closer you are from the hand of God, the less connected potentially, so as they age out or opt out, it will be interesting to see what the turnover looks like and how it continues in his image. At some point, the 20% year over year growth will stop. Theoretically, Warren Buffet will also stop doing what he's doing.

{audio:1:00:56} People have been saying that for decades.

{audio:1:00:59} When is the magic going to wear off?

{audio:1:01:04} Constellation is smaller than Berkshire so they have a way to go then?

{audio:1:01:07} Yes, there is a lot of runway for them. I still have too much of my own net worth tied up in this business and believe it will continue for a while.

{audio:1:01:22} I'm making the same bet, so we'll see.

{audio:1:01:29} Yes, thank you for all your insights and your time today, I learned a lot.

{audio:1:01:45} Awesome, thank you very much.

Constellation Software, Jonas, & Portfolio Management

Constellation Software

Constellation Software is a vertical market software (VMS) serial acquirer. Founded by Mark Leonard, the company has several notable attributes: its 21 million shares outstanding have not changed since inception. It has compounded free cash flow at a 29% clip since its IPO in 2006. It has no debt, high returns on capital and maintains a rational, return-based corporate culture.

Leonard and his team are widely regarded as among the best corporate capital allocators in the world. The business itself consists of hundreds of software companies, dominant in their niches with pricing power and sticky customers.

Constellation Software, Jonas, & Portfolio Management

Former Portfolio Manager at Constellation Software

inpractise.com/articles/constellation-software-jonas-and-portfolio-management

Constellation Software

Why is this company interesting?

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Former Portfolio Manager at Constellation Software

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