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.

My fund is a shareholder Constellation; it's top position, owned it for a while, hope to continue to own it for a long time and I'm looking forward to learning more about the culture and what your perspective is on competition. What is your background and what did you do while you were there?

I come from a tech background. I cut my teeth in product management and tried being a SaaS entrepreneur before Mark's learnings. I tried it the hard way and realized what it takes to be an entrepreneur. I was passionate about investing at the time and felt that I was more of a capital allocator at heart. I went to business school and took a more traditional career path in consulting and then banking. I found my way to Constellation Software where, as an investor, I was looking at the world of software investing which typically is heavily growth-focused.

My foundational principles in investing came from following Berkshire Hathaway and Warren Buffett. I was surprised to read an article on Seeking Alpha, about Constellation Software, who was a value focused shop in the world of software and technology. Reading Mark's now famous shareholder letters and talking to folks in the space, I learned so much about the company culture and how they build vertical market software businesses and think about M&A and investing, so it was a learning opportunity of a life time. I was a director of M&A at one of the six operating groups and helped run M&A at the head office level, primarily focused on driving our overall M&A efforts to the portfolio, as well as being responsible for our best practices and learning and strategic efforts around helping scale these businesses. I did that for a while under some solid mentorship, before moving on.

Why did you leave?

My reasons were more personal by nature but I continue to be a shareholder. I have a tremendous respect for the company. For me, it was about moving out of M&A and trying my hand at entrepreneurship. I would love to go back in another capacity but I tried a different path.

How would you characterize the work culture there? Is it very demanding?

Part of the essence of Constellation Software, whether on the M&A side or being an operator, is that it's a learning organization by DNA, which is how Mark has built it, even after years of decentralization. Sharing best practices, learning, coaching and mentoring, is ingrained into how we do things. They have a collaborative transparent culture with a lot of sharing and learning across. M&A, as a profession, can be demanding, especially at a firm like Constellation Software who deal with high volumes, but there are incentives to push yourself because the reward mechanism is structured to allow you to rise through the ranks pretty quickly.

Can you make a lot of money?

You can share in the wealth and take on more responsibility. If you're a solid M&A leader doing a great job, you can build a team and delegate the mechanics to junior staff. You get to participate in integration and operations and, potentially, become a portfolio manager.

How do best practices work, without getting to the specifics of any practice but more generally? How are best practices shared or transmitted among groups?

Every operating group at Constellation Software has somebody at head office – the equivalent of my role at other operating groups – whose key mandate, along with managing the overall M&A pipeline and strategy, is curating and disseminating best practices. We typically do that every quarter or six months and, in our portfolio, at the end of every month, we would run an internal best practices session. These best practices analyze both the operational and M&A tracks. The latter has a more structured formal process, where at the first anniversary of every acquisition, operating groups run a post-acquisition review or a PAR. We look at the original investment thesis and the actuals a year after and have an open conversation on what we got right or wrong, what we missed in diligence, what we could have done better, and how this thesis is playing out versus what we had originally modeled.

Those learnings are codified and, ultimately, get rolled up across all operating groups into the mother ship. Every operating group leader gets to access those best practices from CSI in a codified manner and build on those by adding to it. There are also set metrics we look at every quarter, which adds to CSI’s broader benchmarks. The CSI M&A engine has had over 400 acquisitions in its lifetime and, through those, have built rigor and benchmarks on the metrics of VMS businesses. The socializations are typically done through workshops or seminars, which might be individual off-sites done by operating groups.

These days, that's been decentralized another layer where even the sub-groups in individual portfolios do internal sessions to share best practices. Usually, with these best practice sessions, we would invite other M&A and operating leaders from other operating groups and portfolios, to speak at these sessions. Portfolio managers will invite someone who has dealt with leverage or high customer churn, and managed to turn the ship around. That happens at the operating group level and then, at the CSI level, once a year, we have an annual off-site where M&A and operational leaders come together. It is almost like the Super Bowl of learning if you will; a week-long session with dedicated sessions around best practices, and specialized tracks depending on what each portfolio is dealing with. It is very much a codification of learning, period reviews and socialization of that learning through seminars and off-sites built virtually and in person.

That is incredibly structured and rigorous.

One of the most structured and rigorous processes around learning I've seen, to the point where many of the head office teams have staff who spend their time doing that.

It seems that it is so ingrained in the day-to-day business that everyone is on board and wants to do it, as opposed to being pushed down from the top as a corporate mission. This is real; you guys are building and pushing it up yourselves?

It is organic and an opportunity for folks to showcase what they have learned. Many people want to be speakers at these off-sites because they have seen a unique deal or overcome a challenge. It is also a great way to showcase what you've done with a host of portfolio managers and leaders. That DNA is a core value proposition, not just in recruiting but even in M&A prospecting. Sometimes, we would invite potential high value target founders to an overview session and show them what they could be part of. That is a key value sell when an owner is selling to Constellation Software; they continue to have the autonomy to run their business but are part of a cohort of peers running other vertical market software businesses.

What is the so-called ‘best practices play book’?

Without getting too much into details, it's a series of materials around different topics which are standardized and codified. They might be used as reference material to build out a more fleshed out learning program which would include several of those learnings.

To get among the best practices since these are put together from the ground up, if multiple groups experience the same thing, would those get priority over the one-offs which are not as applicable, or how does that work?

That is exactly right. The one-off nuances may not be captured, but if they are unique and interesting and the firm believes they could reoccur, head office will have an initiative, because the process of how the learning is captured and the frequency of those learnings over time, can be pretty insightful.

People get the impression that Constellation is an M&A machine; is there as much emphasis on the operational side?

The amount of exposure I had into the learnings on the operational side were limited because I wasn't as involved in that part of the business. They have equally dedicated tracks for VMS operations as they do M&A. The M&A side has many junior staff involved, so you get to see practices across various levels; everything from junior M&A training to senior strategic investing M&A thinking. On the operational side, you might have certain functional training, but it's largely focused on at the BU level for BU managers and how they govern a VMS business unit. That is equally codified and structured with off-sites and the operational side is getting more attention than in the past, as Constellation deals with changing markets and think about organic growth more deliberately than they have in the past.

What might a typical M&A trifecta look like in broad terms; how it comes in and how that flow goes, without getting too specific?

In broad terms, it is a very structured process. Prospecting is an integral part of M&A life for senior portfolio managers, M&A leaders or junior M&A staff. Some operating groups have gone to a scale where they have full time individuals who are sourcing deals. The vertical market space is still large despite how many deals Constellation has done. Many BU managers who understand that vertical well, already have a list of competitors in their space who have similar characteristics to a well-run vertical market software business, so a lot of intel and sourcing comes from them. They do a rigorous structured evaluation process which prescribes how to evaluate an acquisition across several metrics. That goes to benchmarks where, when you are modeling a potential deal or acquisition, you can see where that will likely fall within those historical 400 deals that have been done on each metric. Recurring revenue growth, PS, sales and marketing and other metrics can be bench-marked.

Modeling is done in a multi-scenario basis on free cash flow terms, from providing different views of the world, and are also tracked later when you complete a deal in the post-acquisition reviews. Depending on the size of the acquisition, there might be several approval levels required, but a typical CSI acquisition would get approved by the operating group leader. New business unit managers who are sourcing and evaluating deals for the first time might have more support from head office teams at M&A, then as they go through several iterations, that starts to go up the chains and they start to see feedback from head office and iterate on what deals make sense or how to think about these in a more refined manner.

Before I had talked to a former executive at Constellation, my impression was that there were 40,000 VMS businesses that everyone knew about, but it's not like that; there's a lot more digging and sourcing by people who have to find these things. Are there new names that frequently appear?

I agree, there are multiple dynamics. New names come up all the time and some names might change hands. You might have businesses that were run by an owner or founder who sold to private equity and realized they didn't like that structure and took over the business again, so you do see deals return. As Constellation expands geographically, international coverage becomes important and that, obviously, adds to that broad database of vertical market software businesses. The database is simply a name with some information.

Ultimately, M&A’s job is to build a relationship with a founder that would be a good fit for Constellation, both as a business but also as a business unit manager, who is willing to see the opportunity in Constellation, join the family and who has synergies and a marriage of philosophy of how the business is run. It is a relationship-building exercise which takes time and is less of a spray and pray. Constellation is diligent about how it makes these acquisitions and so, even if there is a team finding these businesses, setting up calls, bringing them on and there for a while, senior M&A leadership and portfolio managers are building a relationship with that founder over months and years, in order to find that marriage and see if there's a fit and more importantly to make the pitch that Constellation is the right home for them versus private equity or other avenues.

Do you feel there are enough opportunities out there and could you talk about what their primary strength was, because they have some price disciplines too?

When we would have these conversations, I used to look at the numbers closely in our M&A funnel and, surprisingly, there were many opportunities out there. You might intuitively think that, at some point, it would flatten out, but you would be surprised at the number of businesses out there that do fit the Constellation model, especially if you take a global viewpoint of these markets. There was a wave where anyone starting a software business had a very clear VC path or were going to be a billion-dollar business and go public, and they engineered the business that way. More recently, that has begun to change and permanent capital is becoming a new avenue. Several entrepreneurs in North America are seeing a different lens at running a business, one that is more profitable and resilient, and is potentially bootstrapped.

At the same time, they are looking for a middle ground and an exit opportunity while participating in the up side, without being a billion dollars or bust. There are different plays and that is gaining traction in North America. In the international side, there are many traditional CSI opportunities and coverage is something CSI always tends to look at. As the universe expands and potential competition heats up, even for these type of deals, there will be greater coverage and potentially a stronger appetite on valuations to look at businesses that may not necessarily fit the pure valuation balance that Constellation Software is used to. Market opportunities is not a constraining factor whereas getting coverage fast enough is.

The operating side is also important and Constellation Software isn't only about acquiring a company, it's about running it in a resilient and profitable way. A constraint for Constellation Software in the M&A engine would be future portfolio managers; having enough people who can operate the play book. There are many BU managers they can groom to do that, but how quickly can they scale those BU managers and M&A leaders into taking on a portfolio manager role so that they can also start grooming? There is a critical point in the number of BU managers a portfolio manager can coach, so that is more of a constraining factor.

How many portfolio managers do they have now?

Definitely in the 10s, if we're talking about portfolio managers by definition. Operating group leaders are five or six. There are several portfolio managers and that is a key part of what Constellation is focused on.

Is it difficult to find someone because of the skills required; you have to be good at M&A and operations or is it lack of willingness of people to go there?

There are few people in this world who are great operators and capital allocators; Warren Buffett is one of them and Mark is definitely another. Most high-level leaders at Constellation have that great balance of being strong capital allocators and operators, which is what makes a great portfolio manager. There are examples at Constellation Software, of people who come from M&A backgrounds or portfolio managers who picked up operational chops, which they typically do by also being the CEO of a BU. That is the way they cut their teeth where they are a portfolio manager but also the CEO of a particular BU, thereby picking up operational skills. They are smart and probably come from consulting or private equity backgrounds and have dealt with operations to a certain level.

It is one thing to do that from that perspective versus actually running one. Once they cut their teeth, they can coach other BU leaders on the capital allocation and operation sides. Some BU leaders show signs of being good capital allocators, and there is a structured process on how everyone cuts their teeth. BU leaders make that first or second acquisition that gives them an opportunity to see what M&A is like. They are supported by head office during these times but participate in strategic capital allocation, so it's an opportunity to gauge their ability to deploy capital and drive deals. The cream of the crop within BU managers have got both the willingness and capability to do that, and rise up to become portfolio managers. There are some who are great but don't want to do it and are happy running their business unit because they are operators at heart. In some cases, it might be willingness where a BU leader simply doesn't want to go down the capital allocation route or they are okay doing it for a while but are happy with four business units.

You talked about how I would be surprised at how many VMS businesses there are in North America; do you have much familiarity of other markets?

Without getting into specific numbers, the market outside of North America is large and there are many opportunities. Where the market for CSI North America was 10 years ago, is where the market is today in Latin America and Europe. With TSS and Topicus, the opportunity was substantial enough where that was warranted. There is a strong opportunity in Asia Pacific as well as in Latin America, where there are businesses which were founded several years ago and where owners are looking at succession or have reached the point where they are looking for new ownership and don't want private equity or VC. They are looking for a home where they can continue to run and scale their business, but have the support to scale in a different way and, potentially, be strategic capital allocators.

Most operating groups today have leadership far and wide. The operating group I was part of had leadership in Latin America, Australia and Asia. We had portfolio managers who were overseeing multiple BUs and are now seasoned capital allocators in each of those geographies, to the extent where they are grooming their BU leaders to expand. Constellation will be constrained by some nuances in new geographies, in not just capacity but how deals are done. In certain countries, the deal cycle is simply longer by nature, so they will grapple with that.

How about competition?

Constellation, for the longest time, has been flying under the radar and there was a space that private equity didn't want to touch. Typically, VMS businesses are not great for VC, given you are looking at very pointed TAM. Competition, over time, has been picking up, whether that be in the form of copy cats in North America or mid-market private equity funds looking at the Constellation play and trying to get in there, and also as Constellation looks at larger acquisitions.

I'm sure you're aware of Mark and his thinking on hurdle rates around larger acquisitions and a bit of a push to do that. You will find more heightened competition in those areas but the unique value proposition for Constellation is the structure and how it operates. But they will not compete on valuation and outbid a private equity competitor simply to win a deal; that rarely happens. Constellation would likely win that deal because the founder or the owner doesn't want to go down the private equity route, and that's where a lot of the selling on the M&A happens; where you have a founder who is on the fence and is interested in a financial pay off from private equity. That is when we invite them to those off-sites to give them a flavor for the culture and show them it will be worth it in the long term. Competition will increase for Constellation as it expands and looks at more product mandates.

What are some of the risks in the M&A process that you can talk about?

The key risk is that the M&A engine at Constellation is structured and disciplined, and the flip side to that is that certain deals require creative ways of looking at valuation or creative time lines. The business is disciplined which sometimes comes at a cost to speed and, potentially, requiring a lot of socialization to push an atypical Constellation deal. As someone who was doing some of this, I felt it was a bit of a bottleneck or a risk.

In my mind, the bigger risk on the M&A engine is more on the operating side of finding those leaders who are able to govern and groom these business units and apply the Constellation play book. As much as there is rigor and structure around learning and best practices, you need BU leaders and portfolio managers to run those. To me, it's about how quickly Constellation can scale portfolio managers – maybe not at the same quality as Mark Leonard, but close enough to where the model still worked – which is the more constraining variable and bottle neck for Constellation in the confines of M&A.

How do these VMS businesses die? We know they're such good businesses with sticky customers and usually dominate some niche, but what can go wrong?

A foundational assumption in the investing model of VMS businesses is that they go after small markets which are highly specialized and mission critical to the customer base. Net revenue retention and customer retention are extremely important metrics and Constellation gauges what retention looks like over a long period of time, but retention is only good until you lose that first customer. The VMS space was under the radar and Constellation get very nuanced in vertical market software right, not only banking software. One risk is that if you aren't continuing to innovate and make your product mission critical – which is a tough balancing act to do while trying to maintain strong margins – when there's a new entrant in the space, then that is where the model might break. Again, there are strong barriers to entry, but if they are backed by VCs or growth equity that is willing to throw money at a problem at the cost of profitability, you can see some churn.

Managing churn is extremely important in these businesses and there are some rare instances where a VMS business might lose two or three customers, either because they didn't get an update or there a different dynamic is in play or the vertical is hurting in certain situations. In those situations, if you lose a decent cohort of sticky customers, the model automatically breaks, because even new customer acquisition is very focused and pointed and is highly profitable. Constellation will not accelerate new customer acquisition for the sake of growth so stickiness is a risk factor. Many portfolio managers and BU leaders spend their time talking to those individual top customers, really understanding the business, which is why vertical expertise really matters in this game. Their understanding of that vertical is specifically important to be able to protect down side risk on this problem around retention and actual mission criticality.

One criticism is, if you were going to be bearish on Constellation you would say they are getting all these little tiny software companies and the terminal value is questionable, but so far that hasn't been the case and they've been very durable little businesses, do you think the business will be around a long time or are they vulnerable on some terminal value?

These are durable businesses because that is a very critical diligence factor. Some businesses do see downturns and the space can change, but Constellation takes a long-term view with some of these vertical market software players than most other investors. The risk of taking a long-term view is that you could, potentially, be wrong in the outer years, which has not played out and you can see it in terms of Constellation's performance. There are few outliers who have under-performed and given the periodic nature of running acquisition reviews and learnings, if something is or tending to be a problem, it is usually caught quickly.

There is a strategic initiative or a plan in place to mitigate that, so the learning process is also sometimes a discover process as well, not just with the post-acquisition review. If a portfolio manager or BU hasn't contributed to a learning for a long time, that also might be an impetus or trigger to participate and see what learnings we can garner to also govern the business. In some areas in Constellation, there are businesses which are declining over the longer term. These are some of the very earlier cohorts, but on Constellation's model, those businesses are likely also rolling up and stacking up other BUs and driving inorganic growth.

I'm sure some they bought knowing they would decline, is that possible?

I wouldn't say it's as private equity like, where it's purely returns. At the end of the day, Constellation is about buying resilient high quality vertical market software businesses. I don’t think the company would buy a business that everybody knows will not work out, but it makes a great financial return so they can leverage on it and squeeze in IRR. Constellation simply do not operate that way, but there are certain businesses where, over time, everyone understands they are likely in decline and there is, typically, a good migration and growth path in place on what the successful business units would look like which would stack on top of that, that can then start to become the flagship brand.

What lessons did you learn on how to run an M&A program in the VMS space? Is there anything top of mind you want to share that we haven't talked about?

This balance between investing and operating is so real. Warren Buffett said it once, which is why he is such a great investor and operator. You become a better investor if you're a good operator and you become a good operator if you're a good investor. They go hand in hand and are not two separate sides of the house. That is codified in the portfolio managers at Constellation Software. When I step back outside of CSI and think about vertical market software investing, finding the balance of capital allocation and operational expertise is critical, which is why Constellation sometimes wins out.

Being on the other side you can quickly tell if the private equity firm or investors you are talking to understand your business or domain. There is benefit to having deep domain expertise. In the investing role, lessons do help in how to better run businesses, especially if you are exposed to multiple businesses and get best practices that way as well. When you diligence 10 acquisitions, you get some insights so I think vertical market software is interesting because it requires a unique set of skill sets. It requires you to understand both how a good software business functions and the end market.

Software for golf clubs is unique and you have to understand how golf clubs function, which may not be as easy as it seems on the surface. At the same time, you have to have the insight to be able to understand software businesses. VMS businesses, from that perspective, have barriers to entry both from an investing and learning perspective. These are unique businesses that require time and effort to learn, but from an economic structure are great businesses; high retention, low churn and the potential for high margins. Even in the world of SaaS, there is a move towards verticalization and the solutions are getting vertical specific. Looking at investing both those in operating and investing exercise is the biggest take away from my time at Constellation, which I don't think you would see if you were only in the investing world.

That is a good note to end it.

Yes it really is.