Business Lessons from Mark Leonard
Compilation of business lessons
For some time, I had Mark Leonard's shareholder letters on my reading list. I delayed reading them mainly because I had bias regarding Constellation Software valuation and as a matter of fact, I did not have an interest in analysing the company. However, I have recently read them all. In my view, the letters are among the top in the business. Mark Leonard might be the most intellectually honest CEO I have come across. He created immense value for the Constellation Software shareholders. Those reading Berkshire Heathway shareholder letters will enjoy Mark's letters as well.
Mark had an insight 20-25 years ago into how great a business software was. In a nutshell, a lot of insight was about business software companies' pricing power and profit potential. No matter how you look at it, these businesses are sticky. Customers stay for a long time, suggesting both the high switching costs and the real customer loyalty benefits inherent in businesses software.
Mark not only better understands the quality of software companies, but he also capitalised on that insight in a fascinating manner. Based on his insight, he has built Constellation Software into a world-leading consolidator of software companies in a large number of different verticals.
In Q2 of 2006, Constellation became a public company. Revenue during that year was $211 million. In the last twelve months of this year, revenue was $4,814 million – a 23% compound annual growth rate since the IPO. While some of this growth was organic, the majority of it was acquired. Constellation has not issued shares since the IPO, so the acquisitions were financed from the earnings and borrowings. The acquisition approach is pretty much unique but tends to differentiate on a couple of basic themes. First, Constellation is focused on small and mid-sized vertical market software acquisitions. Most of these businesses have big moats and long-tenured employees and customers. Contrary to that, only 10% of the FCF was invested in the large vertical market software companies during its 26-year history.
The most frequent acquisitions are the businesses that Constellation buys from its founders. According to Mark words – “When a founder invests the better part of a lifetime building a business, a long term orientation tends to permeate all aspects of the enterprise: employee selection and development, establishing and building symbiotic customer relationships, and evolving sophisticated product suites. Founder businesses tend to be a very good cultural fit with Constellation, and most of the ones that we buy, operate as standalone business units managed by their existing managers under the Constellation umbrella”.
The most lucrative acquisitions for Constellation have been distressed assets. Again, in Mark's own words – “Sometimes large corporations convince themselves that software businesses on the periphery of their industry would be good acquisitions. Rarely do the anticipated synergies accrue, and frequently the cultural clashes are fierce, so the corporate parent may eventually choose to sell the acquired software business. The lag is often 5 to 10 years as the proponents of the original acquisition usually have to move on before the corporation will spin off the asset. Our most attractive acquisitions from corporate vendors seem to have happened during recessions. Occasionally, we also acquire portfolio companies from a private equity (“PE”) fund that is getting long in the tooth. These will have been well shopped but for some reason will not have attracted a corporate buyer. While both corporate and PE divestitures tend to be much larger than the founder businesses that we buy, they are usually more of a cultural challenge for us post-acquisition”.
There’s nothing like studying many years of a company’s financial statements and filings to form a clear picture of its business and its managers’ values. My findings while reading the shareholders letters from Mark Leonard and analysing the financial data could be grouped into the following areas:
Perpetual owner: “Constellation’s objective is to be a perpetual owner of inherently attractive software businesses. Part of a perpetual owner’s job is to make sure that energetic, intelligent and ethical general managers are running their businesses and that the GM’s are incented to enhance shareholder value over the very long term”.
Long-term value creation: “We believe that long term shareholders will generate a return on their Constellation shares that cannot exceed the sum of long term ROIC plus Organic Net Revenue Growth. We align compensation with this belief, basing our corporate bonus plan upon ROIC and Net Revenue Growth”.
The trade-off between growth and profitability: “The toughest challenge in the software business is intelligently trading off profitability and organic growth. Many entrepreneurs have a huge bias towards growth at the expense of profits. Most private equity owned software firms have the opposite bias. At Constellation we try to find an optimum position where incremental investment still generates good incremental long term returns”.
Favourite business: “Our favourite businesses are those that are growing just slightly faster than their markets, gradually adding market share and customer share (i.e. “share of wallet”), while generating a good return on the capital that they have invested to produce organic growth. Small market share gains are much less likely to trigger a scorched earth competitive response that erodes pricing and triggers wildly unproductive R&D and S&M binges”.
Organic growth: “I believe that optimizing organic growth investment is the single toughest management task in software. It requires a long-term orientation and an intimate understanding of customers and capabilities from our business unit managers… When we study organic growth, there are no easy answers from CSI’s data. We are just as likely to have good organic growth in our small BU’s as in our large ones. We are just as likely to have good profitability in our small BU’s as in our large ones. If you believe that small implies agile and responsive, then the former observation is counterintuitive. If you believe that economies of scale are the primary drivers of profitability in the software business, then the latter observation is counter-intuitive”.
Hurdle rate: “I anticipate that we will deploy larger amounts of capital on investments each year. We are using a lower hurdle rate for larger transactions but have retained our original hurdles for most of our acquisitions. Unless we use increasing amounts of financial leverage, increased acquisition investment and lower hurdle rates on large transactions will likely drive down our future ROIC”.
Strategy notes: “We sometimes acquire a group of businesses in the same market and run them independently. This can lead to duplication of costs but also tends to make for better market coverage, differentiated products and ultimately, higher market share. We have developed some add-on products to share between these BUs and sometimes share administration expenses, but the BU managers are autonomous, compete vigorously with each other, and are held accountable only for their own results”.
“In some verticals, we are not the #1 or #2 player. There are a couple of strategies that we follow in this instance. We obviously try to use our knowledge of the vertical to acquire our way to a leadership position. That sometimes works (e.g. paratransit, mid-tier utilities, equipment rental software, homebuilding software, agricultural software, public housing software). If we are a small market share player and are unable to grow share via acquisition, we target a defensible niche within the overall market where we can differentiate our offering to compete effectively. Sometimes we can grow that niche, sometimes not. In some markets, it may not be economic to compete for new name clients. In that case, your niche has to be the clients that you already have. You target your service, support and add-on products solely at that base, and if the underlying attrition of the industry that you are serving is low, this can be a very good business model”.
High performing companies: “One of the findings from studying the high performing companies was that they followed a multi-decade pattern, with extraordinary returns in asset-light businesses in their early days, followed by a period of attractively priced acquisitions to which they applied their increasingly refined operating practices. Eventually, they drifted towards paying higher multiples for larger acquisitions as they became very large. The high acquisition prices led to declining pre-tax, pre-interest returns on Total Capital. While the average return on Total Capital for the high performing companies still exceeds that of the S&P 500, it is much closer to that benchmark now than it was fifteen years ago… Reversion towards the mean is consistent with what we found for all the high performing companies, so I don’t disagree with their observation. Our goal, however, is to have our return on total capital revert to the mean as slowly as possible, while still deploying most of the FCF that we generate”.
Dividend policy: “Another obvious fix for our cash constraints would be to axe the dividend. The dividend was a tactic, not a strategic move. It broadened the appeal of our stock and thereby helped us find an exit for our PE investors… Eliminating it would disenfranchise a group of shareholders to whom we owe our independence. That wouldn’t sit right with me and many of the senior management team, so I don’t see it happening”.
Board of directors: “The governance problem is well understood, and the tools-du-jour for fixing boards are Director independence, diversity, and term limits. These tools are a great starting point when you are dealing with most public companies. However, when you are dealing with a high-performance company, I don't think governance should be the key role of the board. Governance is still necessary, but it is not sufficient. Helping extend the extraordinary track record of building intrinsic value should be the board's primary function. You are unlikely to achieve that by replacing their proven and obviously very rare Directors and Officers with new ones who are statistically unlikely to have ever experienced anything like consistent high performance”.
“We’ve been searching for great Directors for years. We’ve gone on long campaigns to land individual candidates whom we admire. One observation from those frustrating pursuits is that a lot of high-quality people don’t want to be Directors. They may be intrigued by the company and the managers and the business philosophy. Despite that, the policing responsibility is an unpleasant one, and the prospect of investing a huge amount of time to learn the business and win management’s trust and respect is daunting”.
“The current movement to limit Director tenure (to 10 years) makes great sense if you think your investee company is poorly governed. However, if you think the governance is good, then limiting Director tenure hurts the company. It is analogous to firing a high-performance employee on their tenth anniversary”.
Talent development: “I have a bias towards developing our portfolio managers internally or having them join us via an acquisition. Our best managers have risen through the ranks and developed a following. When they make it to business unit manager, they act like they own their business unit and they stick with it… It starts small. It’s incremental. It’s slow, but over the course of a long career their mastery, satisfaction, wealth and the number of their followers, all compound”.
“A career path for an ambitious employee joining Constellation might be something like this: Immerse yourself in learning about the peculiarities of VMS economics. At some point, transition from analyst or knowledge worker into a leader of people. I find there is no magic to managing and leading. If you are smart, work harder than everyone else around you, treat people fairly, do not ask them to do anything you would not or have not done, share the credit, keep learning and keep teaching, then pretty soon you have followers. If you make sure that the team members are intelligent, energetic, and ethical people with whom you would want to work for the rest of your career, it won’t be long until you are running one of our BU’s”.
Mark’s compensation structure: “Last year I asked the board to reduce my salary to zero and to lower my bonus factor. CSI had a great year, so despite those modifications, my total compensation actually increased. This year I'll take no salary, no incentive compensation, and I am no longer charging any expenses to the company”.
Contrarian mindset: “One of the causes for declining organic revenues is outside of our control: U.S. housing starts declined approximately 28% in Q1 2007 compared to the same period in 2006, and that seems to have depressed spending amongst our homebuilding, construction, and building products related customers. For the most part, we are pleased with how our homebuilding and related businesses have responded to the tougher operating environment. We continue to seek acquisition prospects among software companies that service these currently depressed markets”.
“It’s not like people bring us opportunities, we go looking for opportunities. And when do we go look? We go look when other people aren’t looking… You got to be contrarian to get superior results”.
Culture: “We have a 14 employee head office staff composed primarily of finance, accounting, acquisition, tax and legal personnel. Head office provides the Operating Groups with capital allocation assistance and decisions, and tries to disseminate some best practices, a few clear rules, a bit of coaching, and coughs up the occasional partly trained employee for the Operating Groups. Compliance, investor relations, and handling the finance function round out the head office duties. Whenever we feel stretched at head office, we download more of our work to the Operating Groups. This delegation to the point of abdication philosophy”.
“As perpetual owners, we care about the long-term health of our many small businesses. We try to provide an environment in which they can flourish. The primary way we can do that is by making sure that they have high-quality managers who are compensated according to rational long-term oriented incentive programs. We make sure that BU managers have access to capital when they have opportunities. We try to foster a collegial environment so that best practices are shared”.
“Constellation is as close to a meritocracy as I have experienced. I hope it will continue to provide an environment where entrepreneurs and corporate refugees can invest their lives and their capital and thrive”.
Valuation: “When really good companies start trading at 5- and 6-times revenues, it’s time to start worrying. I hope our shareholders are never in that position”.
To sum up
Mark Leonard has achieved remarkable results since he founded Constellation Software in 1995. His lessons are a masterpiece in value creation and are worth studying for business operators and investors. Even though I don’t own Constellation Software, the sole activity of reading Mark’s letters provides me with new ideas for improving my investing skills.