The Titan of Tech Acquisitions
Unveiling Constellation's Success Strategy
Constellation Software has an interesting story. The company was founded by Mark Leonard in 1995 who later took it public in 2006. Since then, it has increased in value by over 125x and has produced a substantial historic annual return of over 30%. Mark is a true visionary and an intriguing character. Only a handful of photos of Mark are available online, and most of the communication that the public hears from Mark is through his shareholder letters- highly recommend reading these if you want to understand why his investors have so much faith in him.
How did Constellation become arguably the most successful acquirer of software business in the world ?
Mark focused on VMS or vertical market software companies – these were asset light companies with high margins, and recurring sticky revenues. The companies provided services that were critical to customers (clients absolutely need to have access to these services). This also meant that these VMS businesses had deep customer relationships. There was a lot of trust between the company and the client, fostering open channels of communication which allowed the companies to continuously improve their offering(s).
If a competitor entered the scene, it still would not make sense for the clients of these companies to switch due to the involved switching costs. This gave the companies strong pricing powers, especially for smaller customers where owners/operators had to make decisions. These operators had time constraints (the opportunity cost here was losing out on time operating the business) and didn’t want to spend time switching software.
Constellation Software’s acquisition strategy focuses on identifying leading or potentially leading mid- to large-sized vertical market software companies, with a preference for those showcasing at least $1 million in EBIT and consistent profitability and growth. Under Mark Leonard’s leadership, the firm aims for long-term value creation, often choosing to hold onto these businesses indefinitely. While specific acquisition costs vary, Constellation prioritizes businesses that offer significant potential for sustainable growth and operational synergy. Founders often favor partnering with Constellation due to its commitment to preserving the integrity and enhancing the future prospects of their companies. Post-acquisition, Constellation actively works to expand the acquired business, leveraging cross-selling opportunities and implementing best practices, all while maintaining a strong focus on developing a culture of excellence and autonomy within its management teams. This approach ensures that businesses not only integrate smoothly but continue to innovate and lead in their respective markets. Constellation would essentially buy and hold these businesses perpetually, and build long term relationships with managers. Naturally, for this to transpire, Mark L. needed to cultivate a phenomenal company culture
Company Culture
Constellation has a great company culture with a small central office overseeing six autonomous OGs or operating groups. Mark has allowed the company to flourish in an environment where each OG is allowed (and encouraged) to make significant decisions. This decentralized approach allows units to move quickly while also being able to receive support and resources from the broader entity. I have seen this sort of approach being referred to (in other articles and podcasts) as management by abdication. Leonard thinks that this sort of autonomy drives results while also motivating employees.
A notable aspect of this culture is the company’s strategy of making its employees shareholders. There is a policy in place requiring employees to invest a significant portion of their bonuses in company stock. It essentially aligns incentives while also setting subordinate goals for the whole organization.
In 1995, Mark raised an initial $25M to launch the company and then a few years later, he raised another round of capital to diversify the investor base, though he didn’t need that money. He eventually returned some of it via a special dividend. However, the dilution was permanent, and this decision cost shareholders billions in value over the years. Personally, I believe this was not the optimal strategic decision, and I think Mark would agree. Drawing from this experience, Constellation adopts a distinct compensation model: employees receive cash bonuses but are required to invest in common shares on the open market, which are then held in escrow for a set period of time. For executives, this could be as high 75% of the bonus amount.
This strategy essentially aligns incentives while also setting subordinate goals for the whole organization (If you’re curious about how setting subordinate goals can change group dynamics- I recommend looking into psychological research conducted by Muzafer Sherif in the 1950s). By 2015, over 100 Constellation Software employees became millionaires, as a result of the company’s solid stock performance and the policy requiring employees to invest a significant portion of their bonuses in company stock.
In summary, Constellation Software’s success can largely be attributed to its distinctive corporate culture, emphasizing decentralization, autonomy, long-term holding, and meritocracy.
Why VMS
The VMS businesses that Constellation acquired had specialized software solutions deeply integrated into the workflows of their users, making the cost—both financially and operationally—of switching to competitors prohibitively high. This stickiness contributes to impressive customer retention rates. The competitive landscape for VMS is relatively narrow, as the niches these businesses serve are often too small and specific to attract a lot of competitors. This limited competition, combined with the costs required for new entrants to establish a foothold, ensures that established VMS providers enjoy considerable pricing power.
Moreover, the cost of VMS to customers typically represents a very small percentage of their revenue (I’d estimate less than 3% on average), making these solutions both essential and economically viable, often flying under the radar in terms of cost-benefit scrutiny. It is also worth noting that the best-positioned VMS companies are those selling customized solutions to customers with decent-sized budgets.
Furthermore, revenue models for VMS companies, based on upfront licenses, maintenance fees, or subscriptions, ensure a steady stream of recurring income. This financial stability allows VMS businesses to grow sustainably with minimal capital expenditure, generating excess cash flow that can be reinvested into strategic acquisitions. This self-fueling acquisition engine not only drives expansion but also solidifies the VMS provider’s dominance in its vertical markets, creating a cycle of growth and consolidation that is difficult for competitors to disrupt.
Do new software entrants pose a threat?
With the rise of Gen AI, the upfront cost of starting a software company has come down significantly. However, the issue for most businesses that are using VMS is that the switching cost associated with changing out a piece of software that runs your day to day operations is still high- its a painful process and most customers will avoid that as long as their current software gets the job done.
Constellation also continually deepens the moat in all their existing businesses by ensuring the capabilities of the business are up to date, and also by offering highly customized solutions.
Let's talk numbers
Constellation generated consolidated revenues of over $7.9 billion. They have six operating groups (OGs) that service customers in more than 100 different markets worldwide. Their HQ is in Toronto, Canada, and they have a presence in North America, South America, Europe, Australia, and Africa, with over 50,000 employees.
When initially assessed, Constellation appears to miss the Rule of 40 benchmark with its EBITA at roughly 25% and organic growth around 4-5%. However, this perspective shifts when considering stock-based compensation. A podcast I was listening to a few months ago cited a study to explain why Constellation actually surpasses the rule of 40 even though it may not be apparent at first. The study in question was conducted by a Canadian investment bank on 70+ software firms and found that while the median free cash flow margin stood at 15% excluding stock-based compensation, it dropped down to 1% when this compensation was factored in. This adjustment suggests that on a level playing field that accounts for stock-based compensation as a direct cost, Constellation’s financials indeed meet or surpass the Rule of 40’s criteria, indicating a stronger performance than initially apparent.
Another interesting research study that caught my attention was with respect to high performance conglomerates. The study indicated that two out of the 12 highest performing conglomerates in the world are VMS companies (Jack Henry is the other if you’re wondering).
Why don’t people replicate this strategy ?
In 2014, Mark wrote a shareholder letter where he pointed out that the barrier to starting a conglomerate of vertical market software companies is a checkbook and a telephone. Mark is right about a checkbook and a telephone, and to his point – there are a lot of private equity buyers, and copycat firms that have tried. The real accomplishment here is generating consistently high rates of return on dozens, if not more than 100 vertical market software acquisitions every single year. So, what’s Mark’s secret sauce?
The 3-Pronged Acquisition Trident / Mark's Secret Sauce
Discipline
Mark is fundamentally a value investor. He laid the groundwork for Constellation to strictly adhere to hurdle rates (between 20-30% for small and medium sized acquisitions). In his perspective, if you lower the hurdle rates for one acquisition, you’ll bring down the returns on all of the acquisitions to drop. Proposed deals that are even slightly below the hurdle rates don’t get approved!
Data
The second ingredient in the secret sauce is the vast amount of data that is generated from owning 1000+ VMS businesses. Constellation knows exactly what works and what doesn’t within their niche. They have their own base rate that they’ve come up with using their expertise and proprietary data.
What does that mean in practical terms? Let’s say you have a VMS company valued between $5M and $10M with 25-30% EBITA margins and steady growth. Valuing such a business is straightforward—an undergraduate business school student could probably do it. Naturally, a private equity (PE) firm might outbid Constellation for that specific business (remember, CSU doesn’t like overpaying). However, suppose this $5-$10M VMS is operating at breakeven, or maybe the organic growth is not up to par, making it seem less attractive at face value. In this scenario, Constellation may have the advantage because they can review every business they’ve ever acquired, benchmark this breakeven business against those most similar, and use their specialized knowledge to generate insights and determine if the business has potential or how to improve it. For instance, they might find that a hypothetical firm is spending twice as much as necessary on certain business function, based on data accessible only to them, and decide to acquire it. A PE firm with limited experience in VMS deals can’t compete with the same level of conviction.
Entrepreneur Friendly Reputation
Constellation Software is known for nurturing its acquisitions by introducing new products, expanding the business scale, and instilling best practices. Their strategy revolves around buying and holding these companies indefinitely, fostering enduring relationships with their management teams. This approach has earned Constellation an excellent reputation as a haven for entrepreneurs and business owners post-acquisition, distinguishing them from other buyers who might opt for restructuring, cost-cutting, adding leverage, and reselling within a few years. Mirroring the ethos of Berkshire Hathaway, Constellation offers a genuine sanctuary for selling a business that owners deeply value, making it an exceptionally appealing option for entrepreneurs and business owners alike.
My personal take on the future of Vertical SAAS business
In my perspective, the number of Vertical SaaS businesses is going to increase rapidly over the next 12-36 months. Companies previously recognized pain points and built horizontal platforms across industries and business models. Today we see that the S curve has shrunk, and engineering teams can build domain specific solutions using Generative AI in a fraction of the time and cost.
Products that previously took months to develop with millions in funding can now be built in weeks or days. This is allowing startups to build tailor made solutions and solve problems within a specific vertical in a given industry.
These VMS businesses have the same sort of advantages I mentioned in the previous paragraphs but the data advantage of being able to collect and improve their models is even more prevalent today, making these businesses stickier and allowing them to improve over time.