If ants could speak, they would do so in the first-person plural.
We will carry this leaf.
We will eat this crumb.
We will burrow this hole.
Life in the order Hymenoptera is a social one, with identity and endeavor consolidated at the collective rather than individual level. The ant as a solitary being effectively doesn't exist. Instead, it's part of a larger entity, a cell in a vast superorganism.
Coined by Darwin contemporary Herbert Spencer (author of the expression "survival of the fittest"), the term "superorganism" has progressed from a hazy term referring to the emergent behavior of groups to an increasingly concrete classifier of creatures composed of a plurality.
The coral reef is a superorganism; so too, the cloud of bees or swarm of ants. These miniature cultures' efficacy is remarkable — groupings with as many as 20 million members coordinate to undertake projects in pursuit of the collective good, creating dwellings, finding food, or warding off predators. Divisions of labor are encoded biologically and communicated chemically. While there's undoubtedly a hierarchy — with queens at the apex — there's considerable distribution, with divisions undertaking different campaigns.
In its sprawl, unique take on decentralization, and talent for making the chaotic look concerted, Constellation (CSI) is truly software's superorganism. Even more of an "anti-conglomerate" than IAC, CSI has perfected the art of acquisition. In the process, CEO Mark Leonard has created a generational compounder that may yet have room to run.
In today's briefing, we'll discuss:
- Mark Leonard and CSI's origins
- How Constellation acquires growth
- The company's laissez-faire approach to management
- A rare form of defensibility
- An evolving organism
The maverick capitalist
If you dropped a venture capitalist into a vat of nuclear waste, you might end up with someone like Mark Leonard.
An imposing 6" 5, Leonard sports a beard somewhere between Gandalf and ZZ Top's Billy Gibbons with a stern, owl-like brow that would have made Brezhnev blush. Behind the formidable exterior is one of the most articulate investing minds of his generation.
The paucity of biographical information about Leonard only adds to the shabby mystique of a man colleagues described as "probably the most intensely private individual in IT."
With an accent alternatingly attributed to England and South Africa, no one seems quite sure when (or from where) Leonard emigrated to Canada.
What is known is that Leonard received a BSc from the University of Guelph and an MBA from Western University in Ontario. Before founding Constellation, Leonard reportedly spent 11 years in traditional venture capital, though only after stints working "a banker, valuator, mason, gravedigger, dog handler, bouncer, sapper, and wind energy researcher."
These tidbits bolster the image of early Leonard as a budding capitalistic iconoclast: knowledgeable enough to understand the game but eclectic enough to pervert it. As the story goes, Leonard found the morays of traditional venture capital frustrating, particularly irritated by the industry's unflinching focus on companies operating in large addressable markets.
He had seen plenty of great businesses operating in niche spaces — while they didn't have the upside potential of a traditional venture investment, these were still solid companies. Notably, these enterprises often faced minimal competition because they were tackling a smaller space; big horizontal platforms like Microsoft weren't about to fritter resources building bespoke solutions for marina operators or golf course owners.
Leonard found vertical market software (VMS) — software attacking specific markets like marina management — especially interesting. Businesses in the space were typically high gross margin and sticky, selling mission-critical software imbricated in a buyer's operations.
Leonard decided it was time to create a different kind of investment firm. With $25 million from OMERS and his old venture colleagues, Leonard started Constellation Software in 1995. The goal was simple to articulate but difficult to execute: become the best buyer of VMS businesses in the world.
Eleven years after its founding, Constellation listed on the Toronto Stock Exchange. (Somewhat confusingly, its ticker is $CSU, not CSI.) At the time, the budding conglomerate was valued at roughly $70 million. In the years since, CSI's stock price has appreciated over 7,000%, with the company's fundamental metrics (EBITDA, for example) reliably compounding 30% per year.
That surge has been achieved in unorthodox fashion, at least compared to most. Though individual properties have experienced some organic growth (between 2-5% per annum), the preponderance of CSI's rise has been managed through acquisitions.
Though Constellation has shown some flexibility, by and large, the company acquires small VMS players, with an average price of $2-4 million (some suggest the number is closer to $5 million). On its website, CSI outlines a few rough preferences for businesses it buys:
- A mid-to-large-sized vertical market software company (a minimum of $1-million earnings before interest and tax)
- Consistent earnings and growth — generally EBITDA/revenue + revenue growth of 20 percent or more per year
- Experienced and committed management
- An offering price that has been determined
Since its inception, Constellation has acquired more than 500 VMS businesses spanning over 75 verticals from digital marketing to manufacturing, library management to yachting.
That's been achieved through a virtuous cashflow cycle. The VMS providers Constellation acquires tend to consistently generate funds, which gives the parent company meaningful free cash flow. Constellation uses this to acquire more VMS businesses, subsequently generating even more free cash flow. The efficiency of that flywheel — along with the conglomerate's exceptional picking record — has resulted in a dizzying collection of software businesses; more frenzied ant colony than beatific constellation.
This raises a natural question: how does Constellation manage this software infestation?
There are two answers, both correct, though one is more meaningful than the other.
Structurally, Constellation is composed of a head office which overseas six "Operating Groups" (OGs): Volaris, Harris, Jonas, Vela, Perseus, and Topicus.
As Leonard noted in response to a shareholder question, each of these OGs is essentially miniature Constellation, "the equivalent of what CSI was ten years ago (plus or minus three years)."
That means that each OG essentially serves as a holding company for dozens of underlying software companies. While there appears to be some degree of specialization among these different groups, each OG is ultimately a mishmash of verticalized offerings. Arguably, Topicus is the most focused given its concentration on European companies. (Notably, it's also the only OG that operates independently, having spun out from CSI earlier this year.)
This is the first answer to our question about Constellation's management. It's a response that shows the inadequacy of responding to a philosophical question with a structural riposte. In doing so, we outline the shape of the superorganism without garnering any insight as to how it really operates.
Management by abdication
So, let us ask the quesion again: how does Constellation successfully manage +500 software companies?
That is the truer answer.
In one of his absurdly pleasurable Annual Letters, Leonard outlines the counterintuitive tao that undergirds Constellation's management:
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 (first discussed in the 2010 Letter to Shareholders) seems to have worked so far.
This is an unorthodox approach, even among many "high-performing conglomerates" (HPCs). Take, for example, IAC. Even as a relatively hands-off holding company, the Barry Diller shop still actively bundles related businesses to harvest various synergies. For example, IAC gobbled up dozens of dating apps to bolster its original flagship in the space, Match.
Constellation takes the opposite tack. In its laissez-faire attitude, CSI recalls Paul Rudd's chilled out surfer-dude in the still underrated Forgetting Sarah Marshall. Trying to teach Jason Segel's uncoordinated protagonist how to mount a board for the first time, Rudd's instructor offers a koan, brilliant in its idiocy:
Don't do anything. Don't try to surf, don't do it! The less you do, the more you do.
Rather than stumbling into an insight, CSI's position is the result of organizational study and pragmatism. Leonard is a firm believer that autonomy produces better results and motivates employees.
One of the fundamental beliefs at CSI, is that autonomy motivates people, and bureaucracy does the opposite, so we try to do as many of the important monitoring tasks with as light a touch as possible.
Functionally, that means Constellation is constantly trying to push decision-making downstream and keep head office's influence and headcount limited. As noted in a previous quote, HQ's role is essentially limited to defining a few cardinal rules (the necessary hurdle rate for investments, for example) and coaching. That leaves management of Operating Groups in the hands of GMs. These divisional leaders are permitted to greenlight M&A deals up to $20 million, 4-5x the average deal size. VMS companies themselves typically remain in the hands of legacy management, with CSI intervening only to provide best practices and share company-wide performance data (Leonard enjoys creating competition between units).
It feels almost perverse that CSI's permissive philosophy works so well. More than almost any other company, Constellation has discovered how to do more by doing less.
Moats and mirages
The most seductive folly is to believe that one's business is defensible through culture.
How could anyone do what we have done? the dreamswept CEO wonders in disbelief. Sure, some copycat might ape our logo, pilfer our pricing, and filch our feature set, but no one can be us.
In both its vanity and ineffability, this is one of corporate strategy's most delightful mirages, as compelling as it is unfalsifiable. Leonard would seem to share that cynicism, as noted in response to a shareholder:
I'm leery of corporate culture. The popular business press has touted it as a tool to improve corporate performance for decades. I find it a fuzzy concept (values, beliefs, and?) and a bit threatening. Actively promoting "correct corporate culture" has vague overtones of brainwashing and the cult‐like expectation of acquiescence. I won't accept a set of values and beliefs that are foisted upon me, and I would not expect others to accept them, either.
And yet, despite Leonard's suspicion, CSI is one of the few businesses defensible through its culture. In this rarest of cases, what looks like a mirage is, in fact, a moat.
In part, that's due to the fact that Constellation is a true superorganism — a being that can hold multitudes within itself.
I think we have lots of different sub‐cultures and more than our share of heretics at CSI. Some of these sub‐cultures will thrive, and some will fail. The cultures that are successful are likely to propagate their values and beliefs by example and by selection. With that sort of evolutionary process at play, my sense is that we don't need to be preaching corporate culture from head office.
As with management, CSI excels through restraint, allowing culture to emerge rather than delivering a prescription. Beyond its commitment to autonomy, two other traits define Constellationo: long-term thinking and meritocratic governance.
The very premise of CSI is that focusing on the long-term creates a meaningfully different ownership environment. Unlike the private equity firms with which the company competes, Constellation buys VMS businesses to hold rather than sell. Without the necessity of scoring a quick mark-up, Constellation can manage patiently, letting the existing team helm the ship rather than intervening to aggressively cutting costs.
This philosophy is also expressed at the Board level. Leonard spends much of his 2017 letter discussing the inanity of Director term limits. In particular, he focuses on the importance of experience in Board members being able to deliver actual "coaching" to Constellation, rather than helping with the "table stakes" tasks of governance.
We believe that when you limit a competent Director's term, you limit their opportunity to learn and hence to add value… Our outside Directors spend about 30 hours in board meetings each year, and let's assume preparation time doubles that. For an especially engaged Director, committees, special projects, and extra-curricular Constellation-related activities might drive their time with us up to 200 hours per year. At 200 hours per year, and if you believe the 10,000 hour rule, then this especially engaged Director needs to put in 50 years on the job to offer deeply contextual expert level coaching.
Some prospective Directors don't have the appetite or incentive to invest 10,000 hours to make the transition from a monitoring/governing role to a coaching/nurturing role. Most prospective Directors are simply too old to make that journey. Unfortunately, that means that the default role for most Directors is as a governor, not a mentor. Some investors find that acceptable. I'd argue that governing is table stakes.
Coaching and talent nurturing are the places where Directors can make a significant contribution and help a company become part of Bessembinder's 4% [those companies that have created all market returns in excess of one-month T-Bills over the past 90 years].
Simple math suggests that if a Director is not from the industry or the company, then they have no hope of coaching and nurturing unless they start in the Director job when they are young. Ideally, we'd like to get them in their 40's or 50's and keep them for 30 or 40 years or until their health deteriorates. We certainly don't want to kick them out after they've served for 10 years.
When spelled out so articulately, Leonard's point seems obvious. But it runs counter to the practice of many Boards, particularly when pressured to make changes. Constellation's unwavering stance is a testament to its focus.
In addition to impacting company owners and Board Members, this long-term thinking is a crucial piece of how Constellation treats its employees. In that respect, it intersects with the third critical characteristic of CSI: its commitment to a meritocratic approach.
Leonard wants his employees to stay for a long time. To achieve that, he compensates them well, requires bonuses to be redirected into stock, and provides a clear pathway for advancement.
As of 2015, CSI reportedly had over 100 employee millionaires, with Leonard noting his intention to bring that figure to 500 over the succeeding decade. Much of that wealth has likely been accumulated through Constellation's stock. Depending on their seniority, employees are required to deploy a portion to buy $CSU, up to 75%. This is an impactful move on many levels:
- First, it ensures Constellation has a class of knowledgeable shareholders that invest more than just money into the business.
- Second, it formalizes employees as owners, positioning them as long-term holders.
- Thirdly, it aligns the constituents of discrete business units with the performance of the parent company. Given the autonomy individual companies have, it would be easy for factions to arise or empire-building to occur. This move ensures each group is incentivized to pull in the same direction.
Beyond ample compensation, Constellation lays out an explicit career path for its employees, starting as an employee, before ascending through the ranks to reach "Compounder" status. Leonard outlines this trajectory in his 2018 letter:
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...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 [Business Units]. Whatever vertical you end up in, that specialisation, that focus, will require a multi-year effort to build a trusted network of employees, customers, other industry participants, and even competitors...Become a master Craftsman in the art of managing your VMS business. It is the most satisfying job in Constellation and will generate more than enough wealth for you to live very comfortably and provide for your family.
For those whose ambition exceeds their good sense, we have a role that we call a Player/Coach. A Player/Coach continues to run their BU, but ambition drives them to acquire a sizable business, usually in another geography or another vertical...The BU manager for the newly acquired business is nearly always from the acquisition itself, and hence has deep expertise in the vertical. Should the Player/Coach find a second or third stand-alone business to acquire, they eventually have to give up the day to day responsibilities for running their original BU and become a full-time Portfolio Manager ("PM"). If the PM is good at finding acquisitions, and helping them learn relevant best practices, and continues to deploy at least the FCF produced by their portfolio, then we refer to them as a Compounder.
The clarity around Constellation's different roles and what it takes to attain them is undoubtedly part of the reason Leonard considers his company "as close to a meritocracy as I have experienced."
The organism evolves
About a minute and a half into Logic's "Alright," a slow burn of a track punctuated by the rapper's triple-time wordplay, Big Sean arrives with a line that might speak to Mark Leonard.
Got Champagne problems/ And I order more
Like Kanye complaining about the comfort of his mink bedding ("Fur pillows are actually hard to sleep on"), Constellation has the most privileged of problems: too much money. And like Big Sean, they keep compounding the issue by accumulating more.
While that wouldn't be an issue for many companies, it is for Constellation because of their model. As we discussed, growth relies on acquisitions. It's relatively easy to deploy $100 million by purchasing 20 strong VMS businesses for $5 million apiece, but what do you do when you have $1 billion to invest?
This is the challenge that CSI faces and is in the midst of grappling with. To date, the company has addressed the matter of excess funds by distributing shareholder dividends, but this represents a short-term solution that doesn't allow the company to capitalize on its enviable position.
As part of its next evolution, Constellation is considering changes that should allow it to deploy more capital:
- Lowering its hurdle rate for new investments
- Acquiring larger companies
- Moving beyond VMS
By lowering its hurdle rate, Constellation expands the universe of potential acquisitions. That comes at a cost, namely, the rate of return for the entire portfolio. Leonard outlines both bull and bear case in his most recent letter:
One of our directors has been calling me irresponsible for years. His thesis goes like this: CSI can invest capital more effectively than the vast majority of CSI's shareholders, hence we should stop paying dividends and invest all of the cash that we produce, even if it means lowering our hurdle rates.
I used to argue that we needed to maintain our hurdle rates because dropping them for a few marginal capital deployments would cause the returns on our entire portfolio to drop.
As Leonard goes on to note, he has changed his opinion on the matter, opening CSI up to making lower hurdle rate investments. In concert with that decision is CSI's move to start acquiring larger companies, at a more regular clip.
Constellation has done this rarely, acquiring Total Specific Solutions (TSS) for €240 million in 2013, followed by Topicus for €217 million in 2020. (Constellation subsequently merged the companies, spinning them out under the "Topicus" name.)
This expanding practice may have an interesting effect on Constellation's business. In an excellent, detailed dissection of Constellation, writer "The 10th Man" highlights that these larger acquisitions are likely to have higher organic growth rates thanks to their positioning in larger markets that have more room within which to grow. This was true of both TSS and Topicus. As a result, acquisitions of this type should elevate CSI's overall organic expansion.
Finally, and most intriguingly, Constellation is embarking on a voyage of discovery. As Leonard noted, the company is looking to expand its practice beyond VMS:
In parallel with our established and growing small and mid-sized VMS practise and our nascent large VMS practise, we are trying to develop a new circle of competence. We are seeking attractive returns, a sustainable advantage, and the ability to deploy large amounts of capital outside of VMS. That will require highly contrarian thinking and is likely to be uncomfortable in the early going. Hopefully, we have built enough credibility to warrant your patience as we explore new and under-appreciated sectors.
What might this look like? Could the VMS-focused company start to move into horizontal applications? Could Constellation expand its practice into verticalized marketplaces or mobile apps?
As the company looks for its next act, it may become an even more multitudinous entity as one division hunts big game in its existing market, while the other forages further afield.
Leonard has a habit of ending his annual letters with a quote, a book recommendation, or both. In 2018, he finished with a line from Stanford Professor Jeffrey Pfeffer:
You can't be normal and expect abnormal results.
In almost every respect, Constellation Software is an abnormal business. Founded by a disgruntled gravedigger-turned-venture-capitalist, Constellation is a PE firm that never exits, a compounder that buys its growth, a fine-tuned conglomerate with minimal management, and a culturally defensible business skeptical of the very notion. More than a company, it is a teeming ecosystem of entities, each with distinct personalities and ambitions. And yet, each element serves to help the whole thrive.
As the company embarks upon a new era, few will want to bet against the superorganism's ability to evolve and meet its challenges.
The Generalist’s work is provided for informational purposes only and should not be construed as legal, business, investment, or tax advice. You should always do your own research and consult advisors on these subjects. Our work may feature entities in which Generalist Capital, LLC or the author has invested.