Mark Leonard's Constellation Software Inc. (CSI): The Great Serial Acquirer

Mark Leonard's unwavering commitment to high standards and long-term value creation has defied market expectations, delivering a 19,680% return to shareholders since its IPO in 2006.

Sep 20, 2024

I really admire Mark Leonard, the founder and president of Constellation Software. We share a similar background, having both spent time in venture capital before transitioning to a different investing approach. Leonard truly revolutionized the concept of serial acquirer and continues to follow that path today. Yet, not many news outlets or mainstream media did a cover about him.

Mark Leonard (Constellation Software) Operating Manual · Colin Keeley — Mark Leonard (Constellation Software). Source: Colin Keeley

I. Background

Mark Leonard is an intriguing character, a billionaire who remains largely unknown except through his insightful shareholder letters. There are few photos of him, and he has never given an interview (some said he took an interview once, but then the link has been taken down ever since). Since its IPO in 2006, Constellation Software's share price has skyrocketed, delivering impressive returns. The company's historical return on invested capital (ROIC) has also been exceptional, consistently exceeding 30%. If you had invested $1,000 in CSI’s IPO in 2006, held onto your shares, and reinvested the dividends, you would have over $190,000 as of 2024.

Leonard's brilliance lies in his contrarian approach. He started Constellation in 1995 and penned annual letters to shareholders until 2018 when he fell silent as others tried to emulate his strategy.

"For competitive reasons, we are limiting the information that we disclose about our acquisition activity. We believe that sharing our tactics and best practices with a host of Constellation emulators is not in our best interest. We have discussed the matter with many of the large Constellation shareholders, all of whom (despite grumbling) eventually agreed."
- Mark Leonard, Shareholder Letter 2018

His journey began in venture capital, Venture West, where he worked for 11 years. At Venture West, Leonard met his mentor, Steve Scotchmer, who instilled in him the importance of seeking high-quality businesses. Leonard recognized the value of Vertical Market Software (VMS) companies. He challenged the traditional venture capital model, which often prioritizes short-term gains. Instead, influenced by legendary investors like Warren Buffett and Charlie Munger, he focused on the long term.

Like Microsoft's offerings, horizontal software can be applied across various industries. VMS, on the other hand, caters to niche markets with healthy profit margins. While highly fragmented and requiring strong customer relationships and customization, VMS solutions create a competitive advantage and increase switching costs for customers, resulting in long-term loyalty.

Topicus was spun out from CSI in 2021. Source: CompoundingQuality.net

Leonard's writings in the shareholder letter highlighted the high switching costs associated with VMS. Owner-operators (or founders of the business who also run the company) often prioritize immediate decision-making and are hesitant to invest the time and effort required to switch software providers, even if it might lead to long-term benefits.

Recognizing this, Leonard saw an opportunity. While venture capitalists often focus on short-term gains by preparing their portfolio companies for IPOs or acquisitions, he was drawn to the enduring nature of VMS businesses. He envisioned acquiring these companies and building a holding company where the free cash flow generated by each VMS would fuel further acquisitions.

This strategy is remarkable because Constellation can generate impressive returns on invested capital through acquiring these VMS companies. Venture capitalists, who prioritize quick exits, cannot pursue this approach due to their different mandate. In comparison, Private Equity faces limitations in fund life and perceives VMS businesses as too small to engage with (for instance, the average transaction value of Constellation Software has been $5 million or less).

II. Lessons Learned

In this post, I will share my notes when learning about Mark Leonard investing principles from his shareholder letter and I will not share my thoughts on CS (I will share in my future post).

1. Focus on long terms

Our objective is to be a great perpetual owner of VMS businesses. We like VMS businesses because they are asset-light, have robust moats, and attract the sort of managers and employees with whom we enjoy working.                   
- Mark Leonard, Shareholder Letter 2018

As an experienced venture capitalist, I was initially puzzled by Leonard’s view that a long-term investment horizon was the key to success. He had even spent more than 10 years at Venture West, so he must know how different the investment pace could be for each investment vehicle. However, after delving into CSI's business model as a serial acquirer, it all clicked. Flipping investments quickly simply wouldn't allow them to fully capitalize on their acquisitions.

Leonard's admiration for investing legends like Warren Buffett and Charlie Munger further cements his commitment to holding onto his companies. He even expressed regret over selling one business, underscoring his dedication to building a lasting legacy.

This long-term vision even extends to his choice of board members. Leonard seeks individuals committed to the long haul, prioritizing experience and learning over short-term gains. It's a bold move in a world obsessed with quick turnarounds, but it's a strategy that shields CSI from the pressures of Wall Street and allows them to focus on sustainable growth.

We recently received another challenge to our board practices. This time a significant shareholder (holding hundreds of thousands of Constellation’s shares) expressed concern about extended board tenures and a preference for "board refreshment". They proposed that we consider limiting board tenure
to 10 years. I appreciated them consulting with us directly, rather than just putting it on the ballot as a shareholder proposal. I thought I'd respond to them as part of this letter so that all shareholders can see how we think about Director selection and tenure. We believe that when you limit a competent Director’s term, you limit their opportunity to learn and
hence to add value.
- Mark Leonard, Shareholder Letter 2018

He then went on to explain that experience in the firm is needed, drawing from a theory coined by Malcolm Gladwell in his book Outliers, the 10,000-hour rule, which posits that deliberate practice is necessary to become an expert.

2. Preferring owner-operator businesses and distressed assets

Our favourite and most frequent acquisitions are the businesses that we buy from founders. 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 CSI, and most of the ones that we buy, operate as standalone business units
managed by their existing managers under the CSI umbrella. 
- Mark Leonard, Shareholder Letter 2013

Mark Leonard's acquisition strategy is built on two key preferences: acquiring businesses from owner-operators and targeting distressed assets. He is drawn to owner-operator businesses for several reasons. First, these businesses often have a strong, established culture of success cultivated by the owner's years of experience and dedication. This aligns with Leonard's goal of acquiring companies that are already primed for growth. Second, owner-operators bring invaluable hands-on expertise and deep understanding of their business operations. This allows Leonard to maintain his decentralized management philosophy, where the acquired company continues to be run by its experienced leadership team, ensuring business continuity and fostering organic growth. CSI provides support as needed, but the focus remains on empowering the existing management to drive success.

The most lucrative acquisitions for us have been distressed assets. 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. 
- Mark Leonard, Shareholder Letter 2013

Leonard also sees significant opportunities in acquiring distressed assets - companies grappling with financial or operational challenges. These could include difficulties like mounting debt, unpaid customer invoices, or ineffective cash flow management. Such situations can create attractive buying opportunities, as these companies may be undervalued or eager to find a buyer who can help them overcome their challenges. Sometimes, even large corporations divest from software businesses that fail to meet expectations or create cultural clashes within the organization. These divestitures present another potential source of undervalued assets for CSI to acquire.

3. Keeping himself grounded

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. 
- Mark Leonard, Shareholder Letter 2015

So far, none of the funds that have a similar approach to CSI (like Thoma Bravo and Vista), none of the presidents have had a president who did this. The fact that he did this amazes me. He is taking no salary and no executive compensation. He knows how to manage investor expectations by underpromising and overdelivering, and he also limits himself from making excessive acquisitions that yield low returns.

4. Unconventional approach to debt financing

That led us back into a dialog with our investment bankers. They began to understand what we wanted: a very long-term instrument that we could issue in tranches whenever we needed, that was liquid and would trade at close to intrinsic value at all times so that our investors could get liquidity without taking a haircut, that was tax deductible for CSI as we expect to otherwise pay lots of cash tax, and that can be redeemed by CSI with reasonable amounts of notice if we are producing more cash than we can intelligently invest elsewhere. I’ll refer to this as a Non-Traditional Instrument or “NTI”. The novelty of the NTI was still a concern to the investment banks, but they felt that they could overcome that and sell it to retail investors if the yield were sufficiently high and the transaction fees sufficiently large. Once the first tranche of the NTI was sold, there would be a precedent trading in the market, and the investment bankers felt that the terms of subsequent NTI issues would likely be more attractive to CSI. 
- Mark Leonard, Shareholder Letter 2014

This is interesting. CSI does not like common debt terms because they consider it too expensive. Even though it could increase their return, they are more interested in finding lenders who appreciate being a long-term partner with CSI. Therefore, Mark Leonard approached investment banks to discuss the possibility of issuing a new instrument called a Non-Traditional Instrument (NTI). This is a long-term debt that can be issued in tranches whenever CSI needs it. It is also liquid and would trade at close to its intrinsic value. Additionally, it is non-callable. While I have never heard of such an instrument, I applaud Mark Leonard's ingenuity in finding the best debt instrument that fits his style. He does not conform to norms and is always ready to come up with innovative solutions, in this case, an innovative financing solution. It would be hard to imagine if there would be a demand for such an investment, but if there is, at least Leonard has tried to gauge the interest from the bankers.

5. Prioritizing shareholders and avoiding dilution

I got this from a management Q&A with CSI where Leonard answered investors' questions that CSI received through email. When investors asked about his biggest failure, Leonard responded that his biggest failure was when they raised too much capital. While I could see why this might trouble him because of the scale of acquisitions, where acquiring larger VMS will pull down his IRR, his second point is worth noting. He worried about unnecessary dilution that applied to employee shareholders, people who have worked hard for CSI. He puts his shareholders (both investors and employees) at the highest level and made a bold move by not issuing any new shares when CSI IPO'd in 2006.

6. Embracing decentralization

We count on the fact that with each new acquisition will come general
managers who are steeped in their verticals… veterans who have built industry leading (albeit small) vertical market software businesses with great economics. Having owned more than a hundred vertical market software businesses, we also have some best practices that we can share. We coach the managers of our newly acquired businesses in how to grow their businesses and make them even better. As long as we compensate these managers appropriately, and are not tempted to meddle too much, then I think we can scale up
Constellation for many years to come. 
- Mark Leonard, Shareholder Letter 2010

Certainly, managing a portfolio of over 600 VMS businesses that CSI has acquired would be quite challenging. These businesses not only serve different verticals, but also come from different owner-operator cultures and approaches. The operators may have years of experience, which could make it difficult for them to change and adopt CSI's style. However, Leonard was aware of this issue early on and chose to focus on being a great coach to these managers, compensating them well, and not interfering too much with their businesses. This decentralized approach is suitable for a massive serial acquirer like CSI because forcing a certain culture might create conflicts down the road and be ineffective. Additionally, there is no guarantee that one culture is better than the other. Therefore, CSI limits itself to growing revenue through acquisitions, which in turn generates enough free cash flow to further acquire other VMS.

7. Honesty and transparency: an underrated leadership quality

In the last couple of years, a number of journalists and analysts have hinted that the Constellation Software Inc. (“CSI”) historical performance is too good to be true. They frequently conclude, in the best case, that our performance will revert to the mean. Reversion towards the mean is consistent with what we found for all the HPC’s, 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 Free Cash Flow (“FCF”) that we generate. 
- Mark Leonard, Shareholder Letter 2017

Mark Leonard's commitment to honesty and transparency sets him apart in today's investment landscape. He openly acknowledges challenges and potential headwinds that could impact CSI's stock price, demonstrating a rare level of candor. While the concept of "reverting to the mean" has been a recurring theme in his letters, CSI continues to defy expectations with its exceptional performance and consistent generation of above-average returns on invested capital (ROIC).

Leonard's willingness to address potential risks head-on, rather than hiding them, fosters trust and confidence among investors. In a world where transparency is often lacking, this quality is truly invaluable (e.g., Oaktree vs Advent & Silver Lake). It reflects his integrity and dedication to providing shareholders with a clear and accurate picture of the business, even when faced with potential challenges.

8. Long-term value over short-term gains

Ideally, we’d like CSI’s stock price to appreciate in tandem with our fundamental economics. At any point in time, we’d prefer the price to be high enough to discourage a takeover bid and low enough so that our sophisticated long term oriented investors are not tempted to sell. It takes lots of time and effort to attract and educate competent shareholder/partners. The last thing we want them to do, is sell.
If a stock is over-priced and sophisticated investors sell, they are generally replaced by unsophisticated investors who are ultimately disappointed. This may lead to a stock price that over-corrects and in turn precipitate either a takeover bid, or more insidiously, a significant and predatory share buyback.
Buybacks are tempting to management and boards: they tend to improve the lot of managers and insiders, while being applauded by the business press. I think they are frequently a tolerated but inappropriate instance of buying based upon insider information. Instead of shareholders being partners, they become
prey.
- Mark Leonard, Shareholder Letter 2014

Mark Leonard's investment philosophy is deeply rooted in fundamental analysis, echoing the principles championed by Warren Buffett and Charlie Munger. He firmly believes that in the long run, a company's share price will reflect its intrinsic value. However, he recognizes that significant deviations from this value can have detrimental consequences.

If the share price is too low, the company becomes vulnerable to hostile takeovers ("barbarians at the gate"). Conversely, an inflated share price can lead to the loss of loyal shareholders and employees who might be lured away by seemingly more attractive opportunities.

Leonard's commitment to long-term value creation is evident in his openness about CSI's intrinsic value. This transparency aims to attract like-minded investors who share his long-term perspective and are willing to partner with CSI for the journey, rather than short-term traders seeking quick profits. It's a testament to his conviction that a focus on fundamentals and building sustainable value will ultimately lead to lasting success for both the company and its shareholders.

9. Creative performance measurement

When we think about Invested Capital, we think about the shareholder capital that has been invested in the businesses, plus any Adjusted Net Income less any distributions. Obviously, when you divide Adjusted Net Income by Invested Capital, you get a measure of the return on our shareholders’ investment (i.e. ROIC). If you add Organic Net Revenue Growth to ROIC, you get what we believe is a proxy for the annual increase in Shareholders’ value. In a capital intensive business you couldn’t just add Organic Net Revenue Growth to ROIC, because growing revenues would require incremental Invested Capital. In our businesses we can nearly always grow revenues organically without incremental capital. 
- Mark Leonard, Shareholder Letter 2010

Mark Leonard's approach to performance measurement goes beyond traditional metrics, showcasing his creativity and logical thinking. While ROIC (Return on Invested Capital) remains a key indicator of CSI's overall management effectiveness, Leonard advocates for incorporating Adjusted Net Income (ANI) to provide a more comprehensive picture.

ANI, according to Leonard, serves as a valuable proxy for evaluating CSI's portfolio management on an annual basis. This is particularly relevant considering CSI's reliance on acquisitions rather than capital investment to drive net revenue growth. While organic growth might be modest at times, the combination of ANI and ROIC offers a fairer assessment of CSI's overall business performance.

This approach reflects Leonard's commitment to transparency and investor education. He provides clear metrics and explains their rationale, empowering shareholders to make informed decisions.

10. Upholding investing discipline

I recently worked on a large transaction. With every day that passed, I could feel my commitment to the process growing… not because the news was getting better, just because I was spending more time on the prospect. The investment didn’t quite meet our hurdle rate. We were not able to negotiate a structure that got us an extra couple of points of IRR, and the big one got away. The difference between investing and not, was tiny. 
- Mark Leonard, Shareholder Letter 2017

Mark Leonard's commitment to generating high returns on invested capital is unwavering. He adheres strictly to his investment guidelines, even when presented with opportunities that narrowly miss his target hurdle rate. This discipline is not about maximizing his personal compensation, but rather about honoring his promises to investors and upholding his principles.

Even when faced with an investment opportunity that offered returns well above the typical 20% benchmark, but slightly below his own internal targets (which may have been as high as 25% in the past), Leonard chose to walk away. This demonstrates his steadfast commitment to maintaining high standards and avoiding compromises that could jeopardize long-term value creation.

This unwavering adherence to his investment criteria reinforces Leonard's dedication to delivering superior returns for his shareholders. It underscores his integrity and his refusal to sacrifice long-term goals for short-term gains.