Chapter 154 - Constellation Software Inc.’s President’s Letters
What I learned from Mark Leonard
Today’s Chapter is based on “Constellation Software Inc.’s President’s Letters” by Mark Leonard.
Mark Leonard is the founder and long-time executive of Constellation Software, a Canadian company that acquires and operates niche vertical market software businesses. He is known for a highly decentralized operating model, disciplined capital allocation, and an exceptional long-term track record that has made Constellation one of Canada’s most admired compounders.
Here’s what I learned:
Capital Allocation
“Capital allocation is the CEO’s most important job.”
— William Thorndike
Mark Leonard, the founder and long-time CEO of Constellation Software was a tremendous capital allocator and his insistence on disciplined capital allocation can be clearly shown in his shareholders letters. He repeatedly emphasizes IRR and ROIC as central metrics and explains how Constellation applies hurdles rates, scenario-weighted modeling, and post-acquisition reviews to keep investment decisions rigorous and repeatable. Leonard’s view is quite simple, he understands that his role as a CEO is to measure the returns that matter to shareholders and design incentives and processes so that managers behave accordingly.
As he once wrote, “We use very little capital to grow our business organically. Most of our businesses actually operate with negative tangible net assets. This means that as we grow organically, those businesses consume little or no incremental capital, and may even produce capital in excess of earnings.” By consequence, it is a CEO’s primary job to ensure that this excess capital is put to good use. Leonard mentions that he uses Average Invested Capital metric to evaluate his capital allocation decisions and is quite transparent about it with his shareholders.
“This quarter we would like to begin to explain how we think about capital allocation at Constellation. In the table, we have noted Average Invested Capital. This is a non-GAAP measure that began as an estimate of the amount of money that our shareholders had invested in Constellation. Subsequent to that estimate, each period we have kept a running tally, adding Adjusted Net Income, subtracting any dividends, adding any amounts related to share issuances, and making some small adjustments relating to our use of certain incentive programs, the amortization of impaired intangibles, etc. If you follow the math in the table above, you’ll see that adding the quarterly Adjusted Net Income and subtracting dividends accounts for the vast bulk of the quarter to quarter changes in Average Invested Capital.”
— Mark Leonard
By being transparent on the Average Invested Capital, Leonard holds himself accountable to effectively deploy capital. As such, he doesn’t chase growth for growth’s sake but filters opportunities through hurdle rates set by the board, namely after-tax IRRs for both organic initiatives and acquisitions. He explains that “In practice, the way we actually measure this is on a project by project basis using conventional after tax internal rates of return (IRR’s). Periodically our board sets a hurdle rate, and we filter both prospective organic growth opportunities and acquisitions based upon those hurdle rates.”
However, Leonard recognizes the limits of forecasts and the subjectivity in IRR, as he mentions that “IRR by its very nature requires forecasts, and hence is going to have subjectivity. Nevertheless, we try to beat the unwarranted optimism out of the forecasts, and as time passes, we can increasingly cross-reference history with forecasts.“ As such, he ensures to augments his due diligence with post-acquisition reviews and scenario analysis. He asks teams to use four mutually exclusive, collectively exhaustive scenarios (MECE) and probability-weight the cash flows, allowing a single hurdle rate to be applied fairly across different risk profiles.
“We use a weighted four-scenario approach to assess investment prospects. Academics call this mutually exclusive collectively exhaustive scenario modelling or ‘MECE’. The cash flows of each of the four scenarios are probability weighted, allowing us to use a single hurdle rate across all investment prospects, even if the investments have very different risk profiles.”
— Mark Leonard
Finally, Leonard also recommends us to maintain hurdle rates high among a company and avoid lowering them. In fact, he mentions, that “When we dropped our hurdle rate, it dragged down the expected IRR’s for all the opportunities that we subsequently pursued, not just those at the margin. We try to capture this idea by saying “hurdle rates are magnetic”. It now takes a very brave soul to propose a hurdle rate drop at CSI.“
The lesson for leaders and investors from Mark Leonard is straightforward. You need to establish a disciplined capital allocation rules and judge each decision via their IRR. Furthermore, you need to guard against the temptation to lower standards when capital accumulates. More importantly, use scenario weighting and post-mortems to temper optimism and improve forecasting. If you do that, over a long period of time, you may join the ranks of the great ones at Singletonville.
“We update the IRR forecasts for our acquisitions every quarter. The more “history”, and the less “forecast” that we have for each acquisition IRR, the better a measure it becomes of a manager’s investment performance. It takes years to figure out who are the great capital allocators.”
— Mark Leonard
As we have learned previously from REQ’s team research, for the compounding effect to work via acquisitions, it is clear that reinvested capital must generate high returns. As such, CEOs of compounders are, first and foremost, masters of capital allocation with a fanatical focus on metrics like Return on Invested Capital (ROIC) and Return on Total Invested Capital (ROTIC). They must be extremely disciplined when it comes to valuation as overpaying for an acquisition is a cardinal sin.
REQ explains that “Avoiding overpaying for acquisitions is crucial. Paying a 10x multiple for a private company, compared to 5x, is the difference between 10% ROIC and 20% ROIC assuming 100% cash conversion. The higher the price paid, the greater the need for cash conversion to support self-financing growth. If you overpay, the deal has to work a lot harder to pay for itself.” As a matter of fact, the key for a compounder is to have the newly subsidiary quickly repay itself and to generate free cash flow back to the main company.
This can be perfectly illustrated by the success of Bergman & Beving, whose founders always had a distinct focus on profitability. They invented a profitability benchmark which involved maintaining profits divided by working capital (P/WC) at levels exceeding 45%. REQ explains that “According to the Superinvestors of Bergman & Bevingsville, a business is considered self-financed when the return on working capital (P/ WC) is higher than 45%. By achieving P/ WC > 45%, the business can generate the necessary cash to cover taxes, interest, and dividends, and make required investments in existing businesses through capital expenditures, working capital, and financing acquisitions. The goal of being self-financed means that growth, whether organic or through acquisitions, will not dilute current shareholders through equity raises or rely heavily on debt financing. It highlights the importance of capital efficiency in generating cash.”
Perpetual Ownership
“If we think long term, we can accomplish things that we couldn’t otherwise.”
— Jeff Bezos
Another thing to note from the shareholders letters is how Mark Leonard embodies a long-term orientation, positioning Constellation as a perpetual owner of software businesses rather than a short-term holder. This mindset influences everything from the way they approach acquisitions to management incentives, to prioritizing enduring value over quarterly results.
In one of his letters, Leonard writes, “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 (“GM”) are running their businesses and that the GM’s are incented to enhance shareholder value over the very long term. It is trivial for an experienced GM to run a software company to generate high profitability and shrinking revenues. Far more challenging, is generating reasonable short term profits while continuing to grow revenues, in an industry where investment cycles often exceed 10 years. Understanding a GM’s performance as they make these long term trade-offs is the most difficult part of a perpetual owner’s job.” And, this is true whether Constellation acquires 100% of a private company or a minority ownership in a public company.
“We have the same objective when we buy a piece of a business as when we buy 100%, i.e. we want to be a great perpetual owner of an inherently attractive asset. If we are allowed to join a public company’s board, we offer to sign an agreement that will limit our ability to make an unsolicited take-over bid. This allows existing long-term shareholders of our public investees to continue to enjoy the benefits of ownership. For shareholders with similar objectives to ours, we believe that we are an exceptional co-investor.”
— Mark Leonard
Therefore, Leonard understood that he had to align this long-term vision with everyone involved in Constellation Software. As he once mentioned, “In previous letters (for instance, the 2008 letter to shareholders), I’ve talked about how important longterm oriented employees, customers and shareholders are to both our strategy and organisational design. A long-term orientation requires a high degree of mutual trust between the company and all of its constituents.”
For example, to ensure alignment between the companies’ long-term approach with those of his employees, Leonard set up a great incentive structure at Constellation. A significant portion of employee and manager pay, especially for seniors, is in Constellation stock, with long escrow periods. This ensures that those running the business think and feel like owners, their fortunes tied directly to long-term value creation.
“We incentivize managers and employees with shares (escrowed for 3-5 years) so that they are economically aligned with shareholders. In return we need and want loyal employees… if they aren’t planning to be around for 5 years, then they aren’t going to care much about the outcome of multi-year initiatives, and they certainly aren’t going to forego short-term bonuses for long-term profits.”
— Mark Leonard
This owner mindset also extended to how Leonard viewed his shareholders. He actively seeks “partners” rather than traders, expressing a desire for a stable, understanding shareholder base that supports the company’s multi-year initiatives. He is acutely aware of the dangers when a company’s stock price deviates wildly from its intrinsic value, as it can disrupt these crucial relationships. He writes, “I’m coming around to the belief that if our stock price strays too far (either high or low) from intrinsic value, then the business may suffer: Too low, and we may end up with the barbarians at the gate; too high, and we may lose previously loyal shareholders and shareholder-employees to more attractive opportunities.”
What is even more impressive about Leonard is that, in order to align himself better with this shareholders, Leonard decided to reduce his salary to C$0 in 2015! As he explains, “One of the results of this compensation change is that I get to side-step the agent-principal problem. My compensation for being president is now tied solely to my current ownership of CSI shares. In essence, I’m your partner in CSI, not your employee. I like the feel of the partner relationship a whole lot better.”
This long-term focus reminds me of Jeff Bezos’ tenure at Amazon. He ****understood the importance of long-term thinking as an owner. In fact, as a majority shareholder of Amazon, he understood that in the short-term, the stock price is not reflective of the value of the company, but it would be in the long-run if the company continues to increase its future cash flows. As he once explained, “Why focus on cash flows? Because a share of stock is a share of a company’s future cash flows, and, as a result, cash flows more than any other single variable seem to do the best job of explaining a company’s stock price over the long term.”
Furthermore, Jeff Bezos believes that he can correctly align the interests of the customers with the interests of the shareholders by taking a long-term approach. In fact, long-term thinking shareholders can allow the company to make constant innovations, despite having failures from time to time. As such, Bezos was not timid in making investment decisions where he had an opportunity in gaining market leadership advantages even when he knew that some of his investments would not pay off. As he once said, “We like to invent and do new things, and I know for sure that long-term orientation is essential for invention because you’re going to have a lot of failures along the way.”
“Long term thinking is both a requirement and an outcome of true ownership. Owners are different from tenants. I know of a couple who rented out their house, and the family who moved in nailed their Christmas tree to the hardwood floors instead of using a tree stand. Expedient, I suppose, and admittedly these were particularly bad tenants, but no owner would be so short-sighted.”
— Jeff Bezos
Autonomy
“Some of you fellows may think I tie you to Capital Cities by corrupting you with compensation and stock options. But I’ve decided the reason you are afraid to leave this company is more because our system naturally corrupts you with autonomy and authority. And I suspect that after living that way for a time, you’re fearful that someplace else might not operate in the same manner.”
— Frank Smith
Perhaps one of Mark Leonard’s valuable insight we can learn from is his organizational philosophy. Similar to other serial acquirers, Constellation is structured as a collection of autonomous business units. Leonard believes deeply that bureaucracy suffocates performance, whereas full autonomy empowers general managers to lead small teams efficiently.
As such, the goal at Constellation Software was never to integrate acquisitions into a huge conglomerate, but to preserve their entrepreneurial spirit and expertise under a supportive umbrella. This delegation to the point of abdication allows the company to scale without needing to build a massive headquarters. Leonard explains that, “We’ve handled our geometric growth to date by largely abdicating management to the general managers of each of our vertical businesses. We have a very thin overlay of infrastructure at CSI. 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.”
This model creates an environment where trust, clarity, and purpose can flourish. Nonetheless, Leonard admits that there is always a constant battle to fight off centralization the larger the company gets. However, when Leonard studied other high performing conglomerates (”HPC”), it is clear that decentralization is the way to go.
“Only one other HPC has followed a strategy of buying hundreds of small businesses and managing them autonomously. They eventually caved in to increased centralisation. My hunch is that it takes an unusually trusting culture and a long investment horizon to support a multitude of small businesses and their entrepreneurial leaders. If trust falters the BU’s can be choked by bureaucracy.”
— Mark Leonard
By consequence, Leonard understands that the role of headquarters is deliberately minimal. It is to allocate capital, share best practices and handle the essential corporate functions. It should not be controlling or commanding. As Leonard once said, “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.” Nonetheless, even without centralization, Leonard believes that Constellation Software has a huge competitive advantage due to its sheer size.
“While there are terrific moats around our individual business units, the barrier to starting a “conglomerate of vertical market software businesses” is pretty much a cheque book and a telephone. Nevertheless, CSI does have a compelling asset that is difficult to both replicate and maintain: We have 199 separately tracked business units and an open, collegial, and analytical culture. This provides us with a large group of businesses on which to test hypotheses, a ready source of ideas to test, and a receptive audience who can benefit from their application.”
— Mark Leonard
This reminds me of what we have learned from Ken Iverson at Nucor, where he structured the company around decentralization, granting divisions near-complete autonomy to make decisions locally, which fostered innovation and responsiveness. This model contrasted with centralized bureaucracies, allowing Nucor to adapt quickly to market changes while holding managers accountable for results. By keeping divisions small and pushing authority downward, Iverson ensured that those closest to the work drove the business, rather than distant executives.
As a matter of fact, Iverson mentions that “Each division operates its one or two plants as an independent enterprise. They procure their own raw materials; craft their own marketing strategies; find their own customers; set their own production quotas; hire, train, and manage their own work force; create and administer their own safety programs…. In short, all the important decisions are made right there at the division. And the general manager of the division is accountable for those decisions. That’s where the buck stops at Nucor.“
For Iverson, this autonomy was non-negotiable and managers at Nucor enjoyed this decision-making responsibility and accountability. However, to maintain this autonomy, managers were expected to deliver a 25% return on assets and follow the ethical standards of the company.
“At Nucor, we chose long ago to build our company on a decentralized model in which each operating division enjoys true autonomy. We have told our managers to “trust your instincts”—and we have meant what we said. We’ve urged them to confer the same kind of decision-making autonomy to their people—to make their own decisions based on what they think is best for the business—and we have never backed off our commitment.“
— Ken Iverson
The main reason why Iverson believed in decentralization was because he believed that the frontline employees were the one that were closest to the problems and by consequence, have the best innovative ideas. He once said, “That is, by the people closest to where the work actually gets done. Those businesses must tell people on the front lines to “trust your instincts.” And businesses that tell their people to “trust your instincts” generally should be decentralized. A decentralized structure pushes the power to set strategy, spend money, make decisions, and create policies out toward the marketplace. It promotes local autonomy.“
As such, he believed it was primordial for managers to be maintain close contact with their employees. As he explained, “Managers are supposed to do what’s best for the business. And what’s best is to remember we’re all just people. Managers don’t need or deserve special treatment. We’re not more important than other employees. And we aren’t better than anyone else. We just have a different job to do. Mainly, that job is to help the people you manage to accomplish extraordinary things.”
“That’s the main reason we’ve tried to keep our divisions small. When a business grows beyond 400 or 500 people, it’s hard for management and employees to stay connected. I don’t order our managers to keep in close contact with their employees. But I do nag them. I say, “Andrew Carnegie was a financier. He could afford to treat people like peasants. We’re managers. We can’t.” They may not appreciate my nagging, but I do it with their interests in mind.“
— Ken Iverson
Beyond the Book
Read "CAPITAL ALLOCATION & BUYBACKS" by Investment Masters Class
Listen to "#246 Mark Leonard's Shareholder Letters" by Founders Podcast
Listen to "Mark Leonard: The Best Capital Allocator You've Never Heard of" by We Study Billionaires
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