In this week’s episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle discussed Constellation Software’s growth-through-acquisition-strategy. Here’s an excerpt from the episode:
Tobias Carlisle: So I’ve got this ongoing theme where I’m looking at companies that basically are set up to do acquisitions, so we looked at Barry Diller and IAC first, and looked at HEICO with the Mendelsons… and then if you’re going to do that, naturally, Berkshire Hathaway is sort of the original gangster; maybe Singleton with Teledyne, maybe that’s the original… Buffett kind of perfected it.
Tobias Carlisle: But Mark Leonard and Constellation is kind of… for me, they’re a little bit under the radar. I’ve known about them for a long time; never bothered to read the letters until this last week. So I read the letters, and I was kind of DM’ing you guys as I was going through them. I’m leery, I’m highly skeptical when I see somebody using Buffett’s language in a letter, because I see it in hedge fund letters all the time. And so, when I first started reading it, I was like, “Well, everybody likes this because he writes like Buffett, but so what?”
Tobias Carlisle: And then I kept on reading, and I kind of… I’m kind of in love with Mark Leonard at the moment. I’m having this long distance love affair with him. Guy’s kind of figured out something incredible. What Constellation does… so Constellation, they target these VMS, vertical market software, and they make really small acquisitions. The acquisitions are typically five to 10 million dollars. When I look back at some of the old articles that came about him not that long ago, five years ago… they’re looking at two to four million dollar acquisitions.
Tobias Carlisle: To put that in context, that company is a 30 billion dollar company. And so, the way that he’s achieving these acquisitions is he has sort of distributed this acquisition. So, it’s not like Berkshire where Buffett’s doing all the acquisitions; they’ve got distributed acquisitions, so they’re getting each sort of downline, does their own… it sounds like an MLM marketing kind of thing.
Jake Taylor: It does.
Bill Brewster: You got your upline and your downline, and then you sign people up!
Tobias Carlisle: When it gets complicated like that, immediately you start getting nervous, but not in relation to Constellation, in relation to MLM.
Tobias Carlisle: So, the background on the guy… there’s not much information, not many photographs of him on the internet. By all accounts, he’s a giant, he’s 6’5″; played rugby; might have come from South Africa or England; nobody really knows. Got an MBA, was a gravedigger at one stage; worked in venture capital until 1995; took some funding, 25 million dollars in funding from O-M-E-R-S. I don’t know what that is. I’ve never encountered that before. Do you guys know who that is?
Bill Brewster: No.
Jake Taylor: Uh-uh.
Tobias Carlisle: So he runs from 1995 until they list in 2006, and so, he lists to give them an exit, I think, basically, because they didn’t take any cash in the listing. That allowed all of their outside investors, the venture funds, to exit.
Tobias Carlisle: And so, they basically take Buffett’s principles, targeting high return on invested capital companies, and then they sort of incentivize them to return that capital back to the mothership, and they keep on deploying it. That’s a conscious strategy of theirs to target much, much smaller acquisitions, because as acquisitions get bigger, you pay a bigger and bigger premium. So, they’ve kind of figured out how to not grow the size of the acquisition, but to grow the whole organization.
Tobias Carlisle: They do lots and lots of acquisitions. They don’t use debt. It’s been a kind of monster run. I’m kind of new-ish to it, so I’m not going to give you all of the great insights… that you guys probably know more about than I do, but I’m a fan.
Jake Taylor: Enjoy that honeymoon period.
Tobias Carlisle: So tell me, what am I missing?
Jake Taylor: I don’t think you’re missing anything. I think the only knock nowadays is that… can they keep doing what they’ve been doing at the same rate, and at an increasing rate to justify the increasing market cap?
Tobias Carlisle: So there’s a couple of… so, Value Investors Club, there’s a couple of write-ups about Constellation in there, and that’s the question that gets asked every time. So they say, or the write-ups say, that there are something like 30,000 of these VMS businesses around that are of that sort of scale… five million dollar-type scale… and if they’re prepared to expand into Europe, then it goes up by another 50 percent, something like that; there might be 48,000 or something like that… between that 7 to 10 million dollar, because maybe that’s the level that they’re at… so maybe they go up a little bit.
Tobias Carlisle: But then the problem… I think their real problem, rather than just that running out of kind of runway to buy stuff, is just the fact that software is a service. Everybody’s figured out that’s a good business, so that stuff is expensive now. So I think maybe you slow down the rate of acquisition, you only hit what you can, and you just wait for the market to come back a little bit. I don’t know.
Bill Brewster: Big time. Big time.
Tobias Carlisle: Big time.
Bill Brewster: Yeah.
Bill Brewster: So, I went back to the scuttleboard bullpen to do a little bit of background on this. Something that I think is really awesome… I’m with you, Toby, right, where I start to see people quote Buffett, and I start to get real nervous. But this is Mark Leonard talking about expensing his own stuff: he goes, “I’ve been President of CSU for its first 20 years. I’ve waived all compensation because I don’t want to work as hard in the future as I did in the last 20 years. Cutting my compensation will allow me to lead a more balanced life with a less oppressive sense of personal obligation. I’m paying my own expenses for a different reason. I’ve traditionally traveled on economy tickets and stayed at modest hotels because I wasn’t happy freeloading on the CSU shareholders, and I wanted to set an example for the thousands of CSU employees who travel every month. I’m getting older and wealthier and find that I’m willing to trade more of my own cash for comfort, convenience and speed, so I’m afraid you’ll mostly see me in the front of the plane from here on out.”
Bill Brewster: I mean, he reminds me of those guys from Fastenal. The management team from Fastenal takes pride when they go to a town and they can stay at their in-laws’ house. Some of these guys are just… they’re cut from the right cloth, I think. And I had told you, I don’t know that I really love the CSU letters as much as everybody else does; I think part of that is I got such a… I was prepared for nirvana, and maybe I had found out I was just reading normal things… so, a bit of, I think, maybe high expectations hurt my perception, but… he really does seem like the real deal, and his track record certainly supports it. It’s interesting.
Bill Brewster: I thought the same thing, can they continue to do it? I talked to Liberty on Twitter about it; he’s pretty active in the name, and he doesn’t think size is going to preclude good things from here going forward.
Tobias Carlisle: One of the interesting things that Leonard introduced me to is… this is Leonard’s term… high performance conglomerates, or HPCs, and then he lists out some HPCs that I will go into over the coming weeks. But that term, I don’t think, really exists outside of Mark Leonard using it, but I think it’s a good one.
Tobias Carlisle: So, I just sort of looked at… if you search that term, there’s not a great deal that comes up, but there are these guys who’ve done a little analysis of HPCs, and so, what separates an HPC from just a typically acquisitive company is… I think it’s a value discipline. But if they just do this sort of top-down analysis about the thing that they say separates good acquirers from bad acquirers… it’s just doing lots of acquisitions.
Bill Brewster: It’s a learned skill!
Tobias Carlisle: Bill shared this with me this morning, this Bain Capital… Bain Capital has done some research, and they find exactly the same thing. I don’t necessarily trust somebody who’s doing a whole lot of acquisitions just because they’re doing a whole lot of acquisitions, but I think it kind of makes sense if you think about… if you don’t pay very much, your payback period is shorter, you should be able to do more acquisitions… you can recycle the capital faster to do faster and faster acquisitions, and then you get some skill in it, naturally, you’re going to get better at it.
Tobias Carlisle: If you’re set up to do acquisitions rather than thinking about them as a sort of strategic think… you’re thinking about them, how can we just maximize the rate of return? I think that it works.
Jake Taylor: Any concern about the… if you have… think about Rome in its heyday, and the further that you kind of get away from the central part of Rome, the more that it breaks down, and the bigger it gets… almost sews its own seeds of destruction.
Jake Taylor: Well, the culture of Constellation… the further you get down,.away from the mothership, away from Leonard… how could it be as tight? Or how can it be as clean?
Tobias Carlisle: It’s not going to work as well.
Tobias Carlisle: I’m not necessarily advocating investing in the stock. I had a look at… the valuations on any of these companies are just… make you bleed from the eyeballs. They’re just shocking, face-ripping valuations, and my hat is off to anybody who can get comfortable with those sort of levels of valuation… and it’s been expensive for a long time. It’s gone up a lot.
Jake Taylor: Yeah.
Tobias Carlisle: I’m definitely not advocating buying the stock. It’s probably going to quadruple from here because I said that, but I think that-
Jake Taylor: Of course!
Tobias Carlisle: I think that they’re all on 50 times PE’s, and they’re probably getting closer to the mature end of their growth, rather than lots of runway.
Tobias Carlisle: I like the distributed model. I think it’s a much better way of managing than that sort of top-down type model, but I think Buffett has said this, too… it just means that every now and again, you’re going to have an absolute catastrophic era that you could have otherwise avoided if the head office had known about it. But on balance, it’s a better way of doing it.
Bill Brewster: Yeah, I think the other thing that was interesting about Constellation was… it appears as though their incentive structure is total revenue growth and return on invested capital. So, there’s a nice sort of… you can send capital back and maybe you can’t make as much acquisitions and grow your revenue, or you could spend a ton and drive your revenue, but your return on invested capital would go down if you get stupid with it.
Tobias Carlisle: That’s smart.
Bill Brewster: So, it’s a nice tension of alignment of interests, and I wonder… the Bain consulting thing that I sent you… I wonder if that’s why they find that consistent acquirers have better results. Maybe it’s because they’re thinking of incentive structures and how to integrate different cultures… and more than just being a learned habit… I mean, it is a learned habit, but it’s almost a way of life.
Tobias Carlisle: Or even don’t integrate them.
Bill Brewster: Yeah.
Tobias Carlisle: One of the things that Leonard says that I really like… he’s like, what is culture? How would you get all of these cultures? You can’t. And he said some of them are going, so he says, we just leave the cultures alone at the level of the acquired company, and some of them are going to die out because they’re bad cultures, and some of them are going to be very good and they’re going to learn from each other, and they’re going to get better and better as they go along.
Tobias Carlisle: And I think that’s a pretty good approach. That’s a sort of robust to life kind of approach. That’s the way living things kind of make advances, and I think that that’s… if you want to keep the whole species moving, you can’t… if you have one rule for the whole group of them and that rule is wrong, you’re dead in the water. But if you’ve got lots of little variations, some of which will survive whatever comes next, then that’s a good survival mechanism.
Jake Taylor: Yeah, my understanding is that they’ve been… it seems like they’ve been doing more to try to cross-pollinate some of the… if someone has a good idea. I think there’s been more… I don’t know if management moves it around-
Tobias Carlisle: Do they force it?
Jake Taylor: Like GE, but I remember reading about how they’re trying to get more structure as far as the information cascading between the cultures of things that work.
Tobias Carlisle: It’s interesting. I’m just trying to think in terms of the things that unite HEICO, IAC, and Constellation. The really interesting thing, the one thing that I think that stands out more than anything else… and this was the title of the Forbes article for Diller and IAC… no moon shots. I think that’s really been the key to all of them. At HEICO, everybody… all of these guys are just doing smaller acquisitions, small [inaudible 00:14:20] acquisitions all the time, rather than trying for some sort of monster game-changing acquisition.
Bill Brewster: Didn’t Diller pay like four billion for Match, though? I mean, that’s not nothing.
Tobias Carlisle: But I think, in the context of what that… yeah, that is true, but initially he put in a billion, something like that. I think that they’ve been quite… at the four billion level, it was quite mature. They earned half of it. They might have bought the other half of four billion.
Bill Brewster: Yeah.
Tobias Carlisle: Or whatever they got to, up to 85 percent. Anyway…
Bill Brewster: I think it’s interesting. I mean, Markel is one that’s trying to do it, and the time that it seems to take to get the snowball rolling and… I think that they’ve learned, from what I understand, a fair amount from this CATCO issue that they had last year, where they maybe got into a line of business that was slightly different than something they were comfortable with.
Bill Brewster: There are trade-offs to the acquisition strategy, and you’re bound to have some problems. But one thing that I like about Markel a lot, and where I actually think Liz… that LA Hall forever thread went a little wrong… was when she had mentioned that she didn’t think that culture was a competitive advantage there. I think culture is a massively competitive advantage there, and it’s really, really… it’s not tangible. I can’t put it into numbers. People ask me, “How many acquisitions do you think they’ll do in the future, and how would you underwrite that?”
Bill Brewster: I don’t really know. What I’m certain of is those guys are going to work every day thinking about the right things, and that when there is the chance to pounce, they’re going to do it in what I perceive to be a smart way.
Tobias Carlisle: Is it a competitive advantage, though? Is it just table stakes? Here’s what you have to do to succeed.
Bill Brewster: Well, I don’t think that everybody has the same incentive structures, and I don’t think that everybody-
Tobias Carlisle: But that’s replicable, right?
Bill Brewster: I don’t know, man. You’ve got to set your incentives up the same way, and I’m not sure how many people have the freedom to do that.
Tobias Carlisle: But, I mean, even Leonard says… a few years ago, he said, “I’m going to stop sharing so much detail because there are a lot of imitators out there.”
Bill Brewster: Yeah. I mean, that’s fair. I think it certainly can be replicated. I don’t think it’s easy to replicate, though. It’s one of those things that in a text-
Tobias Carlisle: Simple, but not easy.
Bill Brewster: Yeah, textbook, it might be easy to draft, but the execution of it and actually living it, and being patient enough to wait for the deal that makes sense, and then to execute it when the chance is on the table… I just think it’s a lot easier said than done. But I could be wrong; I mean, I don’t know.
Jake Taylor: Do you guys ever want to be in that position of running a holding company like that?
Tobias Carlisle: I mean, that’s the dream, isn’t it? To be the Buffett-style…
Jake Taylor: Permanent capital.
Tobias Carlisle: Yeah, that’s what every dorky Valley guy out there is trying to get to.
Bill Brewster: I’d be good being a sixth man on that team!
Jake Taylor: That’s the value wet dream.
Bill Brewster: Forget about running it! Call me Rick Fox of that type of company. I’d be totally happy with it.
Tobias Carlisle: Who’s Rick Fox?
Bill Brewster: Exactly!
Tobias Carlisle: Who’s Mark Leonard?
Bill Brewster: Rick Fox used to play for the Lakers. He was married to Vanessa Williams.
Tobias Carlisle: Was he the sixth man?
Bill Brewster: He certainly wasn’t a starter… well, maybe he was a starter for a year or two there, but it wasn’t anything… he’s not the guy anybody knows, which I’d be fine with. I don’t need the glory.
Tobias Carlisle: And here you are with your face on a podcast, Bill!
Bill Brewster: Yeah, well…
Jake Taylor: Exactly.
Tobias Carlisle: Getting dozens of downloads.
Bill Brewster: I was just about to quote Tupac and say, “All I want is money. Fuck the fame, I’m a simple man,” and here I am on a podcast making no money, so I don’t know what I’m doing!
Tobias Carlisle: But getting no fame, either, so don’t worry about it!
Bill Brewster: That’s right! Yeah, well, anyway…
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
For all the latest news and podcasts, join our free newsletter here.
Don’t forget to check out our FREE Large Cap 1000 – Stock Screener, here at The Acquirer’s Multiple: