Mark Leonard started the year with a well-founded case of FOMO.
The founder and president of Constellation Software Inc.
built one of the country’s largest tech companies through acquisitions. In a typical year, Constellation snaps up about 90 specialized computer coding businesses, then does whatever it takes to make them, in Mr. Leonard’s words, “exceptional.”
It’s evangelical, and it works. Over 26 years, Constellation has created the leading software players in too many niche markets to count and evolved from a $25-million Toronto startup into a $40-billion global platform.
As Constellation scaled up, its executives began scouting for larger takeovers, targets worth $300-million or more. And that’s when Mr. Leonard found he had something in common with high-school students with a fear of missing out on the cool kids’ parties.
For Constellation, the cool kids are bankers. They were overlooking the company. Constellation figured this out by carefully tracking every major software acquisition. Over the past six years, that amounted to between 40 and 70 deals annually. Almost every business was sold in an auction, run by an investment bank.
Capital deployed on acquisitions by Constellation Software
Quarterly, in millions of dollars
THE GLOBE AND MAIL, SOURCE: RBC CAPITAL MARKETS
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| Date | Capital deployed |
| 2015-03-31 | 21 |
| 2015-06-30 | 118 |
| 2015-09-30 | 67 |
| 2015-12-31 | 30 |
| 2016-03-31 | 27 |
| 2016-06-30 | 48 |
| 2016-09-30 | 43 |
| 2016-12-31 | 57 |
| 2017-03-31 | 69 |
| 2017-06-30 | 79 |
| 2017-09-30 | 54 |
| 2017-12-31 | 94 |
| 2018-03-31 | 344 |
| 2018-06-30 | 37 |
| 2018-09-30 | 102 |
| 2018-12-31 | 82 |
| 2019-03-31 | 68 |
| 2019-06-30 | 101 |
| 2019-09-30 | 266 |
| 2019-12-31 | 167 |
| 2020-03-31 | 141 |
| 2020-06-30 | 75 |
| 2020-09-30 | 93 |
| 2020-12-31 | 222 |
| 2021-03-31 | 546 |
CAPITAL DEPLOYED ON ACQUISITIONS BY CONSTELLATION SOFTWARE
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Mr. Leonard realized bankers weren’t inviting Constellation to these auctions. The company’s research showed it was asked to bid on just 16 per cent of software companies put up for sale. By the time Constellation heard about many opportunities, the business was sold. For a company that relies on acquisitions to expand, missing out on deals was a serious handicap.
Jamal Baksh, Constellation’s chief financial officer, helped diagnose the problem. He said outsiders viewed Mr. Leonard as wedded to high returns on acquisitions, known as hurdle rates, a discipline that dictated Constellation would never pay up at auctions. Bankers believed they were better off pitching takeovers at private equity funds, which were more willing to pay premium prices.
(Students of corporate finance can explain this dynamic. Private equity funds and Constellation work to different time horizons. The funds buy a business expecting to make most of their profit from selling it, typically within five years. In contrast, Constellation expects to own a business forever, which means it takes longer to earn back its investment.)
You don’t build an incredibly successful tech company – Constellation went public in 2006 at $17 a share and now trades as $1,850 – unless you’re willing to embrace radical change. Once Mr. Leonard understood why Constellation was missing out on deals, he took what analysts described as aggressive steps to fix the problem.
In a shareholder letter in February, his first in three years, Mr. Leonard announced Constellation would drop its hurdle rate, accepting a lower return on its capital to find opportunities to invest the $989-million of excess cash it generated last year. Normally aggressively low-profile, Mr. Leonard opted to make a very public statement to bankers in his letter, saying: “If we drop our hurdle rates for these acquisitions, I believe that competent and diligent merger and acquisition brokers will include us in more auctions.”
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Number of acquisitions by Constellation Software
Quarterly
THE GLOBE AND MAIL, SOURCE: RBC CAPITAL MARKETS
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| Date | Acquisitions |
| 2015-03-31 | 3 |
| 2015-06-30 | 8 |
| 2015-09-30 | 10 |
| 2015-12-31 | 9 |
| 2016-03-31 | 6 |
| 2016-06-30 | 10 |
| 2016-09-30 | 15 |
| 2016-12-31 | 6 |
| 2017-03-31 | 12 |
| 2017-06-30 | 16 |
| 2017-09-30 | 14 |
| 2017-12-31 | 13 |
| 2018-03-31 | 18 |
| 2018-06-30 | 7 |
| 2018-09-30 | 14 |
| 2018-12-31 | 13 |
| 2019-03-31 | 23 |
| 2019-06-30 | 22 |
| 2019-09-30 | 23 |
| 2019-12-31 | 25 |
| 2020-03-31 | 25 |
| 2020-06-30 | 10 |
| 2020-09-30 | 25 |
| 2020-12-31 | 24 |
| 2021-03-31 | 29 |
NUMBER OF ACQUISITIONS BY CONSTELLATION SOFTWARE
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One of Mr. Leonard’s key metrics in takeovers is buying businesses that offer a high return on invested capital, or ROIC. In the past, Constellation generated about $30 in cash each year for every $100 it invested in a software company acquisition. That works out to a 30-per-cent ROIC, a key element of the hurdle rate that drives Constellation’s takeover strategy.
It’s a lofty standard, and consistently hitting that goal means Constellation is almost debt free and generates far more cash than it can deploy. By lowering the hurdle rate for larger acquisitions and eliminating special dividends, Constellation can keep expanding, funded by capital it generates from its existing businesses. A 20-per-cent ROIC on a $600-million takeover kicks off as much cash as eight $50-million acquisitions.
To do bigger deals, Constellation created a dedicated team, led by Mr. Leonard, focused on major acquisitions and ventures outside software sectors where it currently operates. In another departure from how it has done business in the past, Constellation recently spun out a subsidiary for the first time – typically, it only buys companies. Constellation listed a major division, Topicus.com, on the TSX Venture exchange as an independent public company, backed by Constellation. That showed executives at potential takeover targets they could enjoy autonomy under the Constellation umbrella. In a report on Thursday, analyst Paul Steep at Scotia Capital said, “We expect Constellation to increasingly consider employing further spin outs as tool to create shareholder value.”
Finally, in an era when many companies feel obligated to hand excess cash back to shareholders through dividends and stock buybacks, Constellation announced it would stop paying special dividends, and could halt its quarterly dividend payout, to squirrel away cash for takeovers. Going forward, Mr. Leonard ruled out special dividends – the company doled out $20 a share two years ago – and warned Constellation may also halt its $4 quarterly payout.
Mr. Baksh, Constellation’s CFO, said a number of investment bankers called the company the day Mr. Leonard’s letter went out, to say they got the message. Investors applauded the moves.
“Mark is one of the great capital allocators of our generation,” said Chris Cerrone, a partner at Akre Capital Management, one of Constellation’s largest shareholders, with a $1.2-billion holding.
Mr. Cerrone calls the company a “compounding machine,” and his US$17-billion firm has owned the stock since 2014 and never sold a share. When it comes to cutting dividends, Mr. Cerrone said: “We would be thrilled to see Constellation reinvest every single dollar of free cash flow in acquisitions, if they meet the company’s threshold.”
To understand how one of Canada’s leading technology players is upping its game, a little background on a founder who enjoys cult-like status is required.
Mr. Leonard, 64, brings cultivated eccentricity to his job. He stopped taking a salary and bonus more than five years ago. His family’s stake in the company is worth more than $2-billion and Mr. Leonard said in a shareholder letter: “I’m your partner in Constellation, not your employee.” He’s tall, trim, bikes to work and sports a long beard – picture an extremely fit Gandalf, from Lord of the Rings. He also politely declines media interviews, although he does speak at events staged by university students.
“Mark has the perfect temperament for an investor: super intelligent, patient, disciplined with a very low need for affirmation,” said Stephen Dent, co-founder and partner in Birch Hill Equity Partners Management Inc., which teamed up with pension plan OMERS to help Mr. Leonard launch Constellation in 1995.
“It’s amazing to me how Mark has managed to instill all of that into the large number of Constellation managers he has now. Their productivity in the M&A arena is really unparalleled.”
Everyone knows Bill Gates. Mr. Leonard is at the other extreme, in both profile and strategy. Microsoft writes programs everyone uses. Constellation is at the other end of the software spectrum. It owns businesses that dominate niches, producing what is known as vertical market software (VMS).
Constellation’s 125,000 customers are split between government agencies and private companies, in more than 100 countries. For example, Texas-based Travis Software is a market leader in automating U.S. employee health benefits. Constellation acquired Travis in 2012. The software that runs in more than 10,000 libraries around the world comes from a firm called Softlink International. Constellation bought that business in 2013.
As investment bankers start calling more frequently, FOMO is no more. Mr. Leonard and his successors can build on a tested game plan, paying for acquisitions with cash from existing software businesses. “Reinvesting is the fuel for compounding returns from a business,” said Akre Capital’s Mr. Cerrone. “Constellation has been incredibly disciplined when it comes to takeovers, and as they get bigger, they get smarter.”