Capital Allocation Insights from Constellation Software
The wisdom from Leonard’s letters - distilled
I recently read chronologically through the shareholder letters from Constellation Software. From 2007-2017 (and again in 2021) the founder and President, Mark Leonard, took the time to write his thoughts on the business performance and provided many insights into how he thinks of capital allocation. Capital allocation is what the CEO or leaders of the organization do with the cash flow after the bills are paid. Ideally, they pursue options that deliver value to shareholders.
Coupled with a great business model, potentially also with some economic moats, the capital allocation decisions are what can dictate long term returns. Many CEO’s have gotten to their positions without much experience with capital allocation and often find it unnatural. As investors, it is also useful to study great allocators to find the insights that make them great. I recommend you read the letters yourself, it will be a couple hours worth spending. That being said, here is some nuggets that I believe gives some insight into the mind of a great capital allocator.
This post was in addition to a long tweet thread that I recently posted. The tweet thread is much longer and has more content from the letters and can be found here:
Monitor and Adjust Strategy
Track and monitor key metrics for their investments and are quick to cut when it isn’t working.
“we instituted a program to forecast and track many of the larger Initiatives that were embedded in our Core businesses...Several of the Initiatives became very successful. Others languished, and many of the worst Initiatives were terminated before they consumed significant amounts of capital.”
Focus on high but achievable long term targets.
“We have an objective of generating average annual revenue growth per share and average annual EBITDA growth per share of at least 20% for the five year period... I recently ran a screen of public companies... that met these criteria for the last 5 year period. I discovered that less than 1% of companies qualified.”
“An investment only becomes a lesson if we diligently track its post-acquisition performance and take the time to analyse the outcome while the investment is still fresh in everyone’s mind. We have a process for this that we call a post-acquisition review…”
Understanding and Aligning Incentives
Aligning incentives of managers with those of long term shareholders.
“Constellation’s resilience is bolstered further by an employee compensation plan that insulates the company if performance lags, and rewards employees when the business is experiencing both high profits and rapid growth.”
Aligning with long term quality shareholders.
“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.”
Appropriate organization structure for sustained growth.
“We’ve handled our geometric growth to date by largely abdicating management to the general managers of each of our vertical businesses. CSI. We count on the fact that with each new acquisition will come general managers who are steeped in their verticals…”
Help managers act like competent capital allocators.
“If managers have the discipline to monitor the IRR’s on their investments in organic revenue growth, then they’ve taken a critical step towards understanding the most powerful lever in software. Some of our managers are there.”
Value and Impact of Culture
Properly investing and valuing talented employees as valuable stakeholders.
“... our senior managers consistently generate rates of return in excess of 25% on the capital that they deploy. As investors you’ll know that this is wildly difficult to achieve. How do we keep these multi-talented managers? Hopefully we provide an environment that is fulfilling, colleagues that are both challenging and entertaining, and work that is meaningful. We also pay them well.”
Understanding cultural impacts to business success.
“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…”
Open Minded and Agile
Understanding the effect of different capital allocation levers.
“If we assume that CSI makes no further acquisitions, the Consensus Model calculates an intrinsic value that is roughly half of the current price...In the early days of CSI, I assumed that shareholders would be somewhat ambivalent between receiving all of CSI’s free cash flow as a dividend, and having us invest a portion of it in acquisitions... that is resoundingly not the case.”
Stick to circle of competence but evolve and grow that competency.
“Unfortunately, our SaaS’y businesses have higher average attrition, lower profitability and require a far higher percentage of new name client acquisition per annum to maintain their revenues. We'll either learn to run them better, or they will prove to be less financially attractive than our traditional businesses - I expect the former, but suspect that the latter will also prove to be true.”
Being comfortable with being different.
“Most CEO's of public companies would rather run a single big business - perhaps two or three big businesses, but rarely 200 businesses. They expect (or hope) to get above average returns on capital by pursuing economies of scale and by crushing or acquiring their smaller competition.”
Discipline and Integrity
Disciplined reinvestment approach that is optimistic for growth but ensures humility wins out over hubris and greed.
“We have publicly reiterated our revenue growth objective...and we have a bonus plan that pays for growth. Those factors create a fierce temptation to stretch a bit and make some acquisitions that aren’t quite up to par. Counterbalancing hubris and greed, we have a good board and many long-term oriented managers. I believe that we have the judgment to maintain our investment discipline, and the humility to adjust our growth objectives downwards if we don’t think that they are achievable.”
Getting an edge in acquisitions by being a good owner.
“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.”
Cost sensitivity runs deep.
“I've traditionally travelled on economy tickets and stayed at modest hotels because I wasn't happy freeloading on the CSI shareholders and I wanted to set a good example for the thousands of CSI employees who travel every month.”
Growth for the Long Term
Growth that focuses on maintaining profitability.
“When we acquire an underperforming company Growth suffers. ...we generally grow our acquired businesses, frequently providing additional products for them to sell into their installed base, and bringing our increased scale and best practices to bear upon their business.... the reduction of an acquired business to a profitable Core will leave us with a smaller, but usually more profitable business.”
Strategic growth that increases share value.
“Rapid acquired growth is not an imperative, it is a choice. For most of the last decade we struggled to find enough attractive acquisitions to consume our operating cash flows. We believe that the situation has now reversed, and we are sorely tempted to buy as many attractive vertical market software businesses as and while we can.”
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