The 12 Best No-Nonsense Lessons from Mark Leonard (Constellation Software)

His self reflective Annual Letters are must-reads

When a Chairman's statement starts with: "One of our directors has been calling me irresponsible for years..." you know it's gonna be an interesting read. Who wrote this? Mark Leonard, the founder and current CEO of Constellation Software.

We like managers who think out of the box and make decisions that only fit in the "Shareholder Value Creation" framework, i.e. ROIC, reinvestment rate and distributing any leftover cash back to shareholders.

He and his team have been great mentors to us, whether it is from a private M&A perspective or a public stock investment perspective. As we’ve mentioned already in the previous posts, there’s a lot to learn from the past and from managers who’ve been very disciplined with applying the fundamental concepts of shareholder value creation.

Here are Leonard’s 12 best thought-provoking quotes. They will generally set the stage for endless discussions about making smart long-term investment decisions.

1. Ideally, we’d like Constellation’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.

2. We continue to seek longer-term capital to defuse the fundamental mismatch inherent in buying permanent assets with short-term debt.

3. I discovered when I was in the venture business that interviews aren’t for me. What little I have to say, I generally put in my letters to shareholders. I do occasionally speak with students, but usually in the vain hope that I can distract them from pursuing careers in investment banking and private equity.

4. Over the last few years we have purchased a number of software businesses (usually SaaS) that have a much higher ‘churn’ in their client bases because of factors inherent in their industry.  By high churn, we mean that they acquire a greater proportion of new clients each year, and lose a higher percentage of existing accounts, than our average business. Sometimes the higher churn is because the clients’ switching costs are low. Sometimes the higher churn is because lots of new potential clients are being created, and old ones are going bankrupt and merging. If it is the latter, these software businesses may be very attractive. If it is the former, then the software businesses are likely to be unpleasant, requiring tremendous effort to stay in much the same place.

5. 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. The lag is often 5 to 10 years as the proponents of the original acquisition usually have to move on before the corporation will spin off the asset. Our most attractive acquisitions from corporate vendors seem to have happened during recessions. Occasionally, we also acquire portfolio companies from a private equity fund that is getting long in the tooth. These will have been well shopped but for some reason will not have attracted a corporate buyer. While both corporate and PE divestitures tend to be much larger than the founder businesses that we buy, they are usually more of a cultural challenge for us post-acquisition.

6. Our favorite 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 Constellation, and most of the ones that we buy, operate as standalone business units managed by their existing managers under the Constellation umbrella. We track many thousands of these acquisition prospects and try to regularly let their owners know that we’d love the chance to become the permanent owners of their business when the time is right for them. There is a demographic element to the supply of these acquisitions.  Most of these businesses came into being with the advent of mini and micro-computers and many of their founders are baby boomers who are now thinking about retirement.

7. Models are only as good as the assumptions that go into them, and there’s no substitute for thinking through scenarios on your own, with your own underlying assumptions.

8. The more interesting part … was using the model to do some sensitivity analysis and to look at alternative strategies. In all of the following examples, we assume that only one variable changes. In reality, our businesses are dynamic and changing one variable has an impact throughout the business.

9. We use a multi-scenario approach to forecasting and I’m struck by how frequently, even outside of our outlier forecast, we end up with actual performance, both at the low and the high end of the outliers. And so you do get a real spread on these things, and this happened to be a spread on the upside.

10. There are two components to Constellation’s growth, organic and acquired. Organic growth is, to my mind, the toughest management challenge in a software company, but potentially the most rewarding. The feedback cycle is very long, so experience and wisdom accrete at painfully slow rates. Growing organically while generating a high ROIC is, to my mind, the toughest task in the software business.

11. We are the anti-economies of scale company. We believe in small teams outperforming large teams, and so given the choice of taking a 200-person business and buffing it up into two smaller ones, we would much prefer to do that and believe that the benefits are there as opposed to ramming businesses together, firing a bunch of people and moving a bunch of work offshore.

12. There are a couple of hundred business units and every one of those managers has their own competitive environment in which they are competing. And they are making decisions around investments and whether they be rewrites or add-ons or things of that ilk and or improving coverage or allocating between farming and hunting, those role decisions that they are making individually and what you’re seeing is the sum total of those decisions. If marketing and R&D are going down as a percentage of the revenues or expenses, then I guess they aren’t seeing the returns on those investments.

With the market’s short-term thinking (just look at how long investors typically hold onto their shares), Leonard’s abnormally sharp long-term vision on corporate finance and value creation is even more valuable today.

There are three main takeaways from 2023 that prove CSI isn’t slowing down at all.