Interview. Constellation Software Head of M&A in the Volaris Group on Copy Cats, Style Drift, and Organic Growth.

Hello and welcome to the Synopsis, a Speedwell Research Podcast. My name is Drew Cohen and this episode of the Synopsis is really exciting because we got permission from AlphaSense to republish the same webinar that we hosted a couple months back with a head of mergers and acquisitions at Constellation Software and so you're going to be listening to that same unedited conversation which a lot of people said they got a lot of insights from and I hope you find out that that is true for yourself as well. However we're going to be doing more of these webinars and so we're going to try to focus on businesses that we've covered in the past but if there's any business in specific and questions that you're curious about be on the lookout for Twitter posts where we're going to try to gauge interest to see which businesses we should focus on next but we will of course focus on Speedwell businesses because I just personally feel like I'm best able to cover those and ask relevant questions there and so that will be coming and so there will be more of these webinars but this is a taste of what those webinars are like and as a reminder though this is basically what an AlphaSense expert call interview is and so they do have a repository of over 200,000 of these expert call transcripts on their service which there's link below that you could use to go ahead and register for that if you do want to get full access to AlphaSense and then in addition to that they are hosting their AlphaSummit October 6th through 8th in Brooklyn, New York it's an event a bunch of different big speakers there's product sections there's expert led workshops and kind of a lot of work went into that to kind of making sure that people there can really get a lot of value out of that and so Speedwell research on proud to announce is actually a sponsor of AlphaSummit which is pretty cool to be able to see our logo up there and so if you are interested in attending that again it's October 6th through 8th in Brooklyn, New York there is a second link in the show notes to register to get a discounted spot so you can go ahead and attend that and that is enough of a plug time to get to the content and so other than the intro which was a little choppy there is no other edits in this podcast and so I hope you enjoy, hello my name is Drew Cohen and I am a founder of Speedwell Research which for those that don't know we focus on producing long-term equity research reports for by-siders today's discussion is really exciting because we are able to talk to someone who is ahead of M&A at one of constellation software's operating groups we have a lot of topics we're going to get through from organic growth to acquisitions all of these questions that people are always asking on the inner workings of constellation software which of course for those that don't know is in a malgamation of well over a thousand of these vertical market software companies and many people like to kind of throw out this idea XYZ is the next Warren Buffett but the founder of constellation software Mark Leonard really does live up to that having compounded their stock at over 30% since they went public in 2006 and their performance thereafter when they started in the the 90s was also very strong as well and so really excited about this conversation and Rohan Nauranya is the expert that we're going to be talking to on today's call and he is AlphaSense sourced expert which is really just a great way to find out a lot more about this kind of hard to find research that doesn't show up in the earnings transcripts or any of the annual reports all of these sort of factors that really go into whether or not a company is a quality company all of that can be found through AlphaSense and AlphaSense for those that don't know is a platform that has over half a billion different documents that is all sorts of different financial documents as well as 200,000 expert interview transcripts all on that platform and it has been a really good resource for me for Speedwell for us to really improve our research and be able to get insights that are very hard for other people to find and so with that let us kick it off. And so for the first question just kind of curious on copy cats so everyone always talks about how constellation software is just better at acquiring these vertical market software companies and it's just very hard for other people to do it but on the other hand Mark Leonard talks about how all you really need is a phone book and a checkbook and you can enter this business and so why is it so hard to successfully copy constellation software? I would say that constellation software first and foremost has the first mover advantage in the software acquisition space so they've been around for a number of years they've had a head start and they essentially wrote the playbook on successful acquisitions and rolling up companies in the sector. You mentioned all you need is a phone book and a checkbook but that phone book is pretty extensive and it's quite hard to get a hold of right so you know constellation tracks every target it's ever had a conversation with and it attracts those all in the database that's managed internally which most of its senior leaders internally have access to so you're talking about you know like I want to guess like 40,000 names in the space so for a startup that's looking to enter the sector I mean it seems you know like a constellation as you mentioned it has been it's been delivering close to 30% annual returns since its IPO obviously a lot of that's been under the radar but more recently it's attracted the attention of a lot of people so people think right so how hard can you know investing in the software space be at the end of the day I mean you know what I've witnessed first hand is there's been a proliferation of the so-called copycats particularly in the last you know couple of years so typically how they start off is you know you get like a couple of investors who may or may not have experience already investing in software they might have adjacent backgrounds you know could be private equity could be banking could be just you know operational expertise but they see you know a path to you know emulating constellations return so they'll raise you know call it you know 25 million dollars euros or pounds in whatever market they are and they'll look to you know go out off to the races and start buying companies I guess the challenge they face is twofold so you know if they're competing with constellation right so say that you know both constellation and a copycat have you know encountered the same target and there is a by-side process to acquire that target what does the copycat bring to the table that constellation doesn't already have right so constellation has the capital it's a more discipline the choir but constellations I mean hold a tremendous advantage over the copycats in the sense that you know it's got like an unparalleled depth of expertise in terms of you know it's it's internal network of operators and knowledge so you know so if you're the owner of a software company and you're looking to sell to a copycat or be constellation at more or less the same price right and you care about you know the legacy and the future of your business and you want to see it in good hands you know constellation is a proven acquire and is you know is it's their modest operandi is you know they're buying hold forever they've never sold the company and they understand every one of these niches these industries right these these verticals that they they operate in very well whereas a startup a copycat might like that expertise so I mean how would a copycat differentiate themselves they would have to probably pay up and that's not generally in their best advantage right you want to be especially if you're looking to emulate the success the constellation has had you want to be a discipline acquire from the get go you don't want to pay up what they what they could do there's a few of them that have found success typically they've landed targets before constellation has been able to you know engage with them themselves and a lot of these copycats that have been successful what they've done is they've carved out their own niche so they you know constellation I guess in broad terms is a value investor that is pretty confident that you know it's it's already they're already in pretty much every vertical globally and they're pretty confident that they can acquire just about any software company and take it to around 30% profitability right so regardless of the shape or size of that business so in order to differentiate themselves the more successful copycats have carved out their niche within this niche which is like you know so we're only going to target companies that you know have you know a predefined level of revenue and that operate in you know these five verticals whichever they may be right so they they stick to this discipline approach and that's how they've been able to you know carve out their own success so when I was a constellation I was part of processes where there was a business that may have been you know the ideal target to one of these copycats but because of the size of the acquisition it may have been you know a few million dollars above the threshold so above the threshold they were willing to you know operate in so they so they thought themselves you know what that's too big for us right now so we'll pass. And I want to kind of double click on a couple of the things you said there so just to kind of distill that down a little bit it sounds like two of the biggest things constellation has going for them is one their reputation as you kind of mentioned if you really care about what happens to your home I know Mark Leonard would often talk about people worried about quote unquote selling their baby and so if you really care about that sort of factor the reputation constellation has for really stewarding the asset the business not firing everyone really is a selling point for some people and that's the first thing. The second aspect is just kind of the amount of coverage they have I think they at one point said they now have a database of 70,000 businesses that they're now tracking and so it's very hard to find a lot of these niche businesses and so simply knowing that they exist is is a value add and so there's those two aspects but then you also kind of talked about how if someone is willing to pay the same price you would want to go to constellation software that makes sense but why aren't these copycats coming in and driving up prices especially given that a lot of people kind of believe that constellation software's hurdle rates are too high and investors in the past have even complained that they should be willing to accept lower hurdle rates because they themselves can't find better investment opportunities elsewhere. Yeah so I mean you've seen a phenomenon in the vertical market software place which has occurred you know over the last few years so there there has been a drive up in multiples not necessarily because of copycats per se but because there's been a lot of entrance into certain certain verticals right I would say more than others but you have you know strategics typically you know multi-billion dollar companies that operate in a few industries that are looking to you know undertake acquisitions within our particular industry and you also have private equity right so typically again for larger acquisitions you know those over you know ten or twenty million dollars in revenue and private equity is more willing to pay up from the get co right so that has driven up multiples and then you know you factor in copycats the thing is is that you know sometimes this ramp up in multiples it takes because we're talking private markets it takes a while for people to actually you know I guess agree amongst themselves as to what a suitable multiple is right if you're the seller of a business every seller knows someone whether it's a peer or a neighbor or a competitor who was sold for an elevated multiple in the past few years right so what you and and without taking into the the specifics what without it without taking into consideration the specifics of the particular business that sold at that high multiple you know you you'll have that seller anchored at that multiple and say well listen you know like so and so sold their business for you know five times revenue so I want to sell my business at five times revenue but you know because these are private markets it's not like you know you're it's the public market where you look at your brokerage screen and you whenever there's a valuation reset you see that instantly on on your screen right sometimes this takes two years a guy who has you know the five X multiple anchored at the back of his mind might it might take a couple of years of conversations from to realize that you know no one wants to pay that amount for his company so therefore it's not worth that much right so um in competitive process processes you might see you know a ramp up in multiples but it's it's marginal because you know a lot of these copycats it's they're not bootstrapped but you know they've raised like I said typically in the 20 million dollar range and they want to start off discipline because they're held by the standards of constellation right which is a you know a disciplined acquire who you know is very cautious about overpaying regardless of the asset so typically the discrepancy will be a little if any right you're not going to see um you know it's it's rare to see one of these copycats offering double the multiple that constellation has offered what about assuming this copycat was able to win the auction now they have this new company I've heard that some of them actually have trouble running these businesses what is it operationally that constellation software would do differently or what is it that these copycats are messing up yeah I mean it's it's hard to say messing up without knowing the inner workings of each and every one of these businesses but certainly what constellation has going for it right it's it's created this fine tuned well oiled machine that's specialized in you know acquiring hundreds of companies and you know building out a playbook so that they operate successfully going forward so you know constellations ideal world is they acquire a business um you know that's well managed typically it's found or led even though it's a more mature business that it's been around for you know 10 10 20 years whatever it may be they they'll incentivize the owner through an urn out to remain in the business for you know three four years whatever it may be but statistically speaking a lot of these owners do end up staying beyond the urn out period so the statistic I've heard is that 70% of constellation senior management so senior executives at constellation were former entrepreneurs who sold their businesses back to console to constellation back in the day and have decided to remain so so so what that's created is this in-house network of essentially software experts around the world in different niches who you know are incentivized to exchange best practices and and you know gather every few months at you know leadership summits to you know discuss you know I guess you know hot topics or you know troubleshooting or you know any issues that they had or creative solutions they may have found so that creates this kind of you know camaraderie inside the organization which a lot of these copycats perhaps lack right so a lot of them I guess do look to incentivize management to stay on beyond an acquisition but in terms of messing up I guess the case is obscene is you know I guess overpromising and under delivering particularly with regards to deal structures and incentive structures right to remain competitive a lot of them have offered you know not only a price upfront but also you know a sweetener in the form of an earnout that's you know at a significant multiple compared to what the the entry price was and many times that doesn't materialize so then you have management to satisfaction and you don't you know if management were to leave so say you acquire a business you're a copycat you require business and the founder of that business or the manager of the business decides to leave you don't have a bench that's deep enough right to replace them whereas constellation does have that right so if a manager were to sell their business to constellation and were to depart within the earnout period for example it wouldn't be a deal breaker for constellation because you know typically constellation has already thought that out before you know closing the deal to begin with and they've got a bench deep enough of you know maybe two three or maybe more people who more than fit the bill and are more than willing to step up and take that role so obviously you want a good quality manager running these businesses but my understanding or I guess the way I would frame this generally is the higher the quality of business the less of a need there is for such a good manager and a lot of these businesses the vertical market software businesses are very high quality at least on the outside their mission critical they have a very sticky customer base and so even if a manager were to leave why does that really blow up the business what is kind of changing in the day to day that makes it so hard because I think on the outside there's a little bit of a sort of perhaps misunderstanding that a lot of this software is kind of legacy software that's not really updated very long and as long as it continues to run there's really not a lot needed to keep the business going and so what is it about the manager leaving that sort of changes that yeah I guess there's a couple of key factors that stand out right so the way to think about it is a lot of the companies that constellation software requires are typically smaller more mature businesses so you know you're talking businesses that maybe they do 10 million in revenue maybe it's 20 but they've been around for you know over a decade you know 20 years whatever it may be right a lot of them are still founder led and they sell to constellation right because they're concerned the sellers concerned with I guess the long term well-being of his business right because it's a small business with maybe a handful of employees but a lot of these employees have been around for you know the long run they've been with a with with the with the seller of that business since the inception of that business so the seller wants to you know make sure that those employees are taken care of so any attrition or any you know I guess anything that might impact the relationship between constellation and the seller would be detrimental to the well-being of the other employees in that organization and also being that these organizations are very lean a lot of the time you know the seller holds you know the relationships with a lot of the key customers right who have been customers again from the get go so if there were to be you know especially you know these things happen sometimes with a change of control and the large clients or the long-standing clients get cold feet and think oh wow you know this has been a family owned business and all of a sudden you know this this international multi-billion dollar conglomerate is going to take over you know what's going to change if there is that change then sometimes you see that there is some stress which could impact you know the the performance of that organization and the relationship with that client and I guess I'm also wondering what kind of stops them from being able to do more acquisitions of these small types every year because they seem to be a little bit limited around doing a hundred of them but of course they could theoretically just expand the organization to try to continue to do more of these to eat up more of their excess capital and I'm wondering also if kind of whatever that limitation is is also a reason why these copycats haven't really been a problem to them because they really haven't been able to eat up more acquisitions anyway so you know Banyan, Valsoth, Vitech, Visma all these different copycats they're not really taking up constellation software as TAM because there's enough for everyone. Yeah I guess um your last point's a good one right and it helps to really understand this topic a bit better so I guess the consensus is is that this this TAM is large enough to you know um to to accommodate different entrants to the market right so you know there you know there's new software companies coming to market every day to service different niches and and and and provide different tools to the marketplace right at the same way there are new competitors entering the market every day from an acquisition standpoint so um constellations um goal I guess is to deploy every dollar of free cash flow it generates into further acquisitions so but many times you know like even though you've got a database of tens of thousands of software businesses right timing is key so that doesn't mean that every one of these businesses is is ready to be sold at that time it's a very personal journey for the seller right so and that's one of the reasons why it's important to track these conversations because you know you might have um that initial conversation with a prospective seller the owner of a software business he gets acquainted with constellations share some information about his business you know perhaps that that has peaked his interest slightly but um he's still in you know somewhere in the middle of his journey as a founder entrepreneur and he's not ready to sell his business just yet right so that might take a few years and after a few years maybe you know there's a trigger that's you know maybe it's a liquidity event or maybe it's a lifestyle change you know the the seller wants to retire for example or wants to you know set the path for his retirement in motion right and then they'll entertain that conversation so it could be a few years between you know that first conversation and the time of business is actually ready to be sold so so patience is key and if you monitor these conversations and how they progress over the next few years you're able to kind of you know be opportunistic when the opportunity presents itself and I guess the copycats might lack some of that knowledge especially if they've only just entered the market yeah that that all makes sense and I guess kind of just wrapping up this topic of competition Mark has this quote where he talks about how a lot of their managers will have you know three million dollars in stock and that alone is enough for them to go out leave constellation and you know start bidding on some of these businesses themselves how common is it that a CSU manager quits to go into business for themselves to try to go out and acquire these businesses it has happened I wouldn't say it's a very common occurrence like I mentioned right there's been I guess the proliferation of these copycats has really I guess you know accelerated in the last couple of years and you know there's been dozens and dozens of them entering the market particularly in Europe I want to say it does seem like it's a bit of a crowded market from that standpoint a few of them might have you know I guess you know you know first hand knowledge or you know first hand experience working at constellation but I wouldn't see I wouldn't say it's a very common occurrence from an operational standpoint you know the more senior leaders at constellation they they hold enough equity in constellation they hold enough stock in constellation that it won't necessarily be in their best interest to leave and you know the same way constellation is you know a long term you know safe home for the sellers of businesses that sell their business to constellation it's that same way for the operators who have been doing a good job in delivering right the risk return for them might not be worth it you've seen a few people people more on the M&A execution side that have been look have been looking to do something more autonomous but again it's nothing really it's just a blip in the radar at the moment I would say what about that comment he made a couple years ago where he started talking about how they're going to create an internal venture fund and the idea there is that they'll kind of guarantee a lower salary amount but they're not gonna be applicable for bonuses and that way if someone did want to create a software company they could do it within constellation with a little bit more safety but still that upside I he hasn't talked too much about that since I don't know if if you know anything of that yeah so I I do know something about that so valaris which was the largest division where I started my but career constellation at so they had almost like an incubator so it's almost like a VC arm called Verstra that looked to invest in earlier sage software businesses that one day would you know be would fit the bill as the ideal constellation target but my understanding is that those initiatives have been folded and that those companies have transitioned into other portfolios within valaris so I guess constellation has taken a step back and has been focusing more on their bread and butter which is the acquisition of more mature businesses now that's not to say that there aren't other initiatives which are being looked at at constellation because you know they keep a very open mind when it comes to exploring new avenues for growth they're very aware that this is a constantly changing and evolving market and they want to always be a step ahead of things when it comes to adapting yeah I mean that kind of seems to be a theme a little bit with constellation where they'll try these organic growth initiatives they'll talk about wanting to figure out how to grow more organically and then nothing really seems to work as well as them just acquiring other businesses I don't know if you have any thoughts there otherwise I could kind of go more into organic growth yeah absolutely so I mean what do you have is a company that's you know built this playbook since the 90s right it's been tremendously successful in doing so but now you know fast forward it's you know constellation software has reached the market cap of around $75 billion so it's going to take more than just you know these smaller deals you know like five to seven million dollars in revenue to actually move the needle right so they've been proactively looking at pursuing larger and larger acquisitions and also in exploring more creative deal structures which go well beyond the the traditional hey you know like let's acquire 100% of this business and operate it the way we've usually done right so at the same time you know like I said they keep an open mind but first and foremost you know they're a disciplined acquire a disciplined investor and it's of utmost most important to them to acquire at this at the correct price yeah and I definitely want to touch on some of those more creative strategies later on but just sticking on organic growth this is maybe going to sound like a pretty ignorant question but my understanding a lot of mission critical software applications sticky customer base not a lot of substitutes even if there is a substitute product it is such a pain to try to switch to them why isn't there more pricing power on a lot of these different software applications you know it seems like this could be something they could just regularly increase prices on but they don't seem to do that yeah so I mean you know you have to take into consideration the profile of these businesses by nature right so these businesses have been around for you know a long time they have a limited size and a limited time as well so you know there simply isn't much room for these companies to grow significantly to begin with right they've got long-standing customer relationships many times they haven't really reinvested into their software enough to kind of warrant that price increase or maybe it's just a lean organization that's just been you know focused internally on I guess you know like the inner workings of that organization and the product per se rather than you know charging you know a price that would be more adequate at the market right many times there if there is a new customer to be won they'll do everything they can to land that customer maybe it's to fill you know a short-term gap in cash flow right so they'll try and offer that customer a discount right just so they can win that customer but you'll see that I guess the pricing for a lot of these businesses is all over the place right and that I guess is one of the avenues that they provide constellation to kind of you know unlock one of these levers of growth post acquisition so for some of these businesses are you saying that they don't want to take pricing because they just don't feel great about it they have an updated their product and so long they have these long-standing customer relations or you saying they can't take pricing because they're gonna they're gonna lose customers if they do it's I mean a lot of them offer sticky solutions to begin with right so even though so if you take a niche software solution that has little in the way of competition that's the typical business that constellation looks to acquire so maybe the switching cost per se isn't as high of a risk right if they were to raise prices but maybe it's just the fact that you know every price negotiation has to have kind of yeah you have to have a counter offer in terms of what you're offering right so maybe they lack the the I guess the willingness to kind of just go out and negotiate and risk jeopardizing the relationship with that customer but a lot of the times you know on the flip side you have a lot of these businesses that are smaller businesses that service blue chip clients and you'll find that the you know when it's a blue chip client that has you know a smaller software company that it's negotiating with they kind of have the the bargaining power when it comes to negotiations so it's it goes both ways really but it comes down to kind of understanding the market and understanding your clients necessities and what I guess the you know the appropriate price to be charging that client would be obviously this is generalizing but is it your sense that the pricing power they could they could have they're already exercising so it's not like there's a lot of untapped pricing power not necessarily true there sometimes is a lot of untapped pricing power but it just like I said I gave the example of you know a customer win so say you're a small software business and there is a you know a new blue chip client that's coming to market and and you know you have the chance of winning that customer and let's say it's you know that you're engaging with a decision-maker at that blue chip customer put that you know a blue chip prospective customer that is you know that that that can make a quick decision you want to land that customer at any cost before a year and for cash flow purposes or at least have it in the books you might offer them a generous discount you know for a few years and and and then you'll win that customer and you'll lock them in and maybe it won't be a priority to you to kind of you know go back to the the negotiation table in that next couple of years to try and you know extract as much as you could in terms of pricing from that client right maybe maybe there will be a price increase maybe it'll be modest but many times you know it's just a lot of the times these are lean teams everyone's kind of you know in their little silo and they they're not really proactive about going out and trying to charge customers as much as they could but it could be also coupled with the fact that maybe they offer legacy software that hasn't been updated in a while so if they were to charge prices you know or charge you know higher prices to a long-standing customer they wouldn't have they wouldn't feel comfortable with their current offering so they wouldn't really you know have something to kind of back up that request for a higher price so it does sound like there's just a little bit of a sense of wanting to make sure these businesses have good longevity and taking too much pricing up front can jeopardize that yeah I would say if you're a constellation you know I guess the way constellation approaches every deal is I guess you have to think about like what the counterparty would be right so on the other side of the of the negotiation table if there's a process it's typically a private equity firm so the private equity firm you know the private equity funds approaches you know to acquire a business you know hold it for whatever their holding period is you know say it's five to seven years they can do like just about anything to that business they'll rebrand it you know cut off all sorts of costs maybe get rid of management and then look to sell that business in the next five to seven years at a premium right so I guess one of the big I guess ways of unlocking returns for them is the exit multiple they can benefit from constellation on the flip side is is you know as a value investor so it's approaches to buy and hold forever so it doesn't have that exit multiple it can benefit from so then it's it's approach to you know acquiring business is there's a lot more customer centric because you know at the end of the day it's going to hold on to these companies forever and ideally hold these relationships with these clients forever right so every with every acquisition comes the need and the necessity to kind of understand that clients you know requirements the position that's in it's pricing everything about them inside out on a holistic basis right and then based on that you can kind of figure out I guess how to kind of you know I guess unlock returns you know whether whether it's from a pricing perspective of from another perspective so this usually takes place before a deal closes so in the due diligence early due diligence phase you know there'll be a conversation with the seller it'll be a bilateral conversation where you kind of really understand you don't try and understand every one of their key clients you know how long have they they had their tenure with the company for what does their pricing look like and constellation will have you know through their own operators they'll typically have them know how all that you know market already so they'll know you know how that product stacks up compared to other products in that sector and how that pricing compares so and then obviously you know what the client might be willing to pay for that particular product so maybe there is a case where you know a client is grossly underpaying in comparison to what the you know constellation could be charging or maybe it's the case where you know this is a legacy software you know it's a tier three tier four tier five software and the client has been around for a long time and is very comfortable paying that price for that particular software right so if you were to say you know rewrite the software or you know try and kind of you know come up with any or invest an R&D to innovate that software you might win new customers but that might come at the expense of losing existing longstanding customers who you know a might be unwilling to pay more for that particular product or be my suffer from a disruption to their business because again you know like these are small companies and and any implementation any customization kind of is is you know what would cause an interruption to that business yeah and I want to ask kind of the organic growth question a little differently and you covered the pricing pretty well so we don't need to touch on that but more kind of in terms of R&D and their growth of new products because Mark Leonard kind of talked this is you know now 10 years back 15 years back about doing this experiment saying what happened if we did invest more in R&D and he kind of talked about a willingness of lowering the profit margin by one point so increasing R&D is a percent of revenue by one point in exchange for one point of organic revenue growth and he thought that was a pretty good trade off and so they ran this experiment and the kind of conclusion of it was that once again it was just better if they put that money into more acquisitions then more R&D but I know at the same time they've really been trying to figure out different ways to stoke organic growth one of the reasons why they were interested in the sort of topicus transaction was they thought there could be learnings there that could help them grow more organically and so I'm just kind of wondering why is it so hard for them to stoke organic growth is it just a nature of their customers are not interested in anything else they try to sell them is it just that these are you know products that are very old and so if they're going to switch to something new then they're just going to go to something that's entirely new why is it so hard for them to figure out the organic growth aspect yeah I guess um you know I guess organic growth if you look back historically um there's always been some sort of a focus on organic growth but it's never been a tier one priority for constellation per se right so constellations entire growth has pretty much been inorganic throughout the years and it's not a pretty fantastic job through inorganic growth through acquisition right so um you know there's been a huge emphasis there is a huge emphasis internally um you know first of all um their employees are incentivized you know to focus on acquisitions there's a huge huge emphasis on that as opposed to organic growth so you know so the incentive structures and bonus structures for employees are built around inorganic growth and return on invested capital so I would say two of the most important metrics if your uh an employee a constellation software are heroic right so the return you're generating for the price you've invested in an asset as well as you know have you met your capital deployment goals the capital deployment target that's been established for you so as you'll see it's very heavily skewed it's been very heavily skewed towards um inorganic growth um I guess another way of looking at it is right you know like constellation has typically been you know a very disciplined acquire as I mentioned earlier a lot of these companies that acquires haven't really been growing all that much to begin with right so um if you're so you know it's constellation is very decentralized and you know employees have it's very much to eat what you kill culture so an employee especially you know a senior leader a constellation will have full accountability for the outcome of an acquisition right so they're already incentivized through their bonus structure to pursue inorganic growth and if you're looking at um from an investor's perspective you really look like as I mentioned you know you don't have an exit multiple to benefit from you so you're you're you from an investment standpoint you know you're looking at you're thinking in terms of a discounted cash flow model so the company's cash flow right post acquisition in the early years carry a very heavy weighting in determining the returns of that particular investment so typically if you were to invest in organic growth you know on the onset post acquisition there is a risk that comes with that right because I would say you know like uh I mean all growth comes you know through an associated cost um and if there is growth it kind of has to be sustainable so um many times you'll acquire constellation will acquire a business that you know has plateaued and that business you know has been you know conducting its normal day to day activities but you know the seller has been looking to grow through say a product expansion so investing in R&D into whether it's a new product line or you know maybe entering a new vertical to begin with but that there's a lot of associated risk that comes with that so if you're constellation and you acquire that business typically it's a lot safer to bring those R&D you know investments to a halt and focus on what you know so you can generate the returns that all you know at the very least match your investment thesis and many times I guess the the companies that are acquisition targets that do position themselves more as growth the companies they'll want a multiple that's more associated with a growth company to begin with and therefore typically they'll be outside constellations reach from a valuation perspective so I guess there's several ways of looking at it right from an operator's perspective as well as from an investor's perspective yeah and that that all makes sense and I know that obviously a constellation software very decentralized uh they talk about when they're making acquisition they don't rely on any sort of synergies and all that but there was kind of a recent kind of shift a little bit when he talked about payments in this last AGM saying that there's a lot more they could do in payments kind of implying that that could be some sort of uh either cost reduction or booster revenue across all of their different businesses and so it did get me thinking to what extent there is sort of any cross-selling of products uh just within the different business units and businesses but then also how you think about something like this new opportunity with payments whether or not that's actually factoring into any of your decisions or is this kind of a new top-down initiative it'll be another experiment we'll see how it goes yeah so with regards to synergies per se um I guess you know constellations approach is very decentralized so the way it looks to I guess you know the way it looks at an investment from a return's perspective is it'll look at every business on a standalone basis right so even though so say constellation is already present in a particular niche and it's acquiring a business that would be a tuck-in right it'll you know that business will provide you know a new tool um in a niche where constellation already operates in there there might be potential synergies which you know could be there right off the bat but from a modeling perspective and from a perspective of building out the investment thesis um you won't compute those synergies into your investment returns they they won't be they're not allowed to be a driver of synergies constellation essentially would you have to prove if you're bringing a deal or an investment to the table of constellation is that that investment that deal is self-sustainable on you know on a standalone basis without the need for any synergies so you're going to match the hurdle rates you're going to meet the the necessary investment returns without synergies so synergies are almost like a nice to have now with that being said you know they're there right and you know once a company's acquired you know the portfolio businesses are encouraged to explore cross-selling opportunities right so the companies themselves they remain standalone companies with their own identities but they benefit from the fact that all of a sudden now they're part of they might be part of a portfolio that offers you know adjacent tools to which they can be a value add right and or potentially even a geographic expansion so what constellation won't do is invest significantly into building those resources out from from scratch but the company company will then that definitely benefit from the existing structure so it does happen right and and it goes back to the exchange of best practices that I mentioned early and and with regards to payments I've seen that in place that constellation where you know you you you acquire a company that maybe offers a payment processing tool or you acquire a standalone payment processing tool which you can then you know kind of apply or or use across companies in different verticals and that's that's become a more common play with private equity companies in this space too where you know they'll look to roll up companies in certain software sectors and then they'll buy a payment processor or build out their own payment processor so they can then bring value through the table through that. So how much as you kind of think about the style drift because Mark's kind of talked about not only the opportunity for VMS kind of being what it is going to be they're not going to be able to do much more than a hundred or so of these acquisitions annually and now they're layering in a couple of these larger acquisitions once year but Mark's kind of talked about one not wanting to return any capital to shareholders and so wanting to find reinvestment opportunity for that and he's kind of talked about how that's led them to style drift and we haven't seen this yet you know we talked in 2021 at the AGM about how they almost did an oil asset deal and the prices ended up going up on them so they didn't close that but how do you think about style drift and kind of the risk inherited that and is the organization set up for anything other than VMS? I would say I guess by nature so again it goes back to those keywords that we mentioned earlier right so constellation is you know a very disciplined acquire right that's at the forefront of its strategy so you could almost say that they're all they'll pretty much look at anything at the right price right so it's that being said it's not you know a deal won't only be price driven you have to understand exactly what you're buying so obviously the bread and butter the expertise historically has been you know VMS software businesses but they've been looking at other businesses and maybe adjacent industries that might not be you know pure SaaS or pure software businesses but that share common characteristics right so you won't see constellation going into something that's completely new or out of left field doing something completely different but it will it'll be if it is if it isn't a adjacent sector or a new market it'll be something that shares characteristics with the kind of businesses they do acquire so you know maybe a sticky customer base you know a high percentage of recurring revenues and if they're not directly recurring maybe they're recurring in nature right maybe those revenue streams share characteristics with you know what a recurring revenue stream a constellation would look like there's obviously the whole topic of AI which again has become I guess a key priority as well for every organization in that space to at least understand better since the last year or two right so there's the constellation is also looking at you know how that's impacting their business activities and what they could do for that but you know I think you know the I guess their area of expertise will always be software they've been looking at more creative deal structures and looking to do larger and larger deals that you know move the needle rather than just you know be small niche VMS businesses maybe it's you know a multi billion dollar take private of you know of a public business or it's you know it's a non-corrasset of a public listed company potentially a restructuring which you know a few like a few other players are looking at somewhere where it can have a first mover advantage without necessarily you know being at the table with you know whether it's PE or you know other strategics. Is it your sense that if there is kind of style drift and they end up in an area way outside of the traditional VMS that would be an initiative led by Mark or do does each operating group could they potentially allocate that capital into a different industry or do they not have that level of autonomy. So I guess Mark tries to push down as much autonomy and decentralize the organization as much as possible that's part of I guess constellations culture but that being said you know so most of the investments that are pretty much all the investments and acquisitions done by constellation they're not carried out at the holding company level they're all carried out by you know each operating division and the respective groups or portfolios within those operating divisions. So the individuals within those operating divisions are very much empowered to go out and you know pursue their own deals. What Mark likes to you know proactively participate in is the more complex structures and the much larger deals. So those are the ones he likes to directly be involved in right so that's so I guess that fits the bill in terms of what you just mentioned right just kind of breaking off and you know drifting out like the style drift you mentioned early. So I do think that if it's even if it's a smaller experiment I guess Mark would like to have some level of input it's very rare that you'll see all of a sudden because at the end of the day even though you know people within the different groups and the operating divisions are empowered to pursue you know the new acquisitions they all have to get improved approved by an investment committee right and and it's rare that you know you're going to just bring something that's completely from left field to the table without someone having been acquainted with that particular niche beforehand right so typically Mark would be involved in those right and I know in the past at least when he still did earnings call talked about how any deals over 20 million would get kicked upstairs and would have to be approved by them so so that all makes sense. You kind of talked a little bit about these new creative deal structures we know that there's obviously been the topic has been off the loomine sped off and those when he kind of explained those transactions the idea there was that this was a transaction that wouldn't have happened otherwise unless it was in conjunction with a spinoff so they were able to put more capital work and the steel just kind of allowed them to do it because it wouldn't have happened if they didn't have kind of a separate public company for that. More recently we seen them take now these large or at least one large stake in a public company and said they kind of have no interest in actively managing it or wholly acquiring it and they're fine just holding onto that what's going to be I believe the 25% stake in a seco and so I was wondering if you know how they're thinking any differently of these or I guess it's really more the process if it's any different looking for these public companies is that kickstarted by Mark or do you guys now have teams within each business unit that is allowed to look at public businesses obviously these will be businesses that are larger than five million dollars. Yeah so I would say it's pushed down to the individual teams so the individual teams are on the lookout for you know there is that that need to deploy capital right that's like I guess the key mandate at constellation is like you have to go out and deploy as much capital as possible so everyone's on the lookout for the next investment or acquisition and people are incentivized more and more to guys think outside the box when it comes to different acquisitions so the initiative might come from you know one of the individual teams will say but for something that's you know a new initiative you would typically even if it would typically either require Mark's input or you would definitely benefit from having his two cents on that topic right because it's something that he's proactively looking to be involved in and at the end of the day you know like why not have Mark a pine on something like that right so again there's different kinds of structures that they're exploring but obviously they have to be aligned in terms of management and you know not only the external management but also constellation senior leadership. Do you think they and I don't know if he's commented on this if they'd be willing to accept a lower hurdle rate on these public investments because they are easier to execute? So constellation has experimented with slightly lower hurdle rates for larger acquisitions so deals with equity value of at one point it was 50 at one point it was over 100 million but then they there's been some backtrack with regards to that so there's always I guess they're always on the lookout or maybe considering exceptions of the case so perhaps I guess one of the benefits from you know a lot of these you know spinning out or these carve outs of these existing entities you mentioned such as you know topicals or lumen is the multiple arbitrage because you know constellation will acquire companies that allow multiple but then if you look at what the stock is trading at you're looking at what is it's around eight times revenue right so there's an instant benefit from you know carving out and spinning out these existing entities so I guess I would say every opportunity particularly if it's a different opportunity will be looked at holistically but there's still you know they're always going to they're always going to be that discipline supplier and have that you know conservative value investor approach where all alternatives are thought through nothing is going to be done recklessly yeah and that makes sense and I kind of wanted to transition quickly to AI from the lens of us talking both about competition so when there is AI it's lowering the sort of R&D costs to create products it's making it easier it also allows people to make more products than they could have otherwise from the perspective of a software owner that could be a benefit because now your R&D costs went down you could do different projects and you could try to sell them to customers and so I I know he's kind of talked about both of these but I'm curious your opinion on AI how much of it is really just going to increase competition or how much of it is an opportunity to potentially lower R&D costs lower expenses and maybe even stoke some organic growth yeah I mean it's it's twofold right so I guess you know one way to look at it is you know AI is already very it's it's very much real particularly in the software space the the threat seems to be larger you know at these more general horizontal businesses and smaller niche legacy ones which require you know a higher level of customization and integration to begin with you know so I guess in terms of actually carrying out these investments in AI at the individual company level you know a lot of these are smaller businesses to begin with right that have been around for a while so they could think okay so why not you know invest in in AI to maybe you know save on R&D or or maybe you know just automate what we you know what we outsource to a third party why not just do it in house that would be a lower cost or easier in the long term but if you're bringing in these new AI capabilities right they require a tech team that's well versed enough to design them implement and customize them right in into the business right so maybe this means they'll have to get rid of their you know existing tech team and bring in new programmers and as I mentioned previously right any disruption or any new vision initiative at these smaller businesses with a with the handful of employees potentially create like a parallelization at the business right if you're going to kind of all of a sudden you know you you you're a software business you're looking to you know build this new AI tool or maybe even relinquish your existing software and replace it with an AI tool you're going to have to a build that out and be implement and install it and that's going to just essentially paralyze your whole business and maybe even jeopardize relationships with key customers result in you know lost revenue for a period of months or maybe even a year right so that's why if you're looking at vertical market software a lot of these companies are a bit reluctant to do that and and then I guess at the constellation level right you know there are sectors and verticals which you know a constellation operates in which tend to be more innovative and rely more heavily on things such as data analytics automation and risk management right so these might be the first to be impacted and you know and these are the sectors which might be you know first movers in terms of adopting AI capabilities but then would constellation want to actually deploy resources themselves into actually building them out right because again it's from an investor's perspective you're then expending a lot in terms of R&D for for you know a return that you're not sure might be sustainable right no one knows what that return is going to be it's obviously the the hot topic right now but it come it boils down to really understanding what your customers needs for the short and long-term are right and I guess the way a long-term investor such as constellation would approach that is okay we'd be investing now yes AI is a thing but who knows what the return would be for the investment that we're going to undertake at the moment right so so so so so there's different ways of looking at it yeah I'm just curious a quick one have you ever heard of a business selling because they were scared of AI I haven't heard of a business selling that because they were scared of AI I've heard of businesses that were never in AI to begin with and I've seen a lot of those who all of a sudden started incorporating some level of analytics or AI tools into their platform as it means to try and obtain a higher valuation right so it's your it's maybe you're one of the mill vertical market software business that has always been focused on a particular niche has been around for 10 years and all of a sudden you know they're building out this A&I platform this analytics platform at the at the expense of investing more and R&D so maybe the profit has taken a hit but they've been experiencing you know a higher level of growth and they might come to a constellation and say listen you know like because we've been growing now you know double digits for the last year or two we won a multiple that's a lot higher than what we would have commanded a couple of years ago on the flip side constellation might say okay well that growth is unproven and might not be sustainable and that's completely outside the core competency of that company right so constellation but then you know again it goes back to doing its diligence understanding its customers understanding the marketplace and the needs for a tool like that but I haven't heard of a company selling because of the AI threat maybe there's a seller that has come to a certain point where he's already been entertaining the idea of selling and he thinks you know I want to take some risk of the table and maybe now's a right time because you know people are looking to acquire tech and software businesses but never because they thought AI was going to drive their air their their software company out of business but who knows right it's an ever changing marketplace and maybe that is the thing yeah that that's great and just kind of as we wrap things up here I have these three kind of rapid fire questions you could take as short as you want to answer them but I was curious how do you and other people inside of the company feel about kind of having to compulsorily buy stock when the price is high and so it's part of you know incentives that you have to buy the stock even even when it is at a high price how do you how do you and other people feel about that um I first have some reluctance I mean I could I could give you a rapid fire response um maybe reluctance would be that rapid fire response because the stock has always been at an all-time high for the last few years because it's been delivering these tremendous returns but in hindsight I think you'll find that every employee is kind of happy or grateful that they that they have this mechanism in place because the stock has been delivering great returns every year right so especially if you take the long standing employees that been around for a while I'm sure even 10 years ago everyone was like oh wow the stock is high and as long as it's been you know it's it continues to deliver these returns as everyone's happy but it is it can be I guess a source of contention because of the way it's carried out so you know 75% of senior employees employees have to deploy 75% of their bonuses into constellation stock but so far I have no complaints right right historically and but then at the same time in the last AGM Mark Leonard saying I don't see better than a 68% return going forward and so I can't imagine that feels the best yeah I mean there there have been a few qualms with that in the past but who knows right I guess the way constellation has been able to maintain itself as the forefront of his of its industry and how to such a high standard is that you know on from the outside if you're looking from the outside what they what they do is it might look at like you know it's it's your tried and tested kind of like almost like a methodic and boring approach but from the inside they're actually very innovative right they're always exploring creative ways of doing things and more efficient ways to you know deploy capital and generate returns and at the same time you know maintain employee satisfaction so if it were to be a serious point of contention down the road I'm sure they'll come up with an alternative that'll make everyone happy because you know employee satisfaction is key to constellation and to keeping employees you know with them for the long run yeah now I was wondering on intra company competition of when you're trying to acquire one of these companies because I've heard that what happens is there's a database a specific business unit gets kind of dibs on one of the companies and that way it stops multiple people from going after the same company but then I've also heard some contradictions to that that that can happen and so I was just wondering what is that like internally is there kind of competition for the same asset? So rapid fire response I would say that everyone's pet peeve at constellation so it's if you I guess interview every one of constellations employees who's involved in M&A I guess 99% of them would deliver would say their pet peeve is the the intra company competition so yes there is an internal database yes and about first of all when people ask me like who's your number one competitor or who was your number one competitor when you were a constellation I would say oh other divisions of constellation because everyone's going after the same assets there is an internal database they do try and they have there's mechanisms in place to kind of have swim lanes protecting you know people from going after the same assets but a lot of times you know there's there's a loop holes that and it's extremely cutthroat so the way it happens is you know many times there's you're entertained a conversation with a seller the seller is having their first point of contact with constellation they'll go you've had a great call with them or a great meeting and then at the end of that meeting they might get a couple of inbound calls from another division a constellation with a completely different name to yours and all of a sudden they're confused so there is that I would say that I guess specialized sectors don't always get first dibs it does happen but what companies do what what divisions do at constellation as many times they'll trade for an asset that you know they desire but it is pretty cutthroat and and the idea is to pretty much go after everything that that you can write and many times that involves competing with other divisions so it's it's a source of frustration to many but at the end of the day it keeps people on their toes and always engaged when it comes to pursuing M&A okay and so last one let's say that constellations performance over the next decade wasn't good what happened it's that's that's a tricky one right that's if I had that crystal ball I'd probably be somewhere else right now but I would say maybe steering away from their modus operandi which has worked so well at the moment but I you know maybe maybe there's you know different entrance to the market maybe it's competition maybe it's evaluation reset so I guess probably the latter is maybe the number one reason that could happen if you're looking at this at it from a stock performance perspective right you know you've got a hot stock market right now software companies are trading at very elevated multiples but at the end of the day right if that multiple were to come down by you know one or two X there would still be significant multiple arbitrage but what is there to justify that you know elevated multiple to begin with it's the market's confidence and constellations ability to continue deploying capital and you know making successful investments the way it has been from day one right so maybe a loss in market confidence or I guess some sort of an economic crisis might hamper that but from from the company's performance perspective I wouldn't be too worried what about it seems like they basically need to do one of these large acquisitions at least every year just to deploy all their capital do you do have confidence they could do about one of these a year in terms of the large acquisitions I mean they've been doing one a year I want to say on average for the last few years this has become I guess a priority in terms of an internal mandate to pursue larger and larger acquisitions that move the needle many times they have to resort to I guess more creative or outside the box you know out of the box deal structures to begin with right if they're going to be competitive against you know P firms or strategics that are pursuing the same assets but I would say that one a year is certainly attainable just based on what I had seen okay well great and and thank you for answering all of our questions I really enjoyed this conversation I think it was very insightful so thank you Rohan for joining us in a special thanks to AlphaSense for hosting this if you want free access to expert call transcripts which are similar conversations to this you could just go to alpha-sense.com/speedwell there is a free trial there that you could go ahead and get your expert call transcripts and see how the platform works and then you could also go to speedwellresearch.com if you want more constellation software research thank you Rohan this was great thanks a lot you thanks a lot for having me