How Constellation Software wins deals and keeps talent - while remaining ultra-frugal

Disclaimer: Unless noted otherwise, views and analysis expressed here are the author's own and based on public sources. The article is intended for informational and entertainment purposes only. This is not financial advice. Please consult a professional for investment decisions.

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We are building RollUpEurope into the world’s biggest community for serial acquirers of anything. It doesn't matter to us if you are aggregating car washes, YouTube channels or even Starbucks franchisees. We love HoldCos and rollups of all shapes and sizes.      

Alas, no matter how hard we research the “traditional” industries, you people keep asking for one thing: more software HoldCo content. And specifically, more Constellation Software (CSU) content.  

To recap, we have written about ways in which CSU:

• Squeezes cash from Vertical Market Software

• May be great (or not) for your M&A career

• Continues to trade at stratospheric multiples 

However, you keep asking for more. 

And why wouldn’t we give it to you? 

Last month, we had an opportunity to test drive AlphaSense. For those of you not familiar, AlphaSense is a market intelligence and search platform that uses AI to help you quickly find insights from broker research, corporate filings, and of course expert calls. 

By combining the AlphaSense provided expert call transcripts with our own 1-on-1 conversations, we are bringing you fresh insights on two key topics:

1. Deconstructing CSU’s “1x revenue” bargain deals. Specifically,

2. CSU’s approach to variable compensation - and how it influences capital allocation

Now, v1 of the article turned out so long we had to split it into 2. In 2 weeks’ time we will be publishing Part 2 of the deep dive, in which we talk about: 

1. The 6 company metrics that CSU obsesses over;

2. Why CSU isn't afraid of technical debt; and

3. Whether CSU’s business model can survive the AI revolution 

We will repeat: AlphaSense is a great resource. Combine it with SourceScrub - the No.1 deal sourcing platform - to validate theses and to generate acquisition leads even faster! 

Before proceeding with the article, can we draw your attention to an exciting career opportunity submitted by a reader? 

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Interested? Apply here!  

1. Deconstructing CSU’s “1x revenue” bargain deals

It is common knowledge that CSU uses Discount Cash Flow to value acquisitions, with aggressive discount, or hurdle rates. 

A “typical” hurdle rate is 25% for mid-sized businesses, 30% for smaller ones, and 20% for larger deals (e.g. $100M+). As befits a buy-and-hold investor, CSU uses 10-year DCFs with a terminal value calculated according to the perpetuity growth method. The hurdle rates are set by the President i.e. Mark Leonard himself. 

Here comes the interesting part: the spinouts. 

There is a view among the investment community that the spinouts of Topicus (in 2021) and Lumine (2023) were in no small part driven by the CSU’s desire to become more competitive in larger deals - but without materially lowering the hurdle rates. 

CSU achieved this objective by allowing Topicus and Lumine to use their stock as rollover equity. Such a structure a) lowers the upfront consideration and b) creates instant multiple arbitrage given the delta between the multiples these spinouts trade at, and the multiples they pay in M&A. Hawk Infinity follows a similar playbook. 

What about cash flow projections? 

CSU uses so-called “base rates”: internal benchmarks for topline growth and margins. These benchmarks are based on data from 500+ acquisitions (source), taking into account company size, industry, and other factors. 

Because of the vast amount of empirical data, it is nigh on impossible for deal teams to argue for above-average topline growth and/or margin assumptions (following short-term value creation). This in turn puts downward pressure on M&A pricing, especially for younger businesses that are expected to grow above base rates in the next 5 years. 

No wonder CSU is frequently outbid on growth stage situations by PEs and strategics!

Moreover, CSU uses scenario-based financial modeling, also called the First Chicago method. 

The Method is nothing more than probability-weighted cash flows, which, in turn, are based on the base rates as explained above. According to Colin Keeley’s research, CSU uses four main scenarios:

1. Winner (upside)

2. Modest Winner (close to base case)

3. Walking Wounded (downside)

4. Wipeout (major downside)

The weights for the scenarios are based on empirical data, which the CSU teams have to hand since every deal is tracked with religious zeal. 

Let’s zoom in on the "Walking Wounded" scenario. It represents a situation where the acquired business underperforms over the short to medium term - but remains fundamentally viable, provided some turnaround effort. The term “walking wounded” borrowed from medical triage, describing individuals who are hurt but still mobile. 

In practice, the above translates into M&A multiples of:

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