#246 Mark Leonards Shareholder Letters

In this insightful discussion, the hosts delve into the remarkable journey of Mark Leonard, the reclusive founder of Constellation Software, who transformed a $25 million investment into a $40 billion enterprise through strategic acquisitions of over 500 vertical market software companies. Despite his success, Leonard maintains an enigmatic presence, preferring anonymity and letting his company's performance speak for itself. The conversation also explores Leonard's unique management philosophy, which emphasizes decentralization, autonomy, and the nurturing of small, high-performance teams—a stark contrast to the bureaucracy of larger organizations. Leonard's approach, which includes continuous experimentation and the dissemination of best practices across the conglomerate, is likened to Warren Buffett's investment strategies. Insights from Leonard's shareholder letters reveal his belief in the power of small-scale operations and his aspiration to be a perpetual owner of inherently attractive software businesses. Additionally, the hosts reflect on the influence of behavioral economics and other industries on business management, highlighting book recommendations that have shaped Leonard's thinking.

• Mark Leonard, CEO of Constellation Software, is compared to Warren Buffett for his investment and business strategies.
• Constellation Software, started with a $25 million investment, has grown into a $40 billion company by acquiring over 500 vertical market software companies.
• These acquisitions are typically small, but the aggregation and application of Constellation's financial and operational discipline have led to significant growth.
• Leonard has maintained an unusually high level of privacy for a public figure of his stature.

"With an initial $25 million investment in 195, Mark Leonard has built consolation into a world leading consolidator of vertical market software companies."

Leonard's ability to grow Constellation Software from a modest initial investment to a major market player highlights his strategic acumen in the software industry.

• Mark Leonard is described as a recluse, with very little public information available about him beyond his shareholder letters and investor calls.
• Leonard values decentralization, autonomy, and control within his company, reflecting his personal preference for independence.
• He has run Constellation Software for a long period, starting at age 39 and continuing to work on the company at age 66.
• Leonard's approach to management attracts like-minded, highly talented individuals who prefer not to work under centralized command and control.

"I don't like anyone telling me what to do. I don't like anyone saying I'm an authority figure and you will do it this way. I can't think of anything that annoys me more."

This quote exemplifies Leonard's disdain for authoritative command and his preference for a decentralized management structure within his company.

• Constellation Software has achieved economies of scale and growth by selling additional products to existing customers.
• The company also focuses on making acquired businesses more efficient, sometimes by reducing them to a profitable core.
• Leonard's strategies are inspired by other successful business figures, such as Henry Singleton of Teledyne, and Warren Buffett.

"The software business has significant economies of scale. We make money by selling existing customers more products."

Leonard emphasizes the importance of scaling within the software industry and the strategy of cross-selling to grow the business.

• Constellation's preference is to acquire businesses entirely and own them forever, similar to Warren Buffett's approach.
• The company is also open to buying minority interests in businesses with the prospect of eventually acquiring the rest.
• Constellation's objective is to be a perpetual owner of inherently attractive software businesses and ensure they are run by capable managers.

"Our preference is to acquire businesses in their entirety and to own them forever."

This quote reflects the long-term investment philosophy of Constellation Software and its commitment to full ownership and perpetual management.

• Leonard's strategy adapts to market conditions; during the 2008 financial crisis, he considered using debt to take advantage of depressed asset prices.
• The company's approach is to buy attractive vertical market software businesses while prices are low and to use financial leverage when necessary.

"Circumstances, however, may dictate a change in our capital structure."

This quote indicates Leonard's willingness to modify the company's financial strategies in response to changing economic conditions.

• Constellation Software focuses on balancing profitability and organic growth.
• The company's software businesses have low attrition rates, suggesting long-term client relationships.
• Constellation's products help customers run their businesses effectively for a cost that's typically less than 1% of their revenues.
• Leonard's long-term bias is evident in his desire to continually acquire and improve small vertical market software businesses.

"The longer we have owned a small software business, the larger and better it has become."

Leonard's quote highlights the company's strategy of long-term ownership and continuous improvement of its software businesses.

• Mark Leonard discusses the company's approach to growth and management, which is based on extreme decentralization and a dislike for bureaucracy.
• The company's structure is compared to Warren Buffett's, with a lean headquarters and reliance on general managers who are experts in their respective verticals.
• The company has owned more than 100 vertical market software businesses, from which they derive best practices to share across the organization.

"We've handled our growth to date by largely abdicating management to the managers of each of our vertical businesses." "We have a very thin overlay of infrastructure at headquarters, just like Buffett."

These quotes highlight the company's decentralized structure and the minimal bureaucracy at the corporate level, akin to Warren Buffett's management style.

• Liberty discusses the value of reading shareholder letters to gain insights from experienced business leaders like Warren Buffett.
• Both speakers express their interest in learning from Buffett's extensive experience in analyzing a wide variety of businesses for actionable ideas and best practices.
• Mark Leonard and Liberty are interested in understanding the principles behind successful business growth and management from the perspective of seasoned investors and founders.

"The reason I want to read Warren Buffett shareholder Letters is exactly what Mark just talked about." "There's probably no one else on the planet that has spent more time analyzing a wide variety of businesses."

These quotes emphasize the speakers' desire to learn from Warren Buffett's deep experience and the insights that can be gleaned from his shareholder letters.

• The speakers discuss the challenges of scaling a business, especially when it involves managing a large number of software companies.
• Mark Leonard addresses concerns raised by shareholders, the board, and analysts about the company's ability to scale.
• The company's growth strategy includes both organic growth and acquisitions, with organic growth being considered the tougher management challenge.

"Our long term shareholders, our board, and our analysts all seem concerned about our ability to scale." "Organic growth is, to my mind, the toughest management challenge in a software company, but it's potentially the most rewarding."

These quotes highlight the perceived challenges of scaling the business and the inherent difficulties in achieving organic growth in the software industry.

• Mark Leonard describes how the company improved financial performance by understanding human nature and managing initiatives effectively.
• The company separated research and development and sales and marketing spending into initiatives and other expenditures.
• They introduced dedicated initiative champion positions to ensure accountability and prevent wasteful spending.

"Initiatives grew to account for over half of our combined expenditures by 2005, which not coincidentally, was the peak of our spending." "We created dedicated initiative champion positions, so an initiative was less likely to drag on with a low but perpetual burn rate."

These quotes describe the company's efforts to manage initiatives more effectively and the positive impact of appointing dedicated champions for each initiative.

• The speakers discuss the company's acquisition strategy, which favors purchasing businesses from founders due to their long-term orientation and cultural fit.
• Mark Leonard notes that these founder-led businesses operate well under the company's umbrella and align with the company's values.
• The company actively tracks thousands of acquisition prospects, particularly those owned by baby boomers who may be considering retirement.

"Our favorite and most frequent acquisitions are the businesses that we buy from founders." "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 our umbrella."

These quotes outline the company's preference for acquiring founder-led businesses and the rationale behind this acquisition strategy.

• Mark Leonard discusses the opportunity to acquire distressed assets, often from large corporations that fail to integrate software businesses effectively.
• He mentions that these acquisitions are particularly attractive during recessions when corporations are more likely to divest non-core assets.
• The company looks to optimize these distressed assets once acquired, following a similar rationale to Warren Buffett's investment approach.

"The most lucrative acquisitions for us have been distressed assets." "The most attractive acquisitions from corporate large corporations have happened during recessions."

These quotes reveal the company's strategy of acquiring distressed assets, especially during economic downturns, to grow and scale the business.

• Mark Leonard reflects on considering fundamental changes to business strategy.
• He discusses the potential of acquiring large public sector software conglomerates in the UK.
• Leonard contemplates using debt or other financial instruments to finance acquisitions.
• He notes that Constellation's current bank facilities do not support standalone financing for acquisitions.
• Leonard emphasizes the importance of agility and being tight-knit over economies of scale in business units.

"Flirt with a fundamental change. I was recently in the UK where a couple of very large public sector vertical market software conglomerates are for sale. The whisper prices are ones we could just about stomach if we were financing the acquisitions on a standalone basis like PE firms."

The quote explains Leonard's openness to significant strategic shifts, including the acquisition of large companies which would typically be financed through means like those used by private equity firms.

• Constellation owns 125 businesses, with the largest having 307 employees and an average of 44 employees.
• A linear regression analysis found no strong correlation between the size and performance of business units.
• Leonard believes the small size of business units is beneficial for agility and outweighs economies of scale.
• He does not support centralizing to create larger business units and seeks scale through other means.

"One early observation is that our business units rarely get large. The biggest is 307 employees. And the average business we own currently only has 44 employees. Two thirds of our employees are working in businesses with less than 100 employees."

Leonard observes that Constellation's business units tend to remain small and that this does not hinder their performance, suggesting a strategic preference for maintaining smaller, more manageable units.

• Leonard acknowledges the temptation to use cheap debt to finance growth, given current market conditions.
• He would prefer long-term, noncallable debt with flexible interest payments, but investment bankers say this is not available.
• Constellation has resorted to using bank debt due to fast-growing cash flow but insufficient to finance acquisitions.
• Leonard seeks longer-term capital solutions to avoid the risks of short-term debt.

"Debt is cheap right now, so it's pretty tempting to use it. Unfortunately, it has a nasty habit of going away when you need it most."

Leonard expresses caution regarding the use of debt for financing, noting its unreliability in critical times despite its current low cost.

• Leonard and Liberty discuss the benefits of conglomerates, including efficient capital allocation and overcoming industry constraints.
• They reference Warren Buffett's philosophy on the advantages of conglomerates like Berkshire Hathaway.
• Conglomerates can shift capital from cash-rich, investment-limited businesses to more promising sectors without significant cost.
• They can invest in common stocks, which can lead to acquisitions beyond their financial capability.

"It is clear that acquisitions have added tremendous shareholder value over the years, particularly during times of economic crisis or recession."

Leonard highlights the value that acquisitions have brought to shareholders, especially during challenging economic times, reflecting the strategic advantage of conglomerates in capitalizing on opportunities.

• Mark Leonard discusses his decision to reduce his salary to zero, waive all compensation, and pay his own expenses to lead a more balanced life.
• He intends to maintain his role in acquisitions, monitoring, and other key areas, but without the intense workload of his earlier career.
• Leonard's compensation is now tied solely to his ownership of CSI shares, aligning his interests with those of other shareholders.

"Last year I asked the board to reduce my salary to zero. CSI had a great year, so despite these modifications, my total compensation actually increased."

Leonard's decision to forgo his salary reflects a desire for a more balanced lifestyle and a commitment to the long-term success of Constellation, as his compensation is now directly linked to the company's performance.

• Leonard advocates for keeping business units small and decision-making decentralized.
• He cites his venture capitalist experience and observations of competitive markets as reasons for this strategy.
• Leonard suggests dividing large business units, operating acquired businesses separately, and reducing head office costs.
• Constellation's structure allows for rapid testing and adoption of best business practices across its many business units.

"My personal preference is to instead focus on keeping our businesses small and the majority of the decision making down at the business level."

Leonard emphasizes his preference for small, autonomous business units, which he believes are more effective than centralized, larger entities.

• Leonard distinguishes between the moats around individual business units and the low barrier to starting a conglomerate.
• Constellation's competitive advantage lies in its many business units and culture conducive to testing and improving business processes.
• The company's ability to quickly identify and implement best practices across its business units is a key strength.

"Nevertheless, CSI does have a compelling asset that is difficult to both replicate and maintain. We have 199 separately tracked business units and an open, collegial and analytical culture."

Leonard points out that while it is easy to start a conglomerate, Constellation's unique culture and numerous business units provide a competitive advantage that is hard to replicate.

• Buffett's shareholder letters serve as a customer acquisition and distribution channel.
• They are written in a simple language aiming to be understandable to a broad audience.
• The letters are a means for Buffett to communicate directly with stakeholders.

Speaker A: Fifth grade, Mark is obviously very brilliant.

The quote suggests that Buffett's communication style in his letters is straightforward and intended to be accessible to readers of all levels, comparing it to a fifth-grade level for clarity.

• Mark Leonard's writing can be complex and sometimes requires re-reading for full comprehension.
• There might be an intentional choice not to simplify the language, possibly to limit the readership.

Speaker B: Very smart, but sometimes it's like, whoa, I'm trying to translate exactly what you're saying here. I've had to reread certain sections a bunch of times.

This quote reflects on the complexity of Mark Leonard's writing style and the effort required to understand it, suggesting that it may not be easily accessible to all readers.

• Experiments are conducted across the numerous businesses owned by the company.
• Successful, counterintuitive ideas discovered through experimentation are shared among businesses.
• This approach is likened to the management style of Kinko's founder, Paul Orfalea.

Speaker B: Find through experimentation, they're most likely counterintuitive. So other people, unless they're running experiments, aren't going to arrive at those same conclusions, and then we're just going to spread them around.

The quote explains that the valuable ideas resulting from experimentation are often not obvious and are shared across the organization to benefit all businesses involved.

• Decentralized management allows individual managers to have significant autonomy.
• Paul Orfalea's management style at Kinko's is cited as an example of successful decentralized management.
• The strategy involves sharing best practices without mandating their adoption.

Speaker A: He spent no time in the office, all he would do is travel around to different stores, and he wouldn't rule by edict.

This quote describes Paul Orfalea's hands-off, decentralized management approach, where he gathered best practices during his visits to Kinko's stores without imposing them.

• Studying other high-performing conglomerates is a way to identify successful practices and avoid mistakes.
• The focus is on understanding what the company does well and where it could improve.
• Insights from other businesses are used to inform strategic decisions and avoid the pitfalls of centralization.

Speaker A: We study the high performance conglomerates because they help us understand what CSI does well, where we might improve, and what alternatives we could pursue.

This quote highlights the rationale behind studying other successful conglomerates, which is to gain insights into improving and expanding the company's own practices.

• Software businesses are unique in that historical invested capital becomes less relevant over time.
• Successful software businesses can achieve earnings that exceed their original purchase price.
• These businesses challenge traditional financial measurement methods.

Speaker A: One of the problems with growing asset like businesses, software businesses, is that historical invested capital required to purchase the business becomes increasingly irrelevant over time.

The quote points out the distinctive nature of software businesses, where past investment becomes less significant as the business grows and succeeds.

• Mark Leonard recommends books that provide insights into business and medical practices.
• "The Evolution of Cooperation" by Robert Axelrod offers models for thinking about business problems.
• "One Man's Medicine" and "Effectiveness and Efficiency" by Archie Cochrane are recommended for their critical perspectives on medical practices and their applicability to business.

Speaker A: He says, the evolution of cooperation by Robert Axelrod has provided me with models for thinking about a number of business problems.

This quote introduces a book recommendation that has influenced Mark Leonard's approach to business problem-solving.

• A high-trust culture and autonomy are crucial for attracting and motivating the best talent.
• Autonomy helps avoid the bureaucracy that can stifle innovation and growth.
• The company's strategy involves owning many autonomous small businesses that generate high returns on capital.

Speaker A: If trust falters across our businesses, they can be choked by bureaucracy.

The quote emphasizes the importance of trust in maintaining autonomy and preventing the negative effects of bureaucracy on business operations.

• Human-scale companies foster strong trust and communication among employees.
• These companies prioritize increasing the overall value rather than internal politics.
• They are contrasted with large, centralized companies where complexity can hinder innovation and talent retention.

Speaker A: At human scale companies, all the employees know each other, and if a team member isn't trusted and pulling their weight, they tend to get weeded out.

This quote highlights the benefits of smaller, human-scale companies where employees are well-acquainted and accountability is more straightforward.

• As a business grows, managing it becomes more complex, leading to an increase in bureaucracy.
• Talented individuals who may not fit the mold of a large corporation often thrive in smaller, less complex environments.
• Academic research supports the idea that complexity grows faster than headcount in expanding organizations.

Speaker A: The larger a business gets, the more difficult it becomes to manage, and the more policies, procedures, systems, rules and regulations are generated to handle that growing complexity.

The quote discusses the challenges of managing a large business and how complexity can negatively impact the work environment and employee satisfaction.

• Mark Leonard shares advice he would give to his younger self, emphasizing the value of mastering the management of vertical market software (VMS) businesses.
• He stresses the importance of choosing a unique path to achieve extraordinary results.
• The advice reflects a long-term perspective on business success and personal satisfaction.

Speaker A: If I were advising my 35 or 40 year old self on where to go from here, I would tell him to stay put, become a master craftsman in the art of managing your VMS business.

This quote is advice from an experienced business leader to his younger self, advocating for deep expertise in a niche area as a fulfilling and wealthy path.

• Mark Leonard's philosophy is to own and manage numerous small businesses rather than a few large ones.
• He believes in the power of autonomy and small teams to produce superior results in niche markets.
• The key to success is not adhering to the norm but striving for exceptional outcomes.

Speaker A: Our strategy is to be a good owner of hundreds, and perhaps someday thousands, of growing, autonomous small businesses that generate high returns on capital.

The quote summarizes the overarching business strategy of focusing on small, autonomous businesses that can deliver high returns, reflecting a distinct approach to business growth and management.