The Man With A Midas Touch For Acquisitions

December 4, 2012


The Globe and Mail


‘Tis the season for awards – news maker of the year, chief executive of the year – so here is a nominee for acquirer of the year.

It is probably not a stretch to say this candidate would have to be in the running as Canada’s acquirer of the decade, which makes it all the more incredible that not one of the dozens and dozens of deals he has made has ever landed on the front page of the Report on Business. Just two have even made the paper at all.

Yet, this is a man whose company purchases multiple companies every year, sometimes a couple per month. It is a company that has not once had a big writedown because of a deal gone wrong. Good luck finding another executive in Canada with a better track record of taking the cash that comes out of a business and making deals that actually add value for shareholders.

The company, Constellation Software Inc., has turned into one of Canada’s biggest publicly traded technology companies by playing the acquisition game a very different way than most. Rather than seeking large deals that transform the company, chief executive officer Mark Leonard has built a business by constantly buying small software companies for a few million dollars apiece.

Mr. Leonard is on track to do close to 30 deals this year. Through the first nine months, Constellation completed 22. The size of each deal may be unremarkable, but in aggregate they add up, and the returns are nothing short of astounding.

In his May letter to shareholders, Mr. Leonard laid out the company’s track record when it comes to return on invested capital. Over the past 11 years, it has averaged almost 21 per cent. In recent years, it has been better, peaking at 36 per cent last year. ROIC is a bit of a mind-bender, but put overly simply, that means that for every dollar of capital that Constellation had invested in 2011, the company generated 36 cents for shareholders.

What’s more, nowhere on Mr. Leonard’s résumé is a huge deal gone wrong. There’s nothing like Kinross Gold Corp.’s purchase of Red Back Mining Inc., or Hewlett-Packard’s acquisition of Autonomy Corp.

The result is Constellation has been a stellar performer on the stock market. An investor who bought when Constellation went public in 2006 would have booked a total return of 375 per cent, which works out to about 32 per cent a year.

How does Mr. Leonard do it?

He has focused on buying small companies that other acquirers couldn’t even really be bothered to pick up. Constellation has built a network of small firms that may one day want to be bought, and so can source its own transactions. The result is there is rarely competition for the deal, or investment bankers looking to run up the price to maximize their commission. A side benefit of doing lots of tiny transactions is that even if Mr. Leonard did blow a deal here and there, it would hardly matter.

Mr. Leonard has also set up his firm so the incentives for those doing deals are tied very strongly to how those deals work out, linking pay to return on invested capital rather than simple growth in earnings or revenue. What matters is what Constellation pays for that growth.

“It’s shockingly unusual for companies that do a lot of acquisitions to have it [incentives] tied to return,” said John Ewing, co-founder of Ewing Morris & Co. Investment Partners, an investor in Constellation. “In a lot of these acquisition stories the incentives are tied to growth, not the investment needed to get that growth. That’s a really important check on the system.”

Ewing Morris chose to buy into Constellation because it believes Mr. Leonard is a rare example of the “great capital allocator,” a Warren Buffett-type person who is able to recycle each dollar of his company’s profit into new investments with superior returns. Others in that bucket include Murray Edwards, the billionaire behind Canadian Natural Resources. They are the kinds of CEOs you want to be doing deals, because every dollar they put to work tends to multiply.

Where do investors look to find great capital allocators, and avoid capital destroyers such as Leo Apotheker, the HP CEO who bought Autonomy? Mr. Ewing suggests avoiding bosses who rose up through channels such as sales, or outside businesses such as investment banking, because they are not used to putting their own capital to work.

Look for founders who still run companies, and have big stakes. If they have built a company large enough to be publicly traded and of a decent size, they are doing something right. Mr. Leonard fits that bill.

At that point, at least, Mr. Ewing says, at least “you’re fishing in the right pond.”

And as exciting as the front-page deals are, maybe avoid looking in the headlines.

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