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Build a better Constellation
The Constellation model
Constellation is one of the great compounding stories, and it grows largely through acquisitions with a cookie-cutter approach to margins. Arcadia pays a little more for businesses that are growing and mission critical, then builds around platforms: an aviation platform, a small fintech platform, a rail platform, an agriculture platform.
Building platforms
Businesses inside a platform can generate synergies with one another. Build platforms of $100 million or $200 million over a decade, and do it ten or twelve times, and organic growth starts working alongside acquisitions, with high gross margins from the start.
Unlearning old habits
Mitch Rales, an investor in Arcadia, has helped its founders unlearn the muscle memory they had from Constellation's practices. He has pushed them to pay a bit more for a highly strategic asset that makes the platform better than its pieces, even when the purchase would not pass on financial metrics alone. Constellation's founder, Mark Leonard, is looking at reinventing the model now, but a company that large turns like an aircraft carrier, while Arcadia is a little PT boat.
How does Constellation Software grow by acquisition?
Mark Leonard founded Constellation Software in Toronto in 1995. It buys small and mid-sized vertical market software companies and mostly leaves them running as independent business units. Leonard has explained the approach in his annual shareholder letters. The company has completed hundreds of acquisitions since its founding.
Why is vertical market software hard to leave?
Vertical software is built for the workflows of a single industry, such as aviation, rail, or agriculture, and it holds the records the business runs on. Replacing it means moving data, retraining staff, and risking disruption to daily operations. Each niche is also too small to attract large competitors. Software that customers rely on for core operations tends to keep its customers for many years.
Why do add-on acquisitions cost less?
Private equity firms call it buy-and-build when they acquire one platform company and then buy smaller businesses to add to it. Smaller companies often sell for lower multiples of earnings than larger ones. Once added to a larger platform, their earnings are valued at the platform's higher multiple, a gain called multiple arbitrage. Shared customers, technology, and back-office costs can add to the effect.
Why do giant acquirers struggle to grow fast?
As a company grows, each acquisition must be larger to move total results, a pattern sometimes called the law of large numbers in business. A company earning billions needs deals worth hundreds of millions just to add a few percent. The pool of large targets that fit is smaller than the pool of small ones. A smaller acquirer can therefore pursue deals that a large one would find too small to matter.
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