Vertical Market Software - A Perfect Match for Serial Acquirers?

Mark Leonard, the CEO of Constellation Software, famously conducted a study of 12 serial acquirers including Danaher, Jack Henry and Roper. He concluded that vertical market software (VMS) was by far the best fit for the business model. Few would argue to the contrary given Constellation’s remarkable track record.

Since listing in 2006, Leonard has grown Constellation’s share price by 11,865% and returned 44% per annum to shareholders (including dividends) over the last decade.

For a detailed analysis of this performance against its ‘peer group’, Canuck Analysts compared total shareholder returns of serial acquirers from a cross section of industries in a post from October 2021:

Studying Serial Acquirers

Interestingly from their data, Constellation performed only marginally better than the peer group average over three and five year periods. But over ten years Leonard’s performance trumps the average by more than 10 percentage points and his nearest rival by 3 points. You’ll need no reminding how the compounding of this out-performance works over time.

Of course it would be convenient to put this down to the ‘Leonard effect’ as he is surely one of the all-time-great CEOs. And sure, this effect must play its part. But perhaps the ever-humble Leonard himself would admit it has as much to do with the favourable economics of the sector as it has to do with his own genius. So let’s dig a little deeper into the world of VMS. 

Economic Advantages

VMSs are niche software businesses dedicated to specific industry verticals, unlike enterprise (horizontal) software companies serving clients in many industries. Their ‘mission critical’ products are paramount to the day-to-day running of customer’s businesses, delivering the wonderful benefits of automation, speed and functionality.

In many cases VMSs possess excellent economic attributes. They benefit from barriers to entry since switching costs and customer retention rates are high (90% plus). Sticky customers and low competition leads to pricing power, high margins and free cash flow.

On the other hand, these businesses tend not to have the large total addressable markets (TAMs) and enormous growth trajectories of their enterprise software cousins.

Fragmented Market

VMSs are usually designed and purpose-built for their industry and customer. It can lead to a handful of firms serving just one niche or geography, as oppose to one or two big players dominating the entire vertical. For example, the Dutch pharmacy market has several software providers with customized features for local patient records, prescription orders, drug inventories and prices etc. These are not the same providers you find in nearby Germany with an entirely different health system.

The European VMS market in general is quite fragmented, with a wide range of languages and regulatory frameworks. It's not easy for a given VMS to cross borders unless it follows its customers into another country.

These market characteristics are being exploited by an increasing number of high-quality European VMS acquirers such as Topicus.com (formerly part of Constellation), Vitec Software and NetCompany.

VMS and Bacteria

When a company operates in a high growth sector it tends to attract a lot of competition and attention from venture capital, private equity, other corporates etc. This mirrors microbial ecology in which microorganisms inhabiting a nutrient-rich environment compete voraciously for available resources.

In contrast, companies operating in low growth environments - stagnant/declining industries or limited TAMs - tend to be overlooked by investors. Some would say they’re in the wrong petri dish!

Of course, niche VMSs fall directly into this category due to growth constraints. But there could be other reasons they’re overlooked particularly if elements of their strategy and execution were misaligned. For example a VMS may have had limited funding for sales and marketing efforts or it could have chosen the wrong distribution channel partners.

Either way, it certainly doesn’t mean the company is broken. The VMS acquirer simply looks to exploit the attention asymmetry and pay lower multiples for the company when it comes up for sale.

Constellation is a perfect example. Howard Leung of Veritas Investment Research, calculated it pays an average of just 0.8 times price-to-sales (after accounting for any cash acquired). This is way below the recognised industry average. Like Buffett before him, Leonard has been known to walk away from deals where there’s too much competition and too high an asking price.

M&A Process

One of Constellation’s top priorities is on hiring talented people and developing a culture where great ideas can flourish from anywhere in the group. Of course this meritocratic environment is built upon an established set of organisational practices whereby portfolio managers are regularly in touch with entrepreneurs and owners of target VMSs.

In a few cases an initial call into a new target can yield an acquisition in six months. But more often it takes years, even decades, before an owner is ready to sell. When the time is right the acquirer, with its long-standing relationship and promise of perpetual ownership, holds an advantage. The acquirer knows the seller's feelings of security and continuity are paramount.

Arguably it's more important for VMS sellers to find that ‘safe harbour’ for their business than in other sectors. Since their product has a small but very loyal customer base, any major overhauls or unexpected changes could trigger a decision to move their business elsewhere. Having spent so much of their time and energy building those client relationships, the seller typically prioritises the best fit over the best price.

Constellation definitely sees itself as a perpetual owner. In fact it has only ever once sold a business it acquired and only because of the extraordinary price offered at the time. Leonard says it's a decision he will always regret. 

‘Sure Bets’, not ‘Long Shots’

Vitec Software, the VMS market leader in the Nordics, has compounded returns in excess of 35 percent annually since 2004. It's a track record worthy of a place in the Constellation portfolio. 

Vitec has developed its own unique methods and culture over the years. Compared to Constellation it places greater emphasis on developing ‘home grown’ solutions leveraging it’s in-house innovation team. And it simultaneously searches for acquisitions to complement and strengthen its existing offerings. 

These select acquisitions have to endure a similarly rigorous due diligence process focused particularly on the economic and financial attributes. Their website illustrates the criteria set used to determine the suitability of targets:

“One example of such criteria is that the company must offer software in the form of standardized proprietarily developed products aimed at a particular vertical market. Another example is that the acquisition must directly contribute to an increase in the Group’s earnings per share. Consequently, it is vital that the company demonstrate solid profitability and positive cash flows at the acquisition date. We do not invest in future expectations.”

It goes on to point out that acquisitions within their existing verticals contribute towards increased market share, while acquisitions within new sectors increase risk diversification. This all feeds into their robust growth engine with little downside and plenty of upside potential.

Decentralized Structure

The fact that Vitec and other successful acquirers set such a high bar for new acquisitions means they have the confidence to adopt a light touch approach and allow the businesses to operate with independence post-acquisition.

This characterizes the decentralized business model: an entrepreneurial culture, flat management structure, low overhead costs, and delegated responsibility to each business. 

For example, Constellation comprises six operating groups each with an array of underlying software businesses. There is some specialization within these groups, although they each tend to cross a number of different verticals.

In between the operating groups and individual companies are the business units. Each unit is organized to serve a single vertical and the unit (portfolio) managers are afforded a high degree of autonomy as long as they continue to meet their ROIC and revenue growth targets.

Topicus, the former operating group and recent spin-off, describes its managers as possessing “extensive knowledge of their markets and deep customer relationships, which enables them to successfully identify, pursue, structure, acquire and then coach businesses after acquisition.”

The decentralized structure also helps it foster and distill the desired culture throughout the group. It empowers the managers and consequently the staff at each company, and maintains close proximity to and intense focus on serving the end customer. In other words it drives ownership behaviours - even when the owners are no longer there.

Yet all this independence should not be misconstrued as a ‘set and forget’ strategy. As the quote suggests, coaching can make all the difference to improved performance. 

At Constellation, once a business joins the fold it has access to a vast ecosystem of companies, customers, expertise and insights. Assistance is provided in the form enhanced capital allocation, reward and knowledge sharing practices. 

Junto Investments’ Oliver Sung uses the example of how an “insurance VMS can piggyback the best practices from another insurance VMS in the group when creating a new software solution that fully complies with local regulations… cutting valuable development time and costs and increasing the value proposition to clients.”

The result: business units that are optimised for returns on capital and free cash flow. This cash is then pumped back to source and subsequently reallocated to new, higher return acquisitions or internal initiatives.

Plenty of Fish

Of course in order to keep the acquirers growing it’s assumed there’s a constant stream of fresh acquisition targets. While this should never be taken for granted, the assumption seems to hold in the near term.

In fact both Constellation and Topicus were able to significantly grow the number of completed acquisitions over the past decade. In 2010 Constellation completed about 35 acquisitions compared to more than 90 in 2020, whilst Topicus completed one acquisition in 2010 compared to six in 2020. 

Thus, if the trend continues then these acquisition machines appear well set for some time. Constellation for example has an estimated 40,000-plus VMS targets on its radar across more than 12 verticals, and continues to identify new targets at a rate of 4,000 a year.

It's worth mentioning that most of these targets are relatively small, ranging from $10 to $25M in revenues ($2-5M EBITDA). If Constellation’s strategy were to shift towards predominantly large acquisitions then the pool of targets would thin considerably. (So far Leonard has mainly stuck to small and mid size acquisitions although his 2021 President’s Letter indicated more large acquisitions would come).

Risks for VMS Acquirers

Firstly an increase in the number of VMS acquirer (or simply an overall uplift in acquisitions in the sector) could lead to sellers becoming savvier about their potential value. With more acquirers chasing the same deals, it could drive prices north.

Rising multiples on new deals has been seen in other niche markets where serial acquirers operate including medical instruments, pest control, waste management and telecom towers. Obviously this presents a huge challenge to acquirers attempting to maintain returns on incremental capital.

Secondly, there’s an argument that enterprise SaaS companies ( Hubspot, Salesforce, Trello etc.) are getting better at solving universal customer problems and that VMS’s high customer retention rates will fall away. This could be exacerbated as more and more businesses shift from on-premise to cloud services and in the process look to upgrade their software suite. 

Thirdly - and this is more of an issue for Constellation than it is for Topicus or Vitec - there are serious scale disadvantages for the larger VMS acquirers. They need an ever greater number of acquisitions to keep growing at the same pace. And by contrast, as they grow, the market consolidates and hence fewer targets remain. Inevitably at some point in the future we’ll see diminishing returns and slower growth.

There is some evidence of these effects already being felt at Constellation as it approaches a $50Bn market cap. Critics might even point to similarities between the VMS sector today and the newspaper industry prior to the mass commercialisation of the internet. But it's very hard to tell without a crystal ball where we are in the industry cycle and how long the VMS timeline stretches.

In summary

The decentralized, opportunistic growth models of the top VMS acquirers should continue to work well for some years to come. We like the sector for its economic advantages and believe these outweigh the potential downside risks.

Due to the increasing scale challenges of larger groups like Constellation, the smaller acquirers such as Topicus and Vitec may have the edge purely on the basis of their longer growth runways.

Yes, there is the ‘key person’ risk in that neither of these European groups has a Mark Leonard at the helm. However Leonard relinquished control over the majority of capital allocation decisions at Constellation 15 years ago - albeit ensuring the next generation of managers were well-trained in his methods - and returns have certainly not suffered since.

The challenge therefore for these upstarts is to ensure the culture of entrepreneurship and discipline in M&A and operational excellence continues as the group scales. The blueprint for success is there to be replicated.