Mitigating Concentration Risk: The Constellation Software Case

In Security Analysis, we discussed the case of Constellation Software with a hedge fund investor with a concentrated long-only tech portfolio.

The takeaway: unlike the legendary beard of Constellation’s founder Mark Leonard, the secret to the company’s success is short and sweet…

“The facile answer is that we have robust businesses with inherently attractive economics run by good managers whose compensation is tightly aligned with that of shareholders” (read more wise quotes in his letters here).

Let’s break down Constellation’s simple strategy, then figure out how to apply these lessons to building out the Constellation of the gaming industry.

What’s Constellation’s secret to success?

Constellation Software is one of the rarified investments classified as a Compounder, most notable for achieving hall of fame CAGR. Constellation allocates capital to buy vertical software companies, which creates more revenue, which is allocated to more acquisitions. Their mousetrap is this brilliantly efficient M&A machine, where they go in and apply same 4-step transformation:

1. CRM: get pipeline systematized
2. Pay processing: ensure payments coming in on time
3. Price raise: do price discovery and increase take rate
4. Talent: bring in the right talent that isn’t so expensive it will crush EBIT margins

Who else successfully clusters their investments and acquisitions around a thesis?

• Danaher: Buys out clusters of value chain, helps determine pricing power
• Mubadala: Buys one concern, like a QSR restaurant, and then invests additionally in kiosk technology, payment platforms and real estate around the space (as per a meeting with their IC on a Dubai trip, October 2023)

Who tried, and failed, to do this?

1. Our class speaker for the day, from Hedge Fund Aravt Global who went all in on tech stocks like PayPal and Gitlab just before the crash
2. Embracer Group, which I dug into while at Raine to anticipate the disaggregated assets that may be for sale. Embracer’s mistakes:

• They over-invested in the same kind of asset, when the market crashed and games became saturated, their whole portfolio crashed
• They purchased using majority stock, little cash, so the valuations of each of their portfolio companies crashed when the Embracer stock crashed; stock-based deals is a win-win, because it aligns incentives to succeed, but if external forces pull the stock-price down, hard to sell-off those assets at a fair price

How to copy Constellation’s success and avoid Aravt and Embracer’s errors?

Gaming companies aiming to build a more robust, stable business through acquisitions should take a lesson from Mark Leonard:

1. Find the opportunity at a good price before the institutional demand kicks in
2. Diversify the collection of assets into areas that don’t overlap, or else its an unsustainable growth engine that will cannibalize each others’ consumer bases
3. Don’t count on any “hits”; instead, count on the fundamentals of sticky B2B servicers to the industry structure

• Vertical API integrations that solve very specific pain points across monetization, customer support, equipment distributors or suppliers, and developer tools
• No risky content plays; no matter how clever the monetization scheme, unique IP advantage, or experienced team; identify these companies, and help set them up with a suite of services, do not bet on the content itself; be a Switzerland, and serve all!