The next Constellation will acquire its own end customers and then implement vertical software, instead of selling software to end customers or acquiring software businesses.
An overarching conviction at Levante is that teams who rethink distribution to unlock latent spending in sneaky-large industries will win. We’re in a point in the innovation curve with AI where product and R&D is no longer a differentiator - building software is easier than ever before. Getting stuck in implementation, sales-cycles and exploratory budgets with old-school buyers is where startups will lose.
One approach we’re particularly excited by is the idea of vertical integration through roll-ups. Hadrian in the manufacturing space has raised $216M from Founders Fund, Lux, A16Z and others to acquire SMB manufacturing companies. They then implement their own hardware and software to automate machine shop operations. In their first factory, Hadrian has enabled operators with no machining experience to produce spaceflight grade hardware with less than 60 days of training.
One of Levante’s LPs, I2BF, are early investors in Odeko. Odeko went from $0-$140M revenue in 3.5 years by rolling up SMB distributors in the coffee shop industry. This has allowed them to vertically integrate into both the procurement and operations of coffee shops. Odeko monetizes through SaaS and payments at the retailer level, and a cut of supplies ordering at the procurement level.
Levante’s first investment, Scotch, is building POS for liquor stores. This is a historically difficult market to penetrate given existing vendor multi-year contract lock-ins and high upfront setup costs. No existing player has more than 2% market share in this $70B market. The team is currently negotiating acquiring an incumbent player with 500 stores for <3x revenue using a debt facility. This will arm Scotch with the data, credibility in a notoriously word-of-mouth industry and sticky customer relationships on day one. A 2x increase in ACV through payments and inventory automation with Scotch’s integration with distributors would add $50-$60M of EV for <$15M purchase price.
A classic problem in vertical software is that of integration and onboarding. Selling into niches means dealing with unsophisticated buyers of technology, archaic and fragmented data siloes and sometimes physical barriers to entry like replacing points-of-sale or ticketing systems. This leads to large gaps between contracted and live ARR, one that sometimes never gets closed meaningfully, leading to the slow death of many players. Metropolis, which has raised $1.9B in debt and equity, realized that they’d be better off acquiring one of the largest parking providers in the US, SP Plus Corporation, in order to own their end-customer and the implementation that goes with it. Not only do they get an existing, cash-flowing asset, they also control margin expansion through their parking operations software stack without excessively long sales or implementation cycles.
This theme overlaps with our thinking around services businesses. From a timing perspective, these companies are typically run by retirement-age owners who are ready to sell. The real question is whether a business using this playbook will be valued at a high-growth multiple the way true software businesses have over the last 10 years, or more like a low-margin PE rollup. We believe with the right execution on LLMs to reduce overhead and administration expenses, this strategy can create fast margin expansion which can be reinvested into turning the underlying services businesses from low-to-fast growth assets.
Freya
We’re currently working with a founder to explore the idea of rolling up title insurance agencies and using LLMs to automate expensive adminsitrative functions. While title gets a bad rep, we see an opportunity to unlock billions of dollars of value.
Title insurance has the lowest loss ratio in the industry, coming in at 3.2% in 2022. Premiums earned are 98.8% of the $22B of net premiums written, making it the most profitable insurance line in the US. However, the industry suffers from high administrative costs, with expense ratios making up 94.6% of net premiums written. In their latest report, NAIC reported title combined ratios of 103.4%. This means that although title insurance is the most profitable insurance line, they actually lost money in 1H 2023 as a result of administrative expenses.
The most significant operational expense for title agencies is personnel costs, which includes the wages for staff involved in underwriting, claims processing, customer service and sales. These are clear candidates for automation replacement. Given the existing high administration costs already baked into these agencies, selling them another $70 per month software tool like Qualia isn’t an approach we’re excited about. Acquiring the agencies, driving operational efficiencies and retaining a higher portion of the premiums earned is a multi-billion dollar opportunity. Reducing total title operational expenditure in 2022 by just 20% would have unlocked an additional $4.2B of net written premiums.
This model enables previously fragmented services businesses fighting for demand in localized areas build national brands. Splash recently raised $4.5M to acquire small pool companies with the longer term goal to build a “dominant, national brand.” After acquiring a pool company, Splash will integrate with and build its own vertical software to boost margins, driving both margin and multiple expansion. Given pool companies are already profitable, cash flow can be recycled into these small acquisitions. The flywheel compounds at a national level through a single brand that can lower acquisition and supplier costs through a GPO model.
In the title world, Freya has an opportunity to create local tech-enabled brands through consolidation. This may allow Freya to use its scale to negotiate better rates from carriers, in turn passing those rates on to home-buyers.
We’re excited by industries with similar characteristics. First, a highly profitable underlying service-sold. Second, low operational margin due to overhead expenses. Lastly, attractive for acquisition due to aging owners, low margin profile and resistance to software sales. Initial but non-exhaustive markets that come to mind include:
- Pest control
- Roofing and solar
- Accountants
- Wealth management firms
- Life insurance agencies