CA - Black Knight And Intercontinental Exchange Go To Court Vs. FTC

2023-03-10 12:01:09 ET

Summary

• Intercontinental Exchange, Inc. is acquiring Black Knight, Inc. for $68 + 0.0682 share.
• The deal has been amended to where Black Knight is divesting a key loan origination system to Constellation Software contingent on closing.
• The FTC is suing to block the deal.
• Intercontinental Exchange is confident in its case and taking it to court.

On Tuesday, Black Knight, Inc. ( BKI ) and Intercontinental Exchange, Inc. ( ICE ) amended the terms of their initial agreement . Black Knight is divesting the Empower loan origination system to Constellation Software Inc. ( CNSWF ) and agreed to receive fewer ICE shares in the exchange. This translates into a substantial price cut of around $10. This likely reflects some of the costs associated with fighting the FTC in court, some value lost because the most prominent and second-largest mortgage loan origination platforms in the U.S. can't combine. However, there may also be some value leakage to Constellation. Constellation is a firm known for buying niche software at attractive terms.

The FTC sued to block a day after the divestment was announced. The agency explained its reasoning why the divestiture isn't satisfactory as follows (emphasis mine):

Black Knight has proposed divesting Empower as well as certain ancillary products- but not Optimal Blue- to Constellation Web Solutions, Inc. ("Constellation") in an attempt to remedy the anticompetitive effects of the merger. This proposed remedy, which is conditioned upon the closing of the Acquisition and is subject to approval by Black Knight's shareholders, contemplates that, in addition to acquiring Empower, Constellation will act as a reseller for certain Black Knight ancillary services obtained by ICE through the Acquisition, including Optimal Blue. In connection with this proposal, Respondents also have reduced the purchase price of Black Knight to approximately $11. 7 billion. 13 7. Respondents cannot meet their burden of showing that the proposed remedy will restore competition. The proposed remedy does not attempt to address the reasonably probable anticompetitive effects in the relevant PPE markets that will arise from ICE's acquisition of Optimal Blue. Even with respect to the relevant LOS markets, the proposed remedy fails to provide Constellation with the ability, resources and incentive to replace the intensity of the competition between ICE and Black Knight. Among other things, the proposed remedy fails to transfer a standalone business to Constellation and would require Constellation to rely on its post-Acquisition competitor, ICE, to supply many ancillary services to Empower customers via a resale agreement. This arrangement would create a risk of continuing entanglements and conflict between ICE and Constellation, and it would limit the flexibility with which Constellation could innovate, discount, and offer the an array of services Black Knight operates in conjunction with Empower today. Lenders and American consumers benefit from the competition between ICE and Black Knight, and they should not be forced to bear the risk of a divestiture that fails to maintain this competition.

In my view, the case (with Empower out of the way) is now mostly based on the problem of Optimal Blue. But there's a secondary key concern that Empower can't be operated competitively by the acquirer. The FTC also explained what Optimal Blue does and why it perceives its acquisition as a problem:

Most notably, Black Knight owns the Optimal Blue product pricing and eligibility engine ("PPE"). A PPE is software that allows a lender to identify potential loan rates for a borrower, determine the borrower's eligibility for a given loan, and lock in the loan's terms for the borrower. Each of these functions is an important step in originating a residential mortgage. Software integration between a lender's PPE and LOS enables and automates many of the PPE's features for the lender. Black Knight's Optimal Blue is the clear industry leader, serving lenders that originate as much as 40% of the nation's residential mortgages each year. Second to Optimal Blue is its close competitor, ICE's Encompass Product and Pricing Service PPE ("EPPS"), currently available only to lenders who use the Encompass LOS.

However, Black Knight only acquired 60% of Optimal Blue in 2020. At the time, it did only $100 million in revenue ( according to Barron's . Early in 2022, it acquired the rest, implying a valuation of around $2.9 billion for the whole segment. A significant chunk of Black Knight is its $9 billion market cap.

In my earlier article on this deal, I addressed the recent FTC Director Vedova's speech , where she attempted to justify a more aggressive agency stance. With the benefit of hindsight, it is almost as if she's talking about this precise deal (emphasis added):

The Bureau of Competition will only recommend acceptance of divestitures that allow the buyer to operate the divested business on a standalone basis quickly, effectively, and independently, and with the same incentives and comparable resources as the original owner. This type of remedy has a better track record of success and a low risk that it will not maintain or restore the intensity of premerger competition. We will no longer consider remedies where there is heightened risk of failure. These include proposals of less than standalone business units, or where there are forward-looking entanglements between the buyer and seller, such as supply agreements...

It seems likely Optimal Blue is a breaking point for ICE. Unable to convince the FTC of the Empower divestment, the merging parties probably agreed to take a stand here and take it to court. However, ICE demanded some concessions to go through all that trouble. The parties went ahead with the conditional divestment and the reselling agreement for Optimal Blue to strengthen their case. ICE has come out with a PR saying it is confident in its case and will take it to court. I will be surprised if a block holds up in court because of the relatively short period Black Knight has owned Optimal Blue, to begin with, the reseller agreement, the significant divestments made so far, and Constellation's track record of acquiring (ancillary) software businesses.

Currently, Black Knight trades at $59.50. That leaves an upside of roughly 24% to the deal price of $68 + 0.0682 ICE share.

A survey of experts sees a downside to $45 to $55 in a possible deal, according to traders, who cited a Bloomberg survey of 10 merger arbitrage specialists. I've argued in two prior articles on this deal ( here and here ) why I believe the downside is likely not too bad. So, I'm more inclined to agree with the range's $50-$55 end. The downside increases if the market moves down, so it's not set in stone. Not to mention, I could be wrong. If you go with the lower end of the range, the downside balances out the upside. My non-lawyer opinion is the FTC has a much less than 50% chance of blocking the deal successfully. I don't think the downside is much below $50. The deal could still close in the 3rd quarter.

I liked this case a lot better before, as I didn't expect a relatively large price cut. However, I still think it is a decent deal with a significant positive expected value, although the probability of closing is relatively low (relative to the average M&A deal). If I have to choose between calling Black Knight, Inc. a buy or a hold, I will lean towards a buy. It is not the best merger arb opportunity, but it is good enough for me.

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