Does ICE + Black Knight = Shareholder Value?

May 10, 2022 | Premium Service | Just as the financial markets selloff gained momentum last week, the folks at New York Stock Exchange-parent Intercontinental Exchange (ICE) announced that they will acquire mortgage software and data monopoly Black Knight (BKI). The deal values the software and data analytics firm at $13.1 billion.

This price is a bit of a bump from the $1.8 billion valuation in May of 2015, when BKI was spun-out from title insurance giant Fidelity National Information Service (FIS). The equity market value of BKI peaked at $15 billion in October of 2020 and has been sliding ever since. When Mr. Cooper (COOP) announced its strategic relationship with Sagent M&C in February 2022, BKI’s valuation fell by $1.5 billion in a matter of days. ICE is catching the falling knife of Black Knight.

To us, if this deal ever closes, the value of ICE + Black Knight may be less than the sum of the parts today. Like the mortgage market they serve, the valuation of both of these companies is likely to fall as the year progresses, putting added pressure on a deal that will not close at the earliest before Q1 2023. Recall the torment of Better.com and the IPO via SPAC, another deal that may never close.

We view this transaction as ICE rescuing BKI from a rapidly swooning mortgage sector. As this issue of The Institutional Risk Analyst went to press, loanDepot (LDI) had just reported a huge loss for the first quarter, caused by a significant swing in volumes and loan production income over just 12 months. We'll be strolling in particular through the wreckage of the mortgage sector in future issues.

Given the trends in interest rates, volume for BKI’s loan origination tools is likely to fall during 2022 and beyond. Lenders issued $859 billion in mortgages in the first quarter of this year, down 25% from a year ago. Every month, the MBA and GSEs are revising down their loan volume estimates for 2022. Both ICE and BKI make money on volume.

BKI is the incumbent legacy provider of servicing software for the mortgage industry via the old Loan Processing Services (LPS) platform, now known as MSP. Despite a market approach optimized to defend the company’s monopoly position, BKI’s place in the industry is being eroded by new technology and the emergence of more agile competitors. These firms offer better, cheaper and faster solutions that are evolving towards a flat rate, all you can eat model.

The huge financial investment needed to truly change the mortgage industry has not exactly attracted capital to the sector. This is precisely why the larger and more profitable FIS spun off the BKI business almost a decade ago. Likewise payments provider Fiserve (FISV) in 2018 sold a majority stake in its loan servicing business to Warburg Pincus. Yet notice in the chart below that BKI and ICE outperformed FIS as well as FISV in the equity markets, a situation that correlates to low interest rates that we expect to see reversed as extraordinary policy by the FOMC ends.

Source: Google Finance

ICE describes the BKI transaction as a bold new initiative. We see another acquisition by ICE at an excessive valuation for a business that could easily decline or even disappear over the next decade. The destruction of shareholder value at ICE, starting with the Ellie Mae transaction and now with BKI, is truly mind boggling. In both cases, the leadership of ICE is overpaying for the asset, but without a clear goal in terms of really effecting transformation in an industry that stubbornly resists change.

ICE’s fascination with the mortgage industry goes back many years, but was really accelerated by the 2020 acquisition of Ellie Mae from Thoma Bravo. ICE paid $11 billion for Ellie Mae, a provider of loan origination software (LOS). Thoma Bravo had paid just $3.7 billion to acquire Ellie Mae for cash only a year earlier. ICE then proceeded to cut spending on development and other areas at Ellie Mae in order to achieve cost synergies, gradually eroding the company’s position as a trusted partner for smaller lenders.

On an earnings call in 2020, CEO Jeffrey Sprecher described ICE as “building the clearing house for the mortgage industry” and said the residential mortgage market “could prove to be another important chapter in ICE’s 20-year evolution.” Other than driving earnings growth via expensive acquisitions, however, ICE does not seem to be creating a lot of value for shareholders and especially not in residential mortgages. It could take ICE a decade or more to recover its investment in BKI, assuming that the target's revenues do not deteriorate.

Both ICE and BKI are very acquisitive firms that remind us of the Cisco Systems (CSCO) of old, which bought new networking companies by the dozens. In many respects, the investment operations of ICE and BKI are more impressive than the operating results. BKI has done handsomely on its stake in Dunn & Bradstreet, for example.

Yet the irony of the ICE acquisition of BKI is that eventually the Ellie Mae business could be written down to zero in the rapidly evolving market for mortgage services. Whereas ICE looked for $50 million in costs savings and “synergies” from the Ellie Mae transaction, the BKI acquisition involves an estimated $350 million in cost reductions, including $200 in cost savings and $150 million in “revenue synergies.” And most of the cost at BKI is people.

Antitrust Issues

The first obvious objection to the acquisition of BKI by ICE is anti-trust. The transaction has "significant" risk of antitrust issues and there likely aren't any simple remedies, according to Patrick O'Shaughnessy at Raymond James (RJ). The Ellie Mae Encompass platform is the largest provider of loan origination software (LOS), while BKI's Empower is the "clear #2" LOS, according to RJ.

"Our specific concern is that U.S. regulators are already calling out the lack of competition amongst technology providers to the consumer finance area," O'Shaughnessy wrote in a note last week. Add this concern to the fact that BKI has been involved in several litigations with servicing clients, including PennyMac Financial Services (PFSI), which include claims for anti-competitive behavior.

In a similar vein, Piper Sandler wrote:

“PFSI and BKI continue to have lawsuits against each other whereby BKI alleges that PFSI stole its IP when it created its own servicing system, and PFSI alleges that BKI used monopolistic business practices. Considering there are anti-trust concerns with this merger, it's possible ICE/BKI may be pressured to remove the overhang of these lawsuits in order to finalize the merger. We note BKI's lawsuit requests compensation of $300M. Ending these lawsuits could give PFSI more flexibility with utilizing its servicing technology.”

Given that BKI has a monopoly on the provision of software and data to the servicing sector and the #2 loan origination software, just how does ICE expect to navigate the approval process with Joe Biden in the White House? Keep in mind that the investigators from the Federal Trade Commission and Department of Justice can easily gain access to confidential settlements between BKI and other parties, settlements that almost invariably involved releases of claims for anti-competitive behavior.

Technology Issues

Leaving aside the significant anti-trust issues raised by the transaction, ICE’s purchase of BKI seems to be another exercise in value destruction. Despite the huge among of time and financial resources that ICE has invested in the mortgage sector, there seems to be little to show for it save a series of expensive acquisitions of mature technology providers.

“Since our founding in 2000, ICE’s simple mission has been to make analog and opaque financial transactions more digital and transparent, beginning with commodity markets, extending across a large array of asset classes, and most recently working to help streamline the mortgage industry,” said ICE founder and CEO Sprecher.

So far, ICE and many other vendors have not been able to “streamline the mortgage industry,” as Mr. Sprecher declares. Acquiring mortgage registry MERs has hardly resulted in a revolution. Firms like Ellie Mae and Black Knight represent yesterday’s technology and linear manufacturing models for loans that literally stretch back in time to Henry Ford and the Model T. ICE buying the revenue streams represented by BKI is a big bet on yesterday, not a bold initiative to change the future of residential lending tomorrow.

The technology platform used by BKI stretches back to the dawn of the computer era, one reason why users of BKI servicing and LOS tools report that they are unable to customize components required for tasks like distressed servicing. The lore of the mortgage industry says that BKI will not integrate any tool they do not own. But the truth is that the ancient, COBOL based mainframe computer technology employed by BKI makes customization impossible.

We suspect that BKI sold themselves to ICE when it became apparent that a combination of sharply lower volumes and a renewed challenge from Warburg Pincus portfolio company Sagent, which embraces open source and will customize its tools to meet client needs. Like many legacy computer systems in the world of finance, there is no way to transition these systems to newer technology without a massive investment. This was, after all, why FIS spun off BKI and FISV spun Sagent, to avoid the capital drain and political risk of the mortgage market.

Financial Factors

Of the three segments at ICE, exchanges, data and mortgages, the latter is the least significant prior to the BLK acquisition. The ICE segment data for mortgages is shown below. Notice that the revenue for the ICE mortgage segment was down 13% year-over-year.

With BKI, the financial outlook is even less rosy. The firm carried a lot of revenue and volume into Q1 2022, but its all down from here. Like its clients, the results of BKI are highly correlated to the movement of interest rates and the economy. BKI also goes into the transaction with $2.7 billion in debt, including $1.7 billion that is priced at +150 to LIBOR. The table below comes from the Q1 2022 BKI earnings presentation.

In February 2020 BKI completed the acquisition of Optimal Blue from co-investors Cannae Holdings and investment entities affiliated with Thomas H. Lee Partners. Optimal Blue offers a relatively new marketplace platform and related data and analytics.

BKI will describe the Optimal Blue investment as evidence of innovation, but in fact BKI was simply taking out a younger, more agile competitor at a very full price. Another example of this defensive, monopolistic behavior by BKI was the acquisition of eMBS. BKI acquired eMBS and two other small competitors in Q1 2022 alone.

Looking at the dismal results for the mortgage industry in Q1 2022 and the outlook for even worse in Q2 2022 and the balance of the year, it is hard to put a positive face on this acquisition. We expect to see a lengthy and problematic review process by the Biden Administration, which may require BKI to sell significant assets and settle all outstanding litigation before the transaction closes.

But more, as the financial results for BKI deteriorate in coming quarters, we think ICE management will come under growing criticism for tying the company’s future so closely to the mortgage industry. Until this transaction closes, both companies will be held hostage to the movements of the respective stocks.

“If the Merger Agreement is terminated under certain circumstances, we may be required to pay a termination fee of $398 million to ICE and/or we may be required to reimburse ICE for its reasonable and documented out-of-pocket costs and expenses incurred in connection with the Merger Agreement and the Merger in an amount not to exceed $40 million,” BKI notes in its most recent 10-K. Stay tuned.

The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.