CSU Back At It

A review of the Optimal Blue acquisition

In case you missed it, Intercontinental Exchange (ICE) reached an agreement to acquire Black Knight (BKI) back in May 2022. Unfortunately for both parties, the deal caught the FTC’s attention and was challenged for anticompetitive reasons. To help address those FTC concerns, BKI agreed to sell their Empower business to one of CSU’s operating groups, which was announced in March of this year. Apparently, that wasn’t enough to win the hearts and minds of the folks over at the FTC, so earlier this week BKI announced that they would also be selling their Optimal Blue business to CSU. Both the Empower and Optimal Blue transactions are conditional on FTC approval for the ICE/BKI acquisition, but it looks likely that they’ll get a thumbs up.

I don’t know what the Empower details look like, but my educated guess would peg the EV at <$200mn and EV/Sales somewhere just north of 1.0x. I’d call that par for the course on large VMS M&A. While Empower looks like a good transaction, I find the Optimal Blue deal way more interesting. From the 10,000-foot view, it looks like CSU is taking this business at gunpoint.

BKI initially acquired a 60% stake in Optimal blue in June 2020 at a $1.8bn valuation. T12M EBITDA to June 2020 was $46.5mn, which suggests they paid a whopping 39x T12M EV/EBITDA. However, during the first 12 months that BKI owned Optimal Blue, the business generated $75mn in EBITDA. Let’s call that 23.9x forward EV/EBITDA. BKI then acquired the remaining 40% stake in Optimal Blue in February 2022 at a $2.9bn valuation. In the Merger Agreement documents filed last March, BKI indicated that they paid 28.8x F12M EBITDA, implying that T12M EBITDA to February 2023 was ~$100mn. Those are some lofty valuation marks, but the business did grow EBITDA at a 33% CAGR from June 2020 to February 2023.

Despite BKI valuing Optimal Blue at $1.8bn in 2020 and $2.9bn in 2022, they are now parting ways with that business for an EV of just $700mn! If we use the implied $100mn of EBITDA from above, that’s 7.0x EV/EBITDA. A steal of a deal on trailing EBITDA. By my math, even if CSU paid 100% cash for Optimal Blue, and EBITDA declined at 2%/year into perpetuity, they’d generate a reasonable 9.5% return on equity. But this is where I think it gets really interesting.

While the deal itself is valued at $700mn, CSU is only putting up $200mn in cash today. The remaining $500mn is seller financed, and I could not have dreamed up better seller financing terms if I tried (emphasis my own):

“The purchase price payable by Purchaser to Black Knight under the OB Divestiture Agreement is $700 million, comprised of $200 million in cash and a promissory note to be issued by Purchaser to Black Knight at the closing of the OB Divestiture Transaction (the “OB Divestiture Closing”) in the principal amount of $500 million (the “Note”), subject to specified adjustments. After its issuance, the Note will accrue interest at a rate of 7% per annum, compounded annually and payable in arrears. The first cash interest and amortization payment under the Note is due on the day prior to the fifth anniversary of the OB Divestiture Closing and thereafter interest and amortization payments will be due annually on the subsequent anniversaries of that date. The Note matures on the fortieth anniversary of the OB Divestiture Closing, subject to earlier optional prepayment.”

Wut!?

CSU just borrowed 40-year money at 7%, but isn’t paying a nickel for the first 5 years. If I understand this correctly, the interest will accrue and be added to principal through year 5. After year 5, I’m guessing that the accrued principal amortizes over 35 years and CSU pays cash interest on the outstanding balance annually.

It’s difficult to appreciate what this financing structure means for levered IRRs without an illustration, so that’s exactly what I’ve done below. Exhibit A shows the first 10 years (out of 40) in a DCF model assuming CSU paid 100% cash for Optimal Blue. Even though this business has been growing EBITDA at 30%+/year, I’ll hold the $100mn flat into perpetuity. Below the EBITDA line we have amortization of acquired intangibles - as is typically the case in these transactions, CSU will allocate a large portion of the purchase price to intangibles, and then amortize those acquired intangibles down over 10-15 years. This is a non-cash expense but helps significantly reduce their tax bill. Layer in some cash taxes, and viola, ~$80mn of FCFE. In this example, with zero leverage, CSU would expect to earn something like an 11% return on equity.

Exhibit A

Exhibit B takes it one step further, and shows what the economics look like if CSU paid $200mn up front, and borrowed $500mn with cash and principal payments that were due annually starting in year 1. I assume that the 40-year note amortizes linearly, which might not be exactly correct, but c’est la vie. In any event, the levered IRR roughly doubles to ~22%. By itself, that would easily clear CSU’s hurdle rates.  

Exhibit B

Now for the time-value-of-money magic! Exhibit C takes the exact same deal, but instead of principal and interest payments starting in year 1, I’ve deferred them until year 6. I don’t know exactly what the prom note terms are, but I assume that interest during the first five years is paid in kind and adds to the principal balance of the prom note. Beyond year 5, the new principal balance would amortize linearly over 35 years and cash interest would be paid on the outstanding principal amount each year. You can see that all this really does is pull forward free-cash-flow-to-equity. But with that pull-forward, CSU’s payback on equity is just 2.21 years, and their levered IRR nearly doubles again to ~40%. Hell, most of that return is realized in the first five years – if they never pulled another $0.01 out beyond year 5, it would still be a wonderfully accretive acquisition.

Exhibit C

It’s possible I’m missing something but given the deal price and the high-level financing terms, it’s hard to see how CSU isn’t going to knock it out of the park on this investment. Even if EBITDA immediately fell to $60mn (down 40%) and stayed there, CSU would generate a mid-to-high teens levered IRR. What makes this equally impressive is the dollar figures involved. This is $200mn of equity vs the average small VMS deal at <$10mn, with returns that might handily beat their average small VMS transaction. Like I said, it looks like they’re taking this business at gunpoint.

If you want to play around with the numbers and assumptions yourself, you can do so with the Excel file below:

Optimal Blue - 2023.07

23.6KB ∙ XLSX file

Download

Download

When you get new information as an investor, I think it’s important to ask so what? In this case, CSU might make a very large and profitable investment, but so what? Should we expect to see more $200mn equity checks with potential 35%+ levered IRRs? Probably not. But is this yet another example that CSU can scale the large VMS M&A engine at returns above their hurdle rates? Absolutely.

What I find particularly compelling is the different shapes and sizes that these large VMS acquisitions are taking. Alterra was a run-of-the-mill carveout. WideOrbit and Topicus were merger/spins. And now we have a forced seller carving out an otherwise decent business. CSU continually finds a way to get deals done, and they’ve proven to be very creative in the process. That creativity has value.

Recall that for the Altera carveout transaction CSU had been building a relationship with Allscripts “for probably a decade… and then it just came to the right time, right opportunity where there was actually something we could do”. It wouldn’t surprise me one iota to learn that someone at CSU had also been hungrily watching Optimal Blue for a decade. Learning about the business, thinking about valuation, and chomping at the bit. I’m sure that the CSU carveout wish list is long – it’s not just Allscripts, Empower, and Optimal Blue. CSU probably won’t have the opportunity to bid for most of those businesses, but for the few that become available for whatever reason, I think they’re well positioned to gobble them up. They’re prepared, creative, and capable.

I still believe that the market is giving CSU a lot of credit for large VMS M&A, and at the current share price it’s difficult for me to paint a picture where investors earn a meaningful excess return. But as I mentioned in the last CSU update, I think investors can expect to earn a high-single-digit IRR and CSU is still a great way to keep the ball in play.