BURFORD CAPITAL LTD BUR
July 11, 2021 - 2:27pm EST by
Ares
2021 2022
Price: 10.60 EPS 0 0
Shares Out. (in M): 219 P/E 0 0
Market Cap (in $M): 2,321 P/FCF 0 0
Net Debt (in $M): 355 EBIT 0 0
TEV ($): 2,675 TEV/EBIT 0 0

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Description

Burford Capital: Investing in the Leader of Litigation Finance and a Potential 5-Bagger

Burford (BUR US Equity) is the world’s leading and largest litigation finance provider.  I see a potential upside of 100% to ~500% in Burford over the next 24 to 36 months and the opportunity for a possible 10x return over the next five to seven years.  Today, the market is pricing this industry-leading secular growth business with ~25% normalized ROE at a low multiple of ~14.5x 2020 earnings.

There are three Burford pitches on VIC.  All of them have their strengths, and I enjoyed reading all three when they were posted.  Each of them makes strong points from a different angle.  However, a reader who goes through those three write-ups could easily get bogged down in technical details and lose the forest for the trees.  I want to present the “forest” view of the idea since I continue to view Burford as a very actionable investment opportunity. 

What is Litigation Finance and How Does It Work?

Law firms are increasingly facing client resistance to high legal fees and Burford (along with few other firms) has pioneered a better solution for clients.  Burford funds litigation and international arbitration claims by covering all legal expenses in exchange for a share of the litigation award.  Burford does not finance personal injury cases and other spurious claims commonly associated with “ambulance chasers”.  Instead, Burford finances complex litigation where large corporations are involved and legal fees run on average to $20M. 

Burford Has an Outstanding Track Record with 30% IRR Uncorrelated to GDP or Stock Market

While every financing transaction is unique, the payout profile on a standard Burford financing deal is typically structured as follows: when a litigation client wins a case or achieves a settlement, Burford gets its investment back with a 12% annualized preferred return in addition to receiving 20% of any remaining litigation award.  If a client loses a case, Burford gets nothing.

Burford’s investment track record is one of a kind.  Over its 10+ history Burford has generated an IRR of 30% and ROIC (profit divided by the investment made) of 92% on its investments.  Importantly, Burford’s returns are truly uncorrelated as they are driven by the resolution of legal disputes and do not depend on GDP growth or stock market performance. 

Customer Value Proposition

Burford’s customer value proposition is compelling because it allows corporate clients to (1) better monetize their litigation assets, (2) avoid the unfavorable accounting treatment prescribed by GAAP and IFRS (e.g., public market investors generally view litigation expenses as recurring, but consider litigation awards as one-off, non-recurring items; as a result, corporations get penalized but never rewarded), and (3) turns in-house legal departments from cost centers to profit centers.  

Importantly, law firms typically operate as classic equity partnerships and as a result are not well positioned to take the risk of accepting such large cases on a contingency basis.

Industry and Growth Profile

With only 11 years of history, Burford is at the beginning of the litigation finance as the asset class.  The legal industry is very large (~$700B globally), and the penetration of litigation finance is not higher than 3%.  Importantly, litigation finance increases the expected addressable market because it enables many claims that could not have been filed due to inadequate capital to be pursued with the availability of litigation financing.  Low penetration, a compelling customer value proposition, and Burford’s undisputed industry leadership create a long growth runway that could last decades.

Burford Has Multiple Moats around Its Business

Burford’s superior returns are well-protected by high barriers to entry as each of the top 10 players entered the market before 2013.  Given the impressive returns, the lack of new, well-funded entrants in the litigation finance space is the best evidence of how difficult it is to break into the industry.

First, Burford has a scale advantage: Burford has done certain transactions that nobody else in the industry could consider because Burford is several times larger than its closest competitor.

Second, the nature of litigation finance structurally limits competition for any single deal or investment.  Litigation finance does not lend itself well to bakeoffs and auctions.  In the private equity investment bankers who have won a sellside assignment can blast a deck to dozens of potential buyers with virtually zero incremental costs to a client.  The litigation finance world is radically different.  When looking for a finance partner, clients rarely speak with more than a few of litigation finance firms before making their decision.  Engaging in an extra conversation with each new litigation finance provider would generally incur legal costs for the client who would need to pay its own legal counsel to speak with each litigation finance firm to educate the financier about the case.  In addition, clients are usually wary about sharing confidential information widely, as this could waive attorney-client privilege.

Third, litigation finance is very much a relationship-driven business where trust and reputation are critical.  Given the lack of auctions, a litigation finance provider’s existing relationships with law firms play a critical role.  Relationships boil down to a prior history of working with a particular litigation funder, the funder’s overall reputation in the legal community, and the demonstrated track record of delivering the committed capital when it is needed.  Burford has been building relationships with law firms for more than a decade, and Burford’s scale means that it has worked with more law firms than any of its competitors.

Management and Insider Ownership

Burford’s top management is well aligned with public shareholders.  Each of the two co-founders own 4%+ of shares.  To put this into context, each of these executives owns ~$100M+ worth of shares vs. an annual salary + bonus + stock awards of ~$6.5M.  Thus, the incentives are clearly in favor of price appreciation for the stock.

Furthermore, every single professional employee at Burford is a shareholder, which speaks volumes about the company culture and proper alignment of interests.  Very few companies in the world make every employee a shareholder, and those who do it generally create tremendous shareholder value.

Due to the aligned incentives, management has a long-term vision, does not stress about quarterly earnings, and refuses to give guidance.  Their communication style is candid and straight to the point.  Management writes very comprehensive annual reports with the goal of educating shareholders as opposed to fulfilling regulatory requirements.

Valuation – A Back of the Envelope Approach

One simple and intuitive way to get a sense for how cheaply the market currently values Burford is to use a simple Price / Earnings ratio.  At the recent price of $10.60 (July 8, 2021 price), Burford trades at ~14.37x based on the 2020 earnings of $161.5M.  This low P/E multiple does not benefit from any artificial uplift to earnings such as an unusually positive event or realization (2019 earnings benefitted from a large case against Argentina called Petersen vs. Argentina and YPF – see more on that below).  Ignoring any income from the YPF case in 2019, Burford earnings grew ~100% in 2020

A mid-teens P/E is unquestionably cheap for the industry leader in a rapidly growing industry with normalized ROE of 25% that just grew earnings ~100% excluding one-time benefits.  What’s the right multiple for a company like Burford?  It is hard to say, but 20x (e.g., a broad market multiple) to 30x earnings does not sound unreasonable, which should lead to an immediate upside of 1.5x-2.0x+.

Multi-Layered Valuation Approach:  Burford’s Three Components of Value

Burford has three components to its value: (1) its own balance sheet investing business, (2) a growing third-party asset management business, and (3) a potential multibillion dollar litigation outcome stemming from an active case in Argentina.

#1: Balance Sheet Investing.  The best parallel here unsurprisingly comes from the private equity world: KKR is a publicly listed company that both invests its own capital (i.e., balance sheet investing) and manages 3rd party investment funds in exchange for management and incentive fees.

Burford’s total assets are ~$1.8B, which excludes: (1) goodwill as goodwill cannot really generate investment returns and (2) the value of Burford’s significant case against Argentina (see more on this below).  If we assume that Burford needs to keep roughly $300M of cash on hand for working capital (which is likely overly conservative) that means that Burford can currently invest ~$1.5B of its balance sheet assets.  Burford has historically generated ~30% IRR, and those have been very consistent returns over the last 5 years.  However, this figure does include some return that Burford has received from selling off parts of its now large and valuable case against Argentina (the YPF case) which is likely to be an outlier.  Excluding the YPF case, Burford’s IRR would be ~24%.  If we assumed this is the more typical return for Burford going forward, a 24% return on $1.5B in invested capital would come to roughly $360M of normalized profits.  To be clear, these profits are likely to be lumpy and are expected to vary significantly from one year to another, but the average over a multi-year period would be $360M (ignoring reinvestments and compounding).

Burford’s operating expenses (largely salaries to its highly qualified staff) have a current run-rate close to $100M, which includes all operating expenses (including those related to the asset management business).  Subtracting out the operating expenses from investment profits, Burford’s normalized annual operating income should average ~$260M.  As of December 31, 2020, Burford has debt in the form of publicly traded bonds of $650M and pays annual interest of ~$40M.  Subtracting this from the operating income leaves pre-tax income at $220M.

Due to having its holding company incorporated under the laws of Guernsey and thoughtful international tax planning, Burford pays extraordinarily low cash taxes (low single digit cash tax rate).  Over time the effective tax rate is likely to increase to mid-teens.  I will therefore assume a 15% tax rate, which would reduce Burford’s normalized net income to $187M or $0.85 EPS (there are currently 219M shares outstanding).  Thus, this normalized net income of ~$187M (minus a small dividend) would likely be reinvested into the business and continue to grow investable assets, book value, and EPS. 

Given the massive growth opportunity and strong historical growth (Burford has been growing its own balance sheet investment portfolio and 3rd party fund portfolio at 50% CAGR), a multiple of 20x or even 30x is not unreasonable.  This alone will result in a price of ~$17.00 to $25.50 vs. the current price of $10.60 resulting in a 1.6x to 2.4x return.  

#2: Asset Management Business.  Burford manages several private investment funds with overall AUM of $2B+.  Fee structures varies with 2% and 20% being the most common one.  However, in a case of a large sovereign wealth fund on whose behalf Burford manages ~$667M, Burford effectively charges 0% and 40% (not a typo).  Some of these funds do not generate management fees since the capital has already been deployed. 

Somewhat simplistically and conservatively, Burford can earn ~$20M to $30M in management fees per year.  Using the mid-point of $25M and the tax rate of 15%, EPS from management fees is $0.10.

On top of that, Burford is eligible to earn incentive fees.  Let’s use $2B AUM to calculate “normalized” incentive fees.  $2B AUM * 24% IRR (again the IRR excluding the outlier case against Argentina) = $480M of normalized annual gains.  $480M * 20% incentive fee (again – often it is higher) = $96M annual incentive fee.  Since all operating expenses were allocated to the core balance sheet investing business, I only need to account for taxes.  Using 15% tax rate, the incentive fee after tax = $81.5M or $0.37 EPS. 

Assuming a 10x on this average annual after-tax management fee and incentive fee stream (~$0.10 + $0.37 = $0.47), it would add $4.70 per share to Burford’s valuation.  A 15x multiple would add $7.05 per share, and a 20x multiple would add $9.40 per shareLet’s keep in mind that the cash earned from incentive fees can be reinvested by Burford at incredibly attractive returns.

Critically, almost no incentive fees show up on Burford’s income statement today for two reasons.  First, the bigger funds are of a more recent vintage and, thus, have not yet produced many realized gains.  Second, most of the funds managed by Burford use a “European” style incentive fee structure under which Burford cannot recognize the incentive fees until the entire original investment has been returned to its LPs. 

#3:  The YPF Case.  While discussing the YPF case, it is important to note that it has already been a massive success for Burford regardless of what happens from here.  Burford has invested roughly $25M total so far and already received $236M in cash by selling portions (less than 40% in total) of its stake in a potential award to other institutional investors.  That makes the YPF case already a nearly 10x return, which makes it more like a Silicon Valley VC type home run investment.  However, Burford still retains 60%+ of the entitlement to a potential award.  But how big can it be? 

I will state upfront that any litigation is inherently uncertain and binary, and the YPF case is no exception.  Burford can lose the case[1] and receive zero incremental cash.  Both parties have top notch legal teams, making this a courtroom “Godzilla vs. King Kong fight”.  My subjective estimate of probabilities is 70% in favor of Burford.  However, with a sample of size of one, such subjective probability has little utility.  But let’s say that Burford wins the case; how much will Burford get?  The estimated award to Burford is staggering – between ~$2.25B and $5.6B which equates to ~$10.30 to ~$25.6 per shareAn award of ~$3.35B or ~$15.30 per share is the most likely.

Yes, you read that right!  Burford can walk away with a positive verdict from one single case with a value estimated at nearly twice as much as its current market cap!  This potential outcome does not seem to be priced into Burford’s stock at all – and please do not forget you still own Burford’s immensely valuable portfolio of litigation assets expected to produce 24% annualized returns plus the lucrative asset management business with incentive fees that make even hedge fund managers a bit jealous. 

Putting It All Together

Let’s put the three elements of valuation together.  In the bear case I assume that Burford loses the final YPF verdict and receives no further cash from that case.  I also use the lowest range of value for the core business and the asset management business.  In the base case, I assume that Burford wins the YPF case but gets the low range of the value there, and I assume the low end of value for two other businesses.  In the bull case, I take the high end of value for each segment.

One final note: a better and intellectually more appropriate way to value Burford is to model earnings’ reinvestment for the next 5-7 years (remember that normalized ROE = ~25% and it is likely to expand over time), get to the EPS number in 5-7 years, and assign an exit multiple or do a DDM on those earnings.  Ideally, you also want to keep the capital structure composition constant:  as Burford’s equity grows, it is necessary to model the additional debt issuance.  Utilizing this approach numbers get really big.   

DISCLAIMER:  Presented analysis is an opinion of the author.  The author and / or affiliated persons are long Burford shares and / or other related securities (bonds, derivatives, etc.).  The author does not assume any obligation to update the analysis.  The author may engage in transactions involving Burford shares and / or related securities (bonds, derivatives, etc.) at any time.

 

 


 

[1] From a legal standpoint, Burford is not a plaintiff in the case and not a party to a dispute.  Burford is simply financing the case.  However, for the sake of brevity I will be using language that may imply that Burford is a party to the case.  

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

1. Continous growth in earnings. 

2. Incentive fees crystallize. 

3. Potential win of Petersen. 

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