|Shares Out. (in M):||219||P/E||10.7||8.4|
|Market Cap (in $M):||4,498||P/FCF||0||0|
|Net Debt (in $M):||644||EBIT||478||599|
New to VIC, the world's leading provider of litigation finance Burford Capital strikes me as a great investment. Selling for less than 11x 2019 core earnings, this is simply too cheap given Burford’s business quality, a mind-blowing growth opportunity and the owner mindset of its two founder-operators on top.
Highlights of the thesis
- Massive and underpenetrated addressable market by all measures
- Litigation finance rapidly gaining traction amid mounting pressures from corporates on law firms to abandon the bill-by-the-hour standard in favour of performance-based models
- Industry actors mostly exhibit rational behaviour - i.e. return-driven rather than volume-driven
- Largest litigation funder by a wide margin on assets, revenues and # of employees
- Countercyclical - adverse business environment = more cases and less corp resources
- Strong barriers to entry amid scale, reputation, talent and underwriting track record
- The two founders-operators combinedly own ~8% of Burford or ~£280m interest
Stock and Valuation
- $ reporting with an unconventional £ London-AIM listing makes Burford less likable
- While Burford gets notable sell-side coverage it does not translate into better forecasting due to the limited disclosure on ongoing cases amid confidentiality and the huge disparity amongst each individual case in terms of substance, timing and outcome
- Accounting does a poor job on showing Burford’s true economics - costs straight to P&L vs. associated future gains, two segments with different monetization patterns, understated book value, etc.
Brief Industry Overview
As a nascent industry it is legitimate to ask why litigation finance exists and to whom it serves. Litigation finance main reason d'etre is to eliminate the imbalance in risk profile between a claimant and a defendant. Think of two companies having a dispute over a patent infringement. It is not only the legal merits of the case what matters but the financial resources each side is able or willing to deploy. Litigation and law firms are costly animals.
Firms with limited resources find that the typical bill-by-the-hour model that law firms embrace becomes unaffordable for them when trying to bring a promising case forward. Moreover, companies that could safely afford these costs face the opportunity cost of allocating resources to an investment with highly unpredictable pay-offs that could be deployed elsewhere. For listed firms legal costs are recurring-above-EBITDA from an accounting perspective whereas the potential rewards are extraordinary-below-the-line items. While looking good is not necessarily the same thing as being good, you all know the most followed route by corporations in this short-term-stock-price world.
Think of litigation finance as an investment in an asset with its inherent risks and attached probabilities to different outcomes. To put it simple the party that provides the funding to the corporate in order to cover the legal costs of a case (the investment) typically gets a proportion of the proceeds the corporate is entitled to once the case comes to an end.
What I find interesting about the industry is its propensity to enormous price dislocations - thus the potential for outsized returns - when compared to other asset classes as price discovery is difficult to reach. This is essentially the result of the presence of asymmetric info and the impact of dissimilar incentives and time horizons. Some traits of the industry.
- Low competition amid very few sellers and very few buyers
- Iliquidity due to unknown timing & unpredictable outcomes - indeed binary beyond a point
- Difficult to price assets efficiently amid confidential and costly to get information
- Each asset has a full idiosyncratic component - each case is unique
- Low transactional transparency as prices and terms are mostly private
Some papers as the 2018 Litigation Finance Survey provide light on the need for the industry, reporting a skyrocketing proportion of lawyers who claimed their firms had used litigation finance up to the date of the survey (70% of respondents in 2018 vs. 10% in 2012) and a high expectation of using litigation funders for the next 2 years (70% of respondents). These numbers suggest pressure on the long-standing bill-by-the-hour model that has dominated the legal industry and the accelerated growth in litigation finance.
How truly large is the TAM? The short answer is that it really does not matter to provide a specific number as it is very large compared to its current size. Here some facts.
- Market research firms estimate legal fee revenue in a range from $580 billion to more than $800 billion. Of course not all legal fees are litigation-related.
- The proportion of these legal fees specific to litigation finance varies by jurisdiction. Burford’s smaller listed competitor IMF Bentham estimates that litigation finance for the US comprises ~36% of the total legal spend in the country, ~19% in Australia, ~26% in Europe, ~14% in Canada, etc. In terms of conservatism assume a low-end of 20% worldwide, which means a $116-160 billion litigation finance TAM from this angle.
- From the angle of US tort costs Towers Watson estimates them to be 1.5-2% of the country GDP, which is a mindblowing number. The US Chamber of Commerce specifically provides $429 billion as its estimate of US annual tort costs.
- From the perspective of the assets affected the value of US public company assets subject to bankruptcy filings exceeds $100 billion. Other examples that serve as data points are Forbes’s research of $20 billion spent on smartphone IP disputes over a two-year period or Cornerstone concluding 84% of US $100million+ M&A deals involved litigation.
To give some context to these numbers, in 2018 Burford deployed ~$1.1B to investments and it is by far the largest player. While annual deployments at an industry-wide level are difficult to estimate accurately, considering the relative size of Burford and its peers annual deployments sit at the $2-2.2B level, suggesting <2% penetration. I personally believe it is safe to think of actual penetration <1% if we adjust for the growing TAM derived from the classical dynamics of an industry in its early days. In the same fashion low-cost airlines expanded the travel market by bringing to the game millions of price-sensitive first timers, litigation funders make it possible for corporates to pursue disputes that they would have dropped otherwise, and which therefore are excluded from the past calculations of the market size.
Barriers to entry
I generally have a hard time to decommoditize in my mind companies whose model involves some sort of asset funding, be them mortgage lenders, consumer finance providers or lessors. I think however that Burford’s scale and reputation give a company an edge. In other words, size in litigation finance confers a competitive advantage. Why is it?
- Diversification and size of individual investments - Burford’s average single-case investment moved from $3m in 2009 to the current $24m. For a new entrant it would take almost $1B to compete with Burford if we assume 40+ single cases as a healthy level of portfolio diversification. I think the hurdle is indeed higher as the $24m are single-case related and Burford currently invests in larger case-portfolios diversified themselves.
Bear also in mind that unlike investing in businesses there is no benefit from concentration as (1) the outcome of a dispute is subject to more uncontrolled forces than equity investing (i.e. sometimes the result is a matter of a judge’s decision) and (2) while most cases - 9 out of 10 by industry estimates - reach a settlement between parties, those which eventually go to court face riskier pay-off profiles amid their usual “all or nothing” binary nature.
- Reputation - While corporates are certainly not price insensitive, litigation finance is mostly a relationship business. The non-public nature of most ongoing cases makes law firms think-twice before distributing confidential materials amongst a large pool of funders. There have also been instances where a funder “commits” an amount and deploys some initial proportion to eventually turn down subsequent capital calls. Therefore to avoid potential conflicts and because they know that a relationship with a trusted player is likely to work better, law firms typically send materials to the two or three litigation actors they know well. This hurdle to get workflow consistently acts as a deterrent for new entrants.
- Track record - The most common question I get concerning competition is, why not a bunch of litigation lawyers leverage their experience to set up quickly something similar to Burford? The reason is twofold. One, because success in this business does not only relates to legal know-how but more importantly to investment underwriting expertise. In other words, no matter how likely is for a funder to win a case if that funder does not know how to price the odds properly. Think of the many unknown variables to evaluate an investment - deployment schedules, case duration, change of jurisdiction, credit and repossession risks, etc.
Two, because large potential investors in litigation finance are likely to prefer an investment in Burford vs. other smaller players or new entrants. This is because for them (1) it is technically possible, as Burford not only invests through its balance sheet but also operates several large funds - and plans to launch new ones - that allow for massive sums of money and (2) it is a superior choice financially amid Burford’s long and outstanding record paired with the fact that unlike equity investing, returns in litigation finance do not not suffer from diseconomies of scale. Moreover, it is quite the opposite. The larger Burford becomes vs. peers the better access and less competition Burford gets for the larger lucrative cases.
- Absence of conflicts of interest - Literally all companies in the industry are pure players. Leaving aside the challenge I described when it comes to raise a large capital base out of nothing, law firms willing to also have a litigation finance arm would face a paradigm. In other words, were you a law firm would you finance a competing one? Would you phone a competitor to get funding? I guess not. You would actually be in the conflictive position of only funding cases brought in by your own law brand, limiting choice. More importantly having funder and law firm under one roof would compromise legal independence as it would make it more likely that the funder interferes in the decisions taken by the legal arm. This is an important point. With the sole exception of its principal-complex investments Burford neither controls nor interferes in the litigation process. It only funds that process.
There are a number of competitors, all of them way smaller by all measures and with a less comprehensive service offering than Burford. As I stated the barriers are sufficiently strong and the opportunity large enough to think of competition as factor which improves industry dynamics. It indeed increases awareness amongst corps and law firms. Some of the main peers are the following.
There are other smaller competitors and former larger ones that are on exit-mode. Comparing Burford’s and smaller listed IMF serves to better understand the impact of scale.