|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|
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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.
Probably you are asking yourselves two questions. One, how is it that Burford, founded 8 years later, quickly surpassed IMF? Two, how can a business that theoretically requires more people to grow has exhibited such a level of operating leverage?
To the first question I believe there is a combination of two factors. First, back in 2010 the litigation industry was not even a nascent industry but more of a germ in the sense that truly no company in business had built any sort of a brand name, which made it easier for bold movers to quickly catch up with incumbents. More importantly, Burford’s people had - and still do have - a remarkable entrepreneurial spirit underpinned by a strong willingness to grow and keep most of their skin in the game. This is evidenced by something as simple as IMF’s and Burford’s respective dividend payout policies. IMF has historically shared more than 70% of its after tax earnings through dividends. On the contrary Burford has chosen to reinvest most of its profits, historically paying out less than 14% of them (in a decreasing fashion, paying out only 10% in 2018).
Concerning operating leverage while it is true that the investment volume and the number of people on board are positively correlated, such correlation is not linear. In other words, evaluating twice as many investments demands less than twice the people. I think part of the explanation lies on a learning curve effect. Getting quicker to disqualify unpromising investments and better to analyze the worthy ones means in practice the same workforce can achieve improved outcomes. The benefit of size in margins also extends to the level of individual-case size. It is simply hard to think of a $24m investment needing three times as many individuals as a $8m one. Burford’s spectacular growth comes not only from the volume of cases but also from the increase in size of each of them.
Burford business in a blink
Founded and IPOed in 2009 by Chris Bogart and Jonathan Molot - both of them already successful lawyers back then. Since 2010 Burford’s revenues have moved from $5 to $426m and EPS $0.01 to $1.5 - 85 and 150x, which translates into 74 and 87% CAGR respectively. To sum up, Burford has proven a terrific business from all angles and unsurprisingly its current share price is 15x above the one in 2009.
Investment types, structures and pay-offs
The simplest arrangement is a single-case investment where Burford deploys some amount of capital in order to get that capital back first followed by some preferred return on such capital along with a share of the ultimate recovery.
For example, think of a $1million initial investment, a 10% preferred return and 20% share of the net recovery if the customer wins the case. Imagine the proceeds are $2.5m in case the dispute is resolved favourably in one year. The transaction means that Burford would get $1m back first followed by $100,000 (10% return on capital). On top of that Burford is entitled to 20% of the net recovery. What is the net recovery? The proceeds if the case is won after deducting the initial outlay and the preferred return, so $1.4million ($2.5m-$1m-$100K). Burford would get $280K (20%*$1.4m). Burford total proceeds would thus be $380K in one year after getting its $1m back first, which is 38% ROIC. ROIC in this context stands as the multiple on the initial investment. IRR for this case, the annualized return, also stands at 38% as the investment period is 1 year and the investment is fully deployed at the beginning.
Take this example more as a simple theoretical framework to think on how litigation finance transactions work and less as a fair reflection of actual typical transactions. The reality is sometimes far more complex. First, because generally the investment is not fully deployed at time zero. A dollar amount commitment is agreed at the beginning but the actual cash outlays typically occur unevenly over time. Remember the main function of that capital is to serve legal expenses, so capital is called on an as-needed basis. These differences in the timing of deployments tend to have and obvious impact on returns.
Second and more importantly because the timing of a resolution over a dispute is a big question mark. Sometimes the parties reach a settlement before going to court for an agreed amount. Others, less often, each or both parties fail to agree and the case ends up in court, which makes the duration of the investment longer and the pay-off riskier (typically all or nothing, sometimes ends up in the middle) and potentially larger (typically a party disapproves a previous settlement on seeking higher damages). Unsurprisingly, when compared to adjudications (disputes that end up on court) settled investments usually translate in relative smaller dollar amounts earned (lower ROIC) but higher IRRs amid lower durations. Some Burford’s numbers in this regard below - only reflected here core litigation finance concluded investments through balance sheet ex-funds.
On top of evidencing Burford’s stellar historical returns, the data reinforces the relevance of scale. As the weighted average historical blended duration is ~2 years, the weight of adjudications is notably smaller and it is not unrealistic to think of ~1 year as the representative duration for settled cases (ROIC ≈ IRR) it follows that a proportion of cases that end as trials or hearings (adjudications) extends well beyond three years. Add that ROIC and IRR numbers are a the blend of many different cases and then fail to capture extreme individual outcomes, be them investments that return back multiples or those which end up in total loss. The later are the ones that most impact a new entrant as its chances of survival exhibit strong path dependency. Think of a player with limited resources and unduly investment concentration with some four or five-year locked initial investments that eventually turn out to be zeros in the scorecard. Good luck!
Burford’s core litigation portfolio has diversification traits unthinkable for smaller actors.
- No defendant represents more than 5% of commitments
- 1,110 individual litigation claims underlying portfolio
- No single case capital loss would amount more than 3% of total commitments
- Largest law firm accounts for 17% of the investments but the 17% is spread across more than 50 different partners, each of them acting as niche/vertical experts on its own right
Moreover Burford has evolved from a single-case litigation funder to the multi-faceted financial services business for the legal industry it is today. As opposed to portfolio investments where there are multiple paths to recovery, single case investments are (i) riskier as they pursue a sole litigation claim and thus are subject to binary legal risk and (ii) costlier as the smaller rewards are not matched by a proportional decrease in the number of people and time set for the investment. In 2009 the entire portfolio comprised single-case investments. Burford’s current portfolio looks like this.
Note that portfolio cases now account for more than half of the $2.5B total portfolio (56% of the total) and that single case investments just make for 16%. It is remarkable that Burford has an unparalleled relation with corporates and law firms as it offers services befond pure litigation finance (single case and portfolio) that smaller players do not. In a relationship business like this it confers a competitive advantage alongside a further layer of diversification.
Recovery and complex strategies - Cases where Burford typically acts as a principal by buying directly an equity stake in the company involved and where there is thus asset value supporting the investment. These are very idiosyncratic with all types of payoffs and durantions as it happens with core litigation finance.
Legal risk management - Burford provides some sort of legal risk arrangement as indemnity for adverse costs. This is a very small area that serves more to strengthen the relations with law firms and corps as it provides an additional service.
Asset recovery - Enforcement of legal judgements. This is also small-sized but potential returns are significant in terms of ROIC yet it might take sometimes several years to seize assets. How could it be otherwise when one goes after mobsters? Great pain, great risk, great gain. Some accumulated numbers from this promising line to date.
Post-settlement - Situations where litigation has been resolved but there is a time lapse between the verdict from the court and the cash payment. Thus there is counterparty risk. Here Burford serves the party by monetizing its account receivable at a discount. A factoring business. As simple as that. The absolute returns on invested capital here are not high but IRRs are decent as duration is typically very low (significantly less than one-year).
Other initiatives (Insurance and law firm finance) - Not included in the table above as one is already extinct, another is in runoff and the third one is small and there is little information on it, so they are not relevant for the future of the business and thus not central to the thesis. A brief explanation though. Insurance is a legacy business line which Burford entered in 2012 by acquiring Firstassist, a UK litigation insurer, for almost $19m. The table below might be enough to convince you that it was a great deal.
However the business is currently in runoff and will eventually be game over for it. Why is it? Because a regulatory change that took place in 2013 greatly diminished the market appetite for litigation insurance. You can see its impact on the declining income trend after peaking in 2014. The standard of the litigation insurance industry was to offer its clients, in case they lost a case, a limited coverage of the legal fees owed to the winner of that case in exchange for a premium. Burford’s model was very interesting as it did not required its clients premium payments and offered unlimited coverage in the case of a loss. In exchange for this if its client won the case Burford took a percentage of these costs that its client got as income from the losing counterpart.
This low-friction model with no upfront payments unsurprisingly met strong customer demand but at the same time made the regulator uneasy because it changed the whole nature of insurance as an industry as fees for the insurer were outcome-contingent rather than premium-based. The regulator then passed the Jackson Law, requiring customers to pay premia from their own pocket, impairing Burford’s model. Despite it still remains relatively strong as it is currently small relative to Burford’s business and especially because it will be gone soon, I ascribe no value to the insurance business for valuation purposes.
The other two initiatives, law firm lending and law firm investments, are more anecdotal. On the law firm lending vertical Burford entered this line in 2015, providing funding to law firms to cover the legal costs that law firm’s clients took time to cover. Upfront legal operating costs attached to specific services to customers that are not backed by a collected invoice are rarely tax-deductible for a law firm. Financial costs are. That is the main reason d'etre for this line, but the thing is that after investing some millions - circ. $30m - and losing them all Burford exited in 2017.
In 2014 Burford also decided to own equity stakes in other law-related businesses. The only disclosed Burford’s stake was a 16% in Manolete Partners, a tiny - £10m revenues in 2018 - UK-based firm solely focused on insolvency-related funding which Burford already divested.
Sources of funding
Burford invests through its own balance sheet and third-party funds - including a special JV-type fund partnership with a sovereign wealth fund (SWF). To fully align interests with the funds’ LPs Burford also invests in the funds through its own balance sheet. Most Burford’s peers are just third-party fund players with the notable exception of the australian IMF Bentham, which like Burford makes it both through its own balance sheet and investment vehicles yet at a much smaller scale.
Through the vehicles Burford can accelerate growth. Despite fund-investing is costly for Burford as most of the gains accrue to the LPs - excluding the stake that Burford itself owns through its balance sheet and the fees charged to the funds - it serves three functions well.
(1) It provides additional funding that otherwise would be constrained as Burford neither wants to incur in significant amount of additional leverage nor dilute shareholders. Burford is operating at a net debt/equity ratio of around 0.27x (slightly higher if we adjust for the current cash devoted for reinvestment), a low level of leverage for a specialty finance firm. On top of this Burford’s first long-term debt maturity is in 2022. This low-indebtedness is possible because the company uses most of it internally generated cash for reinvestment purposes - i.e. low dividend payout and no buybacks, indeed a small capital increase I will comment on later.
(2) Makes it possible to segregate amongst different vehicles diverse risk, return and duration investment profiles. For example, post-settlement investing is a low-risk low-return low-duration asset class (explained later). It is enticing to a specific type of investor and also serves as a way to strengthen Burford’s relationship with its customers by offering a service they demand. Burford can do this without limiting its investment upside as it can use a fund for this purpose. Moreover, all post-settlement investing is made through funds and none directly via Burford’s balance sheet.
(3) It generates sort of an alternative revenue-stream for Burford through management and performance fees that limits its downside risk to Burford’s stake in the funds and allows to invest in larger cases by raising significant amounts of capital.
Gerchen Keller Capital Acquisition
In December 2016 Burford acquired Gerchen Keller Capital (GKC). Burford and GKC were the largest players in the industry, the former being essentially a pure-balance sheet player and the later only running third party-funds. Burford paid $160 million for GKC in a mix of cash, shares and loan notes for $1.3B assets (leaving aside additional $15m in shares for GKC legacy business). So Burford paid 12-13% of AUM, which seems an unreasonably high multiple given the classic LSD figure the market confers to most investment management businesses. Let’s evaluate the transaction.
By acquiring GKC Burford got 3 pre-settlement ~$787m core funds, a ~$416 post-settlement fund and a “ready to launch” $300m complex-strategies one.
Two points before the quick sanity check to know whether Burford grossly overpaid for GKC.
- ROIC is calculated over deployments rather than over commitments. Deployments over commitments ratio for core pre-settlement litigation has historically averaged 84%
- Funds operate under an European Waterfall Structure, which essentially means that LPs are entitled to get their capital back first before Burford earns a performance fee
An example on it that Burford offers on its presentations. Say that Burford runs a $100m capital fully invested 2-year duration vehicle with 1.4% management fee, 52% ROIC and 23% performance fees. The annual management fee is easy to calculate, $1.4m ($100*1.4%). The performance fees come after investors get their $100m back first and after management fees and expenses. Assuming $4m costs ($1.4 annual management fees for two years is $2.8m in management fees and the remaining $1.2 in other expenses), the performance fee would be $11.04m. ($100 * 52% ROIC - $4m costs)*23% performance fee.
Now let’s apply this to GKC funds in a very conservative way.
For pre-settlement, despite showing 1-year for concluded investments I think it is conservative to assume 2-year duration (now is 1.8) and 55% ROIC (let's assume ROIC = IRR for the concluded 1-year pre-settlement investments yet now ROIC is much higher).
Management fees = 1.4% * $787 * 84% ratio = $9.3m in management fees. I assume at least 30% goes out on opex (labour) so net management fees would be $6.5m
Costs charged on the fund = $21m ($6.5m management fees * 2 years + $8m other costs)
Carry = ($787 * 84% * 55% ROIC -$21m costs) * 23% = $78.8m for 2-year or $39.4m annual
Total annual fees on Pre-settlement = $6.5 + $39.4 = $45.9m
For post settlement, average duration is 1-year. I think here it is safer to assume full deployment as management has more visibility on cases once concluded. This is essentially a factoring business. Calculating the IRR on an annualized basis that is ~7.5% ROIC.
Management fees = 1.6% * $416 = $6.7m. I assume margin here is zero to be conservative
Costs charged on the fund = $10 ($6.7 management fees +$3.3)
Carry = ($416 * 7.5% - $10) *20% = $4.2m
Total annual fees on Post-settlement = $4.2
Therefore total pre-tax income would be ~$50 million, which means Burford would have paid less than 4x pre-tax income for GKC business without accounting for the $300m complex strategies fund that was about to launch.
Current Investment Management activity
Burford now manages investment funds totalling ~$2.5B AUM subject to management and performance fees. A quick check of these vehicles individually.
- The Partners Funds - These are 3 Funds (I,II & III) that closely resemble the pre-settlement core litigation finance investments that Burford completes through its balance sheet. These funds came from the GKC transaction.
Partners I - Raised in March 2013 with $45.5m in commitments it has deployed $31m over 17 investments, thus $1.8m per case, of which 13 have already been resolved. Partners I is no longer generating management fees given its maturity but it is still entitled to more than $27.8m net of invested capital or almost $5m in performance fees.
Partners II - Raised in December 2013 and with a particular emphasis on IP-type investments (longer duration, larger risk, larger potential rewards) it had $259.8 in commitments. It has insofar deployed $119 million to 36 investments. Burford made $1.6m in management fees in 2018 out of this fund. Management fees will cease at the end of 2019 - currently 2% except for $85.9m commitments that have 0% management fee for a 50% performance fee. As the fund has not reached yet the stage of having returned back investors’ capital it has not charged any performance fees yet.
Partners III - Started in January 2016 it $412 million in investor commitments. Partners III has made 56 investments and committed $438.8 million of capital, $204.0 million of which is presently deployed. Investors in Partners III paid a 2% management fee on their total capital commitments during the investment period, regardless of deployment levels, and now that the fund is in harvest mode investors are only paying fees on investment commitments.
From 2020 investors pay no further management fees. Burford earned $5.9 million in management fees from Partners III in 2018, and at the fund’s current level of commitments would earn another $5.9 million in management fees in 2019. The fund has two investment classes. Class A pays 2-20 and class B neither pays any management fee nor is entitled to any return but is only to an 8% coupon if drawn. As Class A must be drawn in its entirely prior to Class B being drawn and the nature of litigation finance suggests that it is unlikely that Class B will ever be drawn it should be thought of as a form of synthetic leverage.
- Burford Opportunity Fund (BOF) - It is a $300m commitments vehicle that began in December 2018. Investors pay 2-20 (the 20% beyond an 8% hurdle with a full catch-up). The 2% annual management fee is over the full commitments ($300m) rather than deployments and lasts till the end of 2023, a period that might be extended for 2-more years under certain conditions. Thereafter investors pay 0.5% fee on commitments until termination. At the end of 2018 BOF had committed $84.5 million to 11 investments.
- Post-settlement fund - Launched as recently as April 2019 This vehicle is the successor of the post-settlement fund that Burford acquired in the GKC transaction. It is a $300m fund that charges 1.5% management fees on invested capital and 10% performance fees after a 5% preferred return with a full catch-up.
- Complex strategies fund - Raised in June 2017 it essentially invests in situations where Burford acts as a principal on the investment, that is bought directly the equity of the company involved in the case. The fund closed at $500 million, including a $150 million commitment from Burford,and was substantially deployed during 2018. Burford earns here 2-20. The 2% management fee is on called capital, not commitments. The 20% carry is over a 5% annual preferred return with a full catch-up. In 2018 the fund earned $3.4 and $1.8 from management and performance fees respectively.
- Sovereign Wealth Fund (SWF) - A $1 billion fund with the Sovereign partner with its investment period until the end of 2022. The $1B comes 67% from the SWF and 33% from Burford’s balance sheet. Interestingly, while Burford’s own capital just comprises one-third of the fund the company earns 60% of the profits from investments along with an annual contribution to operating expenses of up to $11 million taken from the first dollars of fund returns. In other words, the fact that Burford’s share of SWF’s profit is far above its relative capital contribution is supportive of the value Burford brings into the table. Is it that the SWF is naive or is it that Burford is the defining factor for SWF’s success? I think clearly the later.
So presently Burford is investing actively in the BOF, the SWF, the complex strategies fund and the post-settlement vehicle, while the Partners Funds are closed on that regard. To avoid any kind of conflict on capital allocation between balance sheet and vehicles. Burford follows a predetermined formulaic approach. To be more precise:
- Core litigation finance investments are allocated 25% to Burford Opportunity Fund, 50% to the SWF fund(of which the Burford balance sheet is a â investor) and 25% to the Burford balance sheet,so that between the direct allocation and the SWF allocation the Burford balance sheet ends up with 42% of each new investment.
- Complex strategy investments that meet the fund’s mandate are allocated 100% to the complex strategies fund, but Burford’s balance sheet is the largest investor in the fund, and other principal strategy investments are allocated 100% to Burford’s balance sheet.
- Post-settlement investments are allocated 100% to the post-settlement fund and asset recovery investments are 100% allocated to Burford’s balance sheet.
The main reason for the significant rise in opex relates to the increased investment activity - i.e. providing the human and financial resources for the SWF and BOF is no small effort by any measure - that has insofar collected no relevant fruits amid the immature stage of these vehicles and the European Waterfall clause, so expect the margin contraction to be temporary.
A brief remark I deem as important is how Burford accounts for its investments under IFRS. Burford holds litigation investments at cost until there is some objective event in the underlying litigation that would cause a change in value, then IFRS requires to mark up or down the investment accordingly. Increasing/decreasing the asset with its consequent up/down matching on the P&L. Well, nothing substantially different from accounting for other asset classes.
Unlike public equity investing where it is generally easy to get market prices for a sufficiently liquid security, litigation investments do not offer that possibility except for the few occasions which see an investment is partially sold. In other words, the “objective event” - court rulings or settlement offer - consideration and valuation becomes critical.
So unrealized gains as a proportion of investments, income and profits have substantially increased. I do not think that this is something to be worried about for four main reasons.
First, because only one-third of the gains are recognized before the settlement is concluded and when there are significant case developments. Cumulative data for Burford’s concluded portfolio shows that the company just recognises 5,8,10 and 33% in the 4,3,2 and last years respectively to conclude a case. In other words it means two-thirds of the final gains are recognized only when the case is resolved.
Second and related to the first point, as Burford is very conservative to write up a case and does it under strong evidence, the situations where the company has increased the value of an investment to subsequently write it down are very rare. In the 2017 annual report the company states that just 0.2% of the write-ups have ever turned into a loss.
Third, Burford does not blindly rely on secondary market activity when it happens to ascribe valuations, following a more conservative path. The perfect example of this is the Petersen case. Petersen is a claim against Argentina and its energy major YPF. The Argentinian government expropriated YPF to a number of shareholders including Petersen, a Spanish group. In 2017 Burford sold 25% of the case in the secondary market for $106m, implying a $424 total value. After selling the 25% interest there was trading activity in the secondary market at varying price levels, with the weighted average price in 2017 implying a value of around $660m on total original investment and thus Burford increasing the value of its remaining stake. How much? Burford altered the carrying value of 15 investments in 2017 and the net increase in value across all of those investments was $181m, which likely means it did not write-up Petersen to anything close to its secondary market valuation.
Last, Burford’s significant cash generation to mostly reinvest in new cases proves that its fair value accounting is far from a bluff and eventually materialises. Tracking Burford’s historical investments by vintage bodes well for this purpose. If we add up all the Burford’s investments before 2016 (excluding 2016, 2017 and 2018 because of the immaturity of these vintages) the company has $787m in recovered proceeds to date and $191m investments in ongoing matters. In the highly unlikely scenario that Burford lost all those $191m, the company would still deliver 41% ROIC and 15% IRR for the period.
Management and culture
Chris Bogart and Jonathan Molot, who combinedly own almost 8% of the shares, founded Burford in 2009 and have established a culture of excellence, eager to achieve quick profitable growth. In addition to their large ownership in Burford I think it is important to note that their motivation to start Burford was likely enormous given the long standing successful careers that both had in the legal practice. Chris came to fame in 2000 when he worked for Cravath, Swaine & Moore as he managed to get the largest bill - $35m - for legal advice in the ill-fated Time Warner-AOL merger. Do not judge him as a deal maker! Judge him on the basis of fee-generation for the legal practice he ran rather than for insane transactions that some hungry Wall Street bankers and corporate CEOs wanted to complete at any cost. Following the merger Chris landed in Time Warner as Executive VP & General Counsel until starting Burford. Jonathan was an official for the Obama Administration and professor at some top-notch business schools.
Chris and Jonathan are therefore properly incentivized through their interest and the career they left behind as soon as they smelled the huge opportunity ahead. In addition the company passed in 2016 a LTIP for all employees linked to relative performance vs. peers and EPS and net asset growth. All LTIP grants come with a three-year cliff vesting and clawbacks for malus. The plan has a cap of 10% of Burford’s shares over a 10-year period. After three years, the company has just used up 0.32%. In other words the incentives are aligned with those of the shareholders and there is still a lot of upside for employees.
There are two usual criticisms that Burford gets on corporate governance. (1) Elizabeth O’ Connell (CFO) is Chris Bogart’s (CEO) wife and (2) Burford’s AIM listing.
On (1) I seriously doubt Burford is a case of nepotism. While I cannot explain my case with scientific evidence Elizabeth has a great resume to my understanding - CFA + MBA + M&A positions in Salomon Brothers + Equity Syndicate Director at Credit Suisse with a bunch of deals on her shoulders + CFO for a tech company listed on Amex might bode well to explain many things but not to explain nepotism. On top of these credentials I confess I have learnt a lot when I have talked to her and her explanations on the business are clear and convincing. She has been with the company from the beginning and knows the business upside down.
On (2) while a US-firm AIM listing might rise eyebrows it makes sense to me as litigation finance back in 2009 was an industry likely to get better reception amongst UK investors. On top of this while AIM reporting standards might be subpar - being generous - Burford burdens itself with a high level of disclosure and extensive explanations of its business. This is my take and of course you can check their website and read the annual reports to judge. I personally became fascinated with them.
On early October 2018 Burford raised ~£192m capital (~$250m) representing 5% of the shares outstanding. The announcement sent the stock 20% down in ten days, in the classic situation with asymmetric info that means to take a leap of faith on management or not. Is it that the company needs the capital to account for problems which have remained undisclosed? Is it a symptom of a great investment opportunity?
Good management typically brings good surprises. On December the company announced a $1.6B funding arrangement that included the strategic relationship with the SWF. The aggregate position under the new funding structure for these $1.6 billion of litigation finance investments is that Burford will invest directly 42% of the capital for each new investment and will receive 60% of the resulting profits.
I think this is a great deal from all angles. For one because through this synthetic leverage - getting 60% of returns by only investing 42% of the capital - Burford gets the benefits (enhancing returns) without bearing the costs (increased financial risk and interest expenses). Second because Burford will be much less constrained by available capital, making it possible to opportunistically deploy capital in larger cases where it finds little to no competition. Last because a SWF has tons of dry powder to open new vehicles and lines with Burford in case the relation works out well as I think it will. There is a lot of optionality in the deal.
Why did Burford decide to raise equity? I think it was because the company has a low appetite for debt and also the market conditions were not optimal for that kind of funding. Burford’s smaller private competitor Vannin Capital planned a London IPO in 2018 to eventually withdraw it. www.cityam.com/265250/litigation-funder-vannin-capital-pulls-london-float-blaming
This event might give some picture on the difficult market climate to raise capital (debt and equity) so Burford relied on its aligned existing shareholder base to participate in the raise. I think it was simply a safer approach in exchange for a small dilution.
On 30 April 2019 Canaccord Genuity released a critical report on Burford which has generated a bad sentiment on the company and the stock price in May. Leaving aside less central things, the report questions the way the company calculates its investment returns.
In particular the report is skeptical on the historical 85% ROIC the company reports for its concluded investments of the core litigation finance vertical, contending the company is understating the capital employed. Canaccord agrees with Burford on the “recovered amount”, $1,027 million, but there is a discrepancy on the “invested amount”, with Burford claiming it is $555m and Canaccord $1,200m, equating 36% instead of 85% ROIC. This is an excerpt from the report to support Cannacord’s core argument.
We asked the company to explain to us how $555.0m had been calculated. They provided the following response: “This occurs because there is an allocation of deployments to partially recovered matters. For example, as you know we have sold a 28.75% interest in Petersen for $136m in proceeds. So on the concluded table you will see $136m as “total recovered” and 28.75% of the deployed investment in Petersen in the “total investment” column ($5.1m).”
This explanation is problematic in our view. It is incorrect to pro-rate the investment amount to the percentage of economic interest sold i.e. the $5.1m is not a relevant number. If BUR had not invested $18.2m (original investment of $16.9m with $1.3m follow-on) in Petersen, then it is likely it would not have earned any returns.
So basically Canaccord says that invested capital should not be allocated proportionally but the total amount only to the 28.75% sold. I find Cannacord’s explanation nonsensical. On that basis, what would be the future invested capital and ROIC on the 71.25% Burford still owns? Zero invested capital and infinite returns? That would be meaningless. Canaccord critique is made on a pure theoretical accounting basis unsuitable for the case. Moreover the economic substance does not change. This is why I think the 85% ROIC is the right one.
Other points of conflict revolve around (1) fair value accounting and (2) prospective ROIC. On (1) I have already addressed how Burford recognizes unrealised gains. Conservatively. On (2) Canaccord states that complex/principal strategies will likely represent a higher proportion of the future portfolio, which is true, and that these strategies command much lower returns, which is not. While ROICs of concluded investments are significantly lower vs. the core litigation portfolio - 20% vs. 85% - IRRs are not that dissimilar - 24% vs. 30% - and bear in mind that the true future composition of the portfolio is uncertain, that complex/principal strategies data is still not statistically significant amid small sample bias and that these type of strategies typically command lower risk.
As projecting into the future is especially difficult for this business take this as a conceptual framework to assess cheapness rather than an accurate valuation exercise. I divide these projections in two, balance sheet investments and the investment management business.
I think the underlying assumptions behind the simple model below are conservative. This is especially true for the prospective returns associated to the invested assets, a key input for the model. Yes! I know there is a leap of faith to be made here in the same fashion when we as portfolio managers try to convince investors that our future will be bright by showing evidence of a rosy past for that purpose. We are dealing though with the gravity of scale, which Burford is not. Actually quite the opposite. Let’s check out the assumptions.
- 30% IRR - This is at the historical level. I think it is realistic for three reasons. First, because as I said scale is a tailwind for Burford. The average size of an investment will move north of the current $24m, translating in much less competition on that tail. Less competition simply means better pricing and returns. Think about it. While in a $3m case a large company might give it a try with a smaller funder in a $40m one there is simply less room for experiments as the company needs to ensure that deployments are completed as the capital is called. Two, Burford’s returns on its own $333m that go to the SWF are enhanced by the synthetic leverage structure of the vehicle. In other words, that capital - not insignificant compared to the total investment level - would yield the “normal” IRR of the fund if it was entitled to the corresponding one-third of the vehicle returns. The interesting thing is that it is entitled to 60% of those returns, so IRR rises significantly. I have conferred no value to this fact in the model. Finally, the historical 30% IRR is an cumulative amount that has been increasing over time, not an incremental amount. It is simple math that to achieve a growing cumulative number the numbers on the margin must be above the cumulative amount, meaning that marginal IRR >30%.
- 20% opex and therefore 80% operating margin - I assume no operating leverage, therefore 2018 margins to stay the same overt time. Despite (i) Burford can spread overhead over a larger revenue base, (ii) staff becomes more efficient on filtering, researching and following-up investments and (iii) larger average investment size does not ask for a proportional increase in people devoted to that particular investment, I prefer to put a low bar also considering the a SWF’s agreement includes an annual contribution up to $11m opex to run the fund entirely bear by Burford.
- 20% dividend payout ratio - The remaining proceeds are reinvested and are enough to support the projected growth levels, so the model assumes no further share issues.
- Interest expense - I assume no principal repayments over the period. Also assume for 2023 the £90m 2022 maturity gets refinanced.
- Tax rate - Burford’s parent company is under Guernsey’s tax jurisdiction so subject to minimal tax burden. I conservatively project 3% corporate tax based on historical numbers.
A quick sanity check. The numbers mean 27% and 20% CAGR investment income from 2018 and 2019 respectively. Burford has compounded top-line at 74% CAGR post-IPO.
The business consists of ~$1.35B AuM in fee-generating funds - therefore excluding the SWF and $150m Burford’s balance sheet commitment to the complex-strategies vehicle. AuM means commitments in this context, with $892m currently invested.
We can calculate a rough value for the investment management business as a % of AuM. Burford paid for GKC more than 12% of its assets. Considering that (i) the fund management business has got even better now than it was back then in terms of brand recognition and investor preferred choice and (ii) that that the lower-return-lower-income post-settlement vehicle’s weight in the mix is now lower, I find it reasonable to assume this business should command a multiple at least as high as GKC’s. However, I prefer to err on the conservative side as Burford probably paid-up a bit to secure such an important deal strategically, so 10% of AuM, $135m, makes for a very conservative valuation.
Also we can rely on an income approach by calculating the adjusted fee stream for each fund. There are several assumptions here, all made on conservative grounds.
- Partner Funds and BOF 85% ROIC and 2-year duration. Note that for example Partner Fund I, the most mature, got 137% ROIC on concluded investments up to date
- As the Partners Funds are not on investing mode and they are in their late cycle, I base performance fees on invested amounts rather than commitments as I deem as unlikely that the remaining capital will be eventually invested
- Complex strategies 20% ROIC and 1-year duration
- Post-settlement generates no performance fees
- Fund expenses up to 1.5% AuM
- 50% opex on income so 50% operating margins in steady state
$90 million at 50% margin translates into $45m pre-tax operating profit. Considering worse case that all the funds - and the advisory subsidiaries - are and prospectively will be US-based, I apply 21% corporate tax, translating into $36m after-tax profit.
Rather than estimate a fair value per share, which I find a futile exercise for the case getting lost on terminal values, perpetual growth rates and the like, especially given the nascent nature of the business and industry, I guess the 2019 multiple in combination with the capacity to reinvest large amounts of capital at high returns for many years paired with a skilled management on capital allocation with a sound strategy should bode well to provide you with a sense of enough margin of safety.
- Competition - The risk of significant amounts of capital entering the industry gets mitigated by the need for reputation, investment record, know-how, talent and portfolio diversification.
- Petersen - Petersen’s value was updated as the company sold a 28.75% interest for $136m, implying more than $300m value for Burford’s remaining stake. The value of this remaining stake has again increased after the sale above $500m amid other minor secondary transactions. Although it does not disclose individual investments carrying values, Burford has consequently written-up the investment based on this evolution.
The company states that Petersen’s carrying value is well below its market value. Let’s assume all the $181m net write-ups amount in 2017 is attributable to Petersen and that in 2018 the company wrote it up again. Adding also $13m of proportional initial cost of the investment ($18.2m * the unsold 71.25% stake) Petersen’s carrying value might sit at ~$220m (£173m). Burford currently sells for ~2.6 book value, which would imply £450m only-Petersen market value or ~13% of the current market cap. While losing 13% of the investment in case Petersen ends un in total loss - which I personally think it won’t and actually is much more likely to end up making a large sum for Burford - might make you feel very uncomfortable about owning the company and I have read some market narrative around that, I think its long term impact on the thesis would be very limited. The simple explanation to this is the high reinvestment levels at at very attractive returns provided by the market opportunity. The longer you own the company the less important the Petersen outcome becomes, no matter how bad the financial outcome might be.
While Burford's predictive powers are certainly not Nostradamus's the company thinks it is likely that the US Supreme Court will decide whether to hear the Petersen case by this June, and if it decides to hear it, will likely hear oral argument in the fall or winter and render a decision by June 2020. If the Court decides to dismiss the case I guess it might end up in an Argentinian Court and I guess a large write-down would follow amid the lower probability of a favourable outcome.
Burford is a compounder, which means profitable growth is the value provider itself. I think though that increasing secondary market activity can act as a catalyst. In other words the fact there are counterparts bidding up for partial interests in specific investments serves to unlock value that remains buried in the balance sheet.
Although unlikely to happen there is another prospective catalyst. A US listing. When Burford gets asked about a listing in the main London exchange from AIM now that it is a large company it clearly says it does not see it coming as the benefits do not outweigh the costs. On which grounds would a true long-term player who does not seek a high multiple for a quick exit would have a costlier listing? The main reason if any would be increasing investor awareness so it can build an even more aligned shareholder base. Bogart thinks that if it eventually happens a US-listing would serve better that purpose than a UK-main listing (also think $ reporting and $ market values makes it all less messy than reconciling $ and £) but as I say it is also unlikely as management is solely focused on operating and growing the business.
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