Burford Capital: Litigation Funding And Self-Disruption
Summary
- Burford Capital is a unique litigation funder and the only liquid public entity in the space.
- The litigation finance market is expanding rapidly and promises entirely uncorrelated returns.
- We look at the downside of market growth.
- Regulatory risk is a material consideration.
- Burford is a unique asset and could be a diversification cornerstone for a highly pro-cyclical portfolio.
Investing in litigation funding can be difficult, especially for non-accredited investors, but Burford Capital (OTC:BRFRF) is one of the three ways to access the litigation funding space. Burford Capital trades on the London AIM and is available in dollar-denominated shares through an ADR (OTC:BRFRY).
The Thesis in Brief:
Burford Capital operates in a market primed for growth and development through both adoption (increased market size) and sophistication (secondary markets, multi-deal structures, ease of access).
The industry evolution will result in new capital inflows and de minimis scale advantages diminishing. As a result, the ROIC of Burford Capital will meaningfully contract over a 10-year time period.
Considering the unique competitive advantages of Burford Capital, the remaining barriers to entry, and recent corporate events Burford Capital still remains an attractive business and ROIC will not revert to broader market-levels.
The unique uncorrelated exposure, high forward ROICs for the foreseeable future, and excellent management makes Burford Capital a buy for most investors.
Burford is a safe investment in terms of operational and financial risk, but has modest regulatory risk. It would be advisable to adjust the position size accordingly.
Detailed Thesis:
For a more in-depth explanation of Burford Capital, given that this is the first SA article on the business, this article is split into:
1. A qualitative and quantitative overview of the business.
2. The Industry: Burford’s unique position, an explanation for the abnormal returns, and industry evolution.
3. What the evolution implies for the industry.
4. Why Burford Might Still Be A Buy: Capital Raising, Competitive Advantages, Self-Disruption, and exploiting the golden age while it lasts.
5. An Acceptable Price.
A qualitative and quantitative overview of the business.
Understanding the qualitative and quantitative characteristics of a business is important before diving into analysis. An overview is especially relevant as Burford Capital has not previously been covered on Seeking Alpha. Furthermore Burford Capital is the only major litigation funding vehicle open to the public and therefore represents a rather idiosyncratic investment opportunity.
1.1. What is litigation funding?
The official definition from the association of litigation funders (link here) is:
“Litigation funding is where a third party provides the financial resources to enable costly litigation or arbitration cases to proceed. The litigant obtains all or part of the financing to cover its legal costs from a private commercial litigation funder, who has no direct interest in the proceedings. In return, if the case is won, the funder receives an agreed share of the proceeds of the claim. If the case is unsuccessful, the funder loses its money and nothing is owed by the litigant.”
Below is a more concrete example to put the operation into perspective:
Imagine a small, 50 million dollar in revenues, business that sees their IP stolen by a large corporation.
Going to court for a large settlement would be preferred, but could involve a protracted legal battle at expenses far above what the business is willing to risk. The ability for the larger corporation to simply wage a war of attrition dissuades any smaller business from even attempting litigation.
Enter litigation finance. An entity that sponsors litigation offers the small business litigation support for half the proceeds of the case. The litigation proceeds for 3 years and the proceeds are subsequently split between the business and the sponsorship entity.
1.2. Burford Capital
Burford Capital is the largest litigation funder in existence. The operation started in 2009 with current CEO Christopher Bogart as the primary founder. Burford operated a single-case focused litigation funding service, but also started managing investment capital through their first fund in 2011.
Burford currently operates in both single- and multi-contract deals, invests ~1.5 billion and manages 1.7 billion in AUM, and recently raised additional capital through several debt offerings. In terms of deal structure Burford is fairly standard, with a skew towards larger cases. Some cases can amount to tens of millions in investments. Burford is fairly well-diversified in terms of “individual contract risk.” The “traditional” risk-reward split associated with litigation finance is 1:10.
Historically Burford has been able to achieve a 31% IRR on its concluded investments and a 75% ROIC. Over the last 5 years IRR has averaged 27.2% and ROIC has averaged 63.4%. For the year concluded 2017 Burford produced 341 million USD in income with operating expenses equaling 52 million for a total operating income of 289 million. Interest equaled 24 million and due to amortization of goodwill taxes were practically non-existent.
In short Burford Capital produced 264 million in pro-forma profit for the year 2017. Part of the reason was a “lucky” year in terms of cases going to court and winning, instead of being settled. The primary contributor was the Teinver case contributing 100 million. Cash-generation was in-line with stated results.
Burford manages 1.7 billion over many different funds, but also has a material amount of capital invested in those funds themselves. Burford has approximately 1.6 billion in assets to invest. Approximately 1 billion USD was invested as of 2017, but 1.344 billion committed. Subsequent events have resulted in 180$ million of debt being raised for further commitments.
The investment areas are outlined in their annual report. For now the material facts are that portfolio and recourse finance are the primary operations.
(Source - page 21)
More than 80% of cases are dollar-denominated and the largest geography, by far, is the US followed by Europe and Britain at sub-10%.
2. The Industry: Burford’s Unique Position, An Explanation For The Abnormal Returns, And Industry Evolution.
Litigation finance has an interesting history, but to put it succinctly there was little mainstream adoption of the concept till’ (roughly) a decade ago. Burford has been one of the leaders in the field and is by far the biggest player. Understanding litigation finance requires understanding Burford and vice-versa.
Burford and the industry as a whole has IRR’s in excess of 20%, completely uncorrelated returns to the broader market, and seem to be growing at a maddening pace. Why are returns so high? Will Burford under- or outperform the litigation funding market? How will the litigation funding industry perform as a whole?
All questions are dealt with in this chapter. To put it succinctly I believe there is a massive change occurring during the next decade that will transform the industry. Some barriers to entry will be removed, some diminished, other retained. Understanding how the industry will perform and how Burford is different is essential for a potential investor.
We will start by exploring how Burford differs from its peers, delve into the barriers to entry that make the industry so profitable, and then analyze the most likely evolution of the industry.
2.1. Burford’s position.
Burford is a metaphorical giant in the litigation funding space. To give a sense of “why and how” the industry was formally started in the UK in 2009 when Lord Justice Jackson recommended certain measures regarding civil litigation. The recommendations were enacted in the law regarding “Legal Aid, Sentencing, and Punishment of Offenders” of 2012 (LAPSO).
The industry is equally young in the US and Australia. Burford is the largest player in the space with over 3 billion in assets (of which 1.7bn is AUM). The only comparable peer is Chancery Finance, which states they have access to roughly 2 billion GBP in financing. Burford states they have access to roughly 2.3bn BGP (source - Ft.com article)
Burford is a fairly traditional litigation financier operationally with the primary difference being the “split” business of managing AUM and having its own capital. In short Burford operates traditionally in most respects. A non-operational difference is that Burford has access to public markets unlike literally any other peer. No other litigation funder (with over 20 million in capital) is listed on any exchange worldwide. The cost-of-capital reflects this fact with recent bond offerings at only 350 bps above the treasury rate.
The visibility also makes Burford well-positioned for large cases and their history of success strengthens any case they enter. The downside to the visibility is that regulatory matters more easily focus on Burford. The information is all public. The obscene IRR and ROIC, the growth, and the share appreciation (1250% since inception, +100% in 2017). Interest groups in the UK have focused their actions primarily on Burford as the quantitative facts are more easily obtainable from Burford.
2.2. The Abnormal Returns
Why do contracts result in +30% IRRs? How come ROIC is above 50% in almost every single year? As always the barriers restricting entry from new capital explains why.
There are several factors, most prominently:
1. Low TAM and a new, idiosyncratic market made the space overlooked.
2. Permanent capital is often required.
3. Opacity due to illiquid secondary markets.
4. De Minimis size has been difficult to achieve at previous TAM.
5. Few substitutes that are all high-priced.
6. Relationships, people, and data.
The first factor is that the market is very new so adoption has been a determining factor in TAM.
Source: 10-K Burford 2017.
The idiosyncratic nature of the investment combined with the size of market resulted in a lower supply of capital. Normally the small size of the market would not naturally have resulted in such high returns, but the lack of substitute products, the inherent demand for the product, and the need for a very specific type of capital (semi-permanent with no redemption needs) resulted in very little capital inflows as the market was fairly anonymous to the broader investing public.
As I note in points 2 and 3 the capital also needs to be without redemption notice, that is to say almost permanent capital. It is impossible to redeem capital from a litigation funding so traditional capital allocation vehicles such as mutual funds, hedge funds, and open-ended funds have been unable to participate due to the inherent liquidity risk.
The capital also needs to be “broadly” indifferent towards having a secondary market price. While seemingly a small point the mark-to-market model allows many funds to gather variable compensation from returns. Seeing as there is no mark-to-market and quantitative legal case models are highly subjective there has been little ability to adequately adjust performance compensation.
Furthermore many cases are relatively large and the need for diversification is great. If cases go to trial they are almost binary, whereas settlements are lower risk. However it is not up to the funding-partner to decide whether to settle or not. As a result any capital allocator runs the risk of having a series of binary outcomes that could result in extremely poor performance simply due to chance. Therefore diversification is a strict requirement in the litigation funding space.
Achieving de minimis diversification size has been a problem for most of the industry over the last decade as a result of the low TAM and lack of easy capital. A fund would need approximately 100 million to be de minimis diversified and roughly 300 million to be thoroughly diversified.
Another important point is that the pricing process is very subjective and while several firms have started to apply quantitative methods to litigation funding, relationships and expertise have historically mattered. Experience is also paramount as both lawyers, financiers, and litigation funding specialists need to effectively cooperate. In short; to play in the litigation funding space you need to be specialized and highly experienced.
The returns are also partly a result of the bidding process for litigation not currently resembling an auction-bidding process. Cases are highly subjective and require a fair amount of individual (expensive) due diligence to pursue from the get-go.
2.3. The Evolution of The Sector.
The evolution of the sector all relates back to the impingement on capital. The factors that make capital scarce result in higher returns in the absence of substitutes.
So what is happening? First of all the market has clearly expanded as above pie chart demonstrated. Expectations are that the market will keep growing.
Source: 10-K Burford 2017
As the market evolved the sophistication has followed. A general move from single-contract funding to portfolio finance is an example of said sophistication. My favorite outline of portfolio finance was written by Chancery Finance, but the gist is that to collateralize claims leads to more market access and lower cost for both parties.
Traditionally the high payoff, but potential risk caused litigation funders to be extremely selective regarding deals. The practice also lead to high prices for clients and high IRRs for the financier if completed successfully. As the industry matured the “CDO”-approach to single claims took hold and the multi-finance offers out-competed single offer claims simply because ((a)) law firms could simply finance the best claims themselves ((b)) the collateralization allowed for lower volatility and therefore lower prices.
Litigation finance was then further complicated through recourse clauses that allow for equity awards if certain non-cash settlements are reached. A case-study would be Burford and Jaguar Health.
The space has also seen the entry of multiple startups focused on providing easy access for accredited investors. LexShares and TrialFunder being most prominent among them. LexShares has even copied the diversification elements of portfolio finance. The bigger cases are still largely left to Burford and peers, but even multi-million dollars case offerings have been completed on said sites.
The increased market size has led to increasing rounds of funding; the result is litigation funders raising over 10 billion pounds during 2017 (source - financial times). The notoriously uncorrelated returns at incredible ROE’s have attracted many new entrants in terms of both capital and allocators. Burford has encouraged this through their public institutional raises and bond offerings, which signals a viable market to smaller operators.
Burford is also trying to build a viable secondary market, which would eliminate many of the liquidity issues associated with litigation funding.
The accredited investor market and Burford are fundamentally different in size (and the large segment is growing at a faster pace according to Burford), but the space is attracting new capital at every level. Remember that portfolio finance involves case-sizes similar to LexShares and TrialFunder.
Quantitative funds with permanent capital have also entered the space. Legalist is the best example. The way they use data is insightful; the workload of the assigned judge as a key variable in determining expected duration as a prime example of quantitative brilliance. Legalist is focused on a smaller segment, but the move is indicative of increasing sophistication in the investor base. The relative skill disparity is shrinking.
Burford themselves are leading many of these changes. Burford are the largest fundraisers from public markets and investors. Burford is a major player in portfolio finance. Burford is attempting to establish secondary markets. Burford acquired Gerchen Keller Capital to integrate a fund-management model into their core operations. Burford is growing TAM.
They are doing this, I believe, with open eyes to its consequences. Consequences we will explore now.
3. What the evolution implies for the industry.
Remember the 6 reasons why Burford had good returns?
1. Low TAM and new, idiosyncratic market made the space overlooked.
2. Permanent capital is often required.
3. Opacity due to illiquid secondary markets.
4. De Minimis size has been difficult to achieve at previous TAM.
5. Few substitutes that are all high-priced.
6. Relationships, people, and data.
Number 1 is diminished by the day as startups make the space accessible and Burford raises increasing amounts of capital. Permanent capital is still required, but portfolio finance combined with maturity diversification lowers redemption risk. Furthermore more funds are willing to invest in long-term alternatives given the strong track record (performance chasing).
The opacity due to illiquid markets are still a worry, but Burford has stated that they are attempting to build a better secondary market. As sophistication increases and more players enter the space a secondary markets will organically grow. Burford has already sold a stake in a material (100 million) case through the secondary market. While a quoted secondary market might not be in the near future, a liquidity-rich environment as seen in private equity is next.
As described by Bruce Greenwald in Competition Demystified: Growth is the bane of local economies of scale. As the market grows achieving de minimis size (300 million) becomes easy.
Substitutes, relationships, and people are all remaining barriers. The “crop rotation” of litigation funding is 2-4 years, 3 years for simplicity. Given that 2016 was showing slight signs of “popularity” and 2017 was the first year of enormous capital raises it seems that 2018, 2019, and perhaps even 2020 can be expected to retain high returns on capital.
I do not possess the hubris to project precise ROIC and IRRs, but it is safe to say that IRRs and ROE will contract in the 2020-2030 decade. I do believe that returns will stay in excess of 10% as the regulatory risk, permanent capital, and price-setting dynamics all restrict capital inflows. A working secondary market, regulatory acceptance, and introducing a ranking system compatible with auction dynamics would likely reduce ROIC below 5% as investors would chase uncorrelated returns.
The future of litigation finance looks great, but that greatness implies bleak returns for investors. It is also likely that returns will erode at a slower pace than expected as new demand along with sophistication will lower prices. Lower prices can result in increased supply for a more positive equilibrium than anticipated. The litigation market is roughly 200 billion simply in the US; the market still has space to expand materially.
There are still years of good return and advancements take time. Furthermore Burford is growing in international markets and are actually the disruptors themselves. The fact that Burford is leading the charge potentially implies a different fate from Burford.
4. Why Burford Might Still Be A Buy: Capital Raising, Competitive Advantages, Self-Disruption, and Exploiting The Golden Age While It Lasts.
As Burford introduces the dynamics that would eventually have disrupted them they face the dilemma every industry giant faces. Sacrificing profitability for survival. The traditional image of a pirate drowning while clasping a hard-won bag of coins comes to mind. Let go of the treasure or drown.
Burford is ensuring their survival in the market. Growing the market will be done by others if not them. Raising capital at 6% to deploy at 31% is great, but that might no longer be a possible reality. Better to borrow at 6% and deploy at 16% than not existing at all.
While ensuring their survival Burford are entering new markets such as Singapore. Litigation Finance is increasingly becoming an accepted practice across the world and Burford is there to participate.
Burford is also becoming the “go-to” for large law firms and corporate clients. 75% of the AmLaw 100 and some FTSE 100 companies have already utilized Burford Capital.
If ROE contracts but book value expands through cheap debt and reinvestments from “the golden age” FCF generation will remain elevated.
New capital is never good for industry profitability, but if I had to choose one operator (hypothetical; we only have one choice) it would be Burford Capital.
5. Recent Events & An Acceptable Price
Considering Burford as an investment opportunity is a process distinct from the usual valuation & analysis enacted upon other securities. The usual framework simply involves risk and growth in a combination that leads to intrinsic value. Any discrepancy between price and intrinsic value is margin of safety and a decision is made based on potential catalysts, confidence in estimates, and risk-reward. I would describe above decision framework as a "return position," designed to optimize returns.
Burford should be considered as both "a portfolio position" and a "return position." A portfolio position would entail that the position offers advantages besides capital appreciation. Portfolios can be implicitly long oil or short interest rates, but almost all portfolios are long the economy. Even catastrophe insurance, the common example of uncorrelated returns, has a slight correlation to the economic environment. The problem with hedging with broader economy from a portfolio is the cost. Burford Capital is a rare example of hedging economic volatility while receiving dividends for it.
5.1. Material Facts:
Burford recently raised 180 million USD at "treasury rate + 350 bps." The partners III fund that launched in early 2016 also had 412$ million in investor commitments. Burford clearly has access to large amounts of capital.
There is material regulatory risk, but Burford also promises uncorrelated returns. The appropriate required return is subjective as Burford offers rare diversification, but also involves existential risk.
Burford is tax-efficient and the company estimates long-term tax-rates in the low teens. For now the company is able to amortize goodwill.
The company has 210 million shares and sells at 14.3 GBP for an implied market cap of 3 billion GBP. The USD market cap is therefore 4.2 billion.
5.2. The Asset Management Business:
The rule-of-thumb for asset management businesses is 2% of AUM, but given that AUM is likely to grow quite rapidly in the coming years and profitability is currently at ~0.5% of AUM, I believe a 20x multiple is reasonable valuing the asset management side at 170 million USD. The asset management business contributed 8.5 million pre-tax income in 2017.
5.4. The Primary Business
The primary business is quite unique from an operational standpoint. Similar to a financial firm the business is extremely capital intensive (deriving the vast majority of earnings from investing capital). To put it succinctly growth can only be generated through higher returns on capital or more capital. As covered above higher returns on capital seem unlikely in the long run. It must be assumed, then, that the business will need to reinvest FCF to drive growth.
The primary difference between Burford and a regular financial firm is the origin of funds. Almost the entirety of invested capital originates from equity. Whereas commercial banks are spread-businesses that function off liquidity transformations, Burford Capital is more similar to a regular operating company based on project-driven work.
The expanding market has led to large amounts of capital being redeployed at earliest availability complicating the cash flow statement. Therefore a more fundamental look must be undertaken to fully comprehend the expected forward returns.
5.4.1. Free Cash Flow Generation:
There is (almost) no maintenance CapEx associated with the primary business. All EBITDA is fully available for interest payments, reinvestment, or dividends.
To calculate the forward FCF generation from the current batch of assets is done assuming a consistent internal rate of return on the invested assets, adjusting for operating expenses, interest payments, and taxes. While the cash flows will occur on a rolling basis, a simplified model for rough FCF estimates can be constructed assuming a consistent IRR over the 3 year period and a new bundle of assets of 3-years maturity.
The current assets amount to 1.08 billion USD in invested assets along with ~210$ million in cash & equivalents. Since the release of said balance sheet 180 million USD worth of cash has been obtained through a debt offering.
For a simplified model the full 1.5 billion in assets can be construed as the "2018-2020" portfolio. To summarize a portfolio starting January 1st 2018 and concluding December 31st 2020 can be roughly assumed to generate an average 3-year IRR as if the funds were invested today. A table of historical IRRs have been published on the 15th page of the annual report. The aggregate IRR over the 8-year period has been 31%. Assuming a less fortuitous case-environment a 25% IRR is assumed.
For a full turnover of the portfolio the FCF generated is the excess income (above previous asset-size) generated post operating expenses, taxes, and interest.
For a hypothetical 25% IRR the 1.5 billion portfolio is estimated to generate 2935 million as a lump-sum payment at the conclusion of the third year. Operating expenses would amount to ~170 million, interest at 80 million and taxes in the low teens. Subtracting 250 million results in ~2685 million in invested assets.
Subtracting the initial capital, 1.5 billion, illustrates that 1.185 billion in FCF have been generated pre-tax over three years. In a run-rate scenario with NOL's valued separately the company generates 1 billion million in FCF over 3 years post-tax. The additional capital would result in 1.8 billion worth of equity.
If IRRs were constant the 1.5 billion could be continually reinvested every third year to produce 1 billion in excess cash flow. In practice Burford attempts to ladder their investment returns pragmatically. Theoretically there should be little overall difference assuming consistent reinvestment rates over the next 3 years. The per-year FCF generation over the next 3 amounts to ~330 million per year. Given the laddered reinvestment approach of Burford the results are likely to lower in 2018 and higher in 2020.
The important information is that Burford will produce 1 billion in excess cash flow post reinvestment needs from the current period till the conclusion of 2020.
5.4.2. Final Valuation:
I do not believe that a useful DCF can be generated from what we currently know. There is too much uncertainty. There are a few things I do believe:
That the asset management business is worth approximately 200 million.
That the business will most likely generate enough FCF from the current assets to reach a book value of approximately 1.8 billion in 3-4 years (current is 800 million).
That the business will generate lower returns on capital in the long term compared to the current state of affairs.
That the litigation funding market will remain highly valued due to uncorrelated returns.
That the litigation funding market is risky due to regulatory pressures.
Assuming an exit at 20x FCF in 3 years on 1.8 billion worth of equity and an ROE of ~17% the return is ~6 billion. Discounted back 3 periods at 10% the company is roughly worth 4.5 billion. At a 16.6 multiple (8% required return), the exit is worth 3.8 billion USD. Incorporating the asset management the business is worth 4 billion or 4.8 billion at the current moment in time.
As a normal buy, I would not consider Burford a great prize, but considering the unique diversification provided, I would strongly consider Burford Capital if your portfolio has strongly market-correlated elements.
DISCLAIMER: I have not done any work regarding the potential tax implications of this position.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (11)
The reason we haven't seen many new entrants was that the market hosted one large player and size didn't allow others to reach scale. That might change soon.
