Burford Capital: Coattail Investing At Its Finest

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About: Burford Capital Limited (BRFRF)
by: Benen Ling
Summary

Litigation Financing offers an impressive recession-proof cash flow.

The market is under-served, and expanding economies of scale will only fatten Burford's operating margins.

Investing in Burford allows you to buy the largest player in this niche market (as well as ride on the coattails of an excellent investment management team) at a bargain.

Burford Capital (OTCMKTS: OTC:BRFRF) is the largest litigation financing operator in the world. It's business model involves both investing in legal claims with its own capital as well as managing external funds. In this article, we'll first explore what Burford is doing, why their business is a recession-proof one, how the company stands out, and how the market is under-served.

How does litigation finance work?

In litigation finance, there are really only two parties: the financier and the claimant. The claimant is either unable or unwilling to fund a legal case and so the financier provides said funds in return for a cut of the reward if the case is successful. Operators in the field fund everything from class action lawsuits to personal injury cases to inter-corporate disputes. Burford only deals with corporate cases, which is desirable for reasons we'll get into later.

The most common way of valuing cases in litigation finance is to first consider the maximum damages awarded to the claimant and then calculate the probability of the various possible outcomes (an unfavorable ruling, settlement or winning in court). Combining the two gives the financier an expected value for each case. Valuing each individual case is thus similar to valuing an option, with the exception that legal expertise gives you an edge in determining which outcomes are more likely. Much like investing in options, the key to achieving the desired returns depends on diversifying risk across a well-managed inventory of individual cases.

Why is it a recession-proof business?

Given that Burford deals exclusively with corporate cases, the flow of corporate lawsuits is uncorrelated with the economic cycle. In fact, because litigation finance depends on the claimant being unable or unwilling to fund their legal case, a recession has good odds of actually increasing the number of companies looking for outside legal funding. Furthermore, since each deal structure is unique and a recession would mean a greater demand for litigation funding, a recession would give Burford greater leverage in structuring the deal to their advantage.

For example, a common deal structure would be "capital back + preferred return + share of the award". If Burford funded a client to the extent of $100 million with a 10% preferred return and a 25% share of the reward, and the client was awarded $500 million after two years, this would be their return:

Capital back - $100 million

Preferred return - (10% * $100 million) * 2 years = $20 million

Share of the award - 25% * ($500 million - $120 million already paid) = $95 million

Total = $215 million or a return on capital of 115%.

In this case the client would still receive $285 million out of the total $500 million award without putting in any money.

Besides simply taking the risk of capital loss/commitment, Burford adds value by allowing structurally constrained clients without any other options to pursue legal cases. For example, activist investment funds may want to sue management teams but may not want to deal with litigation expenses. Burford's sole focus on litigation finance also allows them to outperform traditional law firms which operate on the classic equity partnership model since traditional law firms are unable to take on enough large corporate cases to fully diversify the risk of any one case. Thus, for a traditional law firm the consequences of capital loss (even if the risk was low) would be unacceptably high.

Burford, on the other hand, has a very well diversified portfolio, with over 80 different investments currently funded and no single case risking more than 2% of total capital.

This is why I like Burford

Burford is the largest player in litigation finance, with AUM of ~$4 billion. The top 10 players in the field have ~$8 billion AUM total, and Burford accounts for half of that. It's 4 times larger than its next largest competitor, Harbour Litigation Funding. However, size is only a good thing if economies of scale exist. Is there evidence of this happening at Burford?

Yes. From 2013 to 2018, Burford's operating expense ratio has gone down from 30% to 14%. Thus, as Burford expands, its increasing economies of scale ensures that more of each dollar in revenue goes to profit.

The average size of capital commitment has also increased eight-fold from $3 million in 2013 to $24 million in 2017. This means that Burford has an advantage compared to its smaller competitors since each case risks less of their total capital.

The corporate litigation market as a whole is also under-served. The top 10 players in litigation finance have a total AUM of $8 billion, which pales in comparison to the case load of corporate arbitration centers. The International Chamber of Commerce (one of the most well-established corporate arbitration centers) alone had a case load of $212 billion as of end 2017. Even if we use the International Chamber of Commerce as a proxy for the total litigation finance market, that's a market penetration rate of less than 4%.

In summary, the implications are that Burford is the largest and best positioned financier in a market that's ripe for expansion. It is likely that Burford will be able to keep up its extraordinary financial performance, with 60+% ROIC and IRR of 31% from 2009 to 2017.

The reason for their strong financial performance lies in the management team, which combines top-tier legal expertise with conservative financial stewardship. For example, both the CEO and CIO have served extended stints with the top US law firms like Cravath, Swaine and Moore. CEO Chris Bogart has also held executive positions at Churchill Ventures and Glenavy Capital before starting Burford in 2009. CIO Jonathan Molot has taught law at Harvard Law School and still teaches at Georgetown Law.

More importantly, the management team at Burford have displayed an admirable focus on improving the business instead of worrying about the stock price by repeatedly refusing to give guidance. In their own words, “We are writing this homily because as we have grown in size and prominence, we have attracted an increasing audience that takes the view that we should give “guidance” on not only what is going to happen in the future but when it is going to happen. With respect, we decline to do so”. (2016 Annual report)

Undervalued?

With 5-year revenue CAGR at 70%, an EBITDA margin that's just shy of 90% and EBITDA/Interest expense of over 10x, it's clear that Burford is both a fast growing company as well as a financially stable one. But is it undervalued? We'll conduct a simple DCF model to check.

Assume a 9% discount rate (the long term return of the S&P 500 Index), 10 years of fast growth and a terminal growth rate of 2.5% (the same growth rate as the US economy):

At a 15% growth rate for net income for the next ten years (it has been 50% for the past 5 years), Burford's future cash flows are worth $37 dollars, a 57% upside to its current $23.50 stock price. Even at a 10% forward growth rate, Burford is worth $26 representing a 13% upside. In fact, at its current price, the market is implying a 8.6% growth rate in earnings looking forwards. The implied growth rate can be solved for by using the same DCF equation, inputting the current stock price and solving for the implied rate of earnings growth.

Of course, fiddling with the discount rate or terminal growth rates would give you different values, but with most reasonable inputs Burford appears to be undervalued.

In my opinion, the current price is grossly undervaluing this fantastic litigation finance play. As a recession-proof cash flow generator uncorrelated to the economic cycle, it offers an excellent way to diversify for any equity portfolio.

Conclusions

It's not often you find a fast-growing, financially stable and undervalued company in an industry that's poised to explode in terms of growth. Burford is one such opportunity. That's without even mentioning the great investment management team which has had a great track record in this space. Coattail investing doesn't get much better than this. Much like Blackstone has dominated private equity and Bridgewater Associates has become the face of the hedge fund industry, Burford is very much likely to have a commanding position in the litigation finance industry going forward. Buying Burford at this price is essentially buying into one of the financial legends mentioned above in their early days at a bargain price.

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.