The Burford Capital Problem
The essential argument here is about how to account for gains that are booked but not actually in cash. That is, if we've got to apply a valuation, without it being possible to have an independent test of that value, how should we go about it?
The obvious temptation is for the management of a firm to be, shall we say, ambitious in such valuations. Or perhaps we might say they'll overvalue gains and thus boost the share price. This is the basic allegation being made by Muddy Waters.
My view, from the available evidence, is that they have been. Further, that Burford (OTC:BRFRF) is now toast as a result. I do not expect a recovery from here.
The Muddy Waters Evaluation
The heart of the claim is this:
We are short BUR. For years, it was the ultimate “trust me” stock. Thanks to a light disclosure regime, the esoteric nature of its business, and unethical behavior by its largest shareholder, Invesco, it turned Enron-esque mark-to-model accounting into the biggest stock promotion on the AIM. This has all recently changed though. Just this year, BUR began publishing more detailed investment data. This data proves that BUR has been egregiously misrepresenting its ROIC and IRRs, as well as the state of its overall business. We have identified seven methods by which BUR manipulates Concluded Investment ROIC and IRR.
To Explain That Claim
To put all of this into less complex, less jargony, language.
Burford invests in litigation - in court cases. A perfectly respectable business to be in and one that could in theory be highly profitable. There are, after all, trial lawyers who become very rich.
The model here is that an outside investor - Burford - becomes an investor in the court case. Carrying some portion of the costs of bringing the case in return for some portion of the award, damages or claim if the case is finally won. It's a common enough practice that it's made it into popular culture. There's a pair of recurring characters in "The Good Wife" who carry on this business.
The profitability will, in the long term, depend upon which cases are chosen for investment. What are the costs that have to be supported over what period of time in return for what recovery from the judgements?
Muddy Waters is alleging that this hasn't been done all that well. That's not the actual problem though.
Such cases take time to wend their way through appellate courts. What then becomes a matter of judgement (sorry) is what is the value of that future revenue while it is still unpaid? Even, still uncertain that there will be any revenue at all?
We are in that horrible world of having to believe someone without our having a firm and fixed benchmark against which to test that belief.
More Of The Claim
What's really being alleged here is that Burford has been over valuing the claims still in the pipeline. It's possible, in theory, for that not to be a particular problem. So, we all just have to wait a little longer to find out.
Muddy Waters is going further than that. They're saying that Burford has been declaring profits as a result of these over valuations. And paying dividends on those over valuations. Even, paying management significant amounts based upon those valuations that aren't going to come true.
If that is so then the stock is obviously worth much less than the market currently thinks. Well, obviously, if recovery is going to be less than we all think then it's worth less. But even that's not really it. Muddy Waters is really saying that there's nothing left inside Burford. What's been paid out is so much more than the real, as opposed to declared, value that there's nothing left in the company.
BUR’s liquidity is risky, and it is arguably insolvent. We believe that BUR’s “real” invested capital is $880.3 million. BUR’s massive operating expenses tax that at approximately 9%, based on LTM expenses. BUR’s financing costs (including dividends) add another 8.3%. Therefore, in our opinion, the first approximately 16.5% of returns BUR’s adjusted investment capital generates goes to keeping the lights on. BUR is arguably insolvent, as its debt and funding commitments greatly exceed the $880.3 million adjusted invested capital.
There Is A Case For Burford
That is made here. I'll not run through it in detail simply because I don't believe it.
To be fair about it, nor does it seem the market believes that bull case.
(Burford Capital share price, from Google)
The Dead Cat Bounce
We can see that dead cat bounce there and the only important question for us now is whether it really is that or the beginning of a rally.
I am something of an aficionado of the various ways that scams can be pulled. I've aided the police on more than one occasion in explaining to them investment scams and boiler room operations.
No, I don't claim that this is one such. But experience does lead to me forming conclusions. This is not the sort of thing that a company recovers from. I can't see anyone providing more capital to the company to be able to invest in further cases. That means that the current iteration of them moving through the company is going to be the last - that's my view at least. This significantly cuts any valuation for we're not witnessing the birth of a new investment technique.
Then there's the real Muddy Waters allegation, that they've already paid out everything and more that is going to be recovered from that current generation of cases. So much so that the company is insolvent. I'm persuaded of that case.
The Investor View
You can have an entirely different view of this of course. And I'm not confident enough to say that this is a good short from this current share price. Obviously it was a great one from before the MW report but that's hindsight. But my view is that this isn't even an issue of a falling knife that should be caught. I'd simply stay well clear of Burford. That is, there's no value at which to buy in because I don't think there's any value there.
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.