- Legal finance as an asset class provides uncorrelated returns from a diversified portfolio of legal claims.
- Venture capital like returns with a better batting average and dispersion of returns partly from the ability to get to negotiated settlements.
- Track record of delivering >30% IRR and attractive money multiples on invested capital, and asset management fees plus future performance fees from third party capital.
- Risks relate to recent short attack, fair valuing legal claims, the esoteric nature of legal finance and limited visibility of future returns.
- For now we take a slightly positive stance on the largest legal finance player.
We like the asset class of legal finance. Investing in legal claims is less esoteric to us than investing in cryptocurrencies. Legal finance lacks the immediate connotation of a meteoric rise to stardom that seems to be required for the sex, drugs and rock & roll part of your portfolio. However, looking under the hood this asset class may well provide venture-capital like returns but then with better dispersion characteristics as well as superior monetization strategies.
The silverback in the legal finance industry is quite an interesting company: Burford Capital (NYSE:BUR), (Burford). It has been the object of a short position and narrative from Muddy Waters starting in august 2019. Please refer to their seven (!) pieces arguing (in a nutshell) that Burford inflates the fair value of some of its legal claims investments on the balance sheet, does not have sufficient liquidity, and that it dresses up some of its performance metrics such as IRR and ROIC.
We believe the opacity of Burford's accounting is mostly a function of fair value techniques required as Burford has classified the legal claims as financial assets. Secondly, we think that client confidentiality and legal privilege prohibit disclosures on fair value per legal claim. For us it is likely that following the scrutiny on its financials from the Muddy Waters intervention and the recent listing in the United States, the risk is to the upside in terms of integrity of financial statements, and that there is no frivolous accounting nor bad faith from management in representing the financial statements.
In this note we'll briefly describe: what legal finance is, an overview of Burford, the investment case for Burford, some of the bear case arguments against Burford, and synthesizing this in a (preliminary) conclusion for further diligence.
Legal Finance - What Is It ?
Pursuing commercial claims is a costly affair and with uncertain outcome. It also is time consuming, can take up precious capital and may result in a company not pursuing an otherwise meritorious claim.
In legal finance a litigant or a law firm uses the asset value of commercial litigation or arbitration to secure capital from a third party, either to finance the litigation or for more general business purposes.
In the most common form legal finance is provided on a single-case basis to pay for costs associated with commercial litigation or arbitration (lawyers’ fees, case expenses, etc.) in exchange for a portion of the ultimate award in litigation or out of a settlement.
This generally takes the form of the provider of legal finance getting a return that consists of the initial financing amount, a preferred return and then a proportion of the award in a favorable adjudication in court or out-of-court settlements. Legal finance is usually non-recourse, which means repayment is contingent upon successful outcomes.
The litigant can thus transform this original claim into an asset without downside risk or ongoing legal costs, whilst retaining the majority of the ultimate award or settlement.
The capital provider on the other hand can often achieve venture capital like returns on the litigation with a favorable adjudication whilst getting still good returns on out-of-court settlements. There will be total losses on cases with an unfavorable adjudication in court.
Burford helps clients unlock the value of commercial legal claims by providing a range of financing offerings and risk management solutions based on these legal claims' expected future proceeds. It funds these legal claims both directly from its balance sheet and managed private funds with private-equity style fee structures.
Burford was incorporated in 2009 (Guernsey) and started trading on the London Stock Exchange's Alternative Investment Market (AIM) in October of that year. In October 2020 Burford's ordinary shares started trading on the New York Stock Exchange (NYSE) under the ticker BUR. It employs 133 FTE as per year end 2020 of which 60 FTE qualified lawyers.
Burford's main business is the core litigation finance practice which is essentially what was described in the introduction. In addition it leverages this capacity using third party funds that are managed by Burford, much like a private equity fund does with limited partners' capital.
Source: Burford, 2020 Annual Report
Burford makes a distinction on how it describes its business activities along the following axes:
- Burford-only or Burford balance sheet: this refers to Burford itself, excluding any third party funds and the portions of jointly-owned entities owned by others;
- Consolidated: this is Burford on a consolidated basis in the financials. It includes those third-party funds, partially owned subsidiaries and special purpose vehicles that are required to be consolidated under IFRS accounting.
- Group-wide: this refers to Burford and its managed funds taken together, including those portions of the funds owned by third parties and including funds that are not consolidated into Burford's consolidated financials.
Simply said we view the Burford-only figures as a pure spread business in which on a cash basis Burford deploys capital and monetizes this over time.
Consolidated is what IFRS tells Burford to do, and Group-wide is effectively a view on how all Burford's activities are performing in which it has an influence (but not always control). The latter two views include the abovementioned asset management activities that generate fee and performance income.
As can be seen below the development over time is to build in further expansion by leveraging third-party funds. These are delivering a small stream of fee income currently and may in the future deliver performance fee income in the event certain hurdle rates are met.
Source: Burford, FY20 Results Presentation
Burford's fund structures looks as follows per year end 2020:
Source: Burford, 2020 Annual Report
The addressable market for Burford can be constructed by looking at some of the drivers below which point to a large market with structural growth potential. We think that Covid-19 driven litigation is still in the early stages and will provide a boost to activity in years to come.
Source: Burford, 2020 Annual ReportThe Pros
We identified the following investment considerations for Burford.Exceptional Cash-On-Cash Returns From Concluded Investments
Burford-only returns on concluded investments have been impressive to date. On its own balance sheet Burford has delivered a 30% IRR and 92% ROIC; or turning $831m of cash investment into $1,597m cash return.
Source: Burford, FY20 results presentation
Burford commits capital to a certain case and then it deploys historically ~89% of such capital. The return profile is really driven by a binary outcome in court: wins or losses. In addition, Burford's clients can settle cases out of court. We only talk about concluded case in the above diagram from Burford in which there is no further litigation risk.
This view allows to look at Burford's performance on its underwriting ability to select legal claims that can deliver the maximum return.
High Batting Average With Asymmetric Return Profile
In its recent disclosures Burford provided a detailed analysis of its stratification of its capital deployed into buckets based on ROIC.
The take-away here is that swinging the bat often, occasionally Burford will hit a homerun (these are the C and D buckets below with ROIC's of respectively 100%-199% and greater than 200%), it will very often hit the 0%-99% ROIC mark (bucket B below), and only on 16% of the deployed capital it will lose money (realize a ROIC of 0% or less, bucket A below).
Source: Burford, FY20 Results Presentation
Considering the longer track-record we are more inclined to attribute some of the batting average to skill, as well as the usual luck factor. The profile of total losses and homeruns resembles a bit a venture capital type shop. We think with the benefit of being able to get the bat on the ball more often and deliver a positive ROIC (i.e. not losing money). This is likely due - compared to venture capital - to get to a negotiated settlement with the counterpart in the legal process. Recalling the earlier slide shown more than 60% of the deployed capital is settled out-of-court between parties.
Burford upon request discloses its full capital asset data book since inception of the firm. Below what it looks like. It has quite a bit of detail by case, status, performance, and if it is on balance sheet or in one of its funds.
Source: Burford, FY20 Capital Asset Data
What our view is: Burford provides maximum transparency without breaching client confidentiality or legal privilege. We cannot name another company that discloses its investments with this type of granularity.
Potential From Deployed And Committed Capital
Taking Burford's full capital asset data information referenced above, we reconstructed the ROIC (which is equivalent to the money multiple (MM) minus 1) on Burford's various investment structures.
On the left hand side in the diagram below is the Group-wide view of the performance from inception to date, and the right hand side reflects the Burford-only performance. Note that the $831m deployment (from concluded and partial realizations) and $1,597m recovery amount triangulate with the Burford-only portfolio shown on the slides above.
Now the interesting parts from this diagram are three-fold.
- The deployed capital that has not been recovered for Burford-only is ~$944m as per year end 2020. This is capital that has been put to work and on average historically has returned a 1.9x money multiple. Note that the deployments are not reflected as such on the balance sheet of Burford, but rather on the balance sheet they are recorded at fair value (which we will discuss below shortly);
- Over $1bn of capital has been committed by the Burford-only balance sheet which should provide a future source of returns if and when deployed; and
- Besides the Burford-only performance the consistency across the portfolio looks to be fairly high from a historical perspective as the total portfolio has delivered a 1.9x money multiple also.
We think that by using a significantly lower money multiple on Burford-only balance sheet investments of 1.5x MM we can project the future value of the (1) deployed capital which is in process of being recovered and (3) the potential committed capital that is to be deployed in the future.
Below we can see the performance data of the various third party vehicles referenced above to show the relative consistency of performance in comparison with the Burford-only assets.
Details of the various Burford funds can be found in the 2020 annual report.
Source: Burford, 2020 Annual Report
Asset Management And Performance Fee Income
Over the years Burford has extended effectively its balance sheet into a third party like private equity model for legal finance: asset management fees and performance fees after meeting a hurdle rate in specific funds.
Source: Burford, 2020 Results Presentation
We think this part of the business can be highly attractive and actually scales Burford from a traditional balance sheet investor into also an asset manager. Note that Burford expects at least $50m from ~26% of its assets under management in the future.
The ConsBurford is not for the faint-hearted. We see a few risks.
Inappropriate Fair Value Accounting Applied To Legal Claims
How do you value a legal claim ? Simple question, difficult answer.
Burford qualifies its legal claims as financial assets under IFRS accounting standards (IFRS 9). It applies so-called fair value through profit and loss (FVTPL) accounting for its legal claims as the contractual terms do not give rise on specified dates to cashflows that are solely the payment of principal and interest on the principal amount outstanding.
The majority of the Burford-only balance sheet consists of capital provision assets. These are effectively all the litigation assets that Burford holds on its balance sheet at FVTPL. Burford initially records the litigation assets at cost on its balance sheet. During the lifetime of the litigation process Burford adjusts the fair value of these assets based on objective events in the proceedings. Any upward revaluation then flows through the P&L as unrealized gains (for Burford-only balance sheet assets this is part of its income on capital assets).
In Burford's disclosures:
VALUATION METHODOLOGY FOR LEVEL 3 INVESTMENTS
Fair value represents the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants as of the measurement date.
The methods and procedures to fair value assets and liabilities may include, but are not limited to: (i) obtaining information provided by third-parties when available; (ii) obtaining valuation-related information from the issuers or counterparties (or their advisors); (iii) performing comparisons of comparable or similar assets; (iv) calculating the present value of future cash flows; (v) assessing other analytical data and information relating to the asset that is an indication of value; (vi) reviewing the amounts funded in these assets; (vii) evaluating financial information provided by the asset counterparties and (viii) entering into a market transaction with an arm’s-length party.
The material estimates and assumptions used in the analyses of fair value include the status and risk profile of the risks underlying the asset, the timing and expected amount of cash flows based on the asset structure and agreement, the appropriateness of discount rates used, if any, and in some cases, the timing of, and estimated minimum proceeds from, a favorable outcome. Significant judgment and estimation goes into the assumptions which underlie the analyses, and the actual values realized with respect to assets could be materially different from values obtained based on the use of those estimates.
VALUATION POLICY ON CAPITAL PROVISION ASSETS
The Group operates under a valuation policy that relies on objective events to drive valuation changes. For the vast majority of our capital provision assets, the objective events considered under the valuation policy relate to the litigation process. When the objective event in question is a court ruling, the Group discounts the potential impact of that ruling, commensurate with the remaining litigation risk. The policy assigns valuation changes in fixed ranges based on, among other things:
▪ a significant positive ruling or other objective event but where there is not yet a trial court judgment
▪ a favorable trial court judgment
▪ a favorable judgment on the first appeal
▪ the exhaustion of as-of-right appeals
▪ in arbitration cases, where there are limited opportunities for appeal, issuance of a tribunal award and
▪ an objective negative event at various stages in a litigation
In a small number of instances, the Group has the benefit of a secondary sale of a portion of an asset. When that occurs, the market evidence is factored into the valuation process; the more robust the market testing of value is, the more weight that is accorded to the market price.
In reality until final settlement or adjudication of a legal claim it is uncertain what the final outcome will be. The accounting requirements force Burford to take a view on the fair value of all its investments.
In our view mistakes can be made in getting the fair value right by Burford. The basic premise is that the legal claims are initially valued at cost and only marked-up based on objective events that convey a higher weighted average of the litigation outcome.
In a sense Burford applies fair value accounting just like a private equity fund would put a fair value to illiquid equity investments, only the type of asset is less well understood.
From this disclosure we can derive that the unrealized gains typically are booked close to ultimate conclusion of the legal claim (as can be seen on the right hand side of the diagram below).
Source: Burford, 2020 Results Presentation
Note, this excludes the unrealized gain booked on the YPF-asset, which in our view is more of an anomaly and is the exception that confirms the general practice shown above.
Inflated Argentinian Claims ?
Burford has received much attention for its treatment of its YPF-assets. This relates to claims as a result of the nationalization of YPF by the Argentinian Government.
In Burford's disclosures we find the following (emphasis added by us):
However, this general approach to fair value has been altered by our YPF-related assets—our financing of the Petersen and Eton Park claims.
We have sold 38.75% of our interest in the proceeds of the Petersen claim for $236 million in cash in a series of third-party transactions from 2016 to 2019. As those transactions have increased in size and number of participants, they have become increasingly relevant to the fair value of the YPF-related assets under the accounting standards, and they have obliged us to record meaningful amounts of unrealized gain given the significant acceleration in implied value from the transactions.
Our most recent sale of a portion of our proceeds of our Petersen entitlement in June 2019 was part of a $148 million placement to a number of institutional investors, of which we sold $100 million and other third-party holders sold the remaining portion. Given the size of this latest sale and the participation of a meaningful number of third-party institutional investors, we concluded that the significant input in valuing our YPF-assets at year-end 2019 was this market transaction. This does not imply that these assets will henceforth be carried based on trading in the secondary market for the Petersen interests. At December 31, 2020, we continue to carry the YPF-related assets (both Petersen and Eton Park combined) at the same carrying value ($773 million) as at December 31, 2019, though our cost basis did increase by $2 million to $41 million because of costs deployed on those assets during 2020, and therefore our unrealized gain on the YPF-related assets decreased by the same amount during 2020 to $732 million. Otherwise, we did not recognize any income on the YPF-related assets during 2020. During 2019, the capital provision income from the YPF-related assets was $188 million, consisting of realized gains relative to cost of $98 million, previous unrealized gains transferred to realized gains of $(78) million and fair value adjustment in the period of $168 million.
Our YPF-related assets have been successful as of December 31, 2020. From an investment on our balance sheet of less than $50 million, we have realized cash proceeds of $236 million and have assets on our books at December 31, 2020, with a fair value of $773 million representing in total over $1 billion in realized and unrealized value to date.
We are not in a position to determine the fair value of the YPF-assets. It can be $0 or it can be the actual fair value on Burford's balance sheet. The issue that this creates is that IF the YPF-assets prove to be worth significantly less than the amount for which they are recorded on the balance sheet, there is a significant over-statement of Burford's net asset value in the order of ~$800m. On the other hand, if the YPF-assets at fair value represent real future cash flows this will be ~$800m ticket to Burford's coffers.
In short: a major swing-factor.
Burford's business is non-linear and fairly unpredictable. The financials can be quite lumpy, for example due to swings in FVTPL accounting due to one specific case. Usually when the business cannot be easily extrapolated it is considered to be more risky, we tend to be more nuanced in our initial view. We think the historic profile allows for some calibration of future returns but likely we need to take into account a good degree of variability of future returns.
Burford measures its portfolio performance with IRR and ROIC metrics.
IRR is a discount rate that makes the net present value of a series of cash flows equal to zero and is expressed as a percentage figure. Burford computes IRR on concluded (including partially concluded) legal finance assets by treating that entire portfolio (or, when noted, a subset thereof) as one undifferentiated pool of capital and measuring inflows and outflows from that pool, allocating investment cost appropriately. Burford’s IRRs do not include unrealized gains.
ROIC is a measure of financial performance calculated by comparing the absolute amount of realizations from a concluded asset relative to the amount of expenditure incurred in funding that asset, expressed as a percentage figure. ROIC is a measure of our ability to generate absolute returns on our assets. Similar to our IRR calculations, when we compute ROICs on the entire portfolio (or a subset of it), we do so by taking the aggregate realizations relative to the aggregate costs incurred, rather than a weighted average of the individual asset ROICs.
We think just looking at this portfolio IRR and ROIC is not sufficient. It requires adding back into the equation the operating cost base of Burford's operations.
Source: Burford, 2020 Annual Report
Over the duration of the existing business we think we taking the nominal FY20 operating expenses of Burford (~$90m excluding one-off items related to listing in the US and also excluding amortization of intangibles) and applying an average duration of cases would be required.
Burford's on balance sheet investments are obviously capital consuming. We do not think this is an issue as the performance to date has been good. In 2021 there are no maturities of debt instruments which should give Burford greater flexibility to pursue increased investments after a softer 2020 year from a capital deployment standpoint.
Source: Burford, 2020 Results Presentation
We believe that the Muddy Waters intervention starting mid 2019 has actually made Burford stronger. Its disclosures give us good reasons to believe that Burford management actually wants stakeholders to really understand their business model. In this sense Burford compares very well to numerous other companies.
We are intrigued by the business model that combines seemingly venture capital-like returns with IRR's >30% on concluded investments, a good betting average and more manageable dispersion of returns due to ability to get to negotiated settlements or outcomes in legal cases.
The anomaly of fair value accounting potentially inflates the balance sheet. We think we need to do some more work in: (i) putting together the valuation pieces and (ii) comparing this with other legal finance firms (there are a few listed), before taking a firm view on the investment proposition. We may be on to something with Burford, maybe not. Nonetheless, we think legal finance asset class can be a nice portfolio diversification module to a more traditional portfolio of conventional assets.
This article was written by
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