Burford Capital – Time to sell the stock?

Summary

Burford capital (BUR LN) is a $4.5bn litigation finance company listed on AIM in London. Aim is a lightly regulated market, similar to the pink sheets in the US. Over the last five years the stock saw a tenfold increase, on the back of a series of beat and raise results. Currently trades on a punchy 4.5x P/BV as the consensus extrapolate the historical 75% ROIC into the future. We find a number of factors that can normalise ROIC: a) litigation finance is becoming more capital intense as new entrants push potential returns lower, b) the whole industry faces disruption from the recent U.S. senators’ bill that requires litigation funding disclosure, c) Burford has significant customer concentration, as the Petersen claim represents 1/5 of the group EV, corruption allegations in Argentina could impair the expected value of this asset.

Background

Burforford capital IPOed in 2009 with a £80m market cap, today it commands a £3.5bn valuation although it employs only about 100 people. Although UK listed, the company is mostly financing cases in the US as in London litigation finance needs to be disclosed. Burford invests in legal cases buying an interest in the outcome of a case, raising capital to pursue claims. Burford doesn’t actively participate in the litigation but collaborates with external law firms. The cases are funded based on their likelihood of generating a return, complicating the claimant vs defendant model of justice, adding the interest of a third party to proceedings. Disclosing financing arrangements could change the course of a court case, as the judge can cap the compensation that ends to vulture funds.

Burford was one of the early entrants in the industry, cherry picking the best cases, which helped the firm generate a historical 75% ROIC. These returns were skewed by the Petersen case, which is currently estimated by Burford at $800m, or ¼ of the company’s EV.  

Burford values its current portfolio of legal cases at $1,218m, using a “mark to model approach” as in the absence of a liquid market, these assets are treated as level 3 securities. This gives management material discretion on marking up the value of these assets. The legal nature of the portfolio defers a potential write down, as the claimant is more likely to appeal on a negative outcome, which  increases the capitalised value of the legal expenses.

Competition is increasing

Burford is the largest participant in the industry, with a $1.218m investment portfolio and $595m in undrawn commitments. We see the low barriers to entry and lucrative potential returns attracting completion from hedge funds, private equity and law firms:

  • IMF Bentham (IMF AU), the Australian listed competitor is the second largest litigation finance provider globally with $667m of reported claims value and a market cap of only A$525m.

Burford capital has a market cap 12x higher than its largest competitor, which appears optimistc.

  • Vannin: Founded in 2007, tried to float in London in September 2018 but the IPO was cancelled, the company was aiming for a £1bn valuation.
  • Harbour Litigation Funding: Founded in 2009 with £586m of total assets.
  • Therium: with £586m of total assets.
  • Calunius Capital: Founded in 2016, with $200m of total assets
  • Longford Capital: with more than $500m in assets.
  • Pravati Capital: with more than $500m in assets.
  • Parabellum Capital: Founded in 2006 and currently has $300m in assets.
  • LexShares: upcoming startup offering peer to peer litigation finance.
  • Benchwalk: Recently funded with £800m assets.
  • Validity Capital: Recently started with $250m
  • Taconic Capital, Soros Fund Management and D.E. Shaw & Co are also getting into litigation finance, backing financial sector cases.

The American Lawyer reports that the litigation industry risks commoditisation after the recent massive fund raisings in the US. On the top of that, the US Senators introduce a bill to require litigation funding disclosure. More disclosure can increase competition and it enables claimants to use past cases as a benchmark.

Unsustainable ROIC

Burford treats the legal cases it finances as financial assets which are valued as level three instruments (IFRS 9) using a mark to model approach. This allows Burford to revalue the cases on each year, based on the final outcome it expects to get. Unsurprisingly, most of the revaluations are upwards. Over the last five years, $424m out of the total $860m in investment returns is driven by revaluations. This indicates than almost half of the company’s earnings are driven by internal revaluations rather than earned cash.

 Burford reports a staggering 75% ROIC on cases completed in FY17. However, the ROIC estimate includes only cases with a favourable outcome, as the claimant on a less favourable verdict is likely to appeal deferring the final outcome of the case. In more detail, out of the 143 cases that the company is currently perusing, only 66 were initiated over the past three years. Interestingly, 4 cases were initially financed in 2010 but still ongoing, 4 cases are ongoing since 2011 and, 3 in 2012 and 2013.  The company provides very little disclosure on the nature of these cases and why they take so long to reach into a conclusion. Overall, it remains unclear why 8% of the portfolio is invested in cases that are older than five years.

Customer concentration

The company’s biggest investment is the Petersen claim. Burford gradually reduced its stake and currently holds 71.25% of the claim. The latest disposal was in July 2018, the company sold 3.75% of the claim for $30m, implying a $570m valuation for the whole claim, or more than 10% of the company’s market cap. Some background on the case:

  • Petersen is a company owned by the Argentinian businessman Enriquie Eskenazi. Eskenazi built a 25% stake in YPF worth $3.4bn with borrowing from Repsol (the previous owner of the asset) and banks. YPF cut the dividend once it got nationalised, which triggered a default on Petersen’s levered holding. A receiver was appointed and the claim was sold to Burford for $18m ,with an obligation to repay 30% of any returns to the lenders. Burford continues to finance the lawsuit, which is for more than $3bn. The 71.25% stake in the Petersen case has an implied valuation of $570m based on the value of the recent 3.75% disposal. 
  • Interestingly, the Argentinian press (Clarin news) supports that Eskenazi built the stake in YPF using cash from corrupt sources. In more detail, the press claims that while Mr Eskenazi was governor of Santa Cruz province, he misused the $654m received form the privatisation of YPF. The same press articles claim that Mr Eskenazi used part of these funds to finance Cristina Kirchner’s 2007 election campaign.
  • If these corruption allegations are ever proven, they could change the course of the Petersen case.

Accounting Flags

  • Unrealised gains from marking-up the value of unresolved cases drive almost 50% of the company’s profits. In the meantime, Burford never reported a material mark down, which implies either that management has an impeccable track record of picking winning cases or that cases with lower chances of winning are deferred into the future.
  • Burford used a conditional sale transaction to accelerate revenue and profit recognition. The Teinver claim was sold in March 2018 for $107m. However, if the Teinver case is lost the sale transaction could be reversed and Burford would retain a $7m fee (p91 of FY17 annual report). Burford recognised the full income on the transaction, although retains a material residual risk.
  • On the face of it litigation finance is a cash generating business, however Burford consumes a lot of cash. Since FY14 Burford consumed $323m of cashflow. Despite reporting a £240m cash position, the company surprisingly raised an additional $250m through a share placement (2 October 2018).
  •  There is a conflict of interest as Burford is building a nascent asset management business where external capital is invested in litigation finance. This creates a potential conflict, as cases can be cherry picked to improve the performance of the asset management business at the cost of the common shareholders. Management faces a potential conflict in deciding whether new cases should be pursued using Burford’s balance sheet or external client capital, under the asset management business.
  • The CEO and CFO are married to each other.
  • Insiders are reducing their stake. Mr Bogart and Mr Molot placed 4.4m and 4.3m shares respectively at £13.5 in 21 March 2018.

Valuation

 Burford reports a legal investments with a carrying amount of $1.2bn, of which $0.4bn is related to the Petersen case. We value the Petersen case at the Burford’s estimated market value ($0.8bn) and the remaining cases on 2x P/BV or $1.6bn, this brings the total assets at an estimated value of $2.4bn. Burford reports $0.5bn of net liabilities which leaves as with a net asset value of $1.9bn. The company’s estimated net asset value is 58% below today’s market cap of $4.55bn. The market has extrapolated the historical returns into the future, ignoring the increased and the customer concentration risk, awarding Burford with a punchy P/BV 4.46x.

Conclusion

Burford stock price rallied on the back of a strong beat and raise results, as the company enjoyed the first mover advantage in litigation finance market. The company’s valuation  and consensus estimates appear optimising, extrapolating into the future past investment returns. If the corruption allegations in Argentina are proven right, the Petersen case could have a surprising result.
Currently Burford trades on a punchy valuation premium on book value. Under a more prudent approach, the company’s net asset value is estimated at about 59% today’s market cap.  

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