BURFORD CAPITAL LTD – INVESTMENT THESIS

Who is Burford Capital Ltd (BUR)?

Burford Capital

Burford Capital Ltd (Burford) is a leading company (50%-60% market share) in the new field of. Burford Capital Ltd stock trades in the Alternative Investment Market (AIM) of the London Stock Exchange under the ticker BUR.

The Litigation Finance Industry

A litigation is and asset of unknown value, but an asset anyway. Accounting standards do not allow corporations to show this asset in the balance sheet. However, all the expenses related to the litigation go straight to the P&L. As a result, many corporations leave money on the table from litigations because they do not want their EBITDA to be reduced and receive a lower valuation from sell side analysts.

Besides, lawyer charge by the hour and law firms do not have a balance sheet that supports a different type of billing. Since every litigation has an unknow result, the truth is that lawyers do not want to assume the risk of financing their customer’s litigations.

In other cases, a company may not have the necessary funds to deal with the litigation, even if the probability of success is very high. Imagine a company that has gone bankrupt as a result of a clear breach of contract by the defendant. In this case, the fact that the company is in the liquidation period prevents it from paying the lawyers’ minutes and therefore recovering assets that really belong to its shareholders.

Another example could be an investment fund that was invested in a company that has suffered a negative event and for which it can litigate as a shareholder. The costs of this litigation, which can be lost, would go against the NAV of the fund. This structure is of no interest to the fund manager, since its success fee would be reduced. Therefore, many of these cases are abandoned. With the use of litigation finance, the fund manager ensures that the NAV will not be reduced by the expenses of the litigation and if the litigation is favorable, the benefit will go against the NAV and increase its success fee.

To solve all of the above examples and many more, a litigation finance company offers to finance the litigation expenses in exchange for a compensation in case of success. If the litigation is lost, the litigation finance firm recovers nothing and therefore would lose all its investment.

From this moment, we have to understand that in order to be successful in the Litigation Finance industry you need excellent execution, diversification and access to significant capital.

Any litigation is a binary event in which it is uncertain what you can earn and what you can lose. As in the insurance industry, any single policy is s binary. However, as you increase diversification, you properly select your investments (Burford only invested in 59 of the 1,561 proposal that it received in 2017) and you are able to price them appropriately, it becomes a wonderful business.

Unlike Private Equity, in Litigation Finance it is possible to lose all the money you invested in one case. On the other hand, the monetization of the profits is much easier, and in cash. Any investor who wants to get out of an investment, needs two things, first that someone provides you with liquidity to get out, and second that this liquidity is at the level of valuation that you want to sell. However, in the Litigation Finance investments, the exit is immediate and in cash, either when a settlement is reached prior to a trial or by a favorable ruling. In both cases, you will receive the total amount in cash. As you can see, the results of this industry are totally independent of the evolution of the financial markets or the state of the economic cycle.

The litigation finance industry is barely 10 years old, but through this decade it has achieved spectacular growth. Measuring the potential size of the market is almost impossible, but we can say that it is huge by any metric that you use to define it. Besides, Burford and the rest of the companies in the industry currently represent just a tiny size of it. That’s why it does not make sense to waste any time right now calculating its exact size. We’ll just say that its potential size is huge.

What is Burford Capital Ltd?

Burford Capital Ltd provides financing to meet the expenses associated with a litigation, in exchange for a percentage of the benefits obtained. If the litigation is lost, Burford will have paid the lawyers and lost its investment entirely. In return, Burford will ask for a return equivalent to several times its investment, a share of the profits, a mix of both or any other formula they may consider attractive.

To get an idea of ​​the profitability of this business, from its foundation in 2009 to 2017, and looking only at closed investments, Burford has committed $ 515 million, of which $ 443 million were invested, and recovered $ 773 million. That implies a multiple on the invested capital (MOIC) of x1.75 times and an IRR of 31%. These metrics are much higher than those of private equity firms. The positive comparision becomes even more relevant if we look at the average duration of an investment. For Burford it takes only 2 years on average to complete an investment, while private equity funds tend to go for a period of 8 to 10 years. Lower duration and higher IRRs definitely make litigation finance a much more attractive investment.

It should be noted that, although Burford’s staff are mainly lawyers and financiers, Burford does not handle the cases. Burford Capital Ltd is limited to financing the lawyers’ fees, but the decisions and settlements reached are fixed by the client and his lawyers, not Burford.

Burford Capital

Where Will the industry be in 10 years?

It is clear that the Litigation Finance industry is here to stay. The product satisfies a need to both clients and lawyers in a superior way. Clients do not have to make payments up front or pay lawyer by the hour. Lawyers can continue to charge by the hour, being able to take more cases and making their customer happier.

Until very recently, the use of Litigation Finance was really low, just because it was unknown. However, as more and more companies try it and discover that there is a superior way of satisfying their needs, there is no way back.

Hence, in 10 year the industry will almost certainly be much larger. However, due to high barriers to entry, we expect the industry will be dominated only by just a few players.

As we stated before, this business has almost no correlation with the economic cycle. Actually, litigation activity increases during bad times. As a result, we expect Litigation Finance to be considered by many asset managers as an alternative to equities, fixed income, FX, commodities, Real Estate, Cryptos, gold, alternative investments and any other type of asset when making their asset allocation decisions.

Burford Capital

 Barriers to entry and competitive advantages of Burford Capital Ltd

To be successful in the Litigation Finance industry you need prestige, size, diversification and execution. Let’s see how Burford Capital Ltd scores on each of these 4 points:

PRESTIGE

Prestige is a prerequisite to both raise capital and get investments:

It is very difficult for a group of lawyers without a proven track record to raise capital from investors. The historical returns that Burford Capital Ltd has achieved have become the standard to beat, and therefore it is difficult to raise money offering a lower return. This helps to avoid pressure on prices. To get investments you must have a very good relationship with law firms and potential clients. To study an investment, you have to make a complete due diligence, and the customer has to grant you access to very critical and confidential information. As a result, the industry will never become an open auction in which everybody can get access to that information. That makes the relationship with Burford very sticky. Nobody has been fired for working with Burford, so why should someone make a change and risk his job?

During the due diligence process, your customer’s lawyers have to invest some time with you for which they will not be compensated if eventually you do not reach a deal with the customer. That’s why law firms are likely to work only with Litigation Finance firms they have a good relationship with. Again, a very sticky relationship. Due to its high success rate, many clients want to work with Burford since it is an indication that the litigation is very likely to be successful

SIZE

Size matters.

Like in the Private Equity industry, there very large investments only available to those with a large amount of capital. Consequently, pricing power is greater and Burford can get more favorable terms. Over the last 5 years, Burford has evolved from an average investment size of $3 million to $24 million. That average ticket size is unmatched in the industry and not accessible to new entrants. At the end of the day, the effort to make a $3 or a $24 investment is the same, the staff cost is the same, but the profit is several multiples higher. Consequently, Burford enjoys higher margins than smaller firms and it is in a better position to hire talent.

DIVERSIFICATION

Diversification is key

Every piece of litigation is a binary event in which you can either win or lose. Therefore, diversification is extremely important in order to avoid what statistically is known as tail risk. By definition, it is almost impossible that a new entrant to the industry can start its business with a widely diversified portfolio. As a result, many financial firms have declined to enter the litigation finance industry since they cannot stand the risk of losing everything in one investment. The current portfolio of Burford has the following risk metrics which are very difficult to replicate:

  • Very large and widely diversified investment portfolio – $1.5 billion on balance sheet, $2.4 billion when adding the investment funds
  • 877 individual litigation claims underlying balance sheet portfolio
  • No concentration – no defendant represents even 5% of total commitments, no single case capital loss would amount to more than 2% of total commitments and our largest law firm relationship accounts for 14% of investments across more than 30 different partners.
EXECUTION

Great execution in risk underwriting and focus on risk-adjusted returns delivers superior investments

The more investments Burford completes, the larger the database and experience that Burford enjoys to assess future investments. All these proprietary data, together with a highly skilled management team, makes Burford’s decision-making process very difficult to replicate. Since every investment has different covenants and terms, and does not follow a standard procedure, Burford’s know how becomes very difficult to replicate and at the same time is critical to achieve such a high level of profitability. The following data summarizes Burford’s successful execution since it was established in 2009.

– Win/Loss historical rate 81%/19%. In multiportfolio cases, the loss rate has been reduced to 3%.

– Return on invested capital was 75% (MOIC: x1.75) on $773 million of investment recoveries to date

– Portfolio investment returns (net of losses but before operating expenses) of 31% internal rate of return (“IRR”)

– Weighted average duration of the portfolio was only 1.5 years

The competitive advantage that comes from execution becomes even more clear when you compare Burford’s metrics with those of IMF Bentham, its only listed competitor. IMF Bentham requires on average of 2.6 years to achieve a MOIC of x1.5 and therefore an IRR of just 17%.

 The Management Team

Burford Capital

The two key employees at Burford are its 2 co-founders, Chris Bogart (CEO) and Jon Molot (CIO). Burford is their baby, their vision, and therefore their interests are perfectly aligned with that of shareholders. Unlike Private equity firms, where employee compensation can be up to 50% of revenues, staff cost at Burford is very contained.

Besides, 20 members of the management own approximately 13% of total shares outstanding, so they are interested in maximizing profits and not in issuing dilutive capital increases. Each of the two co-founders, Bogart and Molot, owns approximately 4% of Burford’s shares.

Inflation

An investment in Burford is a good hedge against inflation. Think that the claims from a litigation will always be updated by inflation, and as staff costs are so low compared to revenues there will be no pressure on margins. Besides, higher inflation implies more difficulties to some companies that will then be open to be more involved in litigation in order to claim more money.

Accounting, balance sheet and margins

Burford has an EBIT margin of 85% and a Net Profit margin of 78%. These margins can only be achieved through a sustainable competitive advantage. As long as I aware no other listed company enjoys such a high level of profitability.

As you Will very easily find out, Burford’s accounts and annual reports are very clear, transparent and easy to understand. There is nothing hidden behind a complex set of financial statements.

Statement of Comprehensive Income

Burford Capital
Statement of Financial Position

Burford Capital

Debt

Burford has a very conservative debt exposure. Burford targets a Net Debt to Equity ratio of 40%. The weighted average cost of debt is 5.8% with an average maturity of 6.5 years. These metrics compares with a 30% IRR on investments with an average duration of 2 years. We may conclude that Burford could afford a higher level of debt, but the management prefers to be prudent and avoid the risk of overleverage in a business that could deliver several losses in a row. Current annual cash receipts are 12 times the cost of debt, providing a huge coverage ratio.

Capital Allocation and Buybacks

Burford allocates all its profits to finance its growth what, looking at its current IRR, seems the most efficient use for shareholders. Increasing the dividend or buying back stock does not make sense at this moment in time. However, in its early years, Burford had a buyback program that allowed to buy share only below a 90% of its cash net asset value. Therefore, we can conclude that capital allocation at Burford is very rational and always in the interest of shareholders.

Future Growth

One of the most beautiful things about this business is that it requires no huge long-term capex plans to row and that is why it can enjoy such a huge level of Roe and RoA. It is true that you need capital to finance new investments, but first most of it can come from current cash receipts and second you are expecting that your investments will become cash in roughly 2 years. When you compare to a high capital intensity industry like Airlines or Autos there is no color. Even when compared to giants like Amazon or Google, its growth seems more certain and requires lower capital intensity.

Therefore, we think that the growth of Burford and the Litigation Finance industry will be huge with almost all certainty. All you require is execution and the capital will come. At the end of the day, it looks like a Blackstone in the early days but with even better returns.

Valuation

Finding out the intrinsic value of Burford is not an easy task. To start with, the duration of every single investment and the final payout are completely unknown and almost impossible to forecast. Without a revenue figure, a DCF valuation model becomes almost impossible. Besides, we do not know for how long Burford will be able to keep such a high profitability and outstanding margins.

Nevertheless, Burford has already a long track record and its current portfolio is well diversified. Therefore, we can make a lineal estimate of future revenues knowing that our estimate and the actual data will differ every year and sometime by a huge amount, but in the mid-term the average of our estimates and actual data should converge. Therefore, we are trying to forecast the trend and not the actual data.

This kind of valuation requires a continuous update every time Burford releases numbers (twice a year) to make sure our estimates are normalized.

At the end of the day, Burford raises capital and invests it. We have to know that there is a difference between the capital committed and the capital invested. The capital committed is the maximum amount that Burford commits to invest in a case. The invested capital is the money that Burford has actually paid out. Historically, Burford has paid out 83% of the capital committed.

We Will start from the H1 2018 data and Will add the $250 million from the recent capital increase, to know the equity that Burford can invest. Then we will add the debt and every year will update the debt to match a target ratio of debt/equity of x 0.4 which is Burford’s leverage target. By adding equity and debt we get the total capital available to commit. Now we assume that Burford will be able to commit all its capital available to commit at least for the next 5 years. Comments at the latest investor day make us believe this is a reasonable assumption.

Then, from all capital available to commit, we assume that Burford Will invest only 80% and the remaining 20% stays in cash pending to be invested if required. Historically Burford has invested 83% of the capital committed, but once again we prefer to be conservative.

From Burford’s Capital Markets Day presentation on November 12th, 2018 we know that Burford has achieved on average a 31% IRR on its investments. We prefer to be conservative and will use a 25% IRR for our calculations. This is another key data we must follow up continuously to make sure our calculations are accurate. Using a 25% IRR we can estimate the average income from investments per year that as we said before it will not match the actual data for any given year, but on average we should be quite close to the actual data.

As operating expenses, we take a 22% of investment income. This is again conservative as the average for the last 3 years was 19% and decreasing. Regarding the cost of debt, we will use an average interest rate of 5,8% as reported by Burford.

Through these calculations we get the net profit that will be added to the equity in year T in order to get the equity available in T+1. Then we repeat the calculations for every year until 2023 so we can have data for 5 years.

As we said from the beginning, this lineal evolution of the financial will only exist on our spreadsheet but, the average for 5 years will be close to the actual average, and that is what we are looking for, Since Burford reports in USD and trades in GBP we will make the FX conversion using the current spot rate of 0,78 GBP/USD.

Then, we apply a P/E ratio of x17 (current market P/E) to the net profit of each year to get an estimate of the intrinsic value at the end of each year. Since Burford has a higher growth profile, has higher margins and earns a higher RoE we could easily justify a higher P/E ratio, but once again we prefer to be conservative.

At this point we have an estimate of the intrinsic value of Burford at the end of each year. In order to make them comparable, be must bring them to the present time and for that we will use a discount rate of 10% which is the minimum IRR that I demand from any investment. Now we just take the simple average of these 5 intrinsic values and get an average valuation of GBP 4.694 million GBP.

Finally we have to make a couple of adjustments. First, Burford has an asset management division that we have not considered in our calculations. Burford has just entered this business which is almost identical to its core business, but instead of investing its own capital, Burford invests third party capital in exchange of a management fee and a success fee. Currently this is a very small part of Burford and we have very limited visibility so we will just value it at the $175 million that Burford paid to acquire the business. Burford has made just a few acquisitions but all of them have been very successful, so we can consider that this is a conservative valuation.

Secondly, we must make an adjustment for an investment known as the Petersen investment. Burford has made partial sales in the secondary market of its interest in this investment, and the last stake was sold at a price that implies a total valuation for the Petersen investment of $800 million. Since Burford still owns a 71,25% interest in this investment, its stake would be worth GBP 444 million. Burford, has not disclosed what part if these GBP 444 million has already been considered as investment income in previous years. However, we know that historically Burford accounts 65% of income from an investment in the year the investment is closed. Hence, we can estimate that GBP 289 million have not been recognized as investment income yet.

Adding all these adjustments, we get an adjusted intrinsic value for Burford of GBP 5.119 million, which implies a 62,5% upside potential when compared to current market cap of GBP 3.150 million.

VALUATION SUMMARY

 Burford Capital

Risks

 

Risk 1: Execution

During a recent Capital Markets Day, Chris Bogart, Burford’s CEO, was asked about what could stop Burford from becoming a GBP25 billion market cap company in 5 years. Without a doubt, Mr. Bogart replied “execution”, Choosing the right investments at a price that provides a favorable risk-adjusted return is the key in this business.

Risk 2: Pipeline

The larger Burford becomes, the more difficult it is to achieve an attractive pipeline of cases that meet Burford’s investment criteria. The same is true for the industry as a whole. Consequently, some firms will start accepting litigation cases at a lower risk-adjusted return, and some of them will fail. If Burford continues to prefer quality versus quantity its growth may be limited as well.

Risk 3: Shareholders

The two largest shareholders of Burford are two investment funds who may be forced to sell if they have withdrawals regardless of their opinion on the company. Besides, Burford is a top 3 position in both funds, so they may be forced to sell due to risk concentration concerns. However, this risk has to be seen as an opportunity for a value investor as it may provide you with a great buying opportunity.

BURFORD’S TOP SHAREHOLDERS

Shareholder Name             Amount                 %Holding

Invesco Perpetual              33,556,172                15.35%

Woodford Investment     20,724,001                 9.48%

Old Mutual                            10,903,211                  4.99%

Christopher Bogart           8,786,290                  4.02%

Jonathan Molot                  8,559,394                   3.91%

What is the market missing?

Markets tend to be efficient most of the time and all the available information is usually included in current market prices. Hence, to be a successful investor you need to see something that the market is not seeing. Otherwise you will always be average at most.

Looking at Burford, we believe the reasons why the market is missing this opportunity are:

1.- Just a few analysts follow the stock and none of them from a global sell-side firm.

2.- Burford trades on the Alternative Investment Market of the London Stock Exchange, and therefore many investor or portfolio managers are not allowed to invest in that segment of the market

3.- Until last year, Burford’s market cap was so low that many portfolio managers were not allowed to invest in it.

4.- Although liquidity on Burford’s stock has improved recently, it is still limited for those who want to take a large position. So once again many investors cannot invest in it.

5.- Calculating the intrinsic value of Burford implies a valuation model with many hypotheses that sell side analysts cannot feel comfortable with.

6.- Litigation Finance is a new industry with a very reduced number of listed companies. As a result, running a comparable analysis to value Burford is simply not possible and consequently Burford does not appear on many screenings.

Would I buy if I could not sell in 20 years?

Absolutely yes! It is almost impossible that Burford Capital Ltd can experience a huge permanent loss of capital. My only doubt is what the growth rate will be and whether I am paying too much for it.

If at some point, Burford cannot find new investments, its cash pile will increase as old investments are over and with very limited operating costs Burford can patiently wait for new opportunities or return that cash to shareholders.

Burford already enjoys huge competitive advantages like size, execution, diversification and prestige that become even stronger and become permanent as Burford continues to grow.

It is clear to me that Burford is one of those companies that can become a 10-bagger.

Disclosure

I do not hold a position with Burford Capital Ltd such as employment, directorship, or consultancy.

I personally hold a material investment in Burford Capital Ltd.

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