Description

Main points

Burford Capital, the market leader in litigation finance, is 80% off its highs. Simply put, the market has never gotten over the fraud allegations made against this firm last summer. As a result, the shares change hands at 4x earnings and .66x book value. However, Burford is a compounder and deserves to trade at 2-3x book. In which case, the shares are worth 5x their current price.

Background

Burford is a litigation finance firm. It funds lawsuits and then gets a split of the proceeds. The firm handles only commercial litigation, so it isn’t involved in matters of personal tragedy, such as someone suing a hospital over the loss of a loved one. 

The historical economics of the business are incredible. Burford’s 10-year IRR on their concluded cases is 30%. Excluding Peterson, the firm’s homerun investment, the IRR is 24%. Add in income from Burford’s other businesses to that 24% IRR, then net out opex, taxes and interest, and you have a security with 20% ROE. At .66x book, that’s a 30% annual return to investors. But that’s only half the story. The company is growing book value 15-20% a year. By 2021, book value will likely be at least $10/share. A company with 20% ROE and strong growth deserves at least a 2.5x book multiple. That would make the shares worth $25 a share in USD or £19.50 in GBP, 5x today’s price. In terms of earnings, that would be a 14x P/E. And this assumes that IRRs going forward are 24% instead of the 30% they’ve been in the past.

There’s also another factor that investors have ignored. Litigation isn’t levered to the broader economy the way almost all other companies are. In fact it’s countercyclical. IMF Bentham, another public litigation finance firm, put up record results in the wake of the financial crisis. Burford is poised to do the same. Except unlike IMF, which compounded only its own capital back then, Burford can do this both on its own capital and on the $2.8 billion it manages.  

This situation exists because a cloud hangs over Burford in the form of a short thesis published in August 2019 by Muddy Waters (“MW”). MW largely focused on attacking management’s credibility, which it accomplished with at best mixed results. However, the real scare factor from MW was actually a totally valid point. Burford uses Level 3 accounting, so as investors, our lives are in Burford’s hands. But, contrary to MW’s argument, the fact that Burford uses Level 3 accounting should come as a surprise to no one. Most of the firms in the space mark to fair value. Litigation finance is basically private equity but with a two-year time horizon instead of ten. Level 3, in this case, is also useful to investors. Without it, returns will look depressed relative to reality because the firm is growing rapidly and there’s a lag between deployments of capital and recoveries.

Ultimately we view Burford in the following way. One, there’s a 10% chance the accounting is aggressive. In that case, the shares are near liquidation value. (That said, the downside is always worse than you think it is.) Two, there’s a 30% chance that ignoring Petersen and other one-offs, Burford is just an average player in this industry. If so, the shares are worth 1.5x book, which equates to 2x the current share price. Three, there’s a 60% chance Burford is the real deal and can maintain IRRs on its investment portfolio well above 20% while continuing to grow. That would make the shares worth 5x their current price. 

Margin of Safety

Before getting into the potential upside, it’s worth looking at how low Burford’s current valuation is. Instead of trading at a premium to NAV, as one would expect with a company with strong returns, Burford trades at a 35% discount to NAV. At the current price, which is just 4x earnings, the company could write off its stake in Petersen, a lynchpin of the company, and it’d still be trading below net asset value. In fact the current price resembles forced liquidation value more than anything else. Running through some quick math, Burford has $160MM in cash, $180MM in complex strategies, and $1 billion in litigation and other investments at cost. Its stake in Petersen is worth at least $400MM, bringing the total minimum asset value to $1.7 billion. Net out the debt and the non-controlling interest, and the remaining $950MM roughly equals the company’s market cap. The market is saying there’s a real risk this business will be unable to continue as a going concern.

On top of this, there are worries about liquidity and 2019’s poor results. We don't share these concerns because we think 2019's results are a one-off and because Burford's liquidity issues stem not from debt but from funding commitments, which it has the option to delay. Ultimately, though, an investment in Burford comes down to one thing and one thing only. Do we believe in the long-term economics or not? Confidence in the numbers is required or any investment, and MW’s report detonated investors’ confidence in Burford’s. However, several data points give us a range of answers as to Burford’s true underlying earnings power, and all of them make this a compelling investment.

Going through the numbers case-by-case

The first data point is the most important. For several years, Burford has provided the cumulative cash flows on concluded cases by vintage since the firm’s inception. This allows investors to see beneath Burford’s aggregate numbers, which is important because bad accounting is usually hidden within large aggregate figures. Significantly, because of its specificity, it’s also a dangerous disclosure for Burford to make if it has anything to hide. In total, this disclosure showed that $555MM had been invested in litigation through 2018. Burford then recovered $1 billion from these investments for an ROIC of 85% and an IRR of 30%. After MW’s report, Burford got even more granular, releasing both returns on a case-by-case basis and the fair value marks it had made in this those cases. This second disclosure showed that management’s fair value marks had been uniformly conservative. In all its material concluded cases where fair value marks had been taken, Burford realized $313 million in net profit. And prior to that realization, it had only written up those investments by $96 million. In other words, the fair value marks were only 30% of the realized profits. This, more than anything else, completely kneecaps the short thesis and shows that Burford’s successful history reflects real results, not accounting optimism. 

Going back to zero

The next data point is the simplest. If we don’t trust Burford’s marks, then there’s an easy way to correct for this. We just deflate the carrying value of their investments to cost and then look at the returns using only realized gains. When we do this, we find that from 2014 to 2018, returns on investment were 22% a year. Not 30% a year, like their published IRR number. But it was never going to be 30% because they’re growing investments rapidly and returns on investments have a 1.5-2 year lag. This is in line with what you’d expect.

The next question is: could they be manipulating their net realized gain figures? Could they be treating returns of capital as returns on capital? The way to answer this is to look at ROIC, which keys off total cash recoveries rather than relying on management to allocate recovered money between profit and basis. Incidentally the method we just used above allows us to do exactly that—to back into their ROIC figures. Comparing investments at cost to total realizations with a two-year lag, we get an average time-weighted ROIC from 2012-2018 of 81%. Almost identical to management’s dollar-weighted figure of 85%. We find this exercise useful because it uses independent numbers which management hasn’t cherry-picked and which are very difficult to manipulate. 

Mismatch between cash earnings and “Capex”

The next data point also concerns Burford’s net realized gains, which from a cash flow perspective are important because they represent the company's non-fee cash earnings. Burford has announced that 2019 results will be down from those in 2018. Net realized gains are expected to be roughly $130MM when they ought to be almost double that. Renewed worry has been sparked that the cash earnings will never show up.  

However, this ignores the business’s inherent lumpiness. This also ignores the large mismatch between cash returns and cash deployments. Looking at the sources and uses of the company’s cash, when you add up investment recoveries, equity issuance and debt issuance, the company has had $2.5 billion in cumulative source cash flow since inception. Net out the $640MM  from debt issuance, and you see that all the CF that belongs to shareholders, $1.8 billion, has gone into additions to investments. Burford’s asset growth has been exponential. Moreover in recent years this growth has keyed off substantial absolute figures. In 2015, for example, the company had just $250MM in investments at cost. Whereas today it has $1.2 billion. That’s a 50% CAGR on hundreds of millions of dollars. And it’s a 50% CAGR on assets where the stated average duration of 1.5-2 years is misleading. Why is it misleading? Because the variance around that average is massive. In 2014, cash returns on investments (at cost) were just 7%. A terrible result. This firm ceases to exist if it has 7% IRRs. Yet in the three years afterward, the company put up huge cash returns: 29% in 2015, 19% in 2016 and 35% in 2017. Ultimately looking at the cash tells us what the Level 3 accounting does not. It tells us that the dispersion on Burford’s underlying earnings is large. So it’s low-percentage to judge this kind of firm by one or even two years of results. The firm can only be judged by three to five year results. And when we look at those on a cash basis, the business is putting up returns that make it worth multiples of book, not 65% of book.

Precedent for Burford’s performance

The next and final data point concerns IMF Bentham, another public litigation finance firm. IMF Bentham has been in business for twice as long as Burford, and its fundamentals demonstrate the strong economics that established players in the industry can earn for long periods of time. From 2005 to 2019, IMF’s ROE averaged 15% a year. Performance of the company’s shares reflected these superior numbers. Since 2005, when the shares were trading at book value, the stock has returned 15% a year including dividends. If you waited until the shares had fallen to .66x book value in 2006, then the shares went on to return 22% a year for the next 13 years. Burford is also trading .66x book, which implies 22% returns if it enjoys a similar “fate.”

Equally interesting, the years in which IMF really blew out its ROEs were in the wake of the financial crisis. IMF’s ROE jumped to 36% in 2008 and peaked at 49% in 2012. As a result of the coronavirus pandemic, Burford is on the doorstep of a similar situation. Whatever Burford’s true baseline economics exactly are, they are likely to get even better.

Putting it all together

Ultimately, fear about Burford’s accounting seems vastly out of proportion to the actual risk. Meanwhile that risk doesn’t really seem to be that this company is a fraud. Instead the risk is that the company might not live up to its historical economics. And in that case, if ROE is 15% instead of 20%, then it’s merely worth twice where it’s trading. However, if it can even partly live up to its historical numbers, then the upside here is huge. Unlike IMF Bentham, which only ever grew modestly, Burford is a far more ambitious firm and vying for a far larger slice of the litigation finance pie. In eleven years, the company went from nothing to the market leader in the space. It made savvy investments in claims like Petersen, Eton park and Teinver. It’s also the leader in the next phase for the industry, which is risking less of your own capital and gaining synthetic leverage by managing other people’s. The company has funds with $2.8 billion in AUM, only a portion of which has been deployed, meaning fee income is understated. It also has a relationship with a sovereign wealth fund where Burford puts up 40% of the capital and gets 60% of the returns. Burford’s balance sheet investments make it an interesting investment in its own right. But given its asset management business and its countercyclicality, it could put up incredible numbers in the near future.

Valuation

In order for Burford to keep IRRs at 30%, it has to find another homerun like Petersen. A far less demanding assumption is that going forward, they achieve the 24% IRRs they earned ex Petersen. That translates into 20% ROE. Book value is on pace to be at least $10/share by 2021. At 2.5x book, the shares would be worth $25/share in USD or £19.50 in GBP. That’s 5x today’s price. Meanwhile if the company can keep growing while maintaining IRRs, then that only adds to the upside. This is one of the few businesses in the world that could be worth 10x in seven years, no matter what happens in the global economy.

Catalyst

I can't put it better than the analyst who said that for a firm dogged by accounting questions to list in the US, where its management team will be subject to criminal liability, certainly shows if nothing else "self-belief."

The real catalyst isn't the US listing though. It's realized gains catching up to deployments. That's where the rubber meets the road.