Burford (NYSE: BUR): a quality compounder trading at liquidation value

Introduction

There are two types of great businesses to own. Ones that require almost no capital and are able to distribute all of their profits, and others that need a lot of capital but earn high returns on it. Burford is the latter type.

On a basic level, Burford funds legal claims based on their expected future value by deploying capital from their own balance sheet and private investment funds that they manage. They pay for legal fees and costs of commercial litigation in exchange for a portion of the ultimate award or settlement. Burford only funds cases where the potential upside is multiples of the funding cost. The payout on a successful case is highly asymmetric, however, the amount of capital deployable is limited by the associated legal fees, which are currently ~$20 million on average per single case funded by Burford.

In the early days most of this business originated through law firms who were looking for a financing partner to get their corporate client to pursue a case. More recently, Burford has built out their direct relationship with corporate clients who seek legal finance as a source of corporate liquidity. Burford’s business with corporate clients has increased 8x since 2016 and is now bigger than with law firms. This allows Burford to offer more solutions and ultimately deploy more capital at high rates of return. Monetization solutions, i.e. providing liquidity to corporate clients based on the future expected value of pending litigation, allows Burford to write bigger checks beyond just the legal fees associated with a case. And that has helped not only increase deployments but returns as well. Burford is able to underwrite these solutions very profitably, because i) they learn to understand these cases better than their corporate clients and ii) corporations are not in the business of betting on binary litigation outcomes; the general counsel of a corporate client is unlikely to bet his career on the outcome of a single case and decline Burford’s offer to monetize it, even if the pricing leaves a lot of upside to Burford.

Burford has an amazing track record of deploying increasing amounts of capital at high and growing rates of return.  Since inception, 12 years ago, Burford has generated $1,738 million of cash proceeds from concluded or partially concluded assets against deployed cost of $893 million – a 95% return on invested capital. In total, the company has deployed $1,988 million of capital since inception, with H1 2021 seeing record deployments of $398 million. According to the company’s probabilistic model, which has accurately predicted realizations for past periods within ten percentage points, the current portfolio of assets (excluding their large and prominent YPF claims) will produce cash proceeds of $3,400 million over the coming years. YPF could produce that amount again.

If you look past the accounting noise, the most important drivers of value creation for Burford are growth in deployments and return on invested capital. I believe that deployments will grow, because Burford has only just begun penetrating its large and growing total addressable market, while returns will at least be sustained, if not increased over time, due to the company’s durable competitive advantages.

Incentivized and ownership-minded people with world class capabilities

The two co-founders, Christopher Bogart (CEO) and Jonathan Molot (CIO), are heavy weights in the industry. Before co-founding Burford, Bogart served as Executive Vice President and General Counsel of Time Warner Inc as well as the CEO of Time Warner Cable Ventures. Jonathan Molot is a Professor of Law at Georgetown University and a thought leader in the legal finance industry. He earned his BA magna cum laude from Yale College and his JD magna cum laude from Harvard Law School, where he was Articles Co-Chair of the Harvard Law Review and won the Sears Prize, awarded to the two top-performing students in a class of over 500. He clerked for US Supreme Court Justice Stephen Breyer.

Each of the two gentlemen own more than 4% of the company or close to $100 million worth of stock. They are regularly adding shares, having each purchased $1.1 million worth of stock in 2021, at prices ranging from $8.23 to $10.09 per share.

Just from reading the annual reports you get the sense that management is very ownership-minded (the conclusion of this write-up has a direct quote from the FY 2019 Report that is very telling). Notably, every single professional employee at Burford is a shareholder, which says volumes about the culture of the company and the mindset of the founders. As a shareholder your interests are aligned with the best people in the industry, who work relentlessly to create value for themselves and other shareholders.

Burford creates value for their clients

Corporations are generally penalized by public market investors for pursuing litigation because associated legal expenses are generally treated as recurring while litigation awards are considered one-offs. On top of that, most corporations are not in the business of suing people, so taking away corporate liquidity from core business operations can be a tough sell. Thus, corporate clients prefer to pay law firms for success rather than on an hourly fee basis. Law firms, however, operate a cash business with little balance sheet capacity or access to capital markets and often need the steady stream of income provided by hourly fees to operate. Burford bridges this gap.

Burford allows corporate clients to unlock and accelerate value generation from litigation claims by providing financing – enabling litigation without incurring associated legal fees upfront – and monetization – offering immediate liquidity for pending litigation – turning hidden assets into actual cash on the balance sheet. Instead of taking corporate liquidity away from core business operations, Burford helps turn litigation claims into additional liquidity for its corporate clients. Notably Burford’s business with corporate clients has increased 8x since 2016 and is now larger than their business with law firms. This speaks to the adoption of legal finance as a corporate finance tool.

For law firms, Burford provides them with cash to pay their lawyers even when they work on a contingent fee basis. It also allows law firms that prefer to operate on an hourly fee basis to compete for contingency fee work. In essence, Burford helps law firms get more work.

Finally, on the asset management side of the business, Burford’s private investment funds provide capital allocators with an alternative asset class that can generate >20% IRR while being uncorrelated to the stock market.

High returns protected by durable competitive advantages

Burford is the pioneer and market leader in the business of legal finance by a long shot. According to market research cited by the company, 86% of interviewed lawyers had Burford top of mind as the first or only legal finance provider in 2020. Having a reputable brand is crucial because the selection of a litigation finance provider does not lend itself to a competitive auction process. The legal costs of educating multiple providers on complex cases are significant. Clients are usually wary about sharing confidential case related information with many firms. The nature of the business makes clients want to be comfortable with the capital provider and as a result some clients are just going to immediately go with the experienced market leader from the start, even if a lesser known shop offered better prices.  

Being the market leader comes with a scale advantage. With $4.8 billion in AUM (managed funds + own balance sheet) and $1.6 billion of equity, Burford is much larger than publicly listed peers like Omni Bridgeway ($1.7bn AUM, $549mm equity) and Litigation Capital Management ($336mm AUM, $90mm equity). Burford deployed $398 million in H1 2021 alone, $277 million of which went into a single claim family. The average commitment size for single cases has increased from $8 million in 2009-2012 to $21 million in 2017-2021. While most of the players have to compete for smaller cases, Burford is going bigger and bigger. Burford’s larger capital base also gives them the ability to offer other solutions like monetizations in addition to simply funding legal fees, making clients that are after liquidity more likely to choose Burford as a financier. The move towards bigger engagements has been paying off, larger matters have produced even higher ROIC for Burford.

The nature of the business, which involves suing big companies, lends itself to pure plays like Burford as opposed to multi-strategy financial services firms like investment banks or private equity firms because they would inevitably end up financing lawsuits against companies with whom they have business relations with in other branches of their business. This makes it awkward for firms like Blackstone or Goldman Sachs to really embrace litigation finance. Imagine Goldman Sachs financing a lawsuit against Apple while simultaneously competing to advise them on an M&A deal or trying to get access to information for their sell-side research. Similarly, if Blackstone was working on a carve out with Unilever, it probably wouldn’t be conducive to the deal to fund a lawsuit against them at the same time or even to have done so in the past.

Finally, much like in any other asset class, talented investment managers can generate relative outperformance. Burford has the best people in the business and will continue to attract the best people in the business due to their market leadership. I encourage you to browse the LinkedIn profiles of some of their employees and see for yourself.

Deployments will likely continue to grow

The total addressable market for legal finance can be viewed through three areas of legal activity: i) a portion of the amount paid to law firms each year as legal fees, ii) the underlying asset value of claims, settlements, judgments and awards and iii) the value of assets affected by legal and regulatory processes (patents, IP, etc.). Each of these areas is of significant size and suggests that we’re at early stages of total market penetration.

According to Grand View Research, the size of the global legal services market was $850 billion in 2020 and is anticipated to reach close to $1.2 trillion by 2028, suggesting a 4.4% CAGR over the forecast period. Global Arbitration Review valued pending arbitration cases at the top thirty law firms at over $2 trillion in 2019. Not all of this can be captured by legal finance, but it shows how large the legal market is and how little of it is penetrated by legal finance today.

I’d also expect the emergence and growth of legal finance to further increase the size of the market by providing funding and liquidity for legal claims that otherwise would not have been pursued. The prevalence of legal finance as a corporate finance tool is still in its early days. As Burford and other firms build their brands and create value for clients, more and more corporations will look at their legal assets as a source of liquidity.

The elephant in the room #1: YPF

No Burford discussion is complete without mentioning YPF, fair value accounting and the Muddy Waters short report. From my experience they are the first points that come up when discussing the stock with anybody who has a cursory understanding of the company.

A couple of things to note about YPF – Burford’s investment in claims relating to the renationalization of YPF by Argentina. First, YPF has been a massive success already regardless of what happens from this point forward. From an initial investment of $45 million, Burford has realized cash proceeds of $236 million from selling 1/3 of its entitlement to damages to third parties. The remaining claim on the balance sheet is valued based on those sales at $775 million. However, the actual proceeds from the resolution of the case will not be that. It will either be $0 – in case of an adjudication loss – or as high as close to $6 billion on success, with the most reasonable estimates ranging from $2.25 billion to $5.6 billion.

“What is the chance of an adjudication win for Burford?” I’m not a lawyer and I’m not going to pretend that I’ve read all the case dockets, but there are some facts that lead me to believe that the case is more likely to go in Burford’s favor than not. First, YPF’s bylaws state that if Argentina were to reacquire a controlling stake in the company (after IPO’ing it on the NYSE in 1993) it would have to make a mandatory tender offer to the remaining shareholders at a fair price. Argentina disregarded this clause after expropriating a 51% controlling stake in YPF from Repsol in 2012. The bylaws are a binding contract enforceable against Argentina and YPF, which is likely one of the key reasons why Burford funded this case in the first place.

Second, New York has been successfully established as the proper jurisdiction for the case, which was a critical factor from the beginning. Many of the damaged investors are US based (remember, YPF is listed on the NYSE) and one of the plaintiffs is US hedge fund Eton Parks. Frankly, I find it hard to imagine that the New York Supreme Court would allow Argentina to damage US based investors without recourse. Fact discovery has recently concluded, and the claims are expected to go to trial in May 2022. The ultimate resolution, however, can take a couple more years, but ultimately there will be an adjudication in the not too distant future.  

“Fine, the case is more likely to go in Burford’s favor than not, but do YPF and Argentina even have the ability to pay damages that are in the $billions?” Personally I’m less concerned about that. There are firms that are specialized in recovering assets in these types of situations and Burford is one of them. Burford has its own asset recovery team that provides assistance to clients on global asset location and enforcement and uses global legal tactics and strategies to ultimately seize assets to satisfy judgments. And as we’ve learned from Elliott Capital seizing an Argentine navy ship over defaulted bonds, where there’s a will, there’s a way.    

And then there’s one more aspect to the YPF discussion, I hear some investors say, “Burford’s business is way too dependent on the outcome of big single cases like YPF”, but that’s really the beauty of the business; you’re betting on binary outcomes with huge asymmetric payouts, but you determine the pricing. If you lose, you don’t lose much, but if you win, you can win really big. It’s a feature of the business, not a bug.

The elephant in the room #2: Fair value accounting

Burford initially records assets at deployed cost until some objective litigation event (a trial, a judgment, an appeal, etc.) occurs that justifies changes in the fair value. As of H1 2021, 39% of the carrying value of capital provision assets on the balance sheet are held at cost. Another 32% of assets are held based on market transactions – that’s all YPF. For the remaining 29% of assets some litigation event has occurred that caused a fair value adjustment (up or down). However, less than a third of those 29% are unrealized gains. Said differently, the fair value portion of the carrying value of the entire capital provision assets is only 8%, if you exclude the YPF claims that are valued based on market transactions. Of the resolved claims, only 21% of the ultimate gains were reported before final resolution. Typically, only very small adjustments get recognized until about a year before a case is resolved.

Burford has invested substantially in its quantitative modeling and considers it a proprietary trade secret. The model has been predictive of actual recoveries within ten percentage points for past periods and provides a foundation for conservative and accurate prediction of future recoveries.

The elephant in the room #3: Muddy Waters short report

On August 7th, 2019, Muddy Waters released a short report on Burford. Even though the claims made by Muddy Waters have been largely refuted, the short report still comes up all the time and is probably still weighing on the stock price. Instead of giving you my summary, I encourage you to read the point by point response by Caro-Kann Capital. They refute all the key claims made by Muddy Waters. Burford has responded to the short report by further increasing its transparency towards investors.

Valuation

I believe that Burford is a valuable franchise that will continue to deploy more and more capital at attractive rates of return for a long time. Yet, at the current share price of $9.39, you’re arguably not paying anything for the value of the franchise and the future business. In fact, under rather reasonable assumptions, you’re paying less than what the current portfolio is worth in run-off mode.  

As of H1 2021, Burford had $1,052 million of deployed cost across legal assets excluding YPF. There’re another $424 million of definitive commitments of which 360 million will eventually be deployed in ongoing cases (historically only 85% of commitments are actually deployed because some cases settle before the entire commitment is deployed). Burford’s internal model, which has historically been accurate within ten percentage points of actual recoveries, projects $3,400 million of cash proceeds from the current portfolio, implying 141% ROIC. Again, this is without YPF.

YPF is currently recorded at $775 million on the balance sheet, but, if successful, will likely produce cash proceeds in excess of Burford’s entire enterprise value. The mid-point award estimate is ~$3,350 million. Thus, cash proceeds from the entire current portfolio, including YPF, could be $6,750 million or more against a current market cap of ~$2,000 million and ~$1,000 million of debt.

Now, you could run the current portfolio off at a fraction of current operating expenses and make a nice return on today’s share price but that’s not what’s going to happen in reality. Instead, Burford will redeploy the cash proceeds into new cases. If returns can be sustained at 141% ROIC, those $6,750 million will turn into ~16,300 million and ~16,300 million will turn into ~39,300 million and so on.

Obviously, there are some caveats to this. First, it would take time. The weighted average life of an investment (from capital deployment to recovery) is 2.3 years. However, the realization of the entire portfolio would likely take up to 7 years. In the meantime, you have to pay operating expenses, which would increase with the number of commitments and the size of the portfolio, reducing the amount of capital available to be redeployed. Though, I’ve also not taken the income from the asset management business into account, which at some point could be able to cover operating expenses; then all the proceeds from the balance sheet investments would accrue to the equity.

Second, the available opportunity set for capital deployments is limited. There’s simply not an unlimited amount of legal cases that have the asymmetric payout profile necessary to generate these types of returns. For the reasons mentioned in the TAM discussion I don’t think this is an immediate issue, but eventually, either i) returns will decrease once the company loosens its underwriting standards, or ii) capital will not entirely be redeployed, but instead returned to shareholders in the form of dividends and buybacks.

Finally, let’s look at a more conservative set of assumptions. Let’s say Burford’s model is wrong and the current portfolio will “only” generate returns that are in line with historical ROIC of 95%. In that case, the current portfolio is worth $1,700 million (excl. YPF). If we value YPF at fair value based on past market transactions of $775 million, the total current portfolio is worth $2,475 million. That’s still close to the entire enterprise value of the company today. Again, I think the true value is in the franchise and future business and you’re still not paying much for it even under these more conservative assumptions.

If the investment fails, what will have been the reason?

The YPF case is lost. As I’ve stated before, the YPF matters have already been a huge success for the company, even if they don’t see another dollar from it. The current non-YPF portfolio of assets could produce $3,400 million of cash proceeds alone – more than the entire current enterprise value. However, if the YPF case is adjudicated in favor of Argentina, the current carrying value of $775 million will have to be written down and the stock price will fall. The narrative that Burford is too dependent on single case outcomes will be confirmed in the eyes of the market.

The business doesn’t scale much further. Legal finance, at least as it is today, isn’t like private equity, where you can write larger and larger checks as your AUM grows without having to increase your headcount of well-compensated investment managers in the same way. Capital deployments in legal finance are inherently limited by the legal fees and future expected value of legal claims. In order to deploy more capital, you have to underwrite a larger volume of cases, which requires more highly trained and expensive people to do so. Burford has done a great job at creating economies of scale by finding larger cases and families of cases that can absorb increasing amounts of capital, but, ultimately, the size of claims – even at the higher end – is much more limiting than the size of companies (to draw the analogy to private equity again). This will especially be relevant as it relates to the capacity of the asset management business. For now, I believe that the asset management business will largely be limited to individual agreements that make economic sense for Burford, like the BOF-C fund – a joint venture with a sovereign wealth fund – where Burford contributes 1/3 of the capital and is entitled to 60% of the profits.

The business performs fundamentally but is not appreciated by the market. I could see a scenario where Burford is dead money for a while because the market doesn’t understand or appreciate the business, especially if YPF drags on for much longer than anticipated. However, If I’m correct about the direction of the main value drivers – capital deployments and return on invested capital – the compounding effect will be impossible for the market to ignore over time. In the meantime, you might need a lot of patience.   

Conclusion

Burford is a fantastic business trading at a cheap price. However, it’s not a great public market story. Results are lumpy and the accounting is somewhat difficult to grasp. The return asymmetry in binary outcomes is a feature of the business, not a bug; public market investors, by and large, don’t understand that, yet. If you’re able to be patient and focus on the business instead of the share price and the cash returns instead of the accounting noise, you should do quite well as a shareholder in the long run.

“Burford is not a business for those focused on short-term profits or for those who eschew volatility and seek predictability. Quarterly earnings are both irrelevant to understanding the value of our business and outside our control. We finance large, complex commercial claims. Our cash flows come from their resolution. There is no “normal” for such claims; they are inherently idiosyncratic. We have had cases resolve in less than a week, and we have matters from 2010 still going strong. That is the opportunity in our business, and it is why we are able to generate the returns we have historically delivered. If litigation were predictable as to outcome and duration, banks could finance it; there would be no need for Burford.

That does, however, create a difficult marriage between legal finance and the public markets. […] But we know that this private equity like approach can sit uneasily in a public-market environment where investors are inclined toward predictability and often take shorter-term views. We are confident in our course, and we will keep doing what we have been doing. We are voting with our own time and money – and so are Burford employees, who own almost 10% of our stock. Dozens of our people are also invested in our funds. We have low turnover and a strong cohort of people who want to work for us. Clearly our team has confidence in our eventual outcomes.” (FY 2019 Report)