Burford Capital: business at a great price, free calling options

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Investment thesis

Burford Capital (BUR) is down around 65% from its 2018 highs, thanks to a combination of a short attack and COVID-19. Yet, at current prices, investors are paying liquidation value for a quality compound with a long track in an underpenetrated market. Plus, you get a free option on YPF (worth between $0 billion and $6 billion) and any future growth for free.

Burford Capital Shares
Data by YCharts

context

Burford Capital is the world’s largest funder of litigation assets. It was founded in 2009 by Chris Bogart and Jon Molot (together they own around 8% of the outstanding shares). It currently has $4.8 billion in assets under management, which includes managed funds ($2.6 billion across 7 funds) and its own balance sheet.

Since inception, Burford has generated $1,738 million in cash proceeds on $893 million in capital deployed (95% return on invested capital (ROIC). In total, Burford has deployed more than $3 billion in claims legal and obtained an IRR of 30% on the investments made.

Burford Capital - Legal Funding Lifecycle

Presentation of the first half of 2021 of Burford Capital Investor

The weighted average life (WAL) of an investment is approximately 2.3 years and has generated a multiple on capital of 1.9x. The typical investment size is around $20 million (which has more than doubled since ~2010).

Burford Capital - Weighted average life of assets entered into since inception

Burford Capital 2021 Half Year Report

Burford’s enterprise value today is approximately $3 billion ($9.50/share) (~$2 billion in equity and ~$1 billion in debt).

Litigation Finance 101

Litigation funding essentially involves a third party (eg Burford) funding legal claims. They pay expenses and legal fees in exchange for a portion of the ultimate rewards. Reimbursement of funding is subject to a successful outcome.

The size of the litigation funding market appears to be quite underutilized. Grand View Research estimates that the global legal services market is ~$850 billion and growing at around 4.4% per year. Recall that Burford’s lifetime deployments were approximately $3 billion.

Wind-up valuation

As of mid-2021, Burford had $1.05 billion invested in various legal assets (excluding YPF, more information below) and approximately $1 billion in unfunded commitments.

Assuming approximately $1.75 billion (75% of unfunded commitments) is eventually deployed and Burford decides to put the portfolio into liquidation (which we expect will take approximately 7 years). Operating costs have ranged from $9 million to $91 million, so let’s just assume $50 million per year.

Using 1.9x as the historical investment multiple, we get that the $1.75 billion will be worth $3.325 billion. Subtract operating costs from $350 million, we get an estimated liquidation value of around $2.975 billion or roughly where Burford trades today.

Liquidation valuation + YPF

YPF is Burford’s largest asset. YPF is Argentina’s largest integrated oil and gas company. As for the legal demand, as indicated on its site:

When the Petersen Group bought shares in Argentine government-controlled energy company YPF in an initial public offering, it was promised that if the energy company was renationalised, Argentina would pay fair value to shareholders.

When Argentina ignored this promise and expropriated a majority stake in the energy company, the share value fell sharply, causing the insolvency of Petersen, the largest minority shareholder.

Yet YPF has already been a success. Burford invested $45 million in total and sold 38.75% of its rights for cash proceeds of $236 million; the rest is held on its balance sheet at $775 million. The case payout will be $0 or up to $6 billion (the median estimate is around $3.35 billion). In other words, the $775 million on the balance sheet implies that Burford sees a 23% chance of success.

To sum up, at current valuations, you’re essentially paying Burford’s liquidation value and getting everything else for free, which includes:

  1. The YPF claims as a free option (potentially worth Burford’s enterprise value or more)
  2. Ongoing business operations, future growth, and revenue streams from funds raised are also added for free.

Risks

  1. Fair value report: In 2019, Muddy Water launched a short attack on Burford, claiming that (among other things) Burford’s use of fair value accounting is questionable. Burford initially records deployed assets at cost, but changes the value if an objective event (lawsuit, judgment, etc.) warrants a change in fair value. Burford has invested in its quantitative modeling capability to predict actual recoveries and has been accurate to less than 10% for past recoveries.

2. Summary report on muddy water:

We’re running out of BUR because it’s a bad deal masquerading as a great one.

– BUR woos investors with non-IFRS metrics, especially IRR and ROIC. However, these measures make no sense. They are heavily manipulated and greatly mislead investors about the actual returns of BUR.

– We have identified seven techniques by which BUR manipulates its metrics to create what we believe to be an extremely misleading picture of its returns on investment. These manipulations usually involve BUR taking credit for a recovery when it is uncertain (or even highly unlikely) or ignoring cases that are likely to be failures.

Manipulation techniques include: 1) classifying a loss as a win, 2) counting rewards or settlements as “recoveries” with uncertain to highly unlikely recoveries as equivalent to cash returns when calculating IRR, 3) misrepresenting the investments BUR inherited from acquisitions as a favorable IRR, 4) choosing its own cost denominator in a case with a recovery when the total cost is much higher, 5) delaying recognition of a loss trial for two years, 6) keeping trial losses out of the “Concluded Investment” category, and 7) failing to deduct various costs from recoveries, including the very operating expenses associated with the investments themselves. *

– The BUR appears financially fragile. In our view, BUR’s operating expenses, funding costs, debt and funding commitments place it at high risk of a liquidity shortage. BUR is probably already insolvent.

In response to the short report, Artem Fokin of Caro-Kann Capital published a 68-page article titled rebuttal, “Muddy Waters dreams of a black cat that just isn’t there”. I would recommend readers to go there.

Additionally, Burford has responded to the Muddy Waters report by increasing its transparency to investors.

3. Competition –> Reduced returns: If Burford earns such high returns on capital, then it would make sense that there would be increased competition that would lease at lower returns. Yet over the past 10 years, Burford has shown no signs of declining yields and is in fact higher (despite capital increases flowing into legal finance). Additionally, as the most important player, Burford enjoys scale; with a larger AUM, Buford can tackle the larger cases and leave the smaller ones behind. It also benefits from the fact that the best talent would be attracted to the best in the field (eg Goldman, Blackstone), which further perpetuates the virtuous circle.

Catalysts

  1. Successful resolution of YPF: quite simple as it would remove the stigma around Burford and YPF could potentially be worth multiples of its enterprise value
  2. Ongoing deployments of Capital + Growth: Burford will continue to grow and deploy capital. Eventually the market will realize that YPF does not define Burford and therefore is not a binary bet on YPF.
  3. Better understanding of the underlying business model: Burford is still a fairly small company (market cap around $2 billion). As more and more investors understand the underlying business model and realize how little they are paying for the company at these prices…

Conclusion

Burford Capital is unique and operates in a niche segment. As a result, it is very misunderstood. With a current enterprise value of $3 billion, investors pay only the liquidation value and get the YPF option (worth $0-6 billion) + future growth for free.

Based on the analysis above, I recommend going long on BUR.

Further reading

  1. Capital of Burford is by far the most undervalued company I know
  2. Emeth Value Capital Letter S2 2021
  3. Burford: a quality compounder trading at liquidation value
  4. Caro Kann: Burford: Investing in the Blackstone of Litigation Funding
  5. Capital of Burford Presentation to investors of the first half of 2021


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