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Burford Capital: Something Rotten In The State Of Litigation Finance

Founded and listed in 2009, Burford Capital comes across as an asset manager of a peculiar kind. Among the first to venture into these largely uncharted territories, the firm funds corporate litigations and class actions for a share of the damages.

Its business consists in appraising the odds and merits of complex legal cases, before picking those that offer the most compelling risk-reward profiles. In the process, it assembles a diversified portfolio of litigation investments, following an approach somewhat akin to the basket model used in venture capital, albeit with a much higher batting average.

Corporate clients do not always have the resources to pursue litigations, or may not be willing to ride the risks alone. Third-party funders provide a handy backing. The value proposition to investors is no less enticing. Litigation finance is a fast-growing industry perceived as uncorrelated to other asset classes, and thus far returns have been astounding.

Over the firm’s ten-years listing history, revenue grew 55-fold (from $7mil to $385mil expected in 2018) and profits grew 173-fold (from $1.5mil to $260mil), with only $990mil in capital raised — excluding the $1.6bn freshly secured and yet to be deployed. As a result, its share price shot up from £1 to £18.

The best is yet to come, management says, for the concept of third-party litigation funding picks up fast and leads to an explosion of demand worldwide. SumZero agrees, and advertises Burford as a “top stock for 2019”. In effect, its impressive performance notwithstanding, the firm is only valued at fifteen times forward earnings.

There may be valid reasons for that:

First, Burford’s fortunes are largely dependent upon the U.S. jurisdiction. Although last year brought a particular focus on Asia — as both Singapore and Hong Kong passed legislation to enable litigation finance for arbitration — it remains to be seen if the winning blueprint can be exported abroad, especially beyond the English-language common law jurisdictions.

Second, abnormally high returns never last forever in the asset management business. Burford’s returns are sure to attract competition, which may push down pricing and lead third-party funders to chase lower-quality bets in order to win or defend market share. More capital committed equals to more big trials needed, but there is a finite amount of litigations that courts and corporations can absorb.

Burford argues that scale matters. It is by far the largest player in its field, and it sports a competitive position supposedly shielded from new entrants by high barriers to entry and a first-mover advantage. In addition, significant capital is required to achieve an adequate level of portfolio diversification. Without a strong track record, good luck with courting investors.

Third, legal investments are carried on the balance sheet at “fair value” — that is, at a value assessed by management based on cost plus amounts “confidently” deemed recoverable. Anyone familiar with how courts work will point out that such estimates are inherently uncertain, for awards and settlements have a wide range of possible outcomes.

Fourth, even more hazardous are management’s incentives to report impressive numbers. An asset manager, after all, must show impeccable credentials if it wants to raise money. This may create a massive bias in estimates, however “confidently” thought through, if not an outright penchant for fraud. Thus far Burford’s valuation standards have been conservative, with less than 0.5% of write-ups turned into a loss — or so the firm claims.

Quality of earnings should nevertheless be subject to a healthy dose of caution. The secondary market, in which litigation assets get sold in pieces or in full to anonymous investors, looks ripe for shady transactions. Burford could sell a small piece of an asset for a ridiculously high valuation to a “friendly” third-party — perhaps an undisclosed affiliate — and, in the process, have the “fair value” of the remaining part carried on its balance sheet adjusted to an unreasonably high amount.

Fifth, the two concerns discussed above — hot capital and liberal accounting practices — may trigger stricter regulations on litigation finance. Supporters think third-party funding promotes better access to justice, while critics think it encourages undesirable lawsuits. Both perspectives have merit but one thing is certain: as the industry grows, the lawmaker will step in to prevent abuse.

Sixth — and that’s another elephant in the room — much of the recent profits were derived from two specific cases in Argentina: the Petersen case, in which a $17mil commitment was recently valued by third-party investors (who?) at $440mil; and the Teinver case, in which a $13mil commitment was ultimately sold into the secondary market (to whom?) for $107mil. Have those buyers really undertaken strict due diligence? Nobody knows.

Though spectacular, the performance of these exotic investments could prove difficult to replicate in the future. In a like manner, valuations would shrink if the secondary market happened to freeze or just cool down. As a tradable asset, legal investments are perhaps more correlated than advertised.

Finally, founders Chris Bogart, a former Time Warner general counsel and “technology investor”, and Jonathan Molot, a former Georgetown University law professor, have recently sold one-third of their holdings at a price of £13.5 per share.

Mr. Bogart declared that he and Mr. Molot unloaded their stakes “with some reluctance given our enthusiasm for the future of the business. However, given that we preach the benefit of a diversified portfolio strategy for Burford, it seemed imprudent for us not to create some liquidity after all this time.” He also added that they are “personally investing significantly in Burford’s investment funds”.

Which begs the question: are those funds a better bet than Burford’s stock, and are the founders’ interests truly aligned with shareholders’?

(No position.)

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