Value Investors Club / Burford (BUR)

Description

Burford Capital

Burford has been posted twice previously on VIC. It also has a long discussion following the Muddy

Waters short report in August 2019. Both memos do a very good job at explaining the business, and I

highly recommend reading them to understand the industry. This memo will focus on how I think about

the business, and how it could potentially be a 10x.

Burford is a litigation finance company with ~110 employees including ~55 lawyers. Litigation finance is

the funding of litigation cases. Most law firms would rather charge an hourly fee, as opposed to a

partner working on contingency on a big case for 5 years and losing the case. Burford’s 10-year track

record is 32% IRR (unlevered and before business expenses). Burford is the largest litigation finance

company in the world. There are mainly two ways Burford makes money: 1) Investing through their own

balance sheet, and 2) investing third-party AUM.

To understand Burford, you need to understand what litigation finance is. The first thing you must

understand is this: A claim is an asset. Let’s say you’ve been harmed by a large corporation and you have

a claim where if you win in court, you win $50M. That is an asset, and its value is dependent on the odds

of winning the case and collecting, factoring legal fees and time value of money. Most lawyers will

charge you by the hour, but let’s say you don’t have money for the legal expenses. Then you need to

find a law firm that will either charge a contingency fee, or a litigation finance firm to pay for your

expenses. Most law firms strongly dislike charging contingency fee. There is career risk and they may not

be able to diversify enough cases. Let’s say you find a law firm that you like, they will not do contingency

fee, but they use Burford to finance the case. Burford assesses the case and figures out the odds of

winning, the time it will take to resolve and other factors. Over ten years Burford has returned a 32% IRR

in its cases. The important part here is that if Burford purchases that claim, they have exchanged cash

(an asset) for a claim (another asset), with the obvious expectation that the claim will be worth more via

a settlement or adjudication.

From out perspective, Burford is an investment firm that invests in cases and has had great judgment to

have a great track record and become the largest and most important litigation funding firm.

Burford traded above 2,000 pence 2 years ago, and after a short-sell report by Muddy Waters the stock

cratered below 500 pence. A month after clarifying the short report Burford traded at a higher level

than it trades today. As a reference, the bonds did fall to 60 and have all recovered above 95. There are

a lot of comments on previous pitches that are relevant.

My investment thesis is that Burford is a name where you can make 10x your investment in if matters go

well for the company and they simple continue to do what they have done since inception, and it will be

difficult to lose money due to the margin of safety embedded in this company.

Let’s quickly discuss muddy waters. In its research it mentions three main topics:

-Burford cannot be trusted since it trades on AIM

-Burford CEO/CFO are married

-Burford uses Level 3 accounting and can mark up its investments and therefore create its own earnings.

All of this was supposedly well-known. In the write-up they call Burford’s liquidity in question and

whether it is an Enron because it uses level 3 accounting (actually quite common). Regardless, over a

year has passed, and Burford now trades on NYSE, there is a new CFO in place, and we have historical

detail of level 3 write ups and write downs, and in fact, based on historical mark to market, Burford has

been too conservative on its write ups, meaning that its book value lags its real economic value (again,

at least from a historical perspective). I believe there is nothing material on that short pitch by Muddy

Waters that holds any importance. In addition, I think the business is in much better shape, with a

stronger corporate governance, and is more valuable today than it was at 2,000 pence. As a reference,

outside of the Petersen case there is only about $38m of unrealized gain, representing only ~2% of book

value.

I think it would be most helpful for other VIC members for me how I analyze Burford’s business.

Burford is similar to my own business, which may be similar to other members that manage a fund. I run

a fund and I also invest my own money. To make things simple assume I own $10 million in the fund and

that I manage $100 million. My personal balance sheet has an equity of $10 million; however, does that

mean I would sell the fund business AND my 10 million for only 10 million? Of course not. Yet many

analysts and sell side value the company with a P/B multiple. When you do this, you ascribe zero value

to the third-party AUM.

This is just the start of it: as a fund manager I collect 20% performance fee, but that is not how Burford

collects its fee in several of their funds; they have what is called the European waterfall, which means

that the investor collects their investment first before Burford books a profit. This means that if Burford

manages $500m of fresh capital and deploys $100m in 5 cases, and that assuming that after a year one

of them is a 5x, the $400m (gain) is NOT recorded as a gain with $100m of profit. However, if the next

case is resolved for $200m, now Burford is entitled to $40m (even if the gain on that particular case was

$100m, note that the revenue accounted is not $20m, it is $40m because the original investment has

already been passed). Currently, Burford has been winning cases in several funds that have not booked

any profits, yet.

Returning to how you calculate your net worth as the fund manager: imagine not collecting your

performance fee until you have doubled your investors’ money?!

The issues do not stop there: what investors have ignored is that these guys have a phenomenal talent.

They are the very best of the industry. They have a team of 10s. Chris Bogart and Jonathan Molot are

the best at this game. Why is this important? Because for the past 11 years they’ve invested capital at an

unlevered return of 32%, and are the thought leaders of the industry. This is important because unlike

the stock market, legal decisions are broadly not correlated with one another, so Burford uses ~30%

margin, resulting in earnings growth of ~50% CAGR. And this is not including the third-party AUM!! As a

reference, Burford’s latest fund (with a Sovereign Wealth Fund) charges effectively 1% of AUM and 40%

of incentive fees. You can do that when you generate 20%+ returns that are not correlated to the

market. Management has told us that going forward they will move from 2 and 20 to a structure more

similar to the SWF.

Let’s return to my original question: how much is my capital and fund worth if it comes with $10m of

equity and $100m of AUM, with some profits realized, but not recognized, and your returns are so good

that you are able to charge over 2 and 20? I think if you think about the business this way, you need to

think about two components: 1) what is the rate of return on my investments? 2) how quickly can you

scale up AUM? I don’t have the answers to those questions. We know what they have done in the past.

Burford just entered the third-party asset management business ~five years ago.

This is why a P/B multiple is highly misleading, though you can be a shareholder today at a 1.2x P/B

multiple. You have an opportunity to own a piece of a fund that has been growing earnings at 50% for

over a decade, and the third-party AUM business that has not produced and material earnings, and you

are buying the firm at a ~7-10x earnings, (excluding Petersen). Mathematically, I understand if you buy a

financial that has an ROE of 10% and you buy it at a 1x p/b, but that is not the case here.

Using sum of the part analysis is tricky here. We can say that given the odds of a win, settlement or loss,

Petersen is worth about $2b, and we can figure out the value of Burford’s funds are, let’s say a 20x

multiple… and then how much for the third-party AUM? One thing that is important here is that no

matter what value you use to the third-party AUM, the profits realized from that will be part of

Burford’s capital and then invested at (hopefully) ~30% unlevered. When you build a model 10 years

out, you can see that the third-party AUM business worth is in the billions.

Petersen Update: Petersen is Burford’s largest single case and asset.

Burford has two investment in claims relating to Argentina’s renationalization of YPF:

In the first case, Burford invested $18.4M in the Petersen claims, which include ~100 million YPF shares

prior to renationalization, and it is entitled to roughly 60% of proceeds net of expenses. Burford has

already sold ~39% of the entitlement of these claims to other investors for proceeds of $236M.

In the second case, Burford invested $26M in the “Eton Park claims” from the hedge fund that shut

down in 2016. The claims include 12 million YPF shares prior to renationalization. Burford is entitled to

approximately 75% of the proceeds recovered from the Eton Park claims. Burford retains 100% of its net

interest in this matter.

Petersen was the largest minority shareholder in YPF, a US-listed public company. Argentina

expropriated the company. Argentina has tried to avoid US courts using Forum non conveniens motion.

They failed to do so as the U.S. Supreme Court rejected appeals from Argentina and it state-run oil

producer. For more information about the case click here.

Our view in this matter is that clearly Argentina egregiously breached a contractual promise to the

minority shareholders. One of the interesting aspects of the Petersen case is that when it listed in the

NYSE investors were afraid of expropriation from Argentina, therefore specific bylaws were drafted that

state what exactly would happen if Argentina takes possession of YPF. The bylaws state 4 cases and that

it is the highest price of any case which will determine the value of Petersen’s award. Assuming Burford

wins they could earn $4.5 billion, which would mean the stock should be up ~150%+ just from this case.

As a reminder, Burford has booked gains for Petersen, because the claim trades in a secondary market,

of ~$734m and roughly another $38m for unrealized gains. If Burford were to lose Petersen it would be

a non-cash event.

It has been 5 years that Argentina and YPF have delayed the Petersen case, but the pre-trial process is

underway. The case is being heard in the New York Southern District with the Republican appointed

judge Loretta Prezka. She has previously ruled favorably in the Repsol (YPF related) case and in favor of hold out funds

against Argentina. I have a hard time a US judge being ok with a country allowing expropriation, and

hurting American investors / American companies listed in the US, and creating a precedent. We expect

one year to conclude the trial, and potentially one more year of appeal.

One thing I think it is important that other write ups is that in order to get more comfortable with

investing in Burford is understanding the dynamic from committing the capital, to deployment, and the

process of settlement or adjudication win or loss. I’ve found management to be very helpful and patient

about explaining their business model. I think the slide below is pretty helpful. You can see that Burford

illustrates how often they’re profitable. Burford’s slides are very helpful, though some charts are not

immediately intuitive.

Risks: There are three main risks. 1) Petersen, a very successful case, potentially represents 25% of the

balance sheet. If Burford wins the case, it could be up to a $4.5B award, but a loss could mean a zero.

2) Burford investment returns could simply be not as good as their historical performance

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Potential Petersen update. Cases are expected to be slow during Covid due to the court system. As a result of covid the amount of business legal disputes should increase significantly and be a huge tailwind.

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			2021	2022
Price:	9.40	EPS	1	0
Shares Out. (in M):	220	P/E	9	0
Market Cap (in $M):	2,050	P/FCF	0	0
Net Debt (in $M):	500	EBIT	0	0
TEV (in $M):	2,550	TEV/EBIT	0	0