Description

At this point, litigation finance is something most people are likely familiar with due to the Muddy Waters/Burford situation in 2019. To date, almost all investment discussion regarding litigation funding has been surrounding Burford Capital - likely due to aforementioned short attack as well as Burford’s meteoric rise and subsequent leapfrog of all other litigation finance companies in terms of size. However, Burford’s public peers have largely been ignored - OBL, LCM, and MANO. I think among these peers, OBL has undergone a large transformation that has been overlooked and deserves a writeup of its own. For clarity, Omni Bridgeway (OBL) was formerly known as IMF Bentham. I will be referring to OBL subsequently as IMF as most dealings in this writeup were undertaken by the company while they were labeled IMF, not Omni Bridgeway. 

Burford was the first public litigation funder to switch to start raising third party funding, or rather buy into third party funding, via its acquisition of GKC in 2016. Subsequently, Burford’s ROE nearly doubled, which is no surprise. The third party funding model requires nearly zero additional capital and generates significant returns for the manager. Seeing the success of Burford and recognizing the market potential ahead, IMF started raising third party capital of their own in 2017. IMF has since launched 5 fund vehicles and purchased 2 along with Omni Bridgeway. They now have a balance sheet of just $150mm invested capital, and just over $1.5B in raised capital among the 7 funds. The effects of these funds will just start hitting IMF’s financials this year, as the average case duration is 2.6 years. I believe as the results start rolling in, IMF will be revalued much higher. 

I would like to put a disclaimer here before I go into detail about IMF. This thesis is not an attack on Burford. Burford is undoubtedly cheaper than IMF. I am not trying to undermine the quality of Burford. In fact, I own both companies. This thesis is simply trying to lay out an investment in IMF, as it seems to have been largely ignored by the investment community despite its attractive qualities compared to other litigation funders. 

Litigation Finance

Most people are probably familiar with litigation finance at this point, but I will still go into a bit about what IMF does and how it differs from the industry.

As is apparent from the name, litigation funding is a form of specialty finance wherein a third-party funder provides capital to a claimant or plaintiff covering attorneys’ fees and expenses during litigation in exchange for an agreed upon proportion of any economic recovery. So why does litigation funding exist and why is it attractive for the claimants/plaintiffs? There are multiple reasons here:

• Engaging a litigation finance company improves P&L for corporate clients - legal fees are treated as above-the-line expenses while recoveries are treated as exceptional below-the-line items. 

•  Some companies may not have the financial strength to pursue litigation. Along the same lines, some may have the financial strength, but find the potential recovery as highly unpredictable and would rather allocate capital to returns in their wheelhouse (capex, R&d, sales & marketing, etc…).

From the financier’s prospective, litigation funding is attractive due to the inherent risk/reward profile. In litigation finance, losses are obviously capped at -100%. Wins, however, can have upsides upwards of 500%, although are typically in the 100-200% range. This is where the big difference between IMF and peers begins to show itself. IMF typically focuses on single case pre-judgement funding. Burford typically focuses on pre-judgement portfolio deals. As common sense would dictate, portfolio deals generally have a lower ROIC but a higher hit rate than single case matters. So, one would assume Burford to have a higher success rate, but maybe a modestly lower ROIC over its lifetime portfolio. When you look at the track record, however, that isn’t the case. IMF has an astounding success rate of 90% while Burford is in the 66% range. Let me take a step back and to summarize the big picture here. IMF operates in an industry with a highly asymmetrical return profile (100-500+% upside, -100% downside), and has a 90% success rate on over 200 completed cases along their 19 year history. That is nothing short of incredible and should be lauded as such. Their impressive track record is likely due to IMF’s investment process, in which they only approve around 3-4% of cases that are brought before them. Among these cases, 80% are settled, 10% are won, and 10% are lost. Their success clearly lies in their ability to consistently fund cases that are successfully settled before they go to court. 

While we are on the topic of differences in the industry, I would be remiss if I didn’t bring up accounting. This was a source of major debate surrounding Muddy Waters’ short attack on Burford. Of the 4 publicly listed litigation funders, Burford and Manolete use fair value accounting while IMF and LCM carry their investments at cost. Among every other private litigation funder I’m aware of, all carry their investments at cost. I’m not going to say one is inherently right or wrong. What I will say is that for litigation financing, fair value accounting requires you to put trust in management as these investment portfolios are highly illiquid assets with debatable mark ups. With IMF’s accounting, investments are carried at cost until completion. This obviously makes it vastly easier to analyze the real revenue and profits of the company generated on completed cases, but has its downsides as well. It makes earnings incredibly volatile, as that is the nature of the industry (you have no clue when cases will come to completion). It is also very conservative, to the point where it likely hurts shareholders. Even after receiving positive judgements on cases, they wait until case completion to recognize gains on their investments. To IMF’s credit, however, they are incredible when it comes to disclosure. Any time there is a judgement in a case, there is an immediate press release detailing what the carrying cost of the investment was, and the income likely to be realized from the investment.

I would like it to be noted - I’m not intending to come across as negative on Burford Capital here. Burford has its own positive qualities as well, and is undoubtedly cheap (much cheaper than IMF currently). I am simply attempting to detail the positives as IMF, as the rest of the industry outside of Burford seems to have been ignored by much of the investing community. 

Track Record

I briefly touched on this in the previous section but I’d like to go further into detail here. It’s a bit difficult to do apples to apples comparisons as some companies don’t release their lifetime track record, investment portfolios aren’t of similar investments, etc… but I will do my best to compare them on an even playing field.

Unfortunately, LCM only releases their track record for the past 8 years, even though they’ve been operating since 1998 and have completed over 200 cases since inception. Their results are clearly best in class for the past 8 years, but they are operating on a much smaller scale than either IMF or Burford. The reason why I believe IMF to be a better investment than LCM is because of their early adoption of managing third-party capital. IMF has raised over $1.5B of third-party capital while LCM has only invested their balance sheet until now. They just recently raised $150mm in a third-party fund but are clearly behind IMF and Burford here. 

Also, LCM’s results may be best in class, but they have yet to prove they can do so on a meaningful scale. IMF has proven that they can generate returns at scale, and its results are barely behind LCM despite consistently deploying about 10x the capital. Further, it has the highest success rate in the industry despite focusing on single-case pre judgement. IMF has proven its ability to select cases bound for positive settlements at scale, and is obviously ahead of its competitors in this regard.

How has the business model changed since 2016

Pre-2016, IMF was an extremely inefficient business. It only invested capital from its own balance sheet. Despite having the ability to achieve 60% IRRs reinvesting its capital, it paid out most income in dividends. It was subscale, turning its 60% IRR at the case level into an average of 14% ROE since going public. Compare this to Burford, which has been earning ROEs in excess of 20% for the past 5 years despite case level IRRs of 32%. Perhaps not helping the matter, over the past 2 decades, it wasn’t out of the ordinary for IMF to have cash in excess of 25% of its equity sitting on its balance sheet.

All of this was caused by a management team that was clearly much too conservative and inefficient when it came to capital allocation. Since 2016, a myriad of changes have occurred:

• Largest change, pivoting to a third party capital model.

• IMF has increased its deployment of capital, and changed its balance sheet structure.

• IMF has adapted its equity based incentive plans to properly incentivize management. 

• Dividend is no longer prioritized. IMF paid zero dividends between the first half of 2018 and the end of fiscal year 2019. Instead, cash is reinvested into the business. 

I think most of these changes speak for themselves, but I’ll dig a little into the impact. First and foremost, the third party capital model. The clear positive here is that this allows IMF to generate additional income without any additional capital. Just some quick, back of the napkin math. For the 5 years before the transition, IMF deployed an average of $35mm capital annually with an expense base of about $10mm and an average tax rate of ~31%. On an average equity base of ~$80-90mm over those years with a 60% IRR, this results in an ROE of ~10%. In a hypothetical here, lets assume IMF then raises $1.5B of third party capital, and returns suffer a little as they scale. Expense base grows to $45mm (which it has), ROIC drops to 120% (which we’ve seen a dip in due to US investments), and duration increases to 3yrs from 2.6yrs. Using these assumptions (and IMF’s current equity), ROE jumps to 28%.

Second, the increase in the deployment of capital and the change to balance sheet structure. It is obvious that this was going to happen given the third party capital raised, but that is glossing over my point. The point here is that the days of 25% of IMF’s equity sitting on the balance sheet are gone. All cash will be reinvested into its funds alongside its third party capital. IMF even went as far as raising $75mm of low cost debt between 2016-2018 in order to scale its business. It is a no-brainer that the current balance sheet is much more efficient than IMF’s balance sheet pre-transition. 

The last point speaks for itself and requires no further discussion. The massive dividend payout ratio is no longer prioritized - instead, cash will be reinvested into the business via its funds aligning its interests with its LPs.    

Why now? 

I believe the business transition to be a good enough “Why now?” answer for me, but the story gets better than that. Excluding 2008-2012, IMF’s average ROE since coming public is about 8%. During 2008 to 2012, IMF’s average ROE was 28%. Economic crises are ripe for litigation financing, and covid has forced us into a similar situation. Given the ROE increases from 2008-2012 financing cases using balance sheet only, operating in a global economic/health crisis with a third-party capital model could see ROEs near triple digits. 

On top of this, IMF has two very large balance sheet investments in runoff that have been question marks hanging over the company for recent memory. These are the 2 W’s, Wivenhoe and Westgem. IMF recently announced that they received a positive ruling for Wivenhoe, in which the Supreme Court of NSW found the 3 defendants liable in negligence to IMF’s clients. 2 of the defendants have appealed, with hearings likely to occur in late 2020 or early 2021. IMF estimates future income to be in the range of A$120-150mm. This is a huge development not just because it was an overhang on the stock, but because this judgement will likely generate upwards of 10% of IMF’s market cap alone.

Further, a number of other recoveries this year, as well as successful judgements with the income yet to be recognized, mean that this year will result in a record level of revenue to be recognized. 

Industry Growth

AUM in the litigation funding space is likely to grow exponentially over the coming years. The market is currently extremely under-penetrated. Worldwide, there is only somewhere between $8-9B in third party AUM. Compare this to Burford’s estimation of the addressable market. There is $825B in total annual global legal fees. There is over $2T of pending arbitration cases at the top 30 firms worldwide. The median spending among large companies on IP litigation in 2019 was 4x what it was in 2015. There were $19B in total recoveries in antitrust class actions from 2013 to 2018. 

IMF gives a little less detail on what they think their total addressable market is, but they do provide the following:

- Australia and New Zealand

Total Estimated Annual Market Legal Spend = A$20.8B

Estimated Litigation Portion of Total Legal Spend = A$4.2B

- United States

Total Estimated Annual Market Legal Spend = A$471B

Estimated Litigation Portion of Total Legal Spend = A$170B

That is excluding Asia and Europe, where 7 of their 18 total global offices reside. It is clear that there is massive opportunity for expansion here.

So the opportunity for expansion is there, but that ignores the LP side of the equation. As an LP, litigation funding provides the opportunity to earn 20+% net returns which are uncorrelated to the market. Moreover, IMF’s ROEs nearly quadrupled in the previous financial crisis. Given the current economic climate, I believe this quality will be more sought after than ever before.

Funds, Agreements in place

Current funds have private equity-like fee structures. They are as follows:

Fund 1: US$167M, 25% funded by IMF

European Waterfall. Unknown management fee. 85% performance fee with investor preferred return hurdle. 

Funds 2&3: A$180M, 20% funded by IMF

European waterfall. 2% management fee. 80% performance fee with investor preferred return hurdle.

Fund 4: US$500M , 20% funded by IMF

American Waterfall. 2% management fee. 20-30% performance fee with 8% hurdle. 

Fund 5: US$500M, 20% funded by IMF

American Waterfall. 2% management fee. 20-30% performance fee with 8% hurdle.

Funds 6&7: €195M, 5% funded by IMF

Hybrid. Unknown management fee. 20-30% performance fee with 10% hurdle on merit investments. 100% performance fee on enforcement investments with 20% hurdle. 

It becomes quite apparent here that given the fee structures and IMF’s typical returns, these funds will result in massive ROIC on IMF’s capital. 

Valuation

I did a brief exercise in this above, but will get a little more in depth here. As stated above, all of IMF’s funds were created in the past 3 years, so results really haven’t started to hit the financials yet. The financials, for the most part, consist of the runoff of IMF’s balance sheet investments. However, using the above fee structures and making some assumptions about future returns, we can get an idea about what financials will look like. 

I think the best way to value this business is a pseudo-SOTP valuation, giving credit for the run off balance sheet investments while assigning an earnings multiple to the third-party fund fee stream. 

Assumptions:

ROIC decreases to 120% moving forward

Average Case Duration Increases to 3 years

Expense Base of $65mm

Tax rate of 31%

Total of ~A$1.9B AUM 

Total of ~A$400mm of IMF’s own capital, ~$1.5B of third-party capital

100% of committed capital is not deployed, due to the majority of pre-judgement single cases settling before forecasted budgets are hit. We can assume ~80% of capital will be deployed. 

Using these assumptions results in the following annual average fee earnings in 2021:

A$128mm Annual Gross Profit from IMF’s portion of funds

A$96mm Annual Gross Profit on performance fees

A$22mm Gross Profit on management fees

- A$65mm run rate expense base

- 31% tax rate

= A$125mm per year, or A$.50 per share. 

Run off balance sheet assumptions:

• There is currently A$335mm, or $1.34 per share in book value

• There are A$132.5mm in investments at cost on the balance sheet.

• I believe the best way to look at these investments are to 1) adjust for income yet to be recognized (which are either agreed in-principle settlements or successful judgements with income yet to be recognized) and 2) assign a NPV to the investments left.

• Income yet to be recognized this year stands at A$217mm, while marked at cost on balance sheet at about $50mm. 

• This brings book value to $2.01 per share (or A$502mm)

• About A$80mm investments at cost remaining on balance sheet, so a NPV of around $130mm. 

• This brings book value per share to A$2.22 (or A$554mm)

• Including contingent consideration for OBF of €32.5mm or ~A$55mm, brings value value per share to $2.00 (or A$500mm)

Bringing these together, you’re getting IMF’s fee earning stream for A$2.92 per share, which is a 5.8x multiple.

Omni Bridgeway Acquisition

While I don’t want to spend a large time focused on the Omni acquisition, it would be negligent of me to writeup IMF without acknowledging a fairly sizable acquisition that occurred in the past year. 

The max purchase price of Omni is split into 3 categories:

• Upfront cash consideration (€35mm)

• Deferred consideration (€20mm) over 3 years

• Deferred and contingent stock consideration (up to €32.5mm) over 5 years based upon performance milestones

What IMF is buying is both the Omni Bridgeway business along with the €150mm fund. The fund (and OB) is specialized in litigation, arbitration, and enforcement (post-judgement litigation) proceedings. OB has an outstanding track record over 30 yrs with >4x MOIC and >135% IRR over all closed cases. However, what makes this acquisition so attractive are the economics of the fund. On enforcement investments (which represent the majority of the portfolio), IMF is entitled to 100% of the profits over a  20% hurdle. Given OB’s average historical returns, it looks as if the €55mm purchase price (excluding the contingent consideration) is roughly in line with the value of this acquired fund. Looking at it this way, IMF is getting the OB business and any future fundraising for free. 

So why would the owners of OB agree to such a deal? Well, 60% of the consideration is in IMF stock. OB is aware of the rapid growth in the litigation finance industry as well as IMF’s rapid growth in step with its transition to a third-party fund model. I believe OB’s willingness to accept these terms to a deal shows exactly how OB views IMF’s future prospects. 

Risks

Major risks to the thesis include:

1. Immense capital pouring into the space, competing out returns for all players.

Counterpoint - More and more capital may be pouring into the space, but by every estimation, litigation finance is an extremely underpenetrated market. It is impossible to put a number on the total addressable market, but every attempt puts the market at many multiples of the size of IMF and Burford combined. The total estimated annual market legal spend FOR THE US ALONE is upwards of $400B. The TAM as a % of that total legal spend is a fairly low percentage, but that still gives IMF and Burford massive room to grow in the US market alone. 

2. As IMF and peers scale up significantly, they will be forced to raise their approval rate and take on cases with unfavorable risk/reward profiles. 

Counterpoint - this is a legitimate risk and should be monitored. I wouldn’t want to see IMF’s case approval rate move out of the 3-4% range. However, as IMF (and Burford as well) has scaled, awareness of the industry has grown. New funding applications have grown immensely, up 160% from 2015 (446 in FY2015 to 1126 in FY2020) while approval rate has remained steady in the 3-4% range. 

3. Investment concentration risk. Considering IMF is a pre-judgement single case litigation funder, it has historically taken on cases that could have meaningful downside for IMF. These include the two Ws still outstanding - Wivenhoe and Westgem. 

Counterpoint - As IMF has transitioned to a third-party fund model, concentration risk has declined significantly. Total ongoing investments have gone from 47 in 2015 to 305 currently. No single case can have a significant cash impact to IMF. As far as the 2 Ws go, which have always been cited as IMF’s concentration risk, Wivenhoe finally received a positive ruling, finding the 3 defendants liable in negligence to IMF’s client. The only large case remaining is Westgem, which only has a carrying cost of A$20mm. 

Catalyst

Results from third party fund model start to show themselves

Returns increase due to economic crisis stemming from covid