Burford Capital Stock: Small Losses, Large Profits (NYSE:BUR)

The following segment was excerpted from this fund letter.

Burford Capital (NYSE:BUR)

Burford Capital is a niche asset manager focused on litigation financing. Put simply, the company finances lawsuits in exchange for a portion of the payout if the lawsuit is successful. To be clear, I think the United States is overly litigious. Our investment in Burford is an attempt to profit from this system, not an endorsement of it. That said, Burford only profits when a claim is successful, and that dynamic incentivizes against funding frivolous lawsuits. With 158 full-time employees (including 60 lawyers on staff) and 8 offices worldwide, Burford finances commercial litigation where the case facts indicate positive expected returns on their deployed capital. (Note: They do not finance personal injury cases.)

The litigation finance model has some variations, but typically the financer (e.g., Burford) pays all the legal expenses. In the event of a loss, the financer loses their investment. If Burford’s client wins the case, the financer’s legal expenses are recovered first, and then the “profits” of the case are split, often 70% for the plaintiff and 30% for Burford. These splits may vary based on circumstances.

The return profile for Burford investments is asymmetric. When they lose, the losses are small. When they win, the profits can be quite large. Historically, 16% of deployments experienced losses, but when that occurred, Burford recovered 42% of deployed cost. The other 84% of deployments were profitable, with 13% generating ROICs >200%. It is likely that one case (YPF, to be discussed later) will ultimately return >100X than the amount deployed supporting the case. When historical returns are aggregated for both winners and losers, Burford’s investments have on average generated returns on invested capital in excess of 90% and annualized returns of approximately 30%.

There are several contributing factors to these elevated returns. As the largest litigation financer, Burford sees the most cases and often is the only funder to see a case, as lawyers and companies are reticent to reveal case details to too many parties. As the largest player, Burford has additional capabilities such as collection/enforcement, which improve collections of judgements awarded in their favor. Burford also has the best proprietary data on legal settlements, which informs their analysis of expected case outcomes and enhances case selectivity. In 2020, Burford funded just 4% of inbound inquiries.

Litigation finance exists, in part, because law firms are not well-suited to undertake large multi-year cases on a contingency basis. Law firms are typically organized as cash partnerships with profits paid out to current partners at the end of the year. Funding a multi-year lawsuit would require today’s partners to write a check out of their own pockets to fund a lawsuit that will benefit future years. As partners typically give up their equity when they leave or retire, they would be giving up the certainty of this year’s profits to fund lawsuits that may or may not be successful and from which they may or may not benefit, depending on if they are still at the firm at the time of harvesting. By partnering with Burford, a firm gets paid for its work in the current year in exchange for giving up some of the potential “upside” to Burford. Law firms like the litigation finance model because they don’t have to take risks and it generates business immediately.

There are also incentives for management teams to partner with Burford, even if the company has the resources to pursue a case on its own. Under GAAP accounting, legal expenses are expensed in the year incurred. Thus, pursuing a multi-year lawsuit means depressing short-term earnings in the pursuit of an uncertain future payout. Do you want to risk this year’s bonus to fund a multi-year lawsuit? Even if the company is successful in winning the case, management typically does not get “credit” for the earnings as investors view the wins as one-time in nature. To make this less theoretical, Sysco Corporation (SYY), a multi-national food distribution company with a market capitalization of $37B and historically >$1.5B cash generated from operations, partnered with Burford in litigation regarding price-fixing by its suppliers. Burford was introduced to Sysco by Boies Shiller Flexner, a very prominent law firm. Burford ultimately funded $140M in legal expenses, preserving short-term earnings for Sysco and keeping Boies Shiller Flexner lawyers quite busy. The case is atypical in that Sysco and Burford are now fighting, and that is how the funded amount has been disclosed. I don’t know how the case will be resolved but cite it as an example of management choosing litigation funding even though they clearly had the resources to pursue the case on their own.

Absent a change in how law firms are structured, or management teams are compensated, the legal finance opportunity appears quite durable. Burford has the best deal flow, much of it proprietary, as well as dedicated assets to improve returns and the best data. While it is likely that future returns on deployments will be worse than historical, Burford should be able to compound their capital at high rates while supplementing their growth with third-party capital. The compounding is aided by very low taxes due to being domiciled in Guernsey.

Under-Earning

COVID brought the closure of courts and a slowdown of the legal system, which in turn slowed liquidity events for Burford such as settlements and wins. As the effects of COVID dissipated, the court system has been slower in processing commercial litigation cases key to Burford’s results, prioritizing criminal cases in the reopening process. While there was no material change in the “win rates” of Burford cases, near-term earnings were impacted. In effect, Burford has been under-earning because of a backlogged court system. In March, the company gave an update that indicated that there should be a dramatic step-up in activity, stating that “2023 is off to a good start, with over 30 trials or final merits hearings scheduled, almost three times as many as actually occurred in 2022.” The first quarter also saw several realizations, including one case with $90M in proceeds, a verdict (which may be appealed) of $67M, and a successful appellate resolution that would produce approximately $40M in group‐wide proceeds (including to Burford’s non-consolidated private funds) and approximately $100M in Burford‐only proceeds.

Another form of under-earning stems from Burford’s asset management business and how those funds are structured. In most cases Burford funds are “on balance sheet” deployments using company capital. However, the company has also raised nine funds to manage $3.8B of outside capital. These funds use a “European Waterfall” payout structure whereby the investors recover all capital before Burford realizes fees. To date, Burford has not realized fees from these funds and thus has not reflected the economic reality of historical earnings. However, as the funds mature and enter the harvesting phase, Burford will realize the fees and earnings will step higher.

Burford’s earnings are quite lumpy and difficult to predict as they are impacted by the timing of case resolutions. A large win or unexpected delays can swing any quarter’s earnings significantly. Predicting annual earnings with a high level of precision is virtually impossible, however, for the core litigation funding business (excluding third-party fund management), we can look at the current portfolio and historical returns to get a range of possible outcomes. In round numbers, Burford currently has ~$1.4B invested in cases at cost. Historically they have generated an ROIC of ~88% over 13 years. Normalized earnings should be north of $1.20 per share and growing.

YPF Case

In 2012, Argentina expropriated the shares of an oil company, YPF, without compensating shareholders. Burford has been financing the lawsuits of two large former shareholders, Peterson and Eaton Park. Argentina has lost in five separate courts and even got to the U.S. Supreme Court, which refused to hear their case. On March 31, U.S. courts gave Burford another favorable ruling, stipulating many things, including that Argentina would have to pay damages in dollars instead of pesos. There are still important details to be worked out that will determine the magnitude of the win for Burford, but in round numbers, it looks like something between $10 and $25 per share (before any discounting/compromises to accelerate payments).

Given the current share price of less than $13 and the fact that the price rose less than $4 on the day of the YPF judgement, the market is heavily discounting Burford’s ability to collect. Argentina has a history of slow-paying legal judgements to foreign creditors, so this is logical. You may remember that one creditor seized an Argentinian warship in their pursuit of collecting amounts due from Argentina. There are two salient points to remember that may reduce the size of the discount one should apply. The first is that, if Argentina wants to appeal the ruling at this point, it will have to post a bond or enforcement can commence. A bond will make collection simpler for Burford if the ruling is upheld. The second is that Burford has an entire collection apparatus to facilitate enforcement of court judgements. The company’s CEO and Chairman each own close to $100M in stock, and Burford is by far their largest asset. As YPF is by far the largest asset within Burford, they are strongly incentivized to maximize recoveries and have had years to consider and plan for enforcement.

What is the appropriate discount to apply to YPF? Brazil’s 2030 bonds currently trade at 27 cents on the dollar or a whopping 73% discount. However, while Argentina has a long history of defaulting on its sovereign debts, it has a history of paying court-ordered debts. As Latam Advisors pointed out, “Since 2000, Argentine taxpayers have paid $17 billion in awards related to lost legal proceedings brought by defaulted bondholders and multinationals who saw their investments expropriated, their contracts terminated or illegally modified by the government. However, beneficiaries of court-ordered awards have consistently faced challenges to receive due payments as the government always puts up a good fight and delays settling with claimants.” (link). Given the history of eventual payment by Argentina, the collection ability of Burford, and the fact that any final award will accrue interest, a substantially smaller discount seems appropriate. I expect the parties will settle for a smaller than 50% discount to be paid out over several years, as it will take time for Burford to deploy the capital anyway. A 50% discount would imply $5-12.50 per share value for YPF.

Valuation

Burford is a company that GAAP accounting is ill-equipped to deal with. Their assets are legal cases that proceed on uncertain timelines with uncertain outcomes. How do you value an interest in a legal case? When do you mark the value of a case up or down? The company is working with the SEC on this issue now and has delayed filing their financial statements as a framework is solidified. This delay, in part, created a buying opportunity (in my opinion) as the stock declined ~15% on the news.

There are three major components of Burford’s valuation: the core litigation finance business, ownership of YPF claims, and a third-party asset management business. As discussed above, the YPF claims are:

Asset Management: Burford has been prioritizing investing balance sheet capital over third-party investments, but still raised $3.8B across nine private funds. In a March 2023 update, management estimated that the existing deployments within a portion of the managed funds should generate ~$500M in performance fees or ~$2.30 per share. These funds also generate management fees based on the specific fund terms and investment period and should generate $15M+ in revenue per year. I believe this business line alone should be worth $4+ per share.

Litigation Finance: The value of the core litigation finance business is highly dependent on the amount of deployments Burford makes, the ROIC of those deployments, and the average years it takes to receive recoveries from deployments. While the earnings will be lumpy, normalized earnings should be on the order of $1.20 per share and growing as the capital base grows and profits are reinvested. Applying a 10X multiple would imply the core origination business is worth approximately $12 per share.

YPF Claims: As discussed above, there is a wide range of potential values, but applying a 50% “collection” discount implies a range of $5-$12.50 per share.

Adding the asset management business ($4) + origination business ($12) + YPF ($5-12.50) gets you a range of $21-28.50 per share, with arguably sizeable discounts applied to all three businesses. Given the current share price of approximately $13 the risk-reward/remains favorable in my opinion.

A large part of investing is asking what can go wrong. In the case of Burford, laws could change that could impair their ability to finance lawsuits. However, there is another question that is not asked as often, what could go right? This is also an important question, and in the case of Burford, if Burford can continue to reinvest at high rates, they have a compounding machine – if you throw in the proceeds of a YPF into this machine and returns do not deteriorate rapidly, you can get earnings growth and multiple expansion. The upside would be substantial.