Making a market in disputes
I’m interested voluntary disclosure, the information that company management choose to reveal to shape a narrative, not the numbers that they are obliged to report by regulations. I think Burford, the litigation funder is a fascinating case study. First some context on litigation finance to understand what Burford does, then the story it’s trying to tell, including why last week’s announcement about an accounting change that reduces reported profits, and why it might be viewed as positive news:
Disputes in context
The size of the legal market is huge. The top 30 law firms have $2 trillion of pending arbitration claims; annual law firm fees are $860 billion globally (of which just over half is in the US). Both corporates and law firms expect the market to grow further as disputes rise following the pandemic, according to a research survey published by Ernst & Young.
One such dispute is the case between Tatiana Akhmedova and her son, Temur. The case erupted after Temur had conspired with his father to hide assets following his parents’ divorce. In April this year in London, a High Court Judge, Mr Justice Knowles ruled in favour of Tatiana. Temur was ordered to pay his mother £75 million. The court heard how Akhmedov senior transferred assets such as their superyacht, Luna (worth around £340 million) and an art collection (worth around £110 million) into the ownership of trusts in Liechtenstein in order to prevent his ex-wife receiving £453 million that she had been awarded following the couple’s divorce.
Burford Capital, a new type of law company that funds court cases, helped Tatiana recover these assets from her ex-husband and son. She (and Burford) reached a settlement with her ex husband and Burford received their cut (which was $103m) this July.
Disputes like this should be uncorrelated with other asset classes such as Government bonds or equities, which all respond to economic cycles. Indeed disputes tend to be unique in nature, and should be uncorrelated with each other. There’s little to suggest the pursuit of the Akhmedov yacht should be correlated with another of Burford’s claims – against the Argentinian Government over the expropriation of an oil company (YPF).
What are legal assets?
For industrial companies, property, plant or equipment make up the bulk of assets recorded on their balance sheet. But financial companies’ assets are more abstract, such as loans like mortgages or bonds, with the debt often secured on tangible assets like property. Companies like Burford take this one step further, and offer non recourse funding of legal claims in return for a share of the money recovered when the dispute is settled. This is inherently risky – court judgments can go against you, even if your lawyers believe you have a strong case.
If the claimant loses, they (and the litigation funder) receive nothing and may have to pick up the other side’s costs. Therium, an unlisted litigation finance company, has suffered a couple of high profile losses. One involved a drunken bet made in the Horse and Groom pub between Sports Direct owner Mike Ashley and banker Jeffrey Blue; Jeffery Blue lost and had to pick up Mike Ashley’s costs. Another was the case brought by Amanda Staveley against Barclays over the bank’s 2008 fundraising. Both cases highlight the risk in litigation finance: the outcome tends to be binary – either a large gain or zero.
Burford says that they lose just 10% of their cases. They win 29% of their cases in court, but the majority of cases, 61%, are settled before going to court. Burford doesn’t own the case, they provide the funding, so it is the plaintiff’s decision whether to settle out of court for less money, or go to court and receive a likely higher reward, but at the risk of losing, and receiving nothing.
Tatiana Akhmedova and her attempt to impound Luna reveals that litigation finance isn’t just about the judge ruling in a claimant’s favour. Defendants often hide assets overseas to evade court orders and some jurisdictions are friendlier than others. Imagine trying to enforce an English court’s award against a Russian oligarch in a Russian court. Asset tracing and recovery are therefore also integral to successful litigation finance.
Burford is the only major litigation funder to keep an asset tracing and recovery team in-house; most funders outsource this activity to firms run by ex-intelligence agents and private investigators. Christopher Bogart, Burford’s CEO, says: “Enforcing judgments is core both to the integrity of the legal system and the success of a litigation finance business. In some cases, scofflaws try to evade payment of court judgments and their obligations.” (I had to look up the word “scofflaws” but it is a word, meaning: a person who flouts the law, especially by failing to comply with a law that is difficult to enforce effectively.)
Sometimes asset recovery can lead down unusual paths. Harry Sargeant, a US billionaire, accused Daniel Hall, who works for Burford, of illegally accessing highly personal materials, stored on a corporate server belonging to the family business. Burford was trying to enforce a $29 million judgment against Sargeant and presumably Hall believed that this would be more likely if he had obtained a compromising video tape of the billionaire.
Returns
Common sense would suggest you don’t see high returns without any risk. At first glance the numbers look very attractive in a low yield environment. Burford reports that on $831 million worth of disputes that they have funded with their own balance sheet since 2009, they have generated a ROIC of 92% and an IRR of 30%. A competitor, Litigation Capital Management reports an even higher ROIC of 135% and an IRR of 78% over the last 9.5 years.
As you would expect, high returns attract new entrants. The Association of Litigation Funders lists 13 members, including Burford, Harbour, Vannin and Therium. Most firms remain confident that competition should not drive down returns, as this is a relationship based business, with law firms tending to recommend the funders who they have successfully worked with in the past.
That may be true, but it’s rare to find an industry where a large inflow of capital does not alter the economics of returns. Like banking and insurance, there will be several years’ time lag between new business written and rewards (or losses) reported. Litigation funders that are writing business based on optimistic return assumptions can do so for several years before the chickens come home to roost.
Accounting
A separate criticism of high reported ROICs, is that the returns are illusory and the sector has opaque accounting. It is important to understand that c. 100% ROICs that funders report is not comparable with the mid to high teens returns that companies like Unilever report. The litigation finance companies report the ROIC on a portfolio of completed cases and exclude i) cases where money has been invested, but have not yet settled and ii) allocating their group operating costs.
Importantly, Burford and its critics do not disagree on the numbers, but how the numbers are presented. By way of example, Burford’s 92% ROIC calculation is based on $831 million capital deployed in completed cases, from which they’ve recovered $1,597 million. Simple. Yet if we sum up all of the capital deployed using the table on page 45-46 of the 2020 FY Annual Report, the sum comes to $1.8 billion. The roughly $1 billion difference represents those cases that have yet to be completed. Should the “Invested Capital” denominator include all capital that has been invested, or just that from completed cases? I think that you can make the case for both calculations; what is important to understand is that the high ROIC figures reported by litigation finance companies are not comparable with what companies in other sectors report.
Burford has a market cap of $2.8 billion versus a total portfolio of $4.5 billion of disputes, though that contains both funds managed for third parties not on their balance sheet and cases that have been written up using Fair Value accounting. Critics have suggested that Burford is quick to write up gains with Fair Value accounting, but slow to recognise losses. Originally Burford management were not keen on Fair Value accounting, in 2010 they said:
“[We] believe strongly that litigation and arbitration returns are inherently speculative and are most appropriately accounted for by holding investments at cost until a cash realisation has occurred, as opposed to taking unrealised gains into income before a litigation resolution has occurred. Moreover, the appropriate metric, in our view, for Burford Capital’s share price measurement is its relationship to net asset value based solely on actual cash realisations. Thus, for the guidance of investors, we publish a cash NAV figure alongside the requisite IFRS-based NAV, and we encourage investors to consider the cash NAV as the appropriate valuation metric.”
Then something changed. In 2011 Annual Report, Burford stopped publishing cash NAV, claiming that:
“We have also historically published a “cash NAV”, but that measure has not been embraced by analysts and investors, and given the increased complexity in its computation following the Firstassist acquisition and the relatively modest and clearly identifiable unrealised gain in the portfolio, we do not intend to continue to use or publish it after this set of accounts.”
Study silence to learn the music
Voluntary disclosure – what companies choose to tell investors – rather than what they are required to reveal, is a fascinating area. And very often when companies change their mind and withdraw disclosure it’s even more significant, though harder to spot. When you walk around the City of London and see large cranes and a new building going up, it’s often hard to recall the building that previously stood in the space. Similarly, unless you are reading corporate results laid out with the previous year’s results in parallel, it’s hard to see what is no longer there. Or, as the Finnish Operatic Metal band Nightwish sang: I studied silence to learn the music.
Perhaps a coincidence, but around this time is when Selvyn Seidel, the co-founder who lived in the village of Burford, left the company. The other co-founder was the current CEO, Christopher Boggart, previously General Counsel for Time Warner and before that Cravath, Swaine & Moore.
Short selling attack
By October 2018, Burford’s share price had risen from its 100p 2009 IPO price to almost £20, and the company raised £192 million (or $251 million) at 1850p per share. Canaccord published a sell note in April 2019 and in August 2019, Carson Block of Muddy Waters led an attack on the company, calling it “a perfect storm for an accounting fiasco.” Block has made a name for himself shorting Chinese frauds: Orient Paper, Sino Forest, Luckin Coffee. He has been aggressive and he has been right. In his report he compared Burford’s accounting to Enron. Block also highlighted the fact that Christopher Boggart’s wife, Elizabeth O’Connell was the CFO, though she has since been replaced by Jim Kilman, formerly Burford’s investment banker at Morgan Stanley.
Muddy Waters can claim victory in their battle: Burford’s share price fell back below £3 in March 2020, helped by a broad sell off in markets due to the pandemic. Following the attack, Burford disclosed that they have written up the value of their court case against Argentina for expropriating the oil company YPF to $773 million. The firm’s rationale is that there is a secondary market in this large claim; they sold 39% of their interest in the proceeds of the YPF/Petersen claim for $236 million in cash in a series of third-party transactions from 2016 to 2019. Burford management says that Fair Value accounting requires them to write up the value of the asset.
Many twists and turns
Burford’s share price has now recovered to 880p at the end of August. Last week they made an intriguing announcement, management flagged an accounting change that will make the group loss making in H1. Burford management have decided to change their accounting policy, to accrue costs in line with the Fair Value gains which reduces profit after tax, to a H1 loss of $70m. The shares were initially down 8% on the morning of the RNS, before recovering most of the lost ground later in the day.
Burford doesn’t pay cash bonuses, or any other incentives, based on Fair Value accounting write ups (unlike Enron or banks pre credit crisis.) However when gains are realised the eligible employees are paid a “carry” based on the vintage (ie when disputes from a particular year are resolved.) This approach meant that assets were written up through the p&l, but no corresponding costs were recognised until the dispute was resolved and Burford received their money. Burford is now going to recognise costs earlier (which reduces profits in the short term). The change means $20m profit after tax swings to a $70m H1 2021 loss.
Management also said that they are considering changing to US GAAP (from IFRS) at the end of the year, which makes sense given the dual listing in New York and attempt to appeal to US investors.
The game that management are playing here is not to massage up numbers with accounting shennanigans. This change to accrual accounting increases costs in the near term and reduces profits. Instead, I think that this is an attempt to make themselves comparable to the likes of Blackstone, which accrues costs in line with Burford’s new accounting treatment and reports using US GAAP. The calculation that Burford’s management seem to be making is that a reduction in profits will be more than offset by an increase in the multiple investors are prepared to pay for accounting numbers that they can have greater confidence in.
Blackstone has a market cap of $87bn, trades on a forecast PER of 32x and a Price to Tangible NAV of 13x, which compares to Burford’s 10x PER and 1.5 P/ NAV.
A catalyst one way or the other is likely in 2022. The case against Argentina will be heard in New York, probably at the start of 2022. Lawyers with large value disputes are tenacious, many of their cases take years to come to judgment, with many twists and turns. The jury is still out.
The author owns shares in Burford.
A version of this piece first appeared in Marc Rubinstein’s substack newsletter. If you enjoyed reading this I do recommend signing up https://www.netinterest.co/p/litigation-finance
Image courtesy of Jonathan Borba at https://unsplash.com/
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