Revisiting Burford

In what seems like ages ago now Fintwit darling, Burford Capital, was flamboyantly attacked by Muddy Waters. The prominent short seller claimed that Burford “misleadingly boosted its IRR numbers”, rendering ROIC and IRR metrics “meaningless”; misled investors through the “egregiousness of its fair value accounting”; and was “arguably insolvent”, raising outside capital as a matter of survival rather than growth. These charges followed on the heels of a Canaccord Genuity analysis from Apr ‘19 that found Burford’s reported ROIC “confusing and significantly above reality”.

I explored these allegations in parts 2 and 3 of my Burford series (please read if you are unfamiliar with this saga). A black box finco in a novel asset class that employed mark-to-model accounting and required external financing to meet the growth expectations priced into its premium valuation (3x book value), Burford was primed to crack under MW’s assault, whether the latter’s substantive claims were valid or not. And sure enough, its market cap collapsed by nearly 60% over the next few months. Since then, Burford has grown tangible book value by 76% and addressed the optically concerning governance issues raised by short sellers – hiring a new CFO (one that wasn’t married to CEO), listing on the NYSE (a venue with more demanding reporting requirements than the London AIM), and overhauling the Board (replacing directors who had served for more than 9 years and were, according to the UK Corporate Governance code, no longer deemed “independent”). Yet, the stock remains nearly 40% off its 2018 highs.

But let’s back it up a bit for those who are new to the story. Why does Burford even exist?

Well, imagine you are General Counsel of a F1000 company and want to sue a competitor for violating your company’s intellectual property. While you have strong case, litigation is an inherently speculative undertaking. You don’t know whether the defendant will settle or fight and, in the latter case, whether a judge or jury will rule in your favor or even how long it will take for them to do so. Rather than run ongoing litigation expenses through the income statement, crimping the reported earnings that investors capitalize, in return for an uncertain payoff, which investors dismiss as a one-time event, you would much prefer the law firm you’ve hired to work on contingency, bearing the expense of litigation and sharing the spoils of a successful outcome. But the law firm, culturally and financially ill-suited to assume such risk, prefers the assurance of hourly fees.

This is where a commercial litigation funder like Burford steps in. Burford will commit to paying the law firm’s fees up to a certain amount and in turn take a percentage of any resulting settlement or damages paid. The F1000 client gets a free option on litigation; the law firm gets fixed hourly fees to pursue damages even as it serves the client on a contingent fee basis; and Burford, who pays fixed hourly fees to the law firm or corporate client¹, gets a piece of any resulting payoff. Most of the value of Burford’s litigation assets (aka “Capital Provision Assets”, the fair value of funded legal claims) are tied up in portfolio deals, where multiple cases are funded for a single client, each individually vetted for inclusion in the portfolio, each cross-collateralized by the others.

The “core legal finance” arrangement that I’ve just described, where a litigation funder covers the legal fees and keeps a piece of the settlement or adjudicated rewards, accounts for the vast majority of Burford’s deployed capital. About 75% of each new deal is funded by Burford’s balance sheet; the remaining 25% by Burford Opportunity Fund C LP (BOF-C), a fund through which an unnamed sovereign wealth fund co-invests alongside Burford.

Two other lower-returning alternative strategies are funded through various funds managed by Burford:

a) “lower risk legal finance” is like Burford’s bread-and-butter “core legal finance”, except with lower risk and lower returns (12% to 20% returns compared to the 20%+). 80% of these assets are originated by the Advantage Fund², in which Burford is also an investor; the remaining 20% by Burford directly.

b) “post-settlement finance”, where 3 private funds (COLP, BAIF and BAIF II, or “other funds”) pay clients for legal claims that have already settled but whose payout may be delayed or distributed over time. So, a law firm on a contingent fee arrangement is owed a $100 settlement that won’t roll in for another 6 months, but they need cash now to pay partners. Burford gives the law firm $100 minus some discount and claims the settlement receivable for itself. As low risk assets, post-settlement claims are expected to return less than 12%. None of these are originated by Burford directly.

Burford’s asset management business reported $3.4bn of AUM across 11 funds at the end of 2023, roughly equivalent to the $3.4bn of litigation assets that Burford funded directly. But while the asset management AUM is roughly equivalent to Burford’s self-funded claims assets, its financial significance to Burford shareholders is far smaller. You should expect the hedge fund-like management and performance fees that Burford clips on its managed funds, which hold lower returning assets, to be but a fraction of the realized and unrealized gains on the high-return claims that its keeps on balance sheet. For instance, across the last 2 fiscal years, Burford reported $120mn of asset management income, 86% of that from BOF-C, compared to $1.1bn of realized gains and fair value adjustments on its on-balance sheet holdings.

Realized gains and FV adjustments are wildly volatile from one period to the next, reliant as they are on the timing of settlements and court rulings. Nevertheless, the point stands: the returns that Burford realizes on its self-funded litigation claims³ is by far the dominant driver of shareholder value, so that is where I will focus my attention for the remainder of this post. I think some investors were hoping that Burford would eventually come to resemble a capital light asset manager. But with AUM growing by just 6% since 2018 and Burford keeping an ever greater share of the highest octane deals for itself, there are few signs that things are evolving this way.

The market potential for legal finance is enormous and the bit of it that Burford has captured up to now has produced impressive returns on capital. Whether they can sustain those returns is another matter, assuming you even trust the reported results in the first place. A reasonable investor can harbor doubts and the point of this writeup is not to rationalize them away. I personally don’t think Burford is as amazing a business as bulls pitch it to be. That said, I do think there are credible retorts to common bear arguments. Let’s go through them.