We believe Burford Capital is one of the most misunderstood, high-quality businesses we’ve come across over the last few years. Last week we interviewed the cofounder and CEO of Burford to share insights into the realities of investing in litigation assets.
On the surface, Burford is like any other capital provision business: invest $1 in an underlying asset and receive a cash return on the $1 in the future. It can be compared to VC or PE where the underlying asset is a commercial litigation case instead of a corporate entity. However, there are unique characteristics of litigation assets that make the return profile particularly interesting relative to other alternative asset classes.
The first unique characteristic of investing in litigation is the uncorrelated return profile. Litigation isn’t at the mercy of wider economic performance or the cyclical flows of capital. For example, the underlying litigation of an antitrust or arbitration case has little relation to capital markets. This is particularly attractive to LP’s looking to diversify a portfolio of traditional alternatives.
Secondly, unlike venture or PE, there is a natural exit for litigation investments. A case is either settled before or adjudicated in court. Burford doesn’t need to force a liquidity event by selling the asset. The litigation process provides an automatic exit.
This natural exit makes for a shorter investment period. Burford’s average case duration is ~2 years relative to a 5-7 year holding period in other alts. Around 60% of Burford’s cases are settled before adjudication because it reduces the risk for both parties. Litigation is a process for opposing parties to better understand their relative positions in a case. As more information is presented, both sides better understand the risk each is taking. Therefore, there is a strong incentive for both parties to reach a settlement to prevent a riskier, binary outcome in court. Bogart explains:
the catalyst for settlement is often seeing the progression of the case and coming closer to a trial or an adjudication result. Generally, as a defendant, if you are unsuccessful along the way in getting a case knocked out or doing something tactical to limit its value, you are now exposed to meaningful risk so you negotiate a resolution as opposed to throwing yourself in the hands of a judge or jury. The timing means you will realistically settle most cases before walking into the court room for trial.
The fact most cases settle before court is a major reason why the return profile is so attractive. Burford has deployed over $500m in cases that settled in ~1.6 years. The historical IRR of settled cases is 31%. So Burford earns a 31% return on assets that have a reduced risk profile. Cases start off as a binary asset, but as new information arrives, both parties adapt their position to reduce the risk of a court judgement.
This is very different to the return profile of VC where ~50% of the book returns the cost of capital and ~10% are home runs that drive the IRR. As an alternative asset manager, Burford has a higher average IRR per investment and less need for home runs like a venture fund or high leverage like private equity.
Historically, ~40% of Burford’s cases have been decided in court: 10% lost and 30% won. But here is where the asymmetric return lies. If Burford loses a case, it loses all the capital invested in legal fees. When Burford wins, the return is a percentage of the ultimate damages of the case plus the original capital invested. This provides significant asymmetric upside risk. When you layer this favourable asymmetric dynamic on top of the 31% IRR from settled cases, Burford generates attractive unlevered returns.
So how sustainable is the 30% IRR? Bogart’s answer was interesting:
If a client brings us a single high-risk case, we will charge considerably more for the capital than a client who brings us a 10-case portfolio which significantly mitigates the risk. The solution with clients is not to end up in a downward spiraling approach to pricing, but to enlarge the market instead. If Time Warner are willing to bear some of the tail risk across a 10-case portfolio, I can get the same net returns on capital and offer them a lower headline number. That point is not well understood. This capital is expensive because of the binary risk element which, if reduced, I can keep the same net returns while reducing gross price.
Litigation cases are binary assets. Over the last 50 years, US contingency lawyers have been pricing single case litigation risk and the premium has hardly changed. However, as Chris explains, what will change is how clients approach litigation. Instead of litigating one case, clients will group all litigation into a portfolio for a lower nominal cost of capital. A portfolio of cases has lower tail risk because multiple underlying litigation cases are effectively cross-collatarized and the client shares the risk. A higher proportion of case portfolios could arguably reduce aggregate IRR’s slightly but the total size of the market will also increase. Either way, Burford aims to price cases so the total risk-adjusted return on the portfolio is 30%. Due to Burford's reputation and the underlying binary risk profile of litigation, we believe the company can sustain higher IRR's than other alts. As with any capital provision business, scale, brand, and reputation define a competitive advantage. There’s a reason top companies go public via Goldman or Morgan Stanley rather than a mid-tier bank. Burford has 140 lawyers and invests across all types of law. It’s arguably the most reputable litigation finance brand in the world and one of a handful of companies that can write a $20m check for an individual case. We also believe experience can be an edge in this industry. Proprietary knowledge and data collected over years of experience compounds to provide a real competitive advantage. It reminds us of Credit Acceptance’s unique data set of subprime auto delinquencies that lead to superior underwriting performance. Burford is similar:
We were the first to institutionalize this business and capitalize it well. Having a decade head start gives us several significant advantages as we are the entrenched brand in the industry. We have the relationships which give us business but also an extraordinary amount of proprietary data from being in a confidential business for a long time and having seen thousands of matters. We put that data to use in our investment process which is neither publicly available, nor replicable. Our team and collection of repeatable processes around investing in this asset class are all proprietary. Somebody with deep pockets who wanted to enter today would face a meaningful disadvantage in terms of being able to catch up on those fundamental points.
Over the last 6 years, Burford’s group-wide portfolio has grown 50% per year to $4.5bn. This is still a fraction of the $800bn annual global legal fees. So how should we value a company that is growing book at 20%+ with 30% uncorrelated IRR’s? We believe it certainly shouldn’t trade at book value. In fact, using book value is possibly a misnomer. By our numbers, Burford earned $180m net realised cash gains in 2020 without completing much of the larger 2017/18 vintages. On top of this realised gain, Burford has increased asset management and performance fees to flow through over the next few years. After deducting operating and interest costs, Burford’s FCF could reach over $200m by 2023. This number excludes YPF which we see as effectively a free option that could return the whole market cap of Burford. Or it could return zero. After all, this is the nature of litigation finance.