In August 2019, Muddy Waters (MW) released a short report on Burford Capital (BUR) claiming it had turned ‘Enron-esque mark-to-model accounting into the biggest stock promotion on the AIM market’. BUR’s market value declined 80% peak-to-trough and still trades ~50% below the pre-MW price per share.

When discussing BUR with investors, questions relating to the short report immediately come to mind. We will share insights to each investor's concern to explore both sides of the story.

Burford Management post-Muddy Waters As investors, a history of owning the stock can create an emotional relationship with the company. Especially for companies under attack, previous and prospective shareholders can interpret information in completely different ways based on their prior emotional experience owning the equity. This was an interesting comment by one investor during our IP Dialogue:

"It is similar to most other things that I invest in where you can’t affirmatively prove that something isn’t a fraud. For example, I couldn’t prove to you that Blackstone isn’t a fraud; it depends on how you frame it. Post Muddy Waters, especially if one lived through it and had an emotional relationship with the investment, you frame it as if you need proof and that’s impossible. If you don’t frame it like that, it looks pretty similar to a lot of things that are out there and I am invested in, so I’m comfortable."

The emotional relationship we have with portfolio holdings can often warp our interpretation of the facts at hand. The emotional rollercoaster of an 80% drawdown can distort one’s view of a company relative to those looking with fresh eyes.

Existing shareholders may feel like they need a 100% complete short rebuttal to maintain their position in companies under attack. As we live in a world of incomplete information, especially with great storytellers such as Carson Block on the other side, this is near impossible. It’s even more difficult for Burford given the company cannot legally discuss the ongoing performance of underlying cases.

This leads to a bifurcation in the investment community between existing BUR shareholders who require complete information to rebut the short thesis and new investors with the luxury of no prior emotional relationship with the stock.

What makes this particularly interesting is the fact that such situations often provide the best risk-to-reward setups. And it’s those existing BUR shareholders that are typically in the best position to understand whether the short thesis is credible. However, often the pressure and career-risk of holding a potentially fraudulent stock leads to a mass exodus in the shareholder base.

This was how one long-time BUR shareholder interpreted the MW thesis:

"My general experience – and this is high level, so take it with a grain of salt – is that when you are looking at a public company, you can generally come up with a short narrative because there is incomplete information. The question is, are you going to trust the short seller with incomplete information, pulling together a mosaic theory of, sometimes, very compelling, intellectual and negative information; usually the negative is satisfying, but wrong and, usually, the optimist is not intellectually appealing, but correct. I think it came down to, do I think they are trying to be more transparent in answering these questions and do you trust the people?"

As outside investors, we can never be 100% sure a company isn’t a fraud. There is always incomplete information that can be spun into a negative narrative.

In hindsight, BUR was the perfect short setup. Firstly, the company was trading at ~6x book and listed on the AIM, a market with lax governance structures and popular with UK retail investors. Secondly, MW spun a narrative connecting Invesco, then Burford’s largest shareholder, with Woodford, previously the largest UK fund and public enemy number one after closing and losing hundreds of millions of UK pension money that year. MW also knew that the large retail investor base, and many institutional shareholders, couldn’t interpret the complicated financial statements, and would likely flee at any accounting confusion.

But, why should we trust a short seller over the management team? Both have known incentives at play. Although MW's storytelling may have been persuasive, there are prior Gerchen Keller funds, owned by BUR, that had fully realised funds with LP's that happily recommitted the returned capital. Shouldn’t this be worth more than a short thesis spun from a mosaic of information?

Regardless of a short report's accusations, the management response is even more important. This was how one investor interpreted BUR's response:

"In my experience, there are generally one of two directions that management teams will take. They either become more transparent or less transparent. That was always the lens that I looked through. Granted, I had a little bit of an unfair advantage in that I had known Chris for several years and I had known his wife for a few years and I knew that she was extremely competent. If you looked, on paper – particularly on the financing side – at the things that she had done for Burford, that talked to me about why she qualified for the job. Besides that, I feel as if you actually look at their responses to Muddy Waters, they went over and above to be transparent. For example, literally putting out an investment table with every line item of an investment. They absolutely do not have to do that."

We believe it's hard to argue that BUR management didn’t act with integrity post-MW attack. The CFO stepped away, the company committed and delivered on a US dual-listing, and provided detailed explanations of the use and history of fair-value mark ups. Some would say they went over and beyond to be transparent. However, we get the sense from investors that it's still a very complex business to analyse. Each investor had a unique way of analysing the intrinsic value of BUR. We will discuss later how BUR value their book internally.

Management compensation

Management compensation was another debated topic. Under AIM regulation, BUR wasn’t required to release the pay of senior management. Also, in March 2018 shortly after the YPF secondary sale, the co-founders both cashed in £50m each of BUR equity. There were two schools of thought from investors on this topic: one credible argument is that £100m was taken out the business with not much added after the short report; the alternative argument suggests:

"The large majority of the wealth of the two founders is in Burford. I think 9% of the carry is channeled to compensation for employees. In the other alternative managers, it’s more like 3%. The gross profit on carry is 70%, I think; maybe sometimes lower."

After a decade, is it really unacceptable that the two co-founders sold a portion of their equity after partly monetising monetising the largest case in the firm’s history? How should we compare their compensation to other alt managers? Although shareholders would prefer leaders to earn modest salaries without selling a cent of equity, the reality is most founders sell equity throughout the life of a company. Bezos, Page, and Benioff all consistently sold stock on the way up. As long as the business is performing well, and management maintains enough skin in the game, is selling stock a real problem to consider?

Promotional management

A common claim by investors is that BUR is promotional. One investor stated:

"On the first three slides of the capital markets day, the first impression was that it was very promotional. Look at page nine, and it basically tells you that the valuation of the company is less the cash proceeds; it is highlighted in a way that is promotional. If you look at the stock returns, it’s selected in a way where it beats the indices and the indices are selected in a certain way. Why is the S&P 500 or NASDAQ not there? "

These are all fair points. Another investor sees it differently:

"I have seen promotional management teams that were just frustrated as to why their stock was so damn cheap and them being right, eventually. In my mind, there is nothing wrong with that. All of us – maybe more than we’d like to – talk to people about what we think are compelling ideas. In many ways, maybe you could say that the CEO should be above that. What comes to mind to me are these things that are all traded at ridiculous prices, after being public for many years, and are going up quite a bit. If you look at the transcripts from Blackstone, Apollo, Carlyle or KKR, basically, it was the CEO saying, we have no idea why we are trading at the price we are trading at and can somebody help me figure this out."

Maybe Burford is in a similar situation to the alts 3-4 years ago?

It’s also worth mentioning that BUR is by definition a black box: by law, you can’t see the ongoing performance of the underlying assets; Burford can’t talk about individual cases in public. Also, Jon’s personality is more reserved and focused on allocating the capital which leaves Chris to be the face and voice of Burford. We see this as a complementary partnership in both personality and skill set.

One investor raised another good on why BUR may come across as promotional:

"The thing I would say about both the promotionalism and the buy backs is that it’s very different if you are in a business where the raw material of what you do is capital. You are constantly in the business of raising capital, from various constituencies, and then deploying that capital into what you do. That is different from a promotionalism standpoint, where it makes sense to put your best foot forward, as opposed to under promise and talk everything down, as many companies that we respect do. It’s also very different from buying back stock, because you are taking the raw material of what you do and how you serve your constituencies and fuel and develop your relationships and you are just buying back stock with it."

BUR needs to keep all avenues open to finance the future growth of the business. Plus, the company has undrawn commitments to fulfil. Although cases may on average last 2 years, they can certainly drag on for longer or conclude quicker. This makes it difficult to manage the cash inflows from concluded cases with future commitments. These are not excuses to be overly promotional, but this framing proves management behaviour is rational given the capital provision business it operates.

Liquidation value

The final topic we explored in the dialogue was BUR’s recent investor day. In short, there was one clear message: BUR is trading at or below liquidation value.  This means if BUR were to stop deploying capital and simply run off the book, the value would be close to today’s market capitalization. If we assume $1.4bn in current deployed assets including commitments and a ROIC of 140%, which is actually 20% lower than historical concluded case returns, the cash realised gains is ~$2bn. Adding back the $1.4bn original investment equates to $3.4bn in cash proceeds from the current book of assets.

What is unknown is how long it may take to liquidate the book.

From this $3.4bn, we have to deduct the $100m in opex, $40m in interest per year and $500m in net debt to get the equity value. If the book takes 4 years to run off, the net value is a $2.3bn. That’s including the full $100m in annual opex which likely wouldn’t be required if you’re just running off the book. Importantly, this calculation excludes YPF and assumes zero future deployments.

Either way, the message is clear; management believes the market is undervaluing the quality of BUR assets. However, as we’ve discussed, there are always different ways to frame the information presented based on our prior experience with the company.

The more and more we study businesses, the more we realise the simple truth that the integrity and quality of the leaders are the most important variable in creating long-term value. After all, a company is a collection of human beings. We believe it’s hard to argue that Chris, Jon, and the Burford team are not a high quality team in a particularly attractive industry. It will be interesting to watch the company evolve with the YPF conclusion next year.