Burford Capital: Moat, Insurance Risks, Sysco, YPF

Disclaimer: This interview is for informational purposes only and should not be relied upon as a basis for investment decisions. In Practise is an independent publisher and all opinions expressed by guests are solely their own opinions and do not reflect the opinion of In Practise.

I think the first broad question is just around the durability of IRRs and overall returns for Burford. How and why is Burford's returns or edge in financing litigation durable?  

Analyst 5: I think the way we've considered it from a risk standpoint is that it ties into what you're hinting at with current prices. The way we've thought about valuation, we segregate the core business from what we term as power law return cases. Then we adjust the returns in there and see what valuations emerge. Our thought process is that if you decrease returns on what we're labeling as core business, you can still reach valuations in the $10 range. So, when you're paying $13, you're already factoring in that returns can significantly decrease. You have these upside options with big cases, and then you have some of the embedded carry that's in the managed funds business because it's a European waterfall. From our perspective, it was pretty much that simple. You're not paying for a lot of upside options, even if returns decrease.

For example, let's say you have a portfolio of cases at a law firm. What is the risk in five to 10 years' time? Suppose in five years' time there is a significantly cheaper form of financing available from insurers or other financiers who are willing to underwrite that portfolio of cases based on a track record, based on that funder's record. This could significantly reduce that core IRR you mentioned, the core business IRR, excluding those power law cases. How do you see that evolving in five years?

Analyst 5: I believe you have to consider it from a couple of perspectives. Firstly, what's the base rate of that occurrence? You can examine when the last major litigation finance firm was established and what its track record was. I believe that's one way to approach it. Secondly, is the sole reason for its existence merely the capital, or are there other components to the financing relationship that are significant? One thing I've tried to analyze and understand is that there seems to be an advantage in seeing more of these cases, particularly with settlements - and having reviewed all the Sysco documents, it's incredibly frustrating to see everything redacted - is Burford doesn't have the redacted files for that, so they almost have a proprietary database of settlement information. I'm unsure how long it would take for someone else to replicate that and how much of it you need to recreate to have the same ability to price or accept.

What about Quinn Emanuel's settlement data or the settlement data from a former big law firm?

Analyst 5: That certainly could be, and that's where I haven't quite settled on it yet. Is it actually as much of an advantage as it might be?

This is my point. What if a major insurer approaches Quinn, or there's a method through which Burford is disintermediated from that law firm funding relationship? The large law firms arguably have access to much more data, potentially, or just as much data. Could there be a less expensive form of financing that makes it cheaper for the law firm?

Analyst 5: Yes, and I believe the only way you can definitively answer that question is if you find an insurance company that's saying, "Hey, we're willing to do this." They would need to have some sort of specialization in that and be willing to set up that type of product. But to frame the question, to assess the risk, let's just assume that this happens in year five and that the company enters runoff after that, based on whatever deployments have occurred from now until year five. Then they enter runoff. What's the business worth? As long as you're not down by 50 on that, is it really a significant concern? That's how I think about it.

Analyst 1: I have a thought on this. I don't have a specific answer, but consider other forms of capital, such as equity markets, venture capital, and private equity. These have been around a lot longer and things have sort of settled down to a base rate, as it were. You could argue that equity markets, GDP plus ROIC, plus whatever it is, plus valuation. Long term for the S&P 500 over 200 years is an 8%, 7%, 10% return, right? And you say, okay, what does equity investing sort of normalize around there? Or thereabouts, potentially.

Private equity? There are a lot of factors that go into this, but let's say valuations are reasonable just from, let's say, buying something at a low double-digit EBITDA multiple and a lot of debt and paying down the debt. You can come back into a 15% IRR with some variation and stuff. So with a lot of competition, maybe you can say that these two things will go to that.

The way I would think about answering your question, long term, is what are the structural constraints for this type of financing activity as a way that the returns could come down? I haven't really thought about what the answer might be, but that's how I would approach what's long term, perfect competition-based return.

Analyst 3: Yes, I believe when you consider them, you mentioned a law firm as potential competition. However, I don't think that's a concern because investing is an entirely different beast. It's one of the best barriers we could hope for, given the emotional energy and the character required to invest for five, 10 or 15 years. Anything is possible in the world, but I think it's highly unlikely that a law firm will develop that capability.

Not a law firm, but what about if they partner with an insurer or any financier?

Analyst 3: They are breaking it into different parts. One owns the data, one owns the ability and the capital structure. I prefer my operations to be integrated. So, who is out there with a track record of doing it? And that's the other huge advantage of Burford that has the kind of capital it has. It's very permanent.

Burford could do this, right? They're now involved in insurance, to some extent. I bring this up because, as I mentioned, we're conducting a survey and speaking to numerous law firms. They've indicated that the number one risk emerging is insurance, specifically new forms of insurance entering the market over the past six to 12 months. New products are being introduced and insurers are experimenting with them. This is an area where we need to do more research. However, I'm curious about your thoughts. Essentially, Burford has proprietary data and is providing quite expensive capital to a law firm that shares part of the risk. What's really stopping that law firm from taking their expanded data set to a cheaper financial provider? There are already types of insurance in the market, such as ATE, WIP insurance, CPI insurance, and forms of collateral insurance. So, this is an area we're exploring. I'd be interested to know if any of you have encountered any insurance-type products in this space.

Analyst 6: Could you please illustrate the type of insurance product that would be a good replacement or substitute for the core litigation finance offering that Burford has?

Analyst 5: This doesn't necessarily apply to the core litigation, but it could factor in there. I believe if you consider Appian, it was the first time I'd seen it. Appian had a claim of upwards of, I think, a little over $2 billion against Pegasystems and won the initial claim. It was then going through appeal, but they were able to secure an insurance product that guaranteed them a payout of $500 million if it wins on appeal. So, if it wins on appeal and the judge awards only $500 million, the insurance doesn't pay out. However, if they only receive $300 million, the insurance will cover up to the $500 million.

There are many forms of insurance already in the market.

Analyst 5: But the question is, if you think about insurance, it's an actuarial process. How much of the data can these new products actually use to look back and give an accurate actuarial prediction of how they should price this, given that now you have a confounding factor of the rise of litigation finance? So, historical numbers and cases may no longer apply.