Weekly Update: Burford Capital & YPF Risk-Reward

Content Published Last Week

1. Burford Capital: A History of Petersen & the YPF-related Assets

2. HEICO: Airline MRO Customer Perspective

3. KONE: European New Installation & Maintenance Contract Pricing

4. Evolution Gaming, NetEnt, & Online Gaming Regulation & Tax Outlook

Burford Capital & YPF Risk-Reward

Since the 2019 Muddy Waters short report, we’ve been following Burford Capital (BUR) very closely as personal shareholders and have also published various pieces of content on the company:

1. IP Interview with BUR Co Founder and CEO

2. Our analysis on litigation finance return asymmetry

3. IP Interview with Investment Manager from Omni Bridgeway

4. IP BUR Investor Dialogue

5. IP Interview with a BUR competitor

6. Our analysis of BUR management team and liquidation value

We’ve explored all the reasons why we believe BUR is unique; the uncorrelated returns of legal assets, asymmetric return profile relative to other alts, the durability of BUR returns as the market leader, and the long growth runway for legal finance market.

However, one important thing we haven’t discussed is BUR’s largest case which amounts to ~50% of current book value: the expropriation of YPF by the Argentinian government.

The case started in April 2015 and in two weeks, on June 23rd, both parties will present final arguments and receive a summary judgment. We interviewed an Argentinian political and capital markets advisor to explore the history of the case to inform our estimation of BUR’s valuation in various scenarios for the conclusion of YPF.

It’s worth reading the interview in full for more context but in short, the Argentinian government privatized YPF, an Argentinian energy company, without abiding YPF’s Bylaws and launching a tender offer for all listed shares. This left Petersen and Eton Park, the two parties that Burford financed, without compensation for the US-listed shares they held in YPF.

On the surface, it seems that this case should be a simple breach of contract upon the change of control, especially as there is clear evidence that the government outright refused to pay for the expropriated shares:

As a matter of fact, we have Argentine politicians going to congress, saying on TV that we are not going to launch a tender offer because we don't want to pay those “stupid banks overseas”. They actually said that, that's the word they used and plaintiffs used those words in the case - In Practise Interview

However, Argentina has changed their core argument multiple times and has received five adverse rulings in an effort to drag out the case over the last 7 years. We’re now at the final stage where Argentina has a few main arguments which center around sovereign law trumping corporate law:

First of all, national law preempts corporate law. I was limited by congress from acquiring more than 51% of the shares outstanding in YPF; I was not allowed to launch a tender offer. Argentina also claims that only shareholders that had shares in April 2014 – when Argentina officialized the expropriation and when it paid Repsol $5 billion and it received the shares – were allowed to bring forward this case. Both Petersen and Eton had already either foreclosed their shares or sold them. Argentina says, these guys didn't have the shares on 2014; they cannot bring the case forward. Argentina is also saying look, there is no way I could actually go through this tender offer, because we are under Argentine law, not New York law. Argentine law says, as a sovereign, I am responsible for following local rules. Local rules say, you don't have to acquire YPF shares because sovereign law trumps local corporate law. - In Practise Interview

There is no doubt the judge can find a way to rule in favor of Argentina. However, if Argentina does win, this landmark ruling could set the precedent for future sovereign nations to expropriate any US-listed company without any consequences. This seems unlikely.

If you are a company or a sovereign nation that goes to the US capital markets to get financing, whether through an IPO or through debt – both Argentina and YPF have bonds issued overseas in Wall Street, and YPF has shared issued in Wall Street – you should be held accountable to the same standards as US corporates, as well as the government is currently. Argentina says look, I'm not going to be held accountable for doing something that was in my bylaws. Burford – as well as Petersen and Eton – is saying look, if you, Judge Preska, rule in favor of Argentina, you are setting a precedent to future sovereign nations that want to expropriate US listed companies without any consequences. This is a major landmark ruling responsibility for Judge Preska, because with her ruling, if she goes in favor of Argentina, you can have Mexico, Chile, Colombia, Venezuela, expropriating US listed companies, without any consequences, leaving investors empty handed, unprotected. - In Practise Interview

There are many ways to value the YPF-related claims, which could result in anything from $2.5bn to $15bn. According to the bylaws formulae, the court filings estimate the combined Petersen and Eton Park claims to be worth over $15bn including interest.

close

Zoom InZoom OutReset

Given its stake in the claims, Burford’s reports potential net proceeds between $1.1bn and $5.6bn.

close

Zoom InZoom OutReset

The mid-range of the formula returns $3.35bn; BUR’s current market cap is ~$2bn. Even if BUR only has a 50% chance of winning the case, the expected value of the case at the midpoint is almost equivalent to BUR’s current market cap.

However, this YPF option isn’t the most interesting element of the current setup in BUR’s equity; the potential asymmetry between YPF’s payoff and the potential downside if YPF is a zero makes the setup fascinating.

The chart below is reconstructed from BUR’s reported investment table which shows every case the company has invested in. BUR reports the weighted average life per case is around 2 years yet between the 2016-19 vintages there are $688m of ongoing deployments that are due to flow through over the next 18 months.

close

Zoom InZoom OutReset

Excluding any major extension of case duration, as the courts open and cases conclude, BUR could receive the largest cash realizations in its history excluding any realization from YPF.

This buildup of case deployments also illustrates why, without looking at the investment table, BUR’s underlying returns look mediocre. The chart below shows how the tangible book value per share excluding YPF has actually declined 35% since 2018. Even including YPF, the TBVPS has only grown by 3.5% per year.

close

Zoom InZoom OutReset

COVID significantly impacted cash realizations; of BUR’s total $1.256bn outstanding deployments, 56% are from vintage 2018 or older. Excluding increased COVID delays, there is no reason to believe that the weighted average life per case should change much. In fact, it could decline if courts adopt more modern technology to process cases.

It’s also clear from the historical results that the underlying case return isn’t deteriorating; if anything, BUR reports increasing ROIC in more recent vintages as case size is increasing.

close

Zoom InZoom OutReset

It’s also worth mentioning that the longer the case duration, the higher the absolute dollar return given the cases go to adjudication.

This combination of cash realizations flowing through from older vintages plus increasing returns with case size leads BUR to be an interesting COVID reopening play. The timely realization of older cohorts is an important variable to minimize the downside risk for the stock if the YPF case loses.

The fair value of YPF-related assets is currently booked at $777m, ~50% of FY21 book value. The table below shows 3 potential outcomes to the YPF case and the resulting FY21 BVPS:

close

Zoom InZoom OutReset

If YPF wins, the BVPS could jump anywhere between $14.5 and $22.4, a 56% and 141% increase to the current share price, respectively.

If YPF loses, the FY21 BVPS will decline to ~$3.5 per share, a 62% decline in the current share price if BUR trades down to 1x book. However, this could be temporary until the large ongoing vintages conclude.

BUR has $1.25bn of ongoing deployments and $520m from the 2016-18 vintages. If we assume 50% of the 2016-18 vintages conclude in each of the next two years, at the average 120% ROIC, BUR will earn ~$200m in cash earnings in 2022 and 2023 (assuming similar fee income from asset management and other).

Also, because YPF is 50% of the book and has been marked at a similar fair value for 3 years, this has been a drag on BUR’s true ROE. If YPF loses, ROE will increase to ~20% and highlight the underlying profitability of the cases.

close

Zoom InZoom OutReset

Such cash earnings would lead to $4.41 and $5.31 BVPS for 2022 and 2023 respectively. For the stock to recover to the current share price, the P/B would have to increase to ~2x post-YPF in FY23.

The big risk for BUR's equity story lies in a combination of YPF losing and a further extension of case case duration. If the next two years of realisations look like 2020 and 2021, the book value will barely grow. This is because of the relatively high cost of running the business: BUR spends $105m in opex and $55m in interest per year. We can see in the table below that the 2016-21 cumulative opex and interest has eaten up ~90% of the core balance sheet net gains.

close

Zoom InZoom OutReset

Today, BUR's balance sheet looks more expensive to run than KKR for example. However, BUR seems to be under-earning and also has higher, uncorrelated underlying asset returns than KKR. In the long run, as older backed up vintages conclude, there seems no reason to us why BUR cannot command a similar valuation to the leading PE listed players.

In summary, the risk-reward seems pretty attractive: on the downside, if YPF loses, the stock could decline 60% to ~1x BV for ~18 months until the older vintages flow through and prove the underlying value of the asset base. Higher cash earnings and ~20% ROE plus the uncorrelated nature of the business suggests the market value will return close to today's value by FY23.

If YPF wins, the BVPS could climb to $15-24 at the midpoint of YPF’s case value. In this scenario, it’s also likely the market gives BUR credit for the underlying value of the book and prices it at 2-2.5x book value, or $30-$45 per share.

A 3-4x return on the upside for a 50-60% decline for ~18 months seems like an attractive risk-reward for investors willing to stomach the volatility.

Either way, the conclusion of YPF should be positive for the equity as it will help investors understand the true book value. As the older vintages flow through, BUR can show a cleaner ROE and tell an uncorrelated book value compounding story to the market.