Litigation Finance: The VCs of the Justice System
Litigation Finance is a burgeoning industry that is turning legal claims into an asset class. An easy way to understand litigation funding is through an example; if someone or a company wants to sue another party due to patent infringement or another reason, but they lack the funding, they can go to a third party funder who will provide non-recourse financing. If the plaintiff wins, the third-party funder gets a pre-determined portion of the proceeds. Litigation funding has appeal to both parties; the plaintiff takes less risk and has potential upside while the funder receives attractive IRRs that is also non-market correlated. If litigation funding is so appealing why don’t law firms all do this in-house? Some are certainly being more aggressive than others with contingency fees however the vast majority don’t because each case is unique with significant differences in potential awards and lengths of time it will take for cases to resolve. Only with tremendous scale can a firm be reasonably sure of a consistent revenue stream. Law firms are also generally structured as partnerships where the most senior lawyers are entitled to draw on the firm's cash profits. A steady paycheck is hard to break away from. Litigation finance helps both plaintiffs and law firms, expanding the TAM for both parties.
The largest player in this space far and away is Burford, followed by several private players and other public ones such as Litigation Capital Management, Omni Bridgeway, and Manolete Partners. For the rest of this article, we will focus on Burford Capital and Manolete Partners as we believe they represent the best plays in litigation funding.
Burford Capital (NYSE:BUR) is the incumbent in the space starting back in 2009 with about a 100mm dollar portfolio size. Fast forward 12 years later and BUR has a 5 Billion dollar portfolio with 3 billion coming from its own assets and another 2 Billion from its AUM arm. As it grew, BUR started to go after larger high dollar cases to be able to scale as the work required to find out if a case was a good investment was roughly the same for a one-million-dollar case vs a ten-million dollar one. These high-dollar cases typically meant international arbitration coupled with enforcement. Enforcement means recouping the settlement awards. Winning a case is just the first step, getting the money is the second. To do this one needs an enforcement team that can track assets through various countries to be able to take possession and liquidate. Burford is unique in that it is the only litigation funder with a top-tier enforcement team that has the means to chase the money down. Its enforcement arm is far and away the best in the business giving it the ability to pursue cases that its competitors cannot.
BUR was a compounding machine returning greater than 30% CAGR until a short report from Muddy Waters in 2019 claimed that Burford was the next Allied Capital. BUR share price collapsed 50% from both large institutional selling (Woodford) and fear that BURs legal claims were at best overvalued, and at worst dross. MW claimed that BUR was juicing earnings by being quick to increase the fair value of its investments and slow to realize losses. BURs accounting murkiness stems from how it classifies its litigation assets, IFRS level 3. These are financial assets and liabilities that are extremely illiquid and hard to value, other examples of these assets are MBS and complex derivatives. BUR increases the fair value of its investments once certain checkpoints are hit during litigation; the problem is some of these cases last for several years. Although Muddy Waters raised several good points- and Burford could certainly be more transparent- we do not think BUR is as shady as MW makes them appear to be. However, this overhang is unlikely to clear as many of BUR’s cases are still open from seven years ago and investors are uneasy about how BUR can properly value these cases. We delve into the mechanics of BUR’s litigation funding below.
Initially before investing in a legal claim BUR has some lump sum of cash that it needs to deploy. The pipeline of potential claims comes from companies or law firms that have worked with or have heard of Burford. A case has to make its way past several filters before arriving at a 9-person committee who will have the final say as to whether to accept it or not. BUR has a high rejection rate which is around 96%. Once Burford makes an investment (either with a law firm or company), it considers that capital to be “deployed” and waits for one of three possibilities: a settlement, a win, or a loss. The likelihood of each scenario is shown below from BURs historical track record. Approximately 60% of BURs cases settle, 30% go to adjudication and win, and 10% of them lose. Although settling is the desired outcome as it is the quickest to resolve, if a case goes to adjudication and BUR wins, the ROIC is 5x higher.
As a third-party funder, BUR does not have a decision-making role in the case and has to accept how the claim lawyers want to proceed. Once the case is settled or if won, BUR contractually has multiple ways of splitting the proceeds, it could be a flat 50/50 split or if BUR expects the case to take longer, a certain IRR (generally around the 20-30% mark) hurdle attached to the initial sum. The average duration of these cases is typically around the two year mark. However in total, from the time it takes to deploy the capital, to the duration of each case, and to finally receiving the payment ( via enforcement or other methods), takes roughly 4-6 years. We have graphed the percent of their cases completed by year below.
From above, one can see that BUR has resolved less than half their cases from 2015 onwards with the last two years being essentially zero. Being the largest litigation funder gives BUR a competitive advantage as most claimants will want to work with them given that BUR is more likely to backstop the finances(due to unknown costs that may occur further along in the case), muck akin to “nobody gets fired for picking IBM”. The last thing you want is a litigation funder to run dry in the ninth inning of a case. Because of this, the litigation funding industry is one that generally falls under the fat get fatter taxonomy. Thus Burford enjoys a greater market share as the cases get larger. However, there is a flip side to taking on larger cases or a portfolio of cases. These complex cases take significantly longer to settle, adjudicate, and enforce. The result is seen in the graph above with less than half the cases in 2015 being resolved. As BUR needs capital to invest in more cases, and previous ones they invested in are taking longer to settle and convert to cash, BUR needs to issue more and more debt/equity. As of the most recent financial report BUR had about 1B dollars in debt. This will likely continue. Faith in the credibility of management is imperative as investors need to believe these long duration cases are being properly valued. Unless a large high-profile case such as the one against the Argentinian government resolves and is a big win, BUR will likely continue to meander along. Investor confidence in management needs to be restored before BUR can reprice.
As the YPF case plays a significant role in BURs valuation, an explanation of this case is in order. Burford has funded two claims (almost 50mm so far) relating to the expropriation of YPF, the Exxon of Argentina. YPF IPOd on the NYSE in 1993. To assuage institutions and investors, Argentina promised to make a tender offer for the shares if it ever decided to nationalize the company or a majority of the company. These promises were written and enforceable against Argentina. Fast forward to 2012 and Argentina made an executive decision to expropriate the shares with no tender offer. YPF share price plummeted, severe damage was done to Argentinian government credibility, and a litany of lawsuits were started, a foreseeable outcome. The largest lawsuit was from Repsol which settled fairly quickly (about two years). Repsol is a Spanish energy company that owned 51% of YPF and upon its expropriation, sued Argentina and halted several shipments of LNGs to Argentina. Repsol claimed damages of 10B but settled to the tune of 5 billion. BUR has invested almost 50mm in the YPF claims since 2012. The two claims, Petersen and Eton Park together owned about 25% of YPF at the time of expropriation. Using Repsol as a base rate (a bit optimistic given the devaluation of the Argentinian currency and the leverage Repsol had over Argentina), the two claims BUR funded could amount to a possible 2.5B expected settlement value. BUR will receive half of the proceeds which equates to about 1.25B or about 50% of BUR’s enterprise value. The timing of when BUR could see this windfall is a guessing game with the case expected to go to trial by mid-2022.
BUR is currently trading around runoff valuation- that is if BUR were to let all its cases go to completion without reinvesting into new ones, its cash proceeds would be close to its current market capitalization. BUR currently has a little over about 1.2B in deployments (not counting asset management nor YPF) and giving BUR the same ROIC as its historical record (about 100%), profits should be about 1.2B. Adding back deployments and subtracting out net debt leaves about 1.8 Billion which is almost where BUR trades today. This is not giving any value to the growth of its business, YPF, nor asset management segment in which some of the fees they charge are staggering (0% management and 60% performance). If BUR wins the YPF Case, it will likely equal half the enterprise value of BUR or about 1.3B dollars. More importantly, this would also restore confidence in the veracity of management and BUR would likely see significant repricing. On an optimistic scenario (which is more likely in our estimates), BUR could easily be a double from todays levels. Conversely, if it does lose the YPF case, that will erase both 700mm of portfolio investments BUR has written up along with investor confidence. BUR would likely drop 30-40% in this case and meander around these levels perennially. The magnitude of the YPF case has made BUR almost a binary investment and should be played as such with about 40% downside and 100% upside.
Manolete Partners (LSE:MANO) is another litigation funder with a more active approach. MANO is based out of the UK and buys cases outright instead of just funding it. The reasons it can do this are the 2013 Jackson Reforms (Small Business Enterprise and Employment Act) along with the Insolvency Act of 1986. The structural dynamics of this industry are unique and need to be understood to see why and how MANO comes into the picture. In the UK, once a company goes bankrupt, the case gets assigned to an Insolvency Practitioner (IP) who has to identify whether the debtor was at fault due to malfeasance, negligence etc. IPs are a regulated industry and are personally liable for the case and the administration of it. The IPs, after due diligence on the case and evaluating possible settlement damages then go to a law firm to litigate the claim and recover the money for the creditor. These agreements between law firms and IPs were structured under a CFA-ATE model. This is like the contingency fee model in the US (where the law firms charge nothing however if they win keep a certain part of the proceeds) however instead of the law firm taking a cut of the winnings, it charges 2x the cost of litigation. These horrible incentives cause tension as law firms have no need to quickly settle/win a case as the longer they drag a case out, the more they get paid. The Jackson Reforms were intended to rectify this as studies pointed out legal costs were almost twice the cost of the damages. These reforms expanded the scope of insolvency cases third party funders could buy along with changing the CFA-ATE models so that law firms could only pay themselves from the damages recovered.
“In some areas of civil litigation costs are disproportionate and impede access to justice. I, therefore, propose a coherent package of interlocking reforms, designed to control costs and promote access to justice.” Sir Rupert Jackson
Buying a case from an IP gives MANO several advantages: MANO can quickly settle (if returns are above IRR hurdle rate) and do not have to passively wait on the sidelines while other lawyers drag a case on for years in hopes of a bigger payout, MANO can end a claim abruptly if it’s not going their way which cuts losses. Owning a claim truncates the downside and converts cases to cash much more quickly than if MANO was a third party funder. 97% of MANOs cases settle compared to 60% for 3rd party funders and the average settlement time is 11 months while for other third party funders it is over 2x that. We have attached their vintage table below which shows how many of MANOs cases are still open. Comparing MANO to BUR, one can immediately see the difference in completion rate. MANO has quickly developed a great reputation in this business and has been awarded as the top litigation funder in the UK for the last five years.
Another peculiar characteristic is MANO’s focus on insolvency cases instead of covering a large array of different legal claims. The primary reason is that these are the only cases a third party funder can buy outright. An advantage of this constaring is that being focused exclusively on insolvencies allows MANO to scale as they typically see the same type of cases day in and day out allowing for a higher degree of automation- with just two new hires bringing the level of litigators to 11, MANO will expand its capacity from 250 cases/year to almost 400. MANO litigators oversee the administration of the cases and typically hire barristers by the hour to litigate the case. The seven types of insolvency cases are listed below.
MANO’s business, although penalized during COVID due to the deluge of aid and government-mandated postponement of insolvencies, should now see a significant increase from pent-up insolvencies. Below is a graph breaking out the different insolvencies seen in the UK. This consists of three legs: Creditors Voluntary Liquidations, Compulsory Liquidations, and other insolvencies. Total insolvencies are 15% higher than 2019 levels without taking into account the all-time lows of other insolvencies as they are still suppressed by government mandates. If those other categories normalize to earlier level pre-pandemic levels, then the total level of insolvencies will be 30-40% higher than pre-pandemic levels. However, the keyword here is when as the government has postponed compulsory liquidations several times with the latest expiry date set for Mar 2022.
MANO is the largest third-party funder in the UK insolvency space with almost 70% market share amongst IPs. A paper written by Walton and funded by Manolete (so take with a grain of salt) took a survey and upon asking IPs which 3rd party funder they used, the primary answer was MANO.
Will future competition change the profitability of litigation funding as more competition will start lowering the juicy ROICs currently seen? We think eventually, but it will occur at a slow pace (> 5 years out). Given the unique position of IPs (personal liability) and their fiduciary capacity, relationships and reputation mean significantly more than earning potentially a bit more on a case. This is to say, even if a tidal wave of new entrants come into the space and offer better rates, IPs will not transition quickly as MANO offers convenience and reliability.
MANO is very illiquid with about 75% of shares held by insiders and institutions. The founder and CEO Cooklin holds about 16% of the company. MANO currently trades at about 10x 2024 earnings and has about 10mm in debt. The insolvency cases will be growing rapidly for the next couple of years as companies go belly up which should provide MANO with significant growth. With litigation funding gaining ground vs traditional CFA ATE methods, MANO is well situated. We see about one hundred percent upside to today's levels.