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Bond of the Week Archive
Bond of the Week: 25 July 2014
Bond of the Week : 25 July 2014
The offering for Golden Lane/ Mencap, the charity bond, has now closed (settles 29th July). It trades at a modest premium. Yet I cannot say the issue was greeted with great enthusiasm by the market. Rather, investors approached the bond with a certain diffidence. There was the justification that the 4.375% was not exciting (true) and there were fears the £11million issue size would mean for illiquidity (come on Mr. Boast, let’s tighten that 1% bid offer price and prove them wrong). But I feel the bond stood on its own commercial feet, so to speak. It was, I think, the association of the word charity with a commercial transaction that really caused the slight air of awkwardness (although possibly dragging in, as a counterweight, an as yet untapped source of new money; the Guardian Reader).
Were investors being touched for a contribution or being offered a sound investment? If this feeling of unspoken obligation kept you from making a purchase of Golden Lane, you have nothing to fear with the new ORB offering. It comes from the dark side. Goodbye tin rattling middle aged woman in moth eaten old clothes, hello Beelzebub in bespoke crocodile skin shoes. And he is offering to cross your palm with a 6 ½% coupon. Burford Finance provides litigation and arbitration finance. In other words they fund (US) lawyers, for a suitable reward, to allow (encourage) A to sue B. The majority of their activity is in the US, but the company is listed on AIM.
Before setting out the terms of the new issue here are two interesting facts. A) There are more than one million lawyers in the US and B) If the top law firms in the UK were incorporated then six of them would be in the FTSE 100. What a horror show.! Now here is the offering:
Let me take you back to the Middle Ages; it is usually a good place to start. They did things better then; Magna Carta, chivalrous quests and the establishment of the principle outlawing Maintenance and Champerty . ‘A person is guilty of maintenance if he supports litigation in which he has no legitimate concern without just cause or excuse’ and Champerty ‘occurs when the person maintaining another stipulates for a share of the proceeds of the action or suit’. The common law restrictions on this type of potentially vexatious litigation continued, if in a more restricted manner, into the modern age both here and in other common law countries, including the United States. Until recently (the precise time is unclear) the business of Burford would therefore have been illegal. However, the principle has slowly been chipped away at such that, although Maintenance and Champerty may lurk in the legal background, it now no longer inhibits litigation finance. Indeed an article to this very point can be found buried away in the bowls of Burford’s website and Chris Bogart, their CEO, also told me that the UK government (quelle surprise) was now actively encouraging the use of outside sources of finance for litigation. So that’s alright then.
The market for legal services in the US is huge. There are 300,000 new civil cases every year and US lawyers generate $300 billion of revenue annually. Very little of this is funded through litigation finance. Although Burford’s total commitments are only $264 million they are the biggest worldwide provider of litigation finance. There is room to grow but more importantly to be choosey.
How does their business work? They do not have a sales force that seeks out good cases as it would be very much a hit and miss affair. Instead they are approached by legal firms when they need finance and Burford then uses its internal expertise to sort out the wheat from the chaff. For example we discussed ICSID cases (arbitration cases under the World Bank umbrella in which one side of an action is a government) and he explained that there were more seekers of finance in that area than any other but they rarely take them on because the cases have a tendency to drag on for years. The average length of the cases they have taken on is only 1.9 years. Chris Bogart did explain that while they spent no money on sales they did spend it on putting their face around and general marketing so everyone knew they were there if needed. As he said, no one likes a litigation lawyer and consequently the offer of conferences, golf days and lunch goes down surprisingly well. Everyone needs a friend.
On what terms does Burford fund? This will depend on the jurisdiction and each case will be individually negotiated. However, the structure of the return is 1) first money received whether by settlement or a trial win goes to Burford to cover costs B) next they get an additional multiple of the costs – maybe 1x and C) finally a performance fee representing a percentage (33%??) of the “winnings”. The investment in each case will typically be from $5-$10 million. Since inception (they started as an Aim listed closed–ended fund in 2009) they have made 59 investments for a total of $419 million and as of December 2013 they had $264 million outstanding across 35 different cases. $62 million of new capital was employed in 2013. Here I should explain, as an additional insight on their credit, that I asked Mr. Bogart what, as of today, were the forward commitments for existing cases. It is in the region of $65 million (commitments are capped not open). Given that there is $81 million of cash and cash equivalents on the balance sheet and an additional $51million due in legal settlements, were all existing cases to fail, they would still avoid default.
What has been their performance? For the most part Burford are prevented by confidentiality agreements from revealing much about individual cases. However, they have compiled statistics on case completions and returns made on those completions. They are as follows. 2009 all completed 33% return (IRR); 2010 56% completions 10% return; 2011 53% completed 31% return; 2012 33% completed; 32% return; 2013 all outstanding. The total investment recoveries to date have been $147million from $97 invested which produces a return of 26% annualised [ (147/97)/ 1.9 av. length of case.]. If you take in the centralised costs of running the business that brings it down to 22% for an equity investor’s perspective. After the inevitable time lag from when the business was set up, the cash and returns are now flowing strongly. Profit was $42.5 million in 2013 up from $34.1 million in 2012 and $16 million in 2011.
Diversity is the key to conceptualising the risk of investing in Burford. The important point that Chris Bogart wanted to emphasise to me is that while individual cases might have a random result, with a large enough sample, passive management in litigation has been proven to produce positive results. For example the insurance industry (a different business model) which offers to insure against litigation risk wouldn’t exist if there were not positive returns to be had and likewise it should be the same for litigation finance. The question is, what should those returns be? There have been a number of academic studies which show passive modelling producing a return of 10-20%. Burford with its expertise aims to beat this. I should also add here that downside risk of total wipe out in each case is limited because ninety percent of all litigation cases are settled out of court (doubtless because it is just too expensive to carry on) and in most cases there will be some quid pro quo so at least some money will go to the plaintiff. And who gets first bite of the cherry? The funder. I also look at it like this. If an oil company has oil wells in different countries it has diversified away some geopolitical/ geographic risk, but if the oil price goes down, no matter what the diversity, the company will suffer. However, for every legal case there will be one winner and one looser. It is a zero sum game (minus harvesting from our legal friends). Therefore if you have enough cases to diversify away risk you must be certain of getting back close to your original investment and we can only quibble about what the excess should be, or what in effect the charge should be for lending money into this 50/50 process. This way of looking at it may not necessarily be reassuring for equity investors but it is for bond holders; especially if the funder has no debt and no gearing, and Burford does not.
Here is a quick look at the balance sheet. As just mentioned, the company has no debt although they do have a USD $40 million preference share (3% fee for the facility or Libor plus 7% for drawn amounts) which has been provided by some of the main shareholders. This is of course subordinated to the ORB bond and may indeed now be superfluous post the issue of the retail bond. To date the preference share facility has never been used. The balance sheet shows cash and cash equivalents of $84 million. There is an additional sum of $51 million due from settlement of litigation related investments. Outlays to lawyers are capitalised and show as $215million. IFRS rules mean there has to be some mark to market of these outlays but Burford sensibly tries to keep any upward valuation revision to a minimum and they never allow for potential performance fees. This ORB issue will of course itself create some debt (probably £75 million). However, there is a covenant limiting the leverage ratio to 0.5x net debt to total assets.
There are no direct competitors to point to to determine value. However, as a former fund with diversified assets which are not directly managed and are unlikely to implode all at once, you could say there is some similarity between lending to Burford and lending to an investment trust. The typical yield on an Investment Trust debenture might be 4 1/2% (that was the approximate rate suggested for Utilico before they pulled the deal). I do of course take the point there is something flimsy and unsatisfying about Burford’s assets compared with shares and bonds, but empirically if not psychologically an asset is an asset and if shares throw off dividends while legal cases reach redemption in fairly short order, so cash flow is cash flow. I was given one comparative bond though. Bentham IMF, a smaller unlisted competitor of Burford’s placed a 5 year retail bond in Australian dollars in May this year. The bond is a floating rate, paying Australian Bank Bill Short Term Rates (think Libor) plus 4.2%. It has now traded up to 103.70-104 = a yield margin of 3.24%. That is a tightening of 1%. On that basis it makes Burford look cheap.
Briefly we should consider why Burford is launching a retail bond. Placing your bets in litigation finance is a somewhat lumbering exercise (only 3 cases undertaken in 2009, their first year) so it is only now with the majority of cash employed that it makes sense to entertain some gearing. In the last year they have had to turn down some opportunities because of lack of cash. By adding gearing paid for at 6.5% they should, if they can maintain returns of 22% to equity holders, be able to increase ROE (for example I make it at a ratio of 100 debt per 300 equity it would increase returns by 5%). And this brings me on to the primary reason for using the retail as opposed to institutional market. Since launch the share price has been, notwithstanding some short term volatility, moribund. By coming to the ORB it is hoped this will draw attention to the share. In March there was a very bullish equity piece from RBC targeting a price of £1.90 (now £1.20 then £1.08) but there has just not been enough interest. With a market cap of £245 million it is just too small for many institutional investors to concentrate on and what Burford do is too nebulous for many to get their head around without a great deal of thinking, which can be time consuming or just create too much brain ache. I have to say I am tempted by the story (and found the CEO very straight forward and open to talk to) and have made a small share purchase.
What do I think of the bond? The yield is certainly excellent compared with other ORB bonds but can this be explained away by extra risk? There are the issues of small market cap, unusual and difficult to comprehend business, maybe a distaste for litigation lawyers and a worry that it is a business substantially based in another country. But these are what might be termed circumstantial risks. They give the feel of risk rather than actual risk. I suppose you might add to the list of potential issues a) governmental attack on the litigation business as a whole (possible but that would mean difficult future business not an attack on existing cases) b) attack on the funding business; very unlikely given current thinking is going in the opposite direction c) Burford develops a taste for debt; but a covenant on the new bond does limit them to 0.5x debt for equity. There just remains the remote risk that there is some mathematical flaw in their business model (surely we should know by now) or a black swan event that would do for the whole litigation business including existing cases – but by definition that is unknowable. [And of course something I have not thought of!]. I therefore have to conclude that the issue is just cheap. I expect others will arrive at the same decision. It is also true, as ever, that all this analysis is unnecessary as some will look no further than the coupon. My first order came as follow:
Me: … there is also a new ORB issue coming to the market; Burford 6.5% 2022. It doesn’t look bad value.
Client: OK I’ll buy £50,000.
Me: Don’t you want to know what they do?
Client: No. It just sounds like a nice English name.
Me: It is a firm that funds ruthless American litigation lawyers.
Client: I’ll buy it anyway. It pays 6.5%.
Conclusion: Should you take the Faustian Pact? Can you sail your upstanding bond portfolio past the siren calls of 6 1/2% without dashing your vessel onto the rocks of unprincipled greed? There is little doubt in my mind that although Burford has a small market cap for an ORB borrower and, unusually, occupies a niche of one, making comparisons difficult, the finances are sound, cash-flow is good and the portfolio of cases diversifies away risk. In short the yield is more than adequate for the risk and I expect the deal to trade to a decent premium. However, I leave to the reader how they are to navigate between the 4.375% Scylla of Golden virtue and the 6 1/2% Charybdis of unbridled financial lust. What will I do? I shall make a purchase. Maybe even a large one. It may not, of course, be a life time commitment. There will always be the intention for a future cleansing of the portfolio. As I carefully scratch my name in the purchase ledger I shall utter the prayer of St. Augustine of Hippo: Domine da mihi castitatem et continentiam sed noli modo – “Oh Lord make me chaste – but not just yet”.
Oliver Butt is a Partner in City and Continental LLP, a leading independent broker in fixed income. The author and or the LLP may hold a position in or trade in any of the securities mentioned above.
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