Welcome to another issue of Net Interest, my newsletter on financial sector themes. This week’s issue is a bit different – it’s a guest post by Bruce Packard. Like me, Bruce is a former equity research analyst; in fact we used to work together at Credit Suisse. I’ll introduce him properly below. In the meantime if you’re reading this, but haven’t yet signed up you can do so here:
An occasional theme here at Net Interest is the study of new asset classes. There’s something quite fascinating about them: how and why they emerge, why some endure and some don't, the types of people who pioneer them and the money they make and lose doing so.
It's hard to believe now, but equities were once a new asset class, at least in institutional eyes. A few years ago some finance professors conducted an appraisal of John Maynard Keynes’ performance as manager of his Cambridge college endowment from 1921 to 1946. Keynes’ top-down macro approach generated disappointing returns in the 1920s, but when he switched to stocks – not permitted by many other colleges until later – his performance improved. “Keynes’ great insight was to appreciate the previously overlooked attractions of a new asset class for long-term investors, namely equities.”
Since then plenty of new asset classes have sparked institutional interest. We’ve discussed here some contemporary ones – crypto of course, and also revenue contracts; we’ve also discussed one that didn’t endure – supply chain finance. With interest rates so low, the demand for alternative asset classes offering i) higher returns and ii) uncorrelated risk has never been higher, making this a ripe environment for new asset classes to incubate.
This week, we take a close look at another new asset class – litigation finance. And there’s no-one better to introduce us to it than Bruce Packard. A couple of years ago, Bruce spent some time working with a mutual friend who was setting up a litigation finance crowdfunding platform: Axia Funder. Today, he writes a weekly column for Sharepad.
Over to Bruce.
Size of the market
The size of the legal market is huge. The top 30 law firms have $2 trillion of pending arbitration claims; annual law firm fees are $860 billion globally (of which just over half is in the US). Both corporates and law firms expect the market to grow further as disputes rise following the pandemic, according to a research survey published by Ernst & Young.
One such dispute is the case between Tatiana Akhmedova and her son, Temur. The case erupted after Temur had conspired with his father to hide assets following his parents’ divorce. In April this year in London, a High Court Judge, Mr Justice Knowles ruled in favour of Tatiana. Temur was ordered to pay his mother £75 million. The court heard how Akhmedov senior transferred assets such as their superyacht, Luna (worth around £340 million) and an art collection (worth around £110 million) into the ownership of trusts in Liechtenstein in order to prevent his ex-wife receiving £453 million that she had been awarded following the couple’s divorce.
Burford Capital, a new type of law company that funds court cases, is helping Tatiana recover these assets from her ex-husband and son. Disputes like this should be uncorrelated with other asset classes such as Government bonds or equities, which all respond to economic cycles. Indeed disputes tend to be unique in nature, and should be uncorrelated with each other. There’s little to suggest the pursuit of the Akhmedov yacht should be correlated with another of Burford’s claims – against the Argentinian Government over the expropriation of an oil company (YPF).
What are legal assets?
For industrial companies, property, plant or equipment make up the bulk of assets recorded on their balance sheet. But financial companies’ assets are more abstract, such as loans like mortgages or bonds, with the debt often secured on tangible assets like property. Companies like Burford take this one step further, and offer non recourse funding of legal claims in return for a share of the money recovered when the dispute is settled. This is inherently risky – court judgments can go against you, even if your lawyers believe you have a strong case.
If the claimant loses, they (and the litigation funder) receive nothing and may have to pick up the other side’s costs. Therium, an unlisted litigation finance company, has suffered a couple of high profile losses. One involved a drunken bet made in the Horse and Groom pub between Sports Direct owner Mike Ashley and banker Jeffrey Blue; Jeffery Blue lost and had to pick up Mike Ashley’s costs. Another was the case brought by Amanda Staveley against Barclays over the bank’s 2008 fundraising. Both cases highlight the risk in litigation finance: the outcome tends to be binary – either a large gain or zero.
Burford says that they lose just 10% of their cases. They win 29% of their cases in court, but the majority of cases, 61%, are settled before going to court. Burford doesn't own the case, they provide the funding, so it is the plaintiff’s decision whether to settle out of court for less money, or go to court and receive a likely higher reward, but at the risk of losing, and receiving nothing.
Tatiana Akhmedova and her attempts to impound Luna reveals that litigation finance isn’t just about the judge ruling in a claimant’s favour. Defendants often hide assets overseas to evade court orders and some jurisdictions are friendlier than others. Imagine trying to enforce an English court’s award against a Russian oligarch in a Russian court. Asset tracing and recovery are therefore also integral to successful litigation finance.
Burford is the only major litigation funder to keep an asset tracing and recovery team in-house; most funders outsource this activity to firms run by ex-intelligence agents and private investigators. Christopher Bogart, Burford’s CEO, says: “Enforcing judgments is core both to the integrity of the legal system and the success of a litigation finance business. In some cases, scofflaws try to evade payment of court judgments and their obligations.” (I had to look up the word “scofflaws” but it is a word, meaning: a person who flouts the law, especially by failing to comply with a law that is difficult to enforce effectively.)
Sometimes asset recovery can lead down unusual paths. Harry Sargeant, a US billionaire, accused Daniel Hall, who works for Burford, of illegally accessing highly personal materials, stored on a corporate server belonging to the family business. Burford was trying to enforce a $29 million judgment against Sargeant and presumably Hall believed that this would be more likely if he had obtained a compromising video tape of the billionaire.
Common sense would suggest you don’t see high returns without any risk. At first glance the numbers look very attractive in a low yield environment. Burford reports that on $831 million worth of disputes that they have funded with their own balance sheet since 2009, they have generated a ROIC of 92% and an IRR of 30%. A competitor, Litigation Capital Management reports an even higher ROIC of 135% and an IRR of 78% over the last 9.5 years.
As you would expect, high returns attract new entrants. The Association of Litigation Funders lists 13 members, including Burford, Harbour, Vannin and Therium. Most firms remain confident that competition should not drive down returns, as this is a relationship based business, with law firms tending to recommend the funders who they have successfully worked with in the past.
That may be true, but it’s rare to find an industry where a large inflow of capital does not alter the economics of returns. Like banking and insurance, there will be several years’ time lag between new business written and rewards (or losses) reported. Litigation funders that are writing business based on optimistic return assumptions can do so for several years before the chickens come home to roost.
A separate criticism of high reported ROICs, is that the returns are illusory and the sector has opaque accounting. It is important to understand that c. 100% ROICs that funders report is not comparable with the mid to high teens returns that companies like Unilever report. The litigation finance companies report the ROIC on a portfolio of completed cases and exclude i) cases where money has been invested, but have not yet settled and ii) allocating their group operating costs.
Importantly, Burford and its critics do not disagree on the numbers, but how the numbers are presented. By way of example, Burford’s 92% ROIC calculation is based on $831 million capital deployed in completed cases, from which they’ve recovered $1,597 million. Simple. Yet if we sum up all of the capital deployed using the table on page 45-46 of the 2020 FY Annual Report, the sum comes to $1.8 billion. The roughly $1 billion difference represents those cases that have yet to be completed. Should the “Invested Capital” denominator include all capital that has been invested, or just that from completed cases? I think that you can make the case for both calculations; what is important to understand is that the high ROIC figures reported by litigation finance companies are not comparable with what companies in other sectors report.
Burford has a market cap of $2.4 billion versus a total portfolio of $4.5 billion of disputes, though that contains both funds managed for third parties not on their balance sheet and cases that have been written up using Fair Value accounting. Critics have suggested that Burford is quick to write up gains with Fair Value accounting, but slow to recognise losses. Originally Burford management were not keen on Fair Value accounting, in 2010 they said:
“[We] believe strongly that litigation and arbitration returns are inherently speculative and are most appropriately accounted for by holding investments at cost until a cash realisation has occurred, as opposed to taking unrealised gains into income before a litigation resolution has occurred. Moreover, the appropriate metric, in our view, for Burford Capital’s share price measurement is its relationship to net asset value based solely on actual cash realisations. Thus, for the guidance of investors, we publish a cash NAV figure alongside the requisite IFRS-based NAV, and we encourage investors to consider the cash NAV as the appropriate valuation metric.”
Then something changed. In 2011 Annual Report, Burford stopped publishing cash NAV, claiming that:
“We have also historically published a “cash NAV”, but that measure has not been embraced by analysts and investors, and given the increased complexity in its computation following the Firstassist acquisition and the relatively modest and clearly identifiable unrealised gain in the portfolio, we do not intend to continue to use or publish it after this set of accounts.”
Study silence to learn the music
Voluntary disclosure – what companies choose to tell investors – rather than what they are required to reveal, is a fascinating area. And very often when companies change their mind and withdraw disclosure it’s even more significant, though harder to spot. When you walk around the City of London and see large cranes and a new building going up, it’s often hard to recall the building that previously stood in the space. Similarly, unless you are reading corporate results laid out with the previous year’s results in parallel, it’s hard to see what is no longer there. Or, as the Finnish Operatic Metal band Nightwish sang: I studied silence to learn the music.
Perhaps a coincidence, but around this time is when Selvyn Seidel, the co-founder who lived in the village of Burford, left the company. The other co-founder was the current CEO, Christopher Bogart, previously General Counsel for Time Warner and before that Cravath, Swaine & Moore.
Burford’s IPO in 2009 was backed by Neil Woodford, while he was still at Invesco Perpetual. He bought 45% of the share capital when the shares IPO’d at 100p, which required a special waiver from the Takeover Panel, as over 30% would normally require a mandatory bid for the entire company. This valued Burford at £80 million market cap in October 2009. Other institutions with disclosable interests were Baillie Gifford, Fidelity, Eton Park and Scottish Widows. Most of those investors have sold out now, Woodford’s fund has been wound down, Invesco owns just 6% and currently the largest shareholder is Saudi Arabian fund, Mithaq Capital, with 10.5%.
Short selling attack
By October 2018, Burford’s share price had risen from its 100p 2009 IPO price to almost £20, and the company raised £192 million (or $251 million) at 1850p per share. Canaccord published a sell note in April 2019 and in August 2019, Carson Block of Muddy Waters led an attack on the company, calling it “a perfect storm for an accounting fiasco.” Block has made a name for himself shorting Chinese frauds: Orient Paper, Sino Forest, Luckin Coffee. He has been aggressive and he has been right. In his report he compared Burford’s accounting to Enron. Block also highlighted the fact that Christopher Bogart’s wife, Elizabeth O’Connell was the CFO, though she has since been replaced by Jim Kilman, formerly Burford’s investment banker at Morgan Stanley.
Muddy Waters can claim victory in their battle: Burford’s share price fell back below £3 in March 2020, helped by a broad sell off in markets due to the pandemic. Following the attack, Burford disclosed that they have written up the value of their court case against Argentina for expropriating the oil company YPF to $773 million. The firm’s rationale is that there is a secondary market in this large claim; they sold 39% of their interest in the proceeds of the YPF/Petersen claim for $236 million in cash in a series of third-party transactions from 2016 to 2019. Burford management says that Fair Value accounting requires them to write up the value of the asset.
Many twists and turns
Burford’s share price has now recovered to 780p. Last week they announced that they had bought back £24m of bonds yielding 6.5% due 2022, which does not appear to be the actions of a company that is worried about its financial position. It’s possible that they do recover a significant sum from the Argentinian Government in the next few years, which would justify management’s accounting. The case against Argentina will be heard in New York, probably at the start of 2022. Lawyers with large value disputes are tenacious, many of their cases take years to come to judgment, with many twists and turns. The jury is still out.
More Net Interest
US banks have a lot of catch-up to do. Last year they were restricted from increasing dividends and doing share buybacks as regulators encouraged them to preserve capital. This week, they all passed their stress tests, with ample buffers against regulatory capital minimums. In aggregate, the banks that participated in this test have around $175 billion of excess capital, equivalent to around 10% of their market cap. Compared with their own capital targets, which are typically more conservative than regulatory minimums, they have around $100bn of excess capital.
Although the stress applied to banks in these tests was not as severe as last year, when the outlook was more uncertain, it remains a pretty severe test. The Fed stressed credit card loans at a loss rate of 16.2%, much higher than what was incorporated into stress tests five years ago (13.4%) and a big gap versus the rates currently being realised. In commercial real estate, where risk might be more apparent today, losses were estimated using a 10.5% loss rate, which is the highest ever used in a Fed stress test (last year a rate of 6.3% was used). Yet the banks are quite well covered and already have a large stock of provisions to absorb such high losses; the top seven banks have sufficient provisions to cover around half of their stress-case losses before capital even has to be tapped into (last year that coverage was only around a quarter).
Banks will report capital plans on Monday (28 June). They will be eager to disgorge their excess capital to shareholders.
I’ve discussed Revolut here a few times before, and I’ve been remiss – I should have disclosed that I’m an investor; I participated in the series A back in 2016. However, first and foremost I’m an experienced analyst and that stops me being starry-eyed. This week the company filed its 2020 financials and they are a bit mixed.
The company lost £168 million on revenue of £261 million (including fair value gains on cryptocurrencies). Between those two numbers, there’s a lot of cost. Much of that is linked to risk, compliance and control enhancements. Based on LinkedIn data, around a sixth of the company’s workforce (of ~ 2,500) now sits in some sort of compliance function. The good news is that those costs are largely fixed and don’t have to scale with the company. Nor do the total costs include much marketing. The company halted marketing and discretionary spending during the year, yet continued to win new customers largely by referral (customer count is 15 million as at March 2021, up from 10 million in February 2020).
Revenues have diversified. Just over a third of revenue now comes from card and interchange, compared with just less than half in 2019. Crypto picked up the slack which may now be taking a hit, but the company also opened up a source of income via subscriptions which now contribute 29% to revenue. Subscriptions are good because the rest of the revenue base is very transaction oriented; there’s no interest income here. In fact, average deposits per customer stand at around £300, much less than at Wise, where they stand at £2,300, so scope to earn substantial recurring revenue from them is limited (notwithstanding the current level of interest rates). Average revenue per customer of £21 for the year is not great, although there is likely a distribution around that number (how many of the 15 million customers are not active?)
Despite the company’s grand ambitions to expand globally, most revenue still comes from the UK – 88% of statutory revenue in 2020 (i.e. excluding the mark-up on crypto). By the end of the year, Revolut had 200,000 customers in the US, where it intends to make a push.
Press reports indicate that Revolut is looking to raise capital. Part of this may be to fund regulatory capital to underpin the bank licenses the company has applied for in the US and the UK. Klarna has been regulated as a bank since 2017 and has had no trouble raising capital, but its core product is higher return than Revolut’s. Key will be whether Revolut can use its banking licenses to win more deposits and introduce more products.
Visa announced this week that it would acquire Tink, a European open banking platform, for $2.2 billion (versus its last valuation of $825 million in December). Founded in 2012, Tink offers customers access to underlying consumer financial data via a single API. It reaches over 250 million consumer bank accounts across 18 markets in Europe via integrations into over 3,400 financial institutions (versus ~11,000 market total). It offers five key products: Transactions, Account Check, Income Check, Payment Initiation and Money Manager.
Account-to-account payments are growing as a credible alternative to payments made via card networks, particularly given the support of unified protocols such as Open Banking in the UK. This deal gives Visa a foothold in the segment. Open banking payments are better suited to large ticket items since fees do not scale with transaction size, and to transfers between a consumer’s various accounts (e.g. bank to fintech). They may also be better suited to variable recurring payments compared with cards kept on file. Depending on the underlying payments network, settlement times can also be faster, such as in the UK under Faster Payments.
Visa was exposed by the DOJ when it tried to buy Plaid. It is unlikely that there will be an incriminating email trail this time (or back-of-the-napkin doodles of volcanoes) but the motivation is similar: to own control of the disruptive play rather than look on passively.