Cube Midcap Report (7 Aug 2019) – Burford unravels #BUR

Cube Midcap Report (7 Aug 2019) – Burford unravels #BUR

Good morning!

Today I’m looking at Burford. Later in the week on a quiet day, I may cover these companies:

  • Flutter Entertainment – Half year report
  • Spirax-Sarco Engineering – Half year report
  • PageGroup – Half year report
  • Ultra Electronics – Half year report
  • Phoenix – Half year report

Burford

  • Share price: 455p (-60%)
  • Market cap: £995 million

There has been an attempted bear raid on Burford by Muddy Waters, which has published a research note (also known as a “short dossier”) here.

Here is a video from Muddy Waters, published today:

Key Claims
1. “Categorising a loss as an investment with significant return”

The first claim by Muddy Waters is all about a case involving Napo Pharmaceuticals.

MW says that Burford booked this as a win, as a “Concluded Investment” in 2013.

However, MW says that Napo actually lost the legal case in court, and was left owing Burford significant sums, which it could not pay.

MW says that an Invesco fund helped to bail out Napo and Burford by investing in a company that acquired Napo. Invesco is Burford’s largest shareholder, thanks to the historic involvement of Neil Woodford (Woodford Investment Management is currently the second largest holder).

This year, Burford finally wrote down the returns generated for it by the Napo case.

Conclusion by MW:

Without the Invesco-led bailout, Napo likely would have been a total loss. We believe BUR investors have been bamboozled by the company and Invesco.

My view: these claims, if true, reflect very badly on the fund manager at Invesco. They would also demonstrate aggressive accounting at Burford. However, I think it’s worth noting that the amounts involved are not so large: profits at the Napo case were alleged to be $14 million, from an investment of $7.4 million. 

The Burford market cap has collapsed by £1.4 billion in two days, so let’s read on…

 

2. “Counting as “recoveries” awards or settlements with uncertain to highly unlikely collections as equivalent to cash returns when calculating IRR”

MW discusses a case that started in 2009 and was claimed by Burford to have concluded in 2013, with an IRR of 51%.

Rather like the example in 1), Burford didn’t receive cash from its client before it presented the case as having concluded. Instead, it received a promissory note where payment depended on a parcel of land being sold. In 2016, Burford sold this note at a discount, and the buyer of the note pushed the issuer (Burford’s former client) into bankruptcy.

Furtherore, MW says that the client’s bankruptcy estate is suing Burford for violating “duties of good faith and fair dealing”, and that Burford has not acknowledged “the significant contingent liability that accompanies this lawsuit”.

MW also discusses a $3 million writedown by Burford which occurred after an individual died: Burford was entitled to value from this individual’s future activities as an inventor!

My view: Again, this suggests that Burford has presented its performance too aggressively. IRR should always be based on cash flows, or the flow of cash equivalents. The receipt of a promissory note should not be treated as a positive cash flow. 

However, I would caution bears that even if the original presentation of the 2009 case was far too aggressive, the final and true performance of the case might still be rather good. Burford only ever deployed $7 million to it. As of H1 2019, it claims to have recovered $38 million from the case.

 

3. “Misleadingly representing an investment that BUR inherited through acquisitions as favourable IRR”

This would not surprise me.

Most listed companies behave similarly: when presenting their results after making acquisitions, they ignore “amortisation of acquired intangibles”. This amortisation is how the purchase price of intangible assets is supposed to be accounted for in financial statements.

If Burford ignores the high purchase price it paid for acquired cases, this would be in line with the type of thing that many other companies do during an acquisition spree.

My view: not surprising, but yet another reason to be cautious about IRRs presented by Burford. 

 

4. “Choosing its own cost denominator when the total cost is much greater”

MW discusses Burford’s position with respect to Tatiana Akhmedova. Burford recorded $5.2 million of partial recoveries against $3.5 million of costs, at 2018 year-end.

However, MW says that Burford made a lump sum payment of “at least $18 million” to Ms Akhmedova, providing this article as a source. I can’t find any evidence that the lump sum is so large – can anyone help me with that?

MW also provides reasons to think that the case is not going particularly well.

My view: the partial recoveries which have been recorded in this case so far are very small, so I doubt that the case is very important in terms of valuing Burford today. But I agree that the value of the case is very unclear and might not be favourable for Burford.

5. “Delaying recognising a trial loss for two years”

MW claims that a $10.4 million case that was lost in 2016 was not recognised as concluded until 2018.

My view: fair criticism.

 

6. “Keeping trial losses out of the “Concluded Investment” category”

MW provides three examples of instances where negative legal developments have not been reflected in Burford’s valuations of its cases.

My view: these all sound fair. Committed capital in the three cases adds up to c. $57 million.

 

7. “Failing to deduct various costs against recoveries, including the very operating expenses associated with the investments themselves”

MW says that return metrics don’t include expenses needed to fund the business and the cases being measured.

My view: the business does have very high operating costs, and it’s reasonable to think that many of these costs will relate to specific cases.

 

“Net realised gains”

This section of the short dossier, beginning on page 15, is the most important part for me. If what it says is true, then the portion of Burford’s returns which are derived from fair value movements are much higher than what the numbers appear to suggest at first glance.

I will explain it as simply as I can.

Suppose we invest $100 in a case. We then mark it up to $120, recording a fair value movement of $20 for the period.

Now suppose that in a later period, we sell the case for $150. How should we account for what has happened in this later period?

Investment income includes net realised gains on investments and fair value movement on investments.

Intuitively, most people would think that in the later period, we record a $30 net realised gain on investments, since we sold the case for $30 more than its carrying value. That’s not how Burford does it, according to MW.

Instead, if we are Burford, we record a $50 net realised gain on investments, and record minus $20 in fair value movements.

As you can see, by doing it this way, we get a much higher net realised gain, and a much lower fair value movement.

Do this with a big portfolio of cases and the net realised gain every period will be much larger, and the fair value movement much lower, than what would make sense intuitively to the ordinary person.

 

My conclusions

Burford has always been a complicated story, and I have always found it difficult to come to any firm conclusions on it. For several years I was extremely sceptical of it, since its financial statements (especially the balance sheet) were so bizarre. In the last year or so, I gradually began to accept the possibility that its profitability was real and that litigation finance, in the right vehicle, might offer extraordinary returns for shareholders.

This short dossier, for me, has cast serious doubt on Burford’s claims with respect to its ROIC and IRR. It is an impressive research note with plenty of sources provided to back up its claims (though in the space of a few hours, I have only been able to verify a few of its assertions).

The section on “net realised gains” is the most damaging part of the dossier for me, since it blows up my trust in the company’s mix of realised gains and fair value movements. As the dossier says, the mix has traditionally been reported around 50:50. But because of the way Burford defines “net realised gains” (which it is entitled to do, under accounting rules), the mix is going to be something else. MW says that in H1 2019, between 72% and 90% of investment income was from fair value gains.

MW says:

To the extent we are correct that most investors misunderstand Net Realized Gains, it is almost certainly because BUR deliberately misled them.

Indeed, if you look at the 2018 annual report (page 3), Burford uses language such as:

Unrealised gains remained generally consistent with prior year levels at 55% of income (2017: 53%; 2016: 54%)

To honest, I am annoyed with myself for accepting this 55% number at face value – if I had studied the annual report in more detail, I hope that I would have figured out the less impressive truth on my own. After all, Burford itself described its fair value movements as being “net of realisations” and it reported that 39% of its entire investment portfolio consisted of fair value gains, with this percentage increasing year-on-year. In hindsight, it does not seem so difficult to figure out that the 55% number was misleading. But well done to Muddy Waters for highlighting it.

“Arguably insolvent” – Muddy Waters stretches credibility in the final section, subtracting Burford’s debt balance and litigation commitments from its “adjusted capital base” to arrive at a negative number, and claiming that this makes the company “arguably insolvent”. This section doesn’t take into account the likely returns on Burford’s capital base and the timing of future cash outflows, and also doesn’t seem to bother mentioning Burford’s cash balance. I view this section of the report as the only section which fails to make a strong case.

So what’s Burford worth? I previously balked at Burford’s valuation, thinking that a price-to-book multiple of 5x was too aggressive for what was fundamentally an investment vehicle. Over time, as I began to accept that Burford’s profitability might be real, I began to warm to the idea that paying a significant premium or even a multiple of book might be justified.

Given the extreme uncertainty which hangs over the value of the company’s balance sheet, and the poor quality of its earnings, as explained brilliantly by Muddy Waters today, I once again think that investors should anchor themselves to book value when it comes to valuing this company. And for those of us who have lost trust in management, we might reasonably think in terms of a discount to book as representing fair value.

Net assets at 30 June 2019 were $1,567 billion ($7.17 per share). If 40% of the investment portfolio are unrealised gains, and we don’t want to pay anything for them, that knocks the value down to $860 million ($3.93 per share). The latest share price is 568p, representing $6.90 at the latest exchange rates.

In other words, normality has been restored to the Burford valuation.

 


 

Thanks everyone – I will be back again with more midcap news here tomorrow.

Graham

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COMMENTS

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  • comment-avatar

    Graham
    :
    There’s a typo (I assume) in the sentence in BOLD preceding your conclusions. You write “That’s now how Burford does it, according to MW.” but I think you meant to type “That’s NOT how Burford does it, according to MW.”

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    Graham,

    Thanks for the overview here, great clarity as always.

    Nick

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  • comment-avatar

    Excellent write up Graham, thanks very much for this.

    It is not a company I have looked at any great detail before, but I am intrigued on the point on fair value adjustments vs net realised gains.
    I presume the relevance is that “net realised gains” are ‘good’ profits, because they are linked to real cashflow whereas “fair value adjustments” are ‘bad’ because they are effectively a matter of opinion, “invented profits” if you will.
    So the argument is that if Burford are overstating their realised gains and understating the fair value adjustments, they are giving a false indication of the quality of their earnings.
    Using the hypothetical numbers you use above (Contract bought for £100, valued up to £120 and then sold for £150.)
    If they were to report only “net realised gains” (‘good’ profits) of £30 does that not create the impression that there are still £20 of ‘bad’ profits having been recorded?
    I do accept that is the conventional way you would account for example for a property disposal, but it would not seem to me fully satisfactory in this case. (In fact would they not effectively need another ‘line’ for “crystallised fair value adjustments”?)
    Maybe I am missing something, but it does seem to me that there is some justification for the method of accounting they are said to use.
    Obviously though if they have been less than transparent with their reporting that could be a black mark.

    • comment-avatar

      Hi Tony, suppose that in the same period, you revalued another case (let’s call it Case B) from £100 to £120.

      Then using Burford’s method:

      Net realised gain is £50.

      Fair value movements are minus £20 on the first case and plus £20 on Case B, adding up to zero.

      Burford would now say that it enjoyed total investment income of £50 during the period and 0% of it was from fair value movements.

    • comment-avatar

      In response to Graham’s reply and example, in principle I don’t have a problem with this, since net fair value movements for the period are zero in this example (£20 of fair value “created”, £20 of previously created fair value realised). If there is sufficient previously created fair value getting realised to net off material quantities of new fair value creation then that suggests that over the long term the fair value adjustments do indeed translate to quality reaslised earnings.
      The issues that do concern me though are a. They could make this clear in a table each reporting period in the notes (new realisations, conversion of existing fair value to realisations, new fair value) and then there would be no confusion, and b. the realisation of fair value adjustments from the sale of portions of the outsized Petersen and Teinver cases could mask a lot of problems with the bread and butter of fair value realisation of many smaller cases. I’m not saying that it does, just that it could.

  • comment-avatar

    Superb dissection of the MW report, Graham. It will be interesting to see their rebuttal.

    Like you, I feel that the examples that MW has given are rather insignificant in the context of the scale of the business. The accusation that they have distorted the split between realised gains and fair value adjustments reminds me of the similar surprise investors had when Plus500 revealed that it was possible to lose money on their unhedged positions.

    The issue is surely that MW are attempting to suggest that Burford’s assessment of the fair value of its investments is inflated. On this point, they are unable to provide any hard evidence. If the fair value adjusted values turn out to be accurate then I can’t see the issue. I can see that the share price is, therefore, based on a higher % of profit derived from mark-to-market than from realised proceeds and that, therefore, the multiple should be lower to reflect the risk that realised proceeds turn out to be lower than their carrying value. But, like you, I think the claim that they are technically insolvent is unconvincing.

    I wonder if, as with Plus500, the market will adjust to knowing something that it probably knew all along if it had bothered to stop and think about it?

    • comment-avatar

      I would agree that the fair value vs. realised argument is overdone, and IMO not the most important issue.

      To me, the most important accusation was that the quoted IIRs ignore the cost of funding and at least some of the cost of litigation. The inference is that the company is not nearly as profitable as it makes out, and that most of the litigation profits will end up in the pockets of the partners and the bondholders, not the shareholders.

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    Usual high standard of analysis. Thank you Graham. PS thought the guy from MW made a good point on Bloomberg. With a valuation of £3bn why was this company still on AIM with its lighter regs and governance

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    Hi Graham
    Thanks for the Burford write-up, much appreciated.

    As a holder here are some additional points if I may. I’m writing these in the hope that at the very least they help me to process my own thoughts for a share that appears to be in free fall.

    I will go through each claim in turn as you have done:

    1)THE NAPO CASE
    As far as I can tell Burford have been open about this situation in their reports. They were initially paid with a mix of cash and stock from a collapsing company (which was better than nothing), and they were not allowed to sell the stock for 3 years. I can’t remember if it was the FY18 or H119 report, but they did state that they would need to take a retrospective loss on this case and that it was rare to do so. They highlighted 5 other similar cases, 4 of which they were sure they would receive all monies, and a 5th where they were more sceptical – the £3m loss you yourself have mentioned above.

    What I find more concerning is why Invesco gave money to a collapsing company – Jaguar/Napo – simply for them to then partially pay Burford’s debt before collapsing again? Burford was extremely tiny at the time too so immaterial for Inveso. It makes no sense.

    2) SALE OF PROMISSORY NOTE
    Again, I’m not entirely sure what Burford has done wrong here. They were entitled to receive money, the debtor didn’t pay, they sold the debt on, the debtor then sued because they subsequently went bankrupt.
    Burford have disclosed this as well, and a quick google search shows that Burford are proceeding with the legal case and trying to get it moved to London (as per agreement made several years ago with the plaintiff).
    Here is the link to the USA case, published last week, in case anyone can translate what it means:
    https://www.pacermonitor.com/public/case/25921021/Epicenter_Partners_LLC_et_al_v_Burford_Capital_Limited_et_al

    3) ALLOCATION OF ACQUISITION COSTS TO INDIVIDUAL CASES:
    MW are claiming that Burford are not fairly representing the IRR of cases brought in through an acquisition, because they don’t apportion the acquisition costs to each of those cases. To be honest:

    a) how could they possibly allocate acquisition costs to multiple individual cases?

    b) surely there is just as much room for manipulation if you attempt to allocate acquisition costs to individual cases?

    c) I personally like seeing the true outcome of each case on an individual basis, as it helps me see how well the underlying business is performing.

    d) I actually like the IRRs from 2 of the acquired cases that MW has highlighted (138% and 75% respectively). One of the “negatives” is that one of these 2 cases went on to make another IRR of 107%.

    4) ALLOCATING COSTS TO PARTIALLY COMPLETED CASES
    Allocating costs in partially completed cases is always going to be tricky to do. Why is MW more correct than Burford here? How would they allocate costs fairly?

    It’s an interesting case they’ve picked out too – the divorce settlement of Tatiana Akhmedova. The dossier states that Burford are funding her lifestyle by paying her a supposed $18m. A bit of a a strange way to write “funding legal costs so that she can continue living.” Isn’t that the entire point of litigation finance? To allow entities to carry on as normal as possible, whilst their litigation is financed?

    5) DELAYING 2016 LOSS UNTIL 2018
    This is an untrue statement, which builds up the case for lack of transparency from MW.
    The case in question (Progas Energy Ltd. v. Pakistan) was ONLY concluded in 2018, so it’s not unreasonable for Burford to recognise the loss in that financial year.

    6) KEEPING LOSSES OUT OF CONCLUDED INVESTMENTS
    The first example mentioned by MW relates to Neptune Generics, stating that it should be in the “concluded” bucket. Keeping aside whether something is listed as concluded or not, I found Neptune claims open as recently as a couple of months ago, so as far as I’m concerned this cases shouldn’t be listed as “Concluded”. There might be an argument for partial conclusion, but to be honest if there is a zero showing in the “Recoveries” column, than I’m not fussed either way.

    Neptune ongoing case reference from Feb 2019:
    https://www.fool.com/earnings/call-transcripts/2019/02/26/corcept-therapeutics-incorporated-cort-q4-2018-ear.aspx

    7) DEDUCTING COSTS
    The largest, and seemingly most important, section. So why leave it until the end? I would have thought they would lead with this.

    Whilst I agree that MW MAY have a point, there are, again, A LOT of assumptions when I work through their numbers for the Peterson case that make me doubt how reliable the remaining figures and assumptions are. MW state that the Peterson case apportioned costs of $2m to a $100m sale in June.

    I’m not sure how they would know this.

    From the detailed investment data published yesterday vs 6 months ago, only $0.2m of additional costs have been deployed for this case, and there is no about on what is or is not recognised in the accounts.

    Which leads me onto my last point about recoveries. I did a deep dive into the investment detail published 6 months ago. I’ve posted this elsewhere before, so apologies to anyone who has seen this before:

    All cases since inception of the company until 2018 and are % figures only.

    Cases concluded or partially concluded = 111
    Cases concluded and won = 62%
    Cases concluded and lost = 27%
    Cases partially concluded = 11%

    Breaking this down further:

    23% of cases had an ROIC>+100%
    19% of cases had an ROIC +50% to +100%
    13% of cases had an ROIC +20% to 50%
    7% of cases had an ROIC 0% to 20%

    27% of cases had an ROIC 100%

    Burford have stated as much. Lumpy outcomes, with a few stars to give those extra-ordinary gains.

    Remember, Burford do not have to give this detail, so why post it with false information?

    If I was going to be concerned about anything it is not how net realised gains/realised gains/fair value adjustments are being reported, but whether the company is recovering cash from its investments.

    I believe Burford have been pretty open about this in their reports. From the last report there 6 aged debts, 4 of which they are confident of receiving, and 2 (both stated in today’s dossier) where they will take small losses.

    As a last point, I noticed that the CFO of Burford used to work for Manulife, who MW unsuccessfully shorted last/this year. I also note that the CFO is on holiday right now. 2 interesting coincidences.

    This is perhaps my longest post so I will stop there. I remain genuinely confused by what I am missing, and even though the share price continues to plummet, I honestly (and fearfully) don’t see a reason to sell.

    It will be interesting to see Burford’s rebuttal.

    Cheers
    A

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  • comment-avatar

    Hi Graham

    With your example, what am I missing as I don’t have an issue with their accounting of realised vs Fair Value P&L (I prefer to call it unrealised)?

    Day 1 – they invest £100 in Case A, so Cash down £100, and they have an Asset of £100 called Investment in Case A at cost

    Day 2 – they Fair Value Case A to £120, Cash still down £100, they now have an asset of £120 (Cost of £100 and a Contingent Gain of £20) with unrealised/fair value P&L of £20

    Day 3 – Case A settles for £150, Cash goes up by £150 to £50, their asset of £120 is now £0, unrealised P&L is £0 and Realised P&L is now £50. Makes sense and you have cash traceability of realised P&L of 50 with 50 in your bank account.

    Day 4 – they invest £100 into Case B, Cash goes down by £100 to -£50, their investment asset is £100 and they still have realised P&L of £50

    Day 5 – Case B is revalued to £120 – Cash remains at -£50, their investment asset is now £120 and they have unrealised P&L of £20 and realised P&L of £50

    That accounting makes sense to me. Lots of other issues as highlighted and I don’t like the subjectivity around unrealised/Fair Value P&L but the accounting seems fine to me.

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    • comment-avatar

      Hi Stuart, you are right in the sense Burford’s method is a legitimate way of accounting for the situation BUT investors (at least partially our own fault – I take responsibility for not spotting it myself) were under the false impression that about half of Burford’s new investment income in each period consisted of realised gains.

      Burford said things like “Unrealised gains remained generally consistent with prior year levels at 55% of income (2017: 53%; 2016: 54%)”. But unrealised gains during that period might “really” be something like 75% of new profits, with 20% then being wiped out by the elimination of prior-period unrealised gains.

      It’s a shame because the annual reports seemed so clear before – but now it feels like they were trying to bamboozle us.

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  • comment-avatar

    Any chance of a look at #LIT ? Same sector (litigation finance) but less aggressive accounting (I believe)

  • comment-avatar

    Hi Graham,

    Excellent analysis as always. One point that I’d like to discuss is your valuation as I’m not persuaded that a book-value approach helps. You discount BUR’s investments as follows:

    ‘Net assets at 30 June 2019 were $1,567 billion ($7.17 per share). If 40% of the investment portfolio are unrealised gains, and we don’t want to pay anything for them, that knocks the value down to $860 million ($3.93 per share).’

    My understanding is 100% of the investment are in in-flight cases not 40% – as none of these cases have concluded and no partial realisation has occurred. If this is correct, then you need to ignore all the $1.5bn and the book value will be negative. Clearly, this is not a helpful valuation.

    Thus, I don’t think that you have a choice but to put a valuation on that $1.5bn of cases. On BUR’s record the likelihood is that a high proportion will be concluded successfully and the award recovered in cash. Assumptions need to be made here and that’s the challenge, and its probably more insightful to take a scenario approach due to the high subjectivity.

    Cheers Maddox

  • comment-avatar

    A lot of time needed to get through this very detailed bit of research rebutting Muddy Waters assertions.

    http://caro-kann-capital.com/pdf/2019_09_09_Burford_Muddy_Waters_Dreams_of_Black_Cat_That_Just_Is_Not_There_by_Caro-Kann_Capital.pdf

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