“There is only one thing in the world worse than being talked about, and that is not being talked about.”
How true the words of Oscar Wilde would have rung for the litigation funding market ten years ago. Struggling at the time for any publicity or endorsement from the broader legal market, the kind of mainstream press coverage generated by the current Burford Capital siege would have been very welcome. The opportunity to promote general awareness of litigation funding; to champion its ability to unlock meritorious claims; and access to very attractive, uncorrelated returns in a low yield environment.
It really would have been a high-quality problem. Let’s put aside for a moment the fair value accounting debate at the core of the Burford siege. The combination of Burford’s H1 2019 investor presentation and 25-page report published by Muddy Waters sheds some fascinating light on the underlying market. 187 cases funded since 2009, committing circa US $2.1 billion of capital (of which approximately US $1.2 billion has been deployed). One very well-known matter, Petersen, demonstrates the possibility of making vast returns (depending on who you believe, of between US $600 million and US $1.4 billion) from a relatively small investment (depending again on who you believe, of between US $7 million and US $20 million): a scale of return usually associated with early-stage investments into eventual unicorns.
To be clear though, this is not to dismiss Muddy Waters’ report, which raises some interesting questions. Their likening of Burford’s fair value accounting to “Enron-esque mark-to-model accounting” is not said lightly. In fact, it is well-argued with a detailed explanation of the seven techniques they say Burford used to create “what we believe is an egregiously misleading picture of its investment returns” which then leads to their even bolder assertion that Burford is insolvent.
But regardless of whether one agrees with Muddy Waters or not, it’s important to stress that Burford does not constitute the entire litigation funding industry. Muddy Waters founder Conrad Block may have described Burford as a “lottery ticket” business model (albeit only in the press post publication, not the report itself) but this seems to be convenient rhetoric to support his “big short” than any argument based on an equally well-informed analysis of the industry. Put another way, remove the recording of unrealised gains in the accounting methodology used by Burford (as both IMF Bentham and Litigation Capital Management, two other listed funders, did almost instantly) and much of the Burford siege loses its teeth.
The key point is that this is very much a siege on Burford, not the industry. And while it has brought closer scrutiny to the industry, it also highlights the opportunities that exist within the litigation funding market, why it has become established and accepted, and how and why a well-accounted for, well-understood litigation funding business can create significant value for both stakeholders and claimants.
Litigation risk is not a lottery
Of the numerous litigation funders that now operate today, very few are structured like Burford. As a listed company, Burford has the benefit of crystallising an equity value in the underlying company, which can be monetised by selling shares on the exchange; as Christopher Bogart, its founder and CEO, has supposedly done to the tune of £59.4 million. But with it comes the reporting and disclosure obligations of a listed company and the headaches of how to account for them.
In the early days of the litigation funding market though, the grey area of using the mark-to-model accounting methodology for the valuation of level three assets (as Burford’s litigation funding investments would be) was a non-issue. One of the earliest litigation funders in the market, Harbour Litigation, grew out of a hedge fund: MKM Longboat. The perhaps much-forgotten but still existent Association of Litigation Funders is made up largely of funds or family-controlled investment groups. As funds, the principals would have likely negotiated a typical hedge fund “2/20” fee structure on the managed monies; that is, a running management fee of 2% per annum of the assets under management and a performance fee of 20% of the fund’s returns. Typically, the running management fee of 2% supports the operations of the business but the real incentive for hedge funds is in the 20% performance fee. As such, for litigation funders on a 2/20 fee structure, the real incentive was to invest in successful, profitable cases.
In practical terms, the only thing that mattered was that the investments were successful and monies were recovered, out of which a portion of the profits would be paid as performance fees. And if a case was unsuccessful, the profits from successful cases would net off against those losses.
The fact that most funders have been operating on the above basis, and have continued to thrive and grow, is clear evidence that they have been able to make money. The fact that the number of funders itself has exponentially increased demonstrates that investing in litigation risk has clearly proven not to be a “lottery”, but a viable business model for those able enough to run it.
But it’s not just funders who have been investing in litigation risk successfully. Insuring may not be investing but they both entail taking risk; and commercial after the event (ATE) insurers have been taking on litigation risk successfully for many years. Since 2006, Acasta has been underwriting ATE and, in the post-Jackson era alone, has taken on north of 4,500 commercial litigation cases in England and Wales profitably.
Perhaps it is simply the emotion of fear that underlies the word “litigation”. This may be because venture capitalists on the hunt for the next AirBnb-esque unicorn, and the emotion of excitement, drown out the knowledge that unicorn-hunting is a considerably more “lottery-based” approach to investing than investing in litigation.
Litigation funding pricing is expensive for a reason
Stating the obvious perhaps, but in any portfolio of risks, whether as an investor, lender or insurer, there will always be losses. The key of course is to make sure the winners more than cover for the losers so that the overall portfolio performance is positive. That means pricing cases accordingly.
It is true that business is all about maximising profits, so most funders will price as expensively as they can get away with. But that doesn’t mean the pricing they charge on a matter is sufficient to cover the “risk” they are assuming. For a start, predicting which cases will lose is impossible, especially when no one invests in a case if they think this is likely to happen. Having made that assumption, the next step is to calculate the returns generated by the winners that will cover the loss and still make an attractive (or target) return at the portfolio level. But both are before the event, which means the “uncertainty” component has to be factored into the pricing. And that’s before going into the nuances of each case, the risks of Arkin (or other unintended cost), risks associated with section 51 of the Senior Courts Act 1981 in England and Wales, recoverability risk, and so on. In fact, pricing litigation risk, in particular in the high value, complex cases, is more an art than a science, where the art is to make sure that it has umpteen layers of buffer to absorb the losses.
That would be no different with Burford. The phenomenal returns on Petersen, regardless of how they are accounted for, may not be replicable very often (the criticism made by Argonaut who also shorted Burford shares), but when the underlying profit is nine figures versus an average investment amount of low eight figures per case, that is a substantial buffer to absorb quite a lot of losses. And that is the foundations of a strong business.
Finally, for all the big numbers and headlines that we all love to focus on, the reality is most litigation cases are rather dull, un-sexy and un-newsworthy and have more modest returns in comparison to Petersen. Nothing for Muddy Waters to get excited about.
Burford does not represent the litigation funding industry
Litigation funding is now well established as a commercially attractive and economically viable industry. It continues to attract an ever-growing number of market participants; whether it be dedicated litigation funding businesses, asset managers, hedge funds or private investment offices. And as the market continues to develop out of its (still) relatively nascent state, so the opportunities will increase as the industry develops a better understanding of risk and how to structure it.
This is totally discrete from the future of Burford. At heart, Burford is about one company in a growing industry that has received criticism for choosing to account for and report its underlying business in the way it has. It could have been a company from any sector. But in no way does it reflect a general malaise in the litigation funding industry.