Lawsuit financing: investors smell profit in classic hold-your-nose stocks
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
There is a trio of what I call hold-your-nose stocks on the UK market — companies that promise stellar returns but will make some investors uncomfortable.
I’m not talking about big sin stocks such as oil, gas, guns, alcohol or gambling. I’m talking about Aim-quoted Burford Capital, Litigation Capital Management and Manolete Partners, which bankroll lawsuits. It’s known as third-party litigation finance or TPLF.
There is a lingering whiff around TPLF that goes back to the Middle Ages, when lawmakers worried that nobles were staking doubtful, even dishonest, claims for a share of winnings. So-called champerty was banned in most jurisdictions, partly out of fear that it encouraged litigiousness.
“We’ve moved on since then,” says Christopher Bogart, chief executive of Burford. “And litigation is a necessary evil of business life.”
When the law against champerty was effectively abolished in the last century it unleashed a new vibrant band of legally savvy financiers prepared to back plaintiffs, both individual and commercial.
Industry participants say virtually every big US private capital firm is now involved in funding lawsuits, some quietly, some less so, and much of it lucratively. Fortress Investment Group says it has deployed more than $5bn in financing litigation since 2012.
There are only a handful of listed companies involved in TPLF. Burford is the only quoted litigation funder in the US. But we get some sense of the size of the possible market with the action, backed by TPLF, against Johnson & Johnson and allegedly carcinogenic talc. The case was settled in May with the US healthcare giant agreeing to pay about $14bn over 25 years — $6.5bn in present value terms.
So far, says Patrick Moloney, LCM’s chief executive, market penetration is low. But TPLF is increasing. He insists it is a force for good and an agent of change, aiding those pushing for better governance or environmental standards and bringing corporate miscreants to book.
He has a point. In the UK, the sub-postmasters in the Post Office Horizon scandal, who fought to overturn wrongful convictions, were bankrolled by Therium Capital, a private financier. Litigation financiers help to level the playing field, giving ordinary people access to justice they otherwise could not afford.
Even so, the sheer size of returns triggered onlookers to mutter about ambulance chasers and profiteering. Alex Chalk, former Lord Chancellor, said Therium received a significant chunk of the millions awarded to sub-postmasters and called for caps on the contracts between plaintiffs and financiers.
The threat of regulation will persist, adding uncertainty to a sector already dogged by questions about visibility, earnings quality and balance sheet opacity. That makes it an easy target for short sellers — they attacked Burford’s bookkeeping five years ago. Burford subsequently revamped its methodology and subjected itself to US oversight by listing shares in New York and the group is now included in the Russell 2000 index of smaller companies. But the shares still trade roughly 47 per cent below their 2018 peak.
To put it plainly, valuing litigation funders is tough. These companies measure returns based on what they think is fair value. In essence, this is a net present value of potential payouts from cases that may settle some time in the future.
Historically, as much as half of gains booked yearly by Burford and LCM have been unrealised, subject to regular adjustments and writedowns. Smaller insolvency specialist Manolete, which buys claims of creditors in windups and turns over cases relatively quickly, reports lower unrealised gains. Steven Cooklin, founder and chief executive, says 90 per cent of gains in any one year are realised.
Even so, Manolete was punished when it reported an adverse decision on one of its larger cases in the High Court in 2022. The group was already struggling with Covid when insolvencies were suppressed and timetables extended. The board wrote down the full value of the case that year, throwing Manolete into a full-year loss of about £4mn.
Things are improving. “Record numbers of companies are going into liquidation — the highest rate since 1960,” says Cooklin, adding that Manolete has renegotiated covenants on its £12mn in debt.
But while Peel Hunt, the broker, forecasts pre-tax profits of near to £6.8mn, one analyst says the market has yet to be convinced after Manolete missed forecasts last year “by a country mile”. Shares in the company are down about a third this year.
Manolete’s woes add grist to the mill of those who argue TPLF makes for a poor stock market investment. Fair-value accounting may smooth revenues but returns from multiyear projects are still lumpy. And small changes in assumptions on timelines, outcomes and interest rates have a big effect on fair values and shares.
Burford’s shares are down a fifth since May after it reported a big drop in first-quarter income, due to the variable timing of revenue recognition. The market is forecasting earnings could drop sharply in the year to December on the back of lower realisations. Some think it will take another favourable judgment on a big case to lift expectations.
Burford was bolstered last year by a New York judgment ruling that Argentina had unlawfully renationalised energy company YPF in 2012. Burford’s share of winnings could be about $6bn, double the group’s market value. That said, it is telling that Burford puts a book value of nearer $1.4bn on the claim.
Still, for those with a ready supply of nose pegs, there is much to be said for shares in companies whose returns are uncorrelated to stock markets and economic cycles. And average historical returns have been high. Burford reckons its long-term return on invested capital is about 82 per cent, equating to a multiple of invested capital of close to two times. The average duration of cases is about 2.5 years, according to Bogart. But it is the big wins that make up for losses and the long-running nature of major litigation.
LCM, which started out life in Australia, seems less hazardous. It is smaller than Burford but more diverse than Manolete. And where Burford invests largely off its own balance sheet, financed through $1.6bn in debt, LCM has no net debt and is shifting more towards fund management and using other investors’ capital to bankroll cases.
It has a more cautious approach to fair-value accounting, too, and its historical multiples of invested capital over a dozen years has been about 2.8 times with cases lasting on average 3.5 years. Zeus Capital reckons rising levels of performance fees will reduce unrealised gains and boost multiples of invested capital to nearer four times. That is fairly stellar.
It is still a hold-your-nose stock, but there seems less likelihood that investors who dive into LCM will come to the surface spluttering.
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