Litigation Capital Management : Pioneering a new, high yielding asset class

Disclaimer: We are shareholders of Litigation Capital Management.

NB: Litigation Capital Management (“LCM”, ticker: LIT-LN) is listed in the UK while its financial reporting is in AUD, as the company was previously listed in Australia. All figures are expressed in AUD and the GBP/AUD exchange rate used in this write-up is 1.71.

Elevator pitch:

With valuations at or near all-time highs, what if we told you that there is an alternative asset class, litigation finance, where some players have been and will be able to double their capital every 3 years? Let us introduce you to Litigation Capital Management (“LCM”, ticker: LIT-LN), a 15-year-old litigation funder operating in Australia and the UK with a market capitalization of A$170m and a net cash position of A$25m. The company is not only a brilliant capital allocator, averaging 2.35x return on capital every 27 months over the last decade, but it is also on the verge of a significant inflection point, shifting its business from investing its own money to managing over A$700m for institutional investors in the next 2 years. Because of a lack of broker coverage and/or because it is unfamiliar with the industry, we believe that the market is asleep at the wheel, simultaneously undervaluing LCM’s legacy business and giving no credit to LCM’s asset management unit. This provides the perfect set-up for a multi-bagger as LCM keep on delivering impressive returns and signals more clearly to the market the financial implications of its push into asset management. Applying an 8% FCF to EV yield target to LCM’s legacy business would mean a valuation for the entire company of A$376m, or 122% above today’s level. Adding the asset management unit would push the valuation up to A$1,090m, 545% above the current market capitalization. Additionally, we believe there is significant upside to AUMs in the asset management division as institutional investors increasingly look for high, uncorrelated asset classes. We would not be surprised to see more funds or an upsizing of the currently announced funds in the coming months. Finally, LCM’s management is first-class, with the CEO and the non-executive chairman being two of the most highly respected figures in the industry. They own c.12% of the company.

 

1.    Company description

LCM is a UK-listed alternative asset manager specializing in disputes financing solutions with offices in the UK, Australia, Singapore and Hong-Kong. It has a market capitalization of A$170m and generates revenues (A$38.4m in 2020) from direct investments made with its own capital. The company recently launched an asset management arm, with a first fund of A$225m, and will start collecting performance fees in the coming years. 

Its current, own balance sheet portfolio of A$171m (both amount funded and committed) is made up of commercial disputes (32%), class actions (33%), insolvency claims (12%) and international arbitration cases (23%).

Being originally focused on the Australian market, the addition of a UK team in 2018 presented the company with a significant opportunity to enter Europe with a strong and immediate presence to the point that the EMEA region now accounts for c.50% of revenues. 

A primer on litigation funding

Litigation funding is the practice whereby a third-party funds the legal expenses of a plaintiff in exchange for a cut of any proceeds that result from the dispute. The cut is determined either as a percentage of the proceeds or as a multiple of capital deployed. The typical investment cycle of a claim can be illustrated by the following:

This type of financing originally appeared in Australia 20 years ago but is increasingly going mainstream as (i) it helps equalize access to the legal system and (ii) it frees-up valuable working capital for companies engaged in disputes. Despite its growing popularity, penetration of litigation funding is still low, at c.5% of total legal expenses in countries where it is the most developed (UK, US and Australia). Among the main listed players, we find Burford Capital (Mkt Cap: £1.35bn) and Omni Bridgeway (Market Cap: £515m).

While initially focused on insolvency claims, the past 10 years have seen a significant expansion of the industry to commercial claims, class actions and international arbitration in an increasing number of countries. Key drivers of this growth have been the prohibitive cost for client of large-scale litigation, the desire to avoid the uncertainties of litigation as well as the recognition of the value of litigation funders as an accounting and working capital tool (no need to expense on the P&L and see cash outflows for legal bills). One specific segment of the industry currently experiencing significant growth is the corporate portfolios, where litigation funders provide capital to multiple disputes of a single corporate. This allows funders to take on multiple cases and minimize risk as their capital is now collateralized against an entire pool of disputes (reducing the risk of a binary outcome from a single case).

Interestingly, institutional investors are becoming more and more acquainted with litigation funding as an asset class and its non-correlated, high return nature.

The company had an outstanding track record over the last decade, with an average return on capital of 2.38x (Money on Invested Capital “MOIC” or Money on Money multiple, “MoM”) over 27 months. The company’s hit ratio has been even more impressive, with 226 cases financed since its inception in 1998 and only 11 losses suffered (of which just 6 were adjudicated by a court or tribunal unfavorably), implying a loss ratio below 5%.

 Lastly, unlike its listed peers Burford and Omni Bridgeway, LCM adopts a conservative accounting standard which recognizes revenue only when it is earned in contrast to ascribing a fair value to its book of investments from time to time (which, in essence, would give management the opportunity to “mark-to-model” its investment portfolio and recognize non-cash earnings – this issue was made abundantly clear by Muddy Waters’ report on Burford). This certainly makes LCM’s results more lumpy and harder to forecast, but for investors willing to put in the work, this should not matter and on the contrary be welcomed.

 

      2.     Moat and Investment Process

The nature of capitalism is that excess returns will eventually be competed out by new entrants. It was therefore key for us to assess whether LCM has an enduring moat that will protect its returns in the coming years. Let us go through why we think it is the case.

 

A strong, mostly proprietary, origination network

·    Litigation finance is a very relationship-driven industry, with most cases being brought to a funders’ attention by referral. LCM benefits strongly from its long-standing reputation and relationships with lawyers, accountants, and insolvency practitioners. Law firms for instance, which represent the bulk of new cases, typically work with only one or two litigation funders that they know they can work with well.

·       This can be seen in the numbers: In the southern hemisphere, where LCM has spent the last two decades building an extensive network of relationships, it is the sole litigation funder recommended to the client in 65%-70% of cases while in the UK, it is closer to 60%.

·      In addition, we would expect law firms to be very picky about which litigation funder they endorse as the consequences of recommending to a client a new funder that fails to honor its funding commitment mid-case or that does not work well with them could prove fatal to their relationship.

·       We think this will result in an industry where new cases are increasingly locked up by a small amount of well-known global litigation funders, which should prevent new entrants and be supportive for the industry returns over the mid to long term.

A disciplined project selection and an active case involvement

·       Given the specific skills required to identify the most promising litigation cases, LCM assembled a team of investment managers that are all ex-practitioners with experience in their respective fields and know it from the inside.

·   LCM considers applications for financing against the following 5 key criteria: 1) there must be proportionality between the size of the claim and the funding commitment; 2) the claim must be based on clear legal principles and not any novel points of law; 3) there should be written evidence supporting the claim; 4) the defendant must have the capacity to meet the expected amount of the claim and 5) the law firm pursuing the claim must have relevant expertise in the concerned field.

·     Its due diligence generally takes the form of a multi-stage approval process, involving a minimum of three investment managers and the partners that will stress-test and bring as many views as possible. LCM will also sometime call specialists for peer-review. As a result, only 3-5% of cases end-up being approved. 

·     We believe that the incentives of the investment managers support a collaborative environment and foster proper capital allocation over the long term. Indeed, the main criteria include the number of quality applications they originated, the financial performance of their investments as well as the financial performance of the group’s investments. Only 35%  of the annual bonus is cash, with the balance being received in stock options vesting over 3 years.

·        On top of that, LCM takes an active role in managing its projects which generally involves maintaining a close working relationship with the funded party and its legal team. It also ensures that the solicitors and barristers engaged by the claimant are proficient and will perform the work on time, and cost effectively.

An experienced team of litigation lawyers

LCM is led by a high-caliber pair of lawyers who are considered pioneers of litigation finance and boast more than 40 years of cumulative experience:

·      LCM’s CEO, Patrick Moloney, started practicing law in 1996 and established his own litigation firm in 2003, at the early stages of the industry. He became Director of LCM the same year and acted in more than 200 commercial cases since then, mostly in Australia.

·    Nick Rowles-Davis, the Non-Executive Chairman leading the UK team, is among the most respected practitioner in the industry. He most notably created and refined the concept of corporate portfolios in litigation finance. He was previously Managing Director at Burford Capital, before founding Chancery Capital with a clear focus on corporate client portfolios. He is also the Director of the Association of Litigation Funders of England & Wales.

This impressive duo holds a substantial stake in the company as Patrick Moloney owns 7.76% of the company and Nick has been granted stock options to the extent of 4.25% of the capital when he joined in 2018.

     3.     Where is the opportunity and why does it exist?

The opportunity is twofold and to a large extent explained by both LCM’s conservative cash accounting, which creates earnings lumpiness and its relisting in 2018 in the UK (from Australia), where investors are less familiar and/or wary of the industry (cf Muddy Water’s short report on Burford).

First, we think that the market is significantly underestimating LCM’s ability to put its own capital to work at high MOIC rates. Indeed, if we take a 2.35x multiple (in line with the company’s historical track record) and keep legal investments flat at A$40m per year, the company should be able to generate free cash flow of A$30.1m per annum.

At an 8% free cash flow yield target, LCM’s market cap should reach A$376.3m in 2025, 122% above today’s level. Put another way, and as shown by the FCF sensitivity table below, the market is currently pricing return on capital of 1.80x, i.e. a 25% reduction over historical levels.

Note: Because capital investment each year relates to starting, ongoing and ending cases, we expect a phasing of total proceeds as follow: 25% collected in the first year, 45% in the second year and 30% in the third year. See below a theoretical example.

The second leg of the opportunity, however, is what could make the stock a multi-bagger: LCM is shifting its business form the current capital intensive, own balance sheet investments, to an asset light, highly scalable asset management business.

The company has so far raised a A$225m fund (US$150m) and is planning to launch a second fund of A$450m-500m (US$300m-350m), when the former is 75% committed. This should happen fairly soon since in September 2020 the company said it was already 60% committed (only 6 months after its official launch in March 2020). The company will get a 35% performance fee if the invested capital’s IRR is superior to 20% (25% if IRR is below 20%). Based on what management is seeing in its pipeline of cases, it is confident that it can invest this capital at a similar MOIC rate as it did in the past and has done so on the fund’s invested capital so far.

If the company manages to raise this second fund successfully, total AUMs will reach A$700m. Assuming a 2.0x MoM over 3 years would yield an IRR above 20% and therefore a 35% performance fee. In that case, LCM will generate total fees of A$245m, or 1.45x the company’s market cap. If LCM manages to keep AUMs constant in the future at A$700m  (which we think is highly conservative in an environment of low returns), these would add A$81.6m (A$245m fees smoothed over 3 years) of proceeds to the company’s existing, own balance sheet investment business.  While the company said it has the capacity to handle these two funds with its current investment manager team, we expect further investments (quantified here at A$5m) in new investment managers to source ideas in other parts of the world and in other areas of the law.

 

Given the high operating leverage of the asset management business, free cash flow would nearly quadruple and lead to a target market cap of A$1,095m in 2025, or 6.3x today’s market cap.

We think that these two funds are only the beginning as an increasing amount of pension and endowment funds will be looking at the litigation funding asset class to diversify their holdings and get uncorrelated, high returns. Two of the current LPs (a US university endowment and the asset management division of a global investment bank) have secured entrenched rights to participate in future funds raised by LCM and given the broader enthusiasm of institutional investors for the sector, we would not be surprised to see more funds announced in the coming months or an upsizing of these two funds.

 

 4.     Risk

The main risk is obviously the inability of the team to keep generating impressive returns while deploying a significant amount of capital. Here are our thoughts on that:

·      With more capital getting deployed into litigation funding, one would worry returns would be reduced due to pricing pressure. However, it is our belief that LCM’s strong relationships with law firms confer the company a significant competitive advantage to source good deals. We also think that a potential supply/demand imbalance (capital inflows vs opportunities to finance) is unlikely to be reached before two full investment cycles are completed (at the very least). On top of that, the total size of the legal market in the developed countries mentioned is huge and funding penetration still very tiny (between 1% and 5%). Oversupply of capital should therefore not be reached at least in the medium term considering the growth prospects of the industry.

Ex: There is c.£40bn of litigation spend in the UK per year of which c.5% is funded, implying a current addressable market of c.£2bn p.a. In the US, numbers are starker as legal expenses represent $400bn per year with less than 1% financed ($4bn addressable market). 

·       The Corporate Portfolio strategy will allow LCM to keep pace with its commitment plans as these multi-cases projects require more capital but also spread the risk of losses among a higher number of cases, therefore cancelling the risk of a binary outcome of one single dispute. We are consequently confident that the capital raised from external investors will be deployed without difficulty even with a strict project selection of 3-5%.

In most countries the litigation funding industry is either unregulated (US), self-regulated through an industry body (UK) or slightly regulated (Hong-Kong, Singapore and Australia). While further regulatory touch is hard to anticipate at this time, we believe that LCM’s long lasting stance on the market and its strong network among industry bodies will be a strong asset to anticipate and deal with further regulatory announcements.

Ex: In Australia in particular, the parliament introduced in 2020 a new rule requiring litigation financiers wanting to fund class action lawsuits to get an Australian Financial Service License (AFSL). LCM anticipated this coming regulation and got its license early on and was, as a result,  the only industry compliant player at the time of implementation.

·    We ultimately believe that regulation will be a tailwind rather than a headwind for LCM as higher regulatory burdens will impact smaller funders.