Litigation Capital Management:Initiation of Coverage
Litigation Capital Management (LCM) is an alternative asset manager specialising in disputes financing, with its main operations in Australia and the UK. The company provides funding for litigation in exchange for a share of any settlement and has built a strong track record of supporting winning cases and realising very strong returns on its investments.
LCM has historically made a profit on 89% of the cases that it has funded, and has achieved a nine-year cumulative return on invested capital (ROIC) of 134% and an internal rate of return (IRR) of 78%.
In this report, we argue that LCM is well-positioned to continue to deliver strong returns on its investment portfolio based on:
- Expertise in selecting its investments via a rigorous due diligence process. This has been a major contributor to LCM’s strong returns on its portfolio.
- Strong capital base to support further investment.
- A sourcing pipeline built up over decades of industry experience back to the company’s founding in 1998.
Importantly LCM has achieved growth while maintaining a prudent approach to risk control. This is evidenced in the high win ratio, but also in the company’s conservative accounting approach, which we examine on p7-8.
Third party fund:
In FY June 2020 the company launched a third-party investment fund allowing institutions to gain direct exposure to litigation financing as an asset class. This provides LCM with an additional source of capital and a new income stream in terms of performance fees. We argue that the value of the asset management business is not reflected in the current share price and we examine this aspect of the investment thesis on p8-10.
Proven track record of strong returns
One of the main attractions of LCM from an investor's perspective is the counter-cyclical nature of its business model. We believe that in the current environment investors should ascribe a significant premium to assets with a low correlation to the economic cycle. In this report we consider the valuation upside for LCM shares, primarily using a price/book framework. We argue that there is significant upside for shareholders based on the unrecognised value of the asset management business and from continuing growth in the overall portfolio of assets under management.
Investment conclusion
Year end Jun 30 · 2019 · 2020 · Current · 2022
Portfolio under management (AUD-mln) · 138 · 250 · 500 · 630
Invested capital (AUD-mln) · 27.8 · 52.0 · 72.0 · 99.0
Revenue (AUD-mln) · 34.7 · 38.4 · 71.0 · 117.0
Pre-tax profit (AUD-mln) · 10.2 · 9.2 · 21.0 · 47.0
Portfolio of direct investments
Source: Litigation Capital Management
The company has significantly grown its UK business (the largest component of the Europe, Middle East And Africa - or EMEA - exposure) over the last two years, and has continued to build out its UK presence with a listing on the LSE in December 2018, and the transfer of the chief financial officer’s role to London during the full-year (FY) to June 2020. The company has also announced its intention for the chief executive officer (CEO) to relocate to the UK.
We expect LCM to grow its asset base across its current industry segments in the coming years. The ‘portfolio’ category in particular has significant potential in our view. This is the funding of a bundle of single disputes for a corporate or other strategic partners, in which LCM’s investment is collateralised against the entire portfolio of disputes. A recent example of this mechanism was a new deal which LCM announced in August 2020, to provide a tailored disputes finance facility with the global law firm DLA Piper. The ability of LCM to continue to innovate bespoke financing solutions for clients represents a material growth driver for the company.We believe that insolvencies will also be an important category in the next few years, and we examine this on p6.
Growth trajectory and funding position
LCM has been growing strongly in recent years. The company raised A$15mln through its listing on the ASX in December 2016 and a further A$10mln in 2018, and A$35mln through its listing on the LSE in December 2018 (delisting from the ASX simultaneously). The company now has a total portfolio under management of A$304mln (sep 2020) compared with A$33mln at the time of the IPO on the ASX.
Furthermore, during FY ending 30 June 2020 the company launched a third-party investment fund. Within this new fund LCM co-invests alongside third party investors and receives its share of any gains together with performance fees charged to the investors. From a shareholder's perspective, this is a key element of the investment thesis: the new asset management business has potential to generate a lot of income for LCM, and we argue that this is not reflected in the current share price. We examine this in more detail on p 8-10.
The following charts show the level of capital invested and the annual cash generation for LCM. The cash generation typically grows with a lag relative to capital invested due to the nature of the investment cycle (more details on p4). We expect strong growth in cash generation in the 2021-2023 time frame.
Financial metrics
Source: Litigation Capital
Business model and returns
Whether balance sheet funded or co-investing through the third party fund, the basis of the business model is the same — finance a litigation process and receive an agreed share of the final payout.
A track record that includes a 90%+ win ratio and a 78% cumulative IRR
LCM has a careful selection process for accepting cases that has resulted in a win ratio of over 90% of the cases it invests in. This has driven a 78% cumulative IRR for Litigation Capital over the last nine years, inclusive of losses.
The typical investments time frame has historically been 25-27 months from taking a case to generating a cash return. As LCM broadens its portfolio and provides financing for large and more complex disputes this investment period is expected to elongate marginally. The following chart illustrates this investment cycle.
Cumulative track record of 2.35x multiple on capital invested
Illustrative single case investment cycle
Source: Litigation Capital Management
There are four phases to the investment process:
1) Sourcing
Multi-channel pipeline for sourcing new investments
LCM has a number of routes for sourcing investments:
- Referrals from insolvency practitioners
- Referrals from law firms
- Strategic partnerships with law firms which provide LCM with access to the firms' flow of cases
- Direct relationships with corporate clients which regularly require litigation financing
2) Due dilligence
LCM’s investment managers undertake a detailed assessment of case participants that apply for funding. In the chart above, the due diligence process is the main component of the first wave of operating expenditure. This process is essential to maintaining a high win ratio and therefore high returns on investment
3) Funding the case
LCM then provides the funding for the litigation in question. This is the main component of the cumulative capital investment in the chart above.
4) Collecting
Historically over 95% of cases are settled by agreement rather than by courts or tribunals, and this results in few incidents of delinquent payment.
Five key principals drive the due dilligence process
LCM applies a rigorous due diligence process before accepting a new investment. This process is based on five key principals:
- Proportionality — there must be proportionality between the size of the claim and the funding commitment. Many applications are immediately dismissed because the potential payoff does not justify the investment.
- Clear legal principals — the case must not be based on any novel or uncertain point of law.
- Written evidence — the claim should be supported by clear documentary evidence.
- Recoverability — it must be demonstrated that the defendant has the capacity to pay out on any judgement or has sufficient insurance cover.
- Experienced legal team — there must be a highly competent and experienced legal team with the relevant expertise to pursue the claim.
The objective is to only ever accept cases that will result in a favourable outcome. Since its inception in 1998 LCM has invested in 226 cases, of which only 11 resulted in losses. Of these only six cases resulted in an unfavourable judgement in a court or tribunal, while five cases resulted in a loss for other reasons outside LCM's control. These statistics demonstrate a very high degree of predictive skill from LCM’s investment managers. The rigour of this process means that only 3-7% of cases that apply for funding will result in an investment.
The accuracy and conservatism of LCM’s case assessment process is a major factor in supporting strong returns from the investment portfolio. The following chart illustrates these returns in terms of two metrics.
Return on invested capital (ROIC) measures the absolute level of return on the capital that LCM invests in its cases.
Internal rate of return (IRR) is an investment industry-standard measure that gives an annualised return reflecting the weighted average capital employed.
It is important to observe that these performance metrics include investments that resulted in a loss and they are not averaged.
Return on LCMs investments
Source: Litigation Capital Management
Counter-cyclical returns
Business environment and growth outlook
From a shareholder’s perspective, one of the big attractions of LCM is the counter-cyclical nature of the business — LCM’s returns on its investments do not go up or down with the economic cycle; in fact, some areas of the business may even benefit during an economic downturn. In particular, insolvency cases tend to become more frequent during a recession.
The following chart shares the number of businesses dissolved in the UK relative to the total number of businesses registered with Companies House.
Insolvency cases potentially to spike higher in 2021/2022
Insolvencies
Source: UK Companies Register
The chart shows that the absolute number of dissolutions is already back up to it 2010 peak level, but looking at the figure relative to the total number of companies on the register we believe there is still a likelihood the dissolutions can go higher. These figures relate specifically to the UK, but the same dynamics apply in Australia and in other markets where LCM is active.
In analysing the company’s ability to grow its business in the coming years, there are three main factors that we view as dictating the ‘speed limit’ for growth:
- Availability of funding capital
- Availability of high-quality new cases
- Capacity within the company for handling additional investments
From a funding perspective, LCM has a strong balance sheet position with A$29.5mln of net cash (post-balance sheet position as of company presentation September 2020). Furthermore, the recently established asset management business (more details on p8) provides the company with an additional route for accessing capital.
The ability to access new cases for LCM is well-established. The company continues to innovate in terms of new structures such as the new disputes financing facility that was established with DLA Piper in August 2020. We believe that the macro backdrop is favourable for finding new investments generally, especially in insolvency.
During the period 2017-2019 the company has demonstrated the ability to keep building internal capacity to handle a growing asset base. Although there will always be limits to how quickly this capacity can be built out, we believe that LCM will be able to continue the recent growth trajectory of its portfolio of assets under management.
Overall we argue that LCM has the necessary talent pool and funding capacity to keep expanding the asset base and that external market conditions provide a favourable backdrop.
Peer group comparison
The competitive landscape for LCM comprises various different types of entity. Main examples of ‘competitors’ include:
- Corporates who fund their own litigation
- Law firms that have their own financing arm
- Specialist litigation financing companies like LCM itself
Specifically, with regard to law firms that have their own financing arm, these can still actually become clients for LCM as for example with the DLA Piper co-financing arrangement.
Direct competitors include a number of privately held companies in the UK, Asia-Pacific, Europe and North America. In terms of stock market listed companies to use for peer comparison we have identified five market listed litigation financing companies globally. Balance sheet data is from the latest statutory reporting for each company.
Five listed comparators globally
The listed peers
Source: Proactive Research
The litigation financing sector has experienced some degree of negative investor sentiment in the last 18 months. In particular, some unrecovered investments for Burford capital have caused investors to question the risk profile of litigation financing as an investment.
Burford Capital – The Petersen case
Burford Capital had an extremely successful period of expansion from 2014-2018 and generated 15x upside for its shareholders. During 2019 the share price came under intense pressures due to difficulties arising in some of Burford's cases. Most notable is the Petersen/YPF case, which concerned investors trying to recover money relating to the 2012 nationalisation of the oil company YPF by the Argentine state. Burford is still carrying US$773mln on its balance sheet relating to this claim, although some investors are doubtful that the money will be recovered.
We believe that Burford’s business model remains intact, and indeed the company has already been making progress in resolving issues that have arisen and resuming growth. Nonetheless, we believe that these events have dented investor sentiment towards the litigation financing sector.
Balance sheet strength and quality – a differentiator for LCM
We argue that LCM’s balance sheet position is a significant positive for the investment case. The following chart compares some balance sheet metrics for LCM to their directly comparable listed peers. Data for the peer companies is from the latest statutory reporting, while our figures for LCM also include post-balance sheet movements as disclosed in the company FY results presentation dated September 2020.
Balance sheet position
Source: Proactive Research
Another important consideration with regard to the balance sheet position is the asset quality, in terms of accounting standards applied in calculating the value of investments in the portfolio. LCM uses IFRS 15 accounting, which values investments at cost until a case has been resolved. The other UK-listed peers, Burford and Manolete, apply asset revaluations when cases reach key milestones, leading to higher valuations being booked. This is a perfectly reasonable accounting practice, but we would argue that LCM’s methodology is clearly more conservative.
LCM raised US$150mln in its third party investment fund
Third party fund
During FY 2020, Litigation Capital Management launched an investment fund for third parties to participate in litigation financing and completed an initial fundraise of US$150mln. As of September 2020, in Australian dollar terms A$133mln has been committed to investments, and A$84mln remains available.
The asset management business operates on a straight forward model – LCM receives its share of gains on its co-investment, together with performance fees. The following schematic illustrates.
Fund model
Source: Proactive Research
The exact calculation of LCM’s share of gains involve various adjustments which vary from case to case but for simplicity, as an illustrative example, we consider a case that generates a gain of a notional $100, and where this represents an IRR of 78%.
In this example, LCM contributes 25% of the capital, retains 51% of the gain
Illustrative example of an investment for the fund
Source: Proactive Research
In this example, which is based on the 78% actual historic IRR that LCM has achieved, the company gets its $25 share of the gain plus around 30% of the third parties’ gross gains.
Valuation upside from attributing a value to the asset management business
Based on the calculations above, we would argue that the market could reasonably value the asset management side of LCM at 30% of the value of third party funds under management; however, the following chart shows that the market currently appears to be effectively valuing the asset management business at zero.
Market cap does not reflect the value of the third party asset management business, in our view
LCM valuation
Source: Proactive Research
If the market were to value third party funds at 30% as we've suggested, this would increase the market cap by around £40mln (with all of the fund having been deployed) or around 50% upside to the current share price.
We don't suggest that the market is likely to immediately change its view in this way.; however, as investments funded by the asset management business begin to mature and LCM begins to recognise a profit contribution, we would expect the price/book valuation multiple to re-rate.
Valuation upside without attaching a value to the asset management business
Even if the market does not reappraise its approach to valuing LCM, there is still strong upside potential for shareholders. The following chart shows what would happen if LCM can achieve:
- Commitment of all of its current available capital by March 2021
- Realising a 2.35x multiple on invested capital (MOIC) over a 3-4 year period
The latter assumption is in line with Litigation Capital’s actual historic performance.
Growth in total AUM assuming a 2.35x MOIC
Source: Proactive Research
Under this scenario LCM ends up with its own balance sheet assets growing to A$643mln ( = A$250mln + A$215mln + A$178mln). If the market continues to value LCM on a multiple of 1.6x price/book (the current multiple), then this scenario would imply 8x upside to the share price
Upside for shareholders, driven by a balanced, prudent high growth business
Conclusion
We believe that Litigation Capital Management offers significant valuation upside for shareholders based on:
- Future increased recognition of the value of the asset management business
- Growth in the asset base driven by continued strong returns on investments
We believe LCM has the ability to continue delivering exceptional returns on its investments, based on:
- A proven track record of selecting profitable cases
- A strong capital base to support further investment
- A market environment that continues to offer opportunities to find new investments, and a well-established sourcing pipeline to access these opportunities