Many of you will have seen my post on Burford Capital and why I think the whole litigation funding sector is set to receive a massive boost in the aftermath of Covid. I recently watched a company presentation from Burford Capital recently reiterating all the attractive growth drivers they are currently enjoying so I feel even more confident that we are beginning to see this potentially multiyear upswing I told you about. I remain very positive on this sector as a whole given how high and uncorrelated the returns are relative to many other asset classes. In an increasingly globalised world where returns are ever converging, this lack of correlation is rare and highly sought after by investors, especially as we have already seen the ‘easy’ stimulus induced recovery gains in virtually every sector.
Today, I would like to tell you about Litigation Capital Management, a smaller UK listed litigation finance business I hold in my personal portfolio, which seems to be totally under the radar and therefore very undervalued (9x PE), and which I believe has incredible upside potential in the next few years.
Litigation Capital Management operates in an uncorrelated industry, has an excellent track record, very conservative accounting, strong market position as well as attractive growth plans. Despite this, I believe it is very much under the radar and therefore particularly undervalued.
Founded in Australia in 1998, operating mainly in Asia Pacific and Europe, Litigation Capital Management is engaged in the business of providing litigation financing and ancillary services to enable the recovery of funds from legal claims. The company was one of the pioneers of this service and management is recognised as amongst the most successful and experienced in the industry. The Company has provided litigation financing to over 40 Completed Litigation Projects, which consisted of approximately 226 cases. The shares were floated on AIM in 2018 to access a broader investor base and a market focused on growth companies.
The company has traditionally funded cases from its own capital but last year it expanded into also providing its expertise to a third party fund (please see below for more detail on this exciting new avenue of growth).
Excellent Long Term Track Record
LIT’s track record is nothing short of spectacular:
- 9-year cumulative portfolio ROIC of 134%
- 9-year cumulative portfolio IRR of 78% per year
I feel what is behind this incredible record is the detailed and effective due diligence undertaken by the company when taking on cases (historically only taking on 3-7% of cases reviewed and in fact, unbelievably LIT has only experienced only 11 losses since 1998).
Why So Undervalued?
Incredibly, for a business with such an enviable track record and strong growth prospects, we can buy the shares on just 9x PE! I believe there are two reasons we are able to buy the shares at such low valuations. Firstly, as we saw with Burford Capital, the sector is not well understood by equity investors. Secondly, perhaps in contrast to Burford, LIT employs the most conservative revenue reporting practices in the industry which has the downside of very lumpy/unpredictable results reported. This uneven year on year profit picture also means that the shares will never be flagged by any quantitative screening methods, limiting the number of investors who come across the shares.
Lumpy Revenues Explained
You can see below that the headline numbers in the recent results announcement showed large falls (68% fall in revenues). However, I will explain how this fall gives a misleading picture and the business is firing on all cylinders.
The Most Conservative Revenue Recognition in the Industry
The lumpiness of their results is exacerbated by the management’s decision to adopt the most conservative revenue recognition approach in the industry. This means that results show 100% of costs incurred on a claim but 0% of the potential payout on these claims until the cash is actually received at the end. This is in stark contrast to the ‘fair value accounting’ basis used by much of the industry to help smooth returns and give some indication as to likely prospects (where a portion of the claim’s value is recognised as settlement of the dispute nears).
To understand why the reported fall in annual revenues is not in any way a true reflection of LIT’s performance, it is important to understand that LIT very conservatively expenses what it spends on a case for about 25 months before actually recognising its return on the investment (only when it actually the cash award from the case). So, at first sight, any company results announced during this period don’t show the prospect of this large payout at the end. In fact, as the graph illustrates, we only ‘see’ costs increasing.
I believe the business and the sector as a whole are ideally placed in the current post Covid environment (for more details please refer to my earlier Burford Capital post). More importantly perhaps, these returns are pretty uncorrelated to economic activity and other asset class returns.
Underappreciated Potential of New Asset Management Business
The market has been slow to appreciate the extent to which their new asset management initiative can not only drive growth but improve the visibility of the results. As part of LIT’s ambitious growth plans, the company decided for the first time to take in third party capital in the form of a new fund to expand their business at an even faster (and more capital light) rate. There was strong demand amongst institutions for this Fund as the proposition of this new fund business is to allow third parties to access these high and uncorrelated returns. The two largest investors in this first $150m fund were a US University endowment fund and a large investment bank. Already close to 75% of this fund has been invested.
I feel the market has so far failed to recognise not only the upside potential here in this new avenue but also the prospect of smoother reported returns (as these funds pay management fees). Importantly, management has stated that they will launch further funds so the potential for this growth avenue to smooth returns and add to the value of the company is huge and growing (and not in forecasts). It is easy to see that there could be follow-on demand for similar funds from other similar institutional investors hungry for uncorrelated assets.
The other point is that the share of management and performance fees looks at first sight to be 25% for LIT and 75% for the third party. But given the high performance fees, if you work through the numbers, LIT stands to gain up to 51% of total fees on these third party funds if they generate their average returns!
Future Prospects - Cases Maturing
One way of more accurately assessing LIT’s business performance is to focus on the amount of committed capital as well as its duration as a forward looking guide to returns from here. On this basis, it is an exciting time for the business as we can see below that 65% of their investments are reaching that maturity phase, with 9 investments with a duration of over 25 months. So if this duration still holds true, we stand to see most of these investments mature in the immediate future and for the upcoming reporting period to show a vast increase in the revenue results.
Looking ahead and using capital committed as a guide to future results, we can see that not only is the capital committed this year up enormously but total applications received are up 10%. So they can continue to be extremely selective in which cases they take on, which augurs well for generating continued high returns.
Sizeable Valuation Anomaly
It seems like the share price has tracked the operating capital so far with no value attributed to the third party funds. Clearly, this is a valuation anomaly given LIT will not only earn fees on this new capital but is very likely to generate similar returns.
If we assume LIT continues to trade on 2x book value, then taking their projected base case book value of $643m in 3-4 years, gives a future market cap of £710m (or c.8x current market cap)! The best case scenario is obviously even higher (12x).
Since mid-May, Litigation Capital has also entered agreements to provide liquidation finance to a partner of FRP Advisory, additional liquidator of the former Comet Group, to cover proceedings issued in the High Court against Darty, a multi-national electrical retailer based in France.
One of the most shocking corporate failures in the UK in recent years was the bankruptcy of Carillion - a FTSE 100 listed company. LIT recently announced it has entered a new £250m claim against Carillion’s auditors, KPMG. To put the size of this claim in context, just 10% of this potential award represents over 25% of the total value of LIT as a company.
This investment demonstrates LCM’s prominence and pedigree in the disputes finance industry and in particular, LCM’s position as funder of choice in the UK insolvency market and we are delighted to be supporting thousands of creditors who have suffered as a consequence of the biggest insolvency in recent UK history. Nick Rowles-Davies, Executive Vice Chairman of LCM
In addition LIT has entered its third major litigation finance agreement in the past seven weeks. The company has agreed to provide a litigation finance facility to Edward Vermeer and David Boyle in an application to commence a collective action launched in the Competition Appeal Tribunal against Govia Thameslink Railway and its parent companies, The Go-Ahead Group and Keolis (UK) Ltd. The facility will fund a claim alleging Govia abused its dominant position in the market for rail services on the London-Brighton mainline, in breach of the Competition Act 1998.
What’s Not to like
There is no investment proposition without risk and the key risks I see for LIT are:
- Risks of returns declining as competition heats up (though their strong market position and their very selective deployment of capital mitigates)
- Risks of market saturation (it is difficult to accurately assess total market size but evidence of strong growth mitigates)
- Risks of covid lockdowns continuing to close courts (further delays to court cases cannot be ruled out though these are likely to be deferrals rather than lost business)
I feel Litigation Capital Management is a very conservatively managed business in a leading position in a fast growing sector and the current valuation leaves tremendous long term upside. As mentioned in my previous posts, the litigation funding sector is an ideal place to be in a post Covid world of increased disputes and bankruptcies and importantly, the sector enjoys uniquely uncorrelated high returns. The market has so far failed to appreciate the fact that LIT’s use of external funding through their new asset management funds boosts their upside and value creation even further (on a comparable book value basis, the shares could be worth 8-12x current prices in the next three years). A near term catalyst could be when they announce that 75% of their new $150m fund is already invested and therefore they are in all likelihood launching a much larger follow on fund ($400m?). On just 9x PE and with the business now throwing off cash leading to higher dividends, the prospects for a near term rerating are high.
This material is not investment research in accordance with the legal requirements designed to promote investment research independence and is also not subject to any prohibition on dealing ahead of the dissemination of investment research; and as such is considered to be a marketing communication.
All investments have the potential for profit and loss and your capital may be at risk. Past performance is not indicative of future results.