Should you borrow in the debt markets to finance litigation? It seems like a risky proposition: the liabilities are fixed in size and duration, while it is unknown if, let alone when and how much, litigation will earn.
But this is the business model of Burford: one of the best known firms in the litigation funding sector, which involves sourcing and underwriting cases and taking a portion of any winnings.
The model looked to be a good one if Burford's share performance was any indicator, up until last week. The price had increased tenfold over the past five years. But a series of allegations and criticisms from short-seller Muddy Waters Research caused its price to plummet.
It has turned into an all-out war. Burford, which refutes Muddy Waters’ report, said on Monday it had evidence of market manipulation and insider trading in relation to its shares, and the UK’s Financial Conduct Authority said it was looking into the issue.
On Tuesday, Muddy Waters issued a further attack on the firm, saying: “We believe that management’s conduct has possibly given rise to sanctions claims by the FCA.”
Muddy Waters’ main criticism of Burford centres around its accounting practices — of being too aggressive in marking fair value gains, overstating what it thinks unfinished court cases it is funding are worth.
Burford also has issued four retail bonds on the London Stock Exchange: £365m in sterling and $180m in dollars. Its ability to do so — paying coupons of between 5% and 6.5% — was aided by the QE-swamped bond markets.
On Tuesday Muddy Waters said that the capital raising from the sterling bonds was based on misleading return on invested capital and internal rate of return metrics. This resulted in particular from a court case involving a pharmaceutical company called Napo, which, according to Muddy Waters, Burford said was more successful than it actually was. Burford said it had been transparent on the matter.
Short-seller Gotham City Research criticised Burford’s financing model more generally in a note released over the weekend. It said “Litigation assets — whose associated cash flows’ size and timing are notoriously unpredictable — should not be financed with debt.”
It added: “This poses a real risk of an eventual asset/liability mismatch nightmare.”
Burford said in response to criticism of its debt financing that it has “laddered” maturities between 2022 and 2026. It also says it is likely to continue accessing the debt markets.
The company’s stock is still down by around a quarter from the time of the original Muddy Waters report. This suggests investors are struggling to work out whether Burford or Muddy Waters is right.
Burford is a unique case. But there is a lesson to be learned for capital markets.
The popularity of litigation finance has come at a time when bond yields are miserly and so investors have been seeking returns by making alternative investments.
Burford's bonds were available to retail investors but at the other end of the spectrum, sovereign wealth funds have taken a punt on the sector. Burford said in its interim results that $112m of $751m total new investment commitments in the first half of the year came from sovereign wealth funding.
Alternative asset classes are often more complex than traditional ones, particularly when the assets are illiquid. This raises questions about how they should be accounted for, particularly when analysts and investors are less familiar with them.
Over the last few months, the rates outlook has changed to even lower for even longer around the developed world. With more and more debt in the traditional bond markets yielding less than zero, the pressures that pushed investors into areas like litigation financing are set to grow.
Meanwhile, with debt still historically cheap, adding leverage to raise capital remains an option for businesses without a certain cash flow.
The scene is set for some episodes of high drama in alternative investments. Investors in these asset classes should be asking more questions than ever about where their money is going.