Burford: Fair Value Methodology

Litigation claims being a new form of asset has caused some trouble for fair value estimations. Burford’s methodology for reporting capital provision assets’ fair value has evolved and adapted to suggestions from the SEC. In this article I’ll go over:

• How Burford values their assets

• GAAP rules for fair value estimation and levels of securities

• What is the risk premium component in the discount rate and how case milestones impact it

• A letter filed to the SEC in which management answers doubts regarding their valuation procedure

Fair Value Accounting

When Burford invests in a litigation claim, the asset’s fair value is initially equal to the deployed cost. For the underlying asset is expected to generate cash flow in the future, the alteration in the reported fair value depends on management’s estimate of this future cash flow. The likelihood of its occurrence and the extent to which it could evolve into different scenarios are considerations embedded in the calculation.

This is an inherently subjective task. Certain clauses, however, might help increase the certainty of the valuation. Arrangements between Burford and the corporation or law firm highly determine it. For instance, imposing a minimum of capital returned to Burford under any scenario in which the backed party receives proceeds can help foresee how the minimum retribution for Burford could look like.

Two further elements that are invariably associated with fair value assessment are: (i) discount rate, in which I shall expand accordingly, and; (ii) duration. The moment in time when the underlying asset is expected to produce the cash flow affects its respective present value. In Burford’s annual report, multiple sensitivity analyses are included as to how would the group’s income and net assets be impacted by: (i) an increase or decrease in interest rates; (ii) a lower or higher expected duration; (iii) a 10% deviation from the estimated fair value.

US GAAP discriminates assets in three different levels. A specific framework is employed for ranking assets’ fair value assessments. The observability of market prices depends on numerous factors, namely: (i) the type of financial instrument; (ii) the peculiarities associated with the instrument; (iii) the “state of the marketplace”. The latter implies the transparency of the market, liquidity, and reliability. Augmenting all three of them helps, theoretically, think the market price resembles the asset’s fair value. The lack thereof is compensated for with higher degrees of personal judgment for fair value assessment. Among the three levels, there is:

• “Level 1 assets and liabilities are comprised of listed instruments, including equities, fixed income securities and investment funds.”

• Level 2 assets and liabilities include non-actively traded debt and equity securities. The valuation taken goes in accordance with the last traded price.

• Level 3 assets and liabilities have unobservable inputs. Their fair value is estimated as the dollar amount that would be required for the asset to be transferred in a transaction; the money the owner would have to receive or pay.

In Burford’s annual report, the company breaks down their capital provision assets by type of investment and level of security. The vast majority of Burford’s reported assets are level 3.

To estimate the value of this type of asset, US GAAP offers several mechanisms one can utilize for getting observable inputs: (i) obtain information from third parties; (ii) obtain “valuation-related information from the issuers or counterparties; (iii) perform comparisons of comparable or similar assets and liabilities.”

Additionally, the asset’s risk profile and status need to be taken into consideration. Management employs an income-based approach, which consists of inferring the time in which the cash flow might be perceived and adjusting it by a risk factor and discount rate.

“The expected entitlement is generally a readily calculable figure based on the contractual terms between Burford and its counterparties and a legal expert’s view on the potential damages”

The risk-adjustment factor varies depending on objective litigation events. As expressed at the beginning of research, taking a claim through a legal process involves numerous stages. Occasionally, motions can be presented for the judge to dismiss or accept. Some events negatively or positively impact Burford’s probabilities of reaching a favorable conclusion. I find the following example very illustrative of the prior note.

“In practice this works as follows: the risk premium at the inception of a new asset is solved for by quantifying, as a percentage figure, the haircut that needs to be applied to the expected proceeds in order to arrive at a net present value equal to the transaction price. This risk premium percentage is then adjusted when milestone events occur by the applicable milestone factor. For example, assume the risk premium at inception is calculated to be 65% which is held constant until there is a milestone event. If we assume there is a favorable trial court ruling one year later for which the applicable milestone factor is 50%, then the risk premium would be adjusted to 32.5%, effectively releasing 50% of the original 65% risk premium haircut that was applied”

The risk-adjustment factor takes the following milestones into consideration, among others:

• “A significant positive ruling or other objective event prior to any trial court judgment

• A favorable trial court judgment

• A favorable judgment on the first appeal

• The exhaustion of as-of-right appeals

• In arbitration cases, where there are limited opportunities for appeal, issuance of a tribunal award

• An objective negative event at various stages in the litigation process

When any of these milestones are reached favorably, Burford will acknowledge it and recognize unfair value gains derived from the asset. The reduction of risk associated with the underlying cash flow increases the likelihood of occurrence and, therefore, its present value.

Burford declares an asset to be concluded when litigation risk remaining becomes nonexistent. The latter stage generally occurs by settlement or final judgment. Thereafter, the legal asset’s corresponding cash flow is reported to have been realized. Realizations results in Burford getting cash or a receivable, which is recorded as due from settlement.

SEC letter

Burford released its 2021 annual report in March of 2022. After reviewing it, the SEC made several comments and suggestions. They intended for Burford to clarify certain elements, inquire about why some financial disclosures were made that way, and to ask pertinent specific questions. Burford filed their response in August 2023, a month after receiving the letter.

Burford had historically done their fair value estimates based on deployed cost and observable events, including milestones and transactions. The revised approach implies for Burford to discount the expected cash flow to the point in time where it stands. Hence, the passage of time has an effect now. Notwithstanding this, fair value adjustments are still mostly explained by case milestones.

In 2023, management wanted to give investors a sense of the velocity the portfolio was acquiring, after slow years due to courts closure. Consequently, they shared more color on positive case milestones and their impact on the portfolio’s value, though it was a temporary “metric.” Cristopher stated they do not intend to continue providing the data in this manner. Although qualitatively relevant, “I want to be clear that I don’t think it’s a financial metric. I don’t think that people should be all of a sudden trying to tie these milestone factors to other numbers in the business.”

After reading the report and going through Burford’s quarter, the SEC staff asked Burford to separately report these milestones. Management commented on the futility of breaking them down. For this would only imply sharing numbers, it would not add relevant information to investors. Burford cannot disclose pertinent case information given their confidential nature. Doing so would do more harm than good to the business and shareholders.

At the same time, the SEC asked Burford to quantify the number of positive and negative milestones that occurred. Management pointed out this would not be helpful either. Milestones differ in the impact they might have, some of them possessing much heavier weight than others. As a sidenote, it was mentioned that some milestones may also affect other factors that impact fair value, such as the duration and entitlement forecast.

Moreover, fair value calculation of each capital provision asset is a “bespoke multi-variable calculation.” A quantitative disaggregation of separate drivers of fair value is, therefore, a very complex matter. With no reasonable explanations to be provided alongside, due to confidentiality, the endeavor is pointless.

When asked to quantify and speak about other elements with material impact on fair value assessments, management expanded on their use of discount rates. These consist of two factors, namely: (i) market-based cost of capital; (ii) asset specific inputs. The former has lately oscillated around 7%, reflecting the market’s broader cost of capital.

However, “the weighted average risk premium adjustment applied to the forecasted cash inflows from capital provision assets increased to 38.1% at December 31, 2022 from 36% at December 31, 2021.” This risk premium tries to quantify the cost of capital that’s associated with the asset class, provided the fact that litigation finance is riskier than other capital allocation initiatives.

Risk premium tries to adjust for remaining litigation risk. For the higher it is, the lower the likelihood of receiving the proceeds at the end. Milestones play a direct role on the evolution of litigation risk. Although the latter diminished during 2022, caused by numerous net positive case developments, risk premium increased due to the writing of new business. Assets tend to be at their riskiest state at the start of their life.

As a final note, I would like to highlight that Burford’s accounting is following uncharted territories. Litigation claims are a new type of asset. There was no standard methodology for fair value assessment nor for financial disclosures. One of the advantages Burford obtained through brand recognition is that it has allowed them to work alongside the SEC to develop best practices. However, perfection has not yet been achieved, as the following commentary from the SEC will show:

• “On undrawn commitments as assets: Please provide us any proposed changes to be included in future filings.

• On carrying value and fair value: Provide us any proposed revised disclosure to be included in future filings.

• On deployed cost and realized proceeds by vintage: Provide us proposed revised disclosure to be provided in future filings that more clearly describes the nature of these expenses.

• On sensitivity analysis: Provide us any proposed revised disclosure to be included in future filings.”

Personal Commentary

This is the last research article I’ll write on Burford in the short term. Following this, I’ll be publishing a one-pager on the company, and an earnings review on the last quarter.