In my mid-year letter, I shared the questions that are left unresolved in my Burford analysis. These are limiting the capital I’m willing to deploy to the position, for, I’m finding that the only sustainable portfolio management strategy is that which goes in full accordance with one’s mind. Encompassed within, there is a body of knowledge, which is utilized when engaging in critical thinking.
With an empty vessel no cup can be filled. It is imperative that one maps out the dots composing their body of knowledge and infers how far they can foresee, though, naturally, probabilistically speaking. Counting with few pieces of knowledge impedes answering many questions, which end up conditioning a decision’s fate. Identifying where dots are missing is crucial when constructing an investment thesis. They provide the roadmap for research and, thereafter, help to thoughtfully assess situations.
Regarding the manner in which I weigh positions, the path I thought the soundest was one of cautiousness. My investment process will follow the punch card approach. I’ll very carefully select potential companies to invest in. But, furthermore, I’ll initially weigh with a margin of safety.
Businesses where I build up a position will, as per my own analyses, count with a margin of safety in the classic sense. However, I noticed there is always some specific percentage of total capital that I’m willing to allocate to a certain equity position, namely what I’m initially inclined to call its “fair weight.” I suspect this fair weight depends upon how certain I am about my answer to the most important question: how much is this asset worth?
I believe this to be highly related to the number of questions an investor is able to answer with respect to the related investment. The broader the range and the deeper they are, I suspect the better can one address future uncertainty, potentially overcoming unseen threats and succeeding.
Instead of adding up to fair weights, I’ve tilted towards staying well below these thresholds. I believe experience and knowledge forge judgment. And it is ludicrous for a relatively inexperienced investor to think their judgment is accurate. Therefore, I try having both margins of safety at this early stage. One in economic terms, whereby I try to purchase equities below what I believe they are worth; and in personal terms, seeking to protect the capital from myself.
Burford Capital operates in the legal finance industry. Litigation finance, differing from the latter in that this is specifically referring to single litigation claims, emerged more than two decades ago in Australia. The markets, however, did not become widely interested in this asset class up until recently. Burford was hugely incidental in the industry becoming better known. But the created mechanism is still relatively young, subject to future vicissitudes, and thereby pronouncedly filled with uncertainty.
An element of this is naturally priced in assets such as Burford’s equity, for the latter will tend to reflect the broader market’s expectations of cash flows. Intellectually, an investor could play the game of analyzing if there are factors the market has missed, mispricing the asset as a result. One could ride certain waves until prices more accurately reflect the previously missed factor.
In Burford’s case, I aim at pairing with two brilliant managers, Bogart and Molot, for as long as possible. But the important question is how long of a runway they will have. The market has systematically mispriced the competitive advantage period of good businesses and it is my intention to analyze if this is occurring with Burford Capital.
I think this can only be done by going after the hard questions. It’s not about numbers, but about words. I suspect thinking is the only approximately correct method of analyzing true asset mispricing, more so when speaking about CAPs. This writing does not include any models. Rather, these are the pieces of knowledge I believe can be used to, at least partially, answer the following questions:
Should legal finance exist?
Is it a net positive for society?
To answer these questions, I have sourced myself with material written by Burford’s Co-founder, Jonathan Molot, documents about insurance, and Economics.
In A Market in Litigation Risk, published in 2009, Molot dives into the role of litigation finance in society and whether the system should be embraced or discarded. For it was written before Burford started operating, it lacks the hindsight bias to which everyone is subject. This was theorization from Molot’s part, which I believe will help us get a better idea of whether this industry is entitled to survive or not.
Risk
Man has long been averse to risk. Since the very beginning of civilization, shamans were sought for advice, while oracles saw the future in the guts of sheep. These special individuals were presumably capable of obtaining insights of a divine nature, helping people make decisions. Being the future plagued with unseen threats, guidance, and to some extent, consulting, were natural outcomes as a common trade.
Risk, broadly speaking, represents the possibility of something going wrong. Encompassed within this definition, I’d argue that catalysts’ essence can be either definable or undefinable. Perhaps out of the latter is that unknown and unknowable territory is created. Unknown and unknowable situations represent obscure twists, which cannot be prevented nor contemplated before the aftermath.
However, humankind has identified potential events whose occurrence poses a threat to individuals. Risk of injury, risk of loss, risk of destruction, are some of the categories underscoring harm to individuals own self or possessions.
Definable risks are those that we know for sure exist. They can very well interfere with ongoing events and tilt future states of nature into undesirable forms. Definable risks may include things such as death and natural disasters. On the other hand, of undefinable risks we cannot get the grasp. They represent things affecting end results that are beyond Man’s comprehension and calculations. The only similarity undefinable risks have with their counterpart is that we cannot predict nor prevent them.
As mankind progressed, methods employed for transacting evolved. At the very beginning, trades may have been performed by trading objects belonging to one another. But different crafts and resources are obtained after different levels of effort, creating a wide array of objects’ values. Therefore, a trading system consistent of spices, which had value on their own, emerged. Spices could be used as the mediating object for estimating the value of things and trading more effectively. Corn, salt, wheat, were some of the favored ones, because of the value derived from utility and low obsolescence.
After several centuries, Man observed this was highly inefficient. Transacting in spices meant carrying and storing them, proving very expensive. Moreover, their estimated value fluctuated and depressed if agriculture was more heavily practiced; the obverse being equally true. This is the point when I suppose people started opting to transact in what were viewed as very valuable resources, namely gold and silver.
Both had held valuable for millennia in the eyes of different cultures. Their value first originated in their beauty, which could be exhibited in furniture or accessories. People caught up with their scarce supply and, being human nature what it is, gold and silver’s value was greatly enhanced.
It was then observed that their peculiar capabilities could be leveraged for transactions. Divisibility was a spectacular feature, as it allowed for much more precise value estimations and thereby a more efficient system. Furthermore, these metals were difficult to mine. Supply couldn’t be brought to market very easily, depressing holders’ net worth as a result.
Ultimately, the employment of currencies, made of silver and gold, later bronze and fiat, gave rise to the accumulation of usable wealth. After performing a trade, earning money in exchange and saving accordingly, people were able to make big purchases, such as a house or a car, thinking about the last century.
The problem lies in that this was only done by exchanging years of labor for these large items. Therefore, if these assets were subject to unfortunate events that led to their destruction, it’d be highly unlikely that the owner, an individual, could financially recover. These people would need to once again exchange years of labor for money and repurchase the asset.
In response to risky and frequent events, insurance companies were given birth. At a broad level, insurance makes individual risks be beared by a group of people. Spreading similar individuals’ risk over a pool containing them is a very effective way to deal with their destructive power.
When statistics can be leveraged to understand the probabilities of an event occurring, a sophisticated entity can price an insurance policy for giving appropriate coverage. The issuer of this instrument can repeat the procedure with other people who seek protection from a similar adverse event to diversify the risk.
This strategy dramatically decreases the probabilities of a single event taking the issuer out. Appropriately pricing policies will generate a large enough base of capital to cover incoming claims. New policyholders renew this base of capital and help sustain the whole system for other newcomers. It’s important to note that, if policies are priced below their fair value, the base of capital will eventually dry up, making the issuer default on remaining policyholders.
Heterogeneous vs Homogeneous Risks
Risks can be further classified as heterogeneous or homogeneous. The former refers to risks with unique characteristics, making it impossible to create a standardized pricing process. Homogeneous risks share characteristics between one another and the probability of claims can be estimated quite precisely because of this attribute.
Insurance against fire is a very pragmatic example to understand both types of risk and the underlying feature that allows for roughly precise pricing. Preciseness, nonetheless, is shown after issuing multiple policies. Every single policy can be mispriced, causing the insurance company to incur a loss. But, on average, over a large pool, policies will show roughly precise pricing.
Prior to the event, a homeowner can buy an insurance policy to cover the damages fire can occasion. The probability of a fire starting depends on numerous factors, most known and somewhat shared by policyholders. Moreover, the cost of damage follows a straightforward array of outcomes, up to the house’s full cost. In some sense, given the large database on this phenomenon, statistics can be used for developing a standardized process, whose inputs derive from these ‘shared’ situations by policyholders. This risk is therefore cataloged as homogeneous.
However, after a fire starts at a homeplace, there’s the risk of this fire spreading. How fast and to what extent it happens is entirely dependent on unique factors, namely the structure of the house, the inflammable properties near the place where the fire started, the possibility of fire extermination, the house’s distance to a fire department. Conditions in the case of fire spreading are unique, intrinsically different between potential policyholders, making this risk heterogeneous.
Insurance actuaries are taught how to price policies when policyholders’ situations resemble each other; when the risk itself is homogeneous. If the probability of a claim and the average dollar cost of the damages are known variables, pricing the policy can be done quite precisely. Spreading an homogenous risk over a pool is very efficient.
Having to carefully assess the consequences of a specific situation makes the pricing incredibly tricky. In the case of heterogeneous risks, you are dealing with something whose probabilities are unknown and potential states of nature present too wide an array of possibilities. Pooling these set of unique risks is possible, but inaccurate. There is more room for craftsmanship in the realm of heterogeneous risks and why I’d argue cannot be dominated by mathematics.
Risk-transfer Mechanisms
Although heterogeneous risks cannot be precisely priced, insurance businesses have found a way to profitably operate. Homogeneous risks, like death risk, gave rise to the most competitive insurance markets, namely life insurance in this case. The insurance industry permitted individuals and other entities to get rid of unwanted risks by paying a premium for coverage.
Turning to the corporate world, when a business operates in many countries, there’s an inherent currency risk that arises. If the currency in which costs are incurred does not match the currency in which income is earned, there’s a possibility of both fluctuating and causing some trouble. In this case as well, companies count with a resource for getting rid of this risk. They can utilize future contracts, whereby they agree to exchange a certain amount of currency with another party, at a predetermined price and future date. Pre-fixing the amount helps escape from an otherwise fragile position, exposed to misfortune and mischances.
Turning to another case, if a farmer will harvest a few months from now, there are two particularly damaging situations that may occur. Firstly, if he invested a lot of capital in seeding, fertilization and maintenance, and needs the income the crop will provide, a storm destroying the farm could leave the farmer in ruin. To avoid this, he can buy insurance. Secondly, if a farmer doesn’t want to be exposed to fluctuations of commodity prices from now until the moment of harvest, he can also leverage the futures market.
Running a bank can get more complex than a normal corporation. But they can utilize swaps, whereby they make custom-made contracts with other entities so that both parties can satisfy their many concerns; one of which may be matching currency and maturity between assets and liabilities. When a bank issues a large loan to an entity with doubtful credit reputation, it mostly does so with a very unique arrangement.
A company that wants to fund a new initiative, for instance launching a new product line, can either look for partners or opt for a joint venture. Otherwise, the manager can raise capital through the public or private markets, exchanging equity for capital, or issue debt at the rate of interest that counterparties think is fair for them to be exposed to the risk of default.
These and more financial instruments have been constructed with the objective of allowing individuals and corporations to transfer a risk they don’t want to or are incapable of bearing to a willing party. Fundamentally, these transactions represent a party who’s exposed to an undesired risk that is willing to pay a premium for another party that’s willing to bear it.
Litigation Risk and Some Benefits of its Transfer
Business managers would much rather be measured by the true performance of their companies. No executive wants to be evaluated by external events. The problem with litigation is that it is a risk outside of companies’ control, for the resolution depends on external factors.
Broadly speaking, I believe companies’ success, or lack thereof, should reflect decisions behind product, pricing, sales, and business-related activities. However, litigation costs have risen dramatically over the past couple of decades, getting to the point that it interferes with business results. Little has been done to develop a mechanism by which companies could get rid of litigation risk.
Appropriately pricing this risk is very complex, for it resembles fire-spreading insurance with increased uncertainties. The two questions are: (i) how much will a litigation cost in legal fees; (ii) how much will (or not) be the payment to the plaintiff for damages. If a third party is willing to take this risk, the following question is who will control the litigation. This last one is of extreme importance, as there is potential for litigation finance to alter the legal system altogether.
Despite there not being any mechanism for transferring this unwanted risk, the cost for corporations is massive:
They have to incur expensive legal fees even when the litigation may be resolved in their favor.
If the manager wants to raise capital, a potentially large litigation is a deal breaker for capital providers. It may be seen as an uncomfortable and unnecessary risk for the investor/lender.
At a society level, having ill-suited entities bearing a risk that could be efficiently spread over a pool of alike risks is simply overall damaging.
In the public and private markets, there’s a further element that impacts companies’ ability to raise capital by affecting the enterprise value of the business.
Businesses are valued upon the cash flows they will generate, with earnings being a commonly utilized yardstick. Incurring legal fees affects the company in two major ways. Firstly, because of the opportunity cost of that capital, which could be deployed within the business’ core competency. But, more importantly, if a business is priced at 20 times earnings and $100M need to be destined to legal fees, it’s ‘costing’ shareholders $2bn in enterprise value.
Another relevant factor that plays a role with public companies involves the balance sheet. When a company has an ongoing litigation and the judgment’s prospects are favorable, the market rarely rewards the company in any form. The cash flow, even if expected, isn’t recorded as an intangible asset. Legal finance allows companies to unlock value from these hidden assets, not shown on the balance sheet. In exchange for a share of the proceeds, companies like Burford offer the monetization of pending claims.
On the plaintiff’s side, it’s often the case that an individual or corporation is damaged by another party, but they don’t have enough resources to start a lawsuit. Litigation finance evens the field. To what extent this causes an increase in litigation claims remains an obscure question. And how, if so, will the legal system react, is unknown to myself.
Jonathan Molot raises the point that the large, aggregated cost imposed by the legal system has an origin in governmental entities. The public and statal interest should be in minimizing these undesired and expensive costs, whose origin is their’s. If a market in litigation risk is feasible and the effects of the industry being created aren’t net negative, the government should help establish legal finance as a systemic solution.
As my last remark, corporations mostly prefer doing deals on a contingency basis, where the law firm gets paid with a share of the claim’s proceeds, hence only when the case resolves favorably. Nonetheless, law firms have a cost structure filled with fixed costs, for which they need to charge an hourly rate. This mismatch is bridged by litigation finance.
Conclusion
Throughout history, society has recognized different sets of risk and developed mechanisms by which risks could be transferred. A party that is exposed to a risk they don’t want to bear can pay a premium to another party, who is willing to bear it. I suspect it was, and is, only natural for this to occur with litigation risk.
Litigation finance, the mechanism by which this risk is transferred, presents numerous benefits to almost all parties. I severely struggle to imagine this incipient industry as a net negative for society. The question that remains obscure is how big of an impact will it have on the legal system, which acts as the backbone of modern society. It must not be overlooked how important this question really is, for it may be the biggest threat to the industry.
The legal system, as long as it keeps depending on human beings, who are subject to miscognition and humanly incurable traces of irrationality, shall always have uncertainty. Similar to what happened with the markets where insurance companies serve, for there to be a long-during market in litigation finance, capital providers need to be good at pricing the claims. The numerous intricacies underlying every single litigation make the cash flow, if any, very difficult to estimate. Consequently, pricing a claim is very complex.
Although there may be room for a sustainably profitable market to keep developing in litigation risk, capital providers can only survive if they count with a very specific skillset. However, for there have been experts capable of profitably pricing policies for natural disasters, I have every reason to believe that this talent can be developed and expertise achieved.
Finally, litigation risk being heterogeneous and lawsuits’ outcome seemingly binary pose two cornerstones to suspect that excess returns cannot simply be competed away. Additionally, something I have covered in the past relates to the customized deals that large corporations and large law firms tend to prefer. This conforms another argument that helps me comfortably make the foregoing speculation.
Thank you for another brilliant read, my friend!