Litigation Capital Management (LIT): a 12-year 15% CAGR?

I am a member of SIGNet and submitted the following on Litigation Capital Management (LIT) for discussion at our meeting this week. A full agenda sadly meant this discussion item was deferred to another time. Oh well, you can read what I submitted in the meantime. I will report back any feedback from here to the members!
Maynard


Litigation Capital Management (LIT) 30 November 2021

(All $ figures AUD = 1.83 GBP)

  • £134m (113p) market cap litigation funder based in Australia, with operations also in the UK and traded on AIM (floated Dec 2018).

  • Litigation activities involve commercial disputes, insolvency claims and class actions.

  • Boasts 10-year "cumulative portfolio ROIC"of 153% and investment timescale of only 27 months.

  • Holds 44 current litigation investments that could have $7b claim size:

  • Boasts long history of successful cases and settlements:

  • Reported book value is $90m or 41p per share. P/NAV therefore 2.75x

  • Premium to book reflects optimistic “theoretical” reinvestment projections…

  • But are the projections realistic?

  • Last four years (2018 to 2021) show total revenue (i.e. income from resolved litigation cases) of $140m generated from litigation service expense (i.e. investments into the associated litigation cases) of $55m:

  • The investment return from the cases resolved during the last four years is therefore $140m/$55m = 156%

  • LIT says typical case return should reduce to ‘just’ 100%.

  • LIT has $181m to invest, of which $104m is invested and $77m is awaiting a suitable case:

  • The $77m still to be invested highlights LIT is not always fully invested. Suitable cases need to appear before the cash can be deployed. The proceeds from settled cases are therefore unlikely to be reinvested immediately.

  • LIT says larger cases will extend the timescale from 27 months to 36 months. My sums below assume reinvestment takes place after 48 months to allow for suitable cases to emerge.

  • Note that LIT’s $181m to invest is represented by cash of $36m + case investments of $89m + third-party fund interests of a net $56m

  • The above “theoretical” presentation calculations do not account for costs.

  • Operating costs for 2021 were almost $14m. My sums below assume $14m per annum, then rising to $18m per annum after four years and then rising to $22m per annum after eight years to reflect greater/larger investment cases:

  • My sums use the same "theoretical" fund performance fees (FPF) as stated by LIT.

  • All those assumptions suggest the $181m could turn into $1.8b or £1.0b after 12 years.

  • Not all of this £1.0b would be LIT’s as c30% of the starting $181m is held by third-party fund investors.

  • But difficult to work out exactly LIT’s share of the possible £1.0b given the fund fees projected to be reinvested, but let’s say 75% or £750m.

  • There is also the subject of tax, which is zero within these sums but is 30% for Australian companies of LIT’s size. LIT has yet to pay tax (I am not sure why).

  • Bear in mind LIT’s history of 100%-plus case ROICs has involved small amounts of capital. Extrapolating such case ROICs with much larger amounts may be optimistic:

  • Note also that LIT has only 44 cases at present, which implies returns can be dictated by just a handful of settlements each year. 65% of 2021 revenue was generated by one case (60% of 2020 revenue by three cases)

  • Turning a £134m market cap into a balance sheet worth £750m over 12 years is a 15% CAGR. Enough of a return to justify an investment over such a long period?

  • Sums also assume the shares in 2033 trade close to book value. In reality, if case ROICs continue at 100%, the valuation may retain a premium to book (presently 2.75x).

  • Investment proposition inherently boils down to whether LIT can continue to enjoy case ROICs of 100%. Do charts such as this imply overly bullish management?

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Having mentioned on other threads some of my successes, I must confess to a failure.

I bought Litigation in Feb 2019 at 86p and topped up 3 months later at 112p. I was drawn to this company partly because of the then wild success of Burford Capital (BUR) and by its more understandable accounting - they carry cases at historical cost rather than marking to “market” as Burford do. However can you really appraise the market value of a court case in progress? Having looked at Burford’s accounts, it was far from clear what they were doing. Liti seemed much easier to follow.

A couple of months later, along came the bear report on BUR, which promptly went into freefall. Liti also went down but on a slower glide path. Since their accounts seemed clean to me and although they were on a declining profit trend I retained sufficient confidence to top up again at 74p in Jan 2020.

I was rewarded by the impact of COVID, on an Australian company (?!), by the accounts at June 2020 showing a further decline in profits, debtors more than doubling, rising to 40% of turnover, ROCE halving to about 11 and the cash level halving. Despite the red lights flashing, I held on.

The decline continued and in December I decided to sell out, at 58p and employ what was left of my stake in something that was weathering the conditions better. Fortunately I chose Sumo. Despite the recovery in LITI’s share price, I don’t see many signs of recovery in the financials. It’s barely above my weighted average cost of 89p after a full year.

But of course investing is about future prospects rather than lamenting the past :thinking:

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Bad luck with this one, Diogenes.

Hi Maynard,

I don’t profess to know this company at all - had a quick look though.

For what it is worth, questions I would have are:

  • Why it has a small pension deficit, despite having been listed at the end of 2018. Possibly it was a private legal firm prior to listing? Why wouldn’t the sellers outsource/sell the risk of the pension prior to listing - presumably to avoid personal fees. Does this indicate a company run for the benefit of management? Not sure.

  • What happens if a company which has just had a judgement against it decides to fold? Could they empty their company of cash via dividends despite the judgement? (I clearly don’t know enough about the law to invest in this company :grinning:)

  • Settlement of trade debtors - when are they due to be converted into cash?

From the latest annual report:

Trade and other receivables
Trade receivables are initially recognised at fair value and subsequently measured at amortised cost using the effective interest method, less any allowance for expected credit losses. Trade receivables generally do not have a specifically defined time frame for settlement, additionally, when the receivable is due from part of the portfolio of litigation projects, the settlement of the receivable is generally made upon an additional resolution of another litigation project within the portfolio which also may not be within a specifically defined time frame

  • Currently burning a lot of cash - 30 June 21 cash of AUD49.7m was funded by new borrowing of net AUD50m during the year. Possibly an indicator of a good business pipeline, but this may increase the risk to an investor because it isn’t using internal cashflow to grow the business. If cash in-flows aren’t certain (ref above point), how responsible is it to borrow? Should we trust a company which was only listed in 2018, with this much ‘jam tomorrow’?

  • LIT is classified within the sectors Financial Services/Finance and Credit Services/Customer Lending (as is BUR).

By contrast RBGP is within sectors Industrial Goods and Services/Industrial Support Services/Professional Business Services.

Is there a reason for this due to a difference in the nature of their respective businesses?

Do LIT just provide finance for cases, but RBGP provide the legal expertise/staff, for the Courts? I don’t get that impression. I would probably need to know the reason for any different classification before investing.

  • LIT audit fees were around GBP90k (BDO), whereas RGBP’s audit fees were GBP177k (also BDO). £18m t/o vs £22m t/o companies. The difference just seems odd to me.

  • I don’t really get the point of the last dividend paid. They would have been better off reducing debt? Seems like a gesture, to attract investor capital and buoy the share price.

A jam tomorrow business, I think (as they clearly indicate in their annual report). It could be undervalued if portfolio cases are settled, debts are eventually paid to the company and passed onto investors. You need to take a lot on trust, though - more than usual?

Regards,

Ben

p.s. Funky’s YouTube channel has deleted it’s videos. It’s a shame - I was looking forward to watching that!

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Hi Ben,

Thanks for looking further and raising these good points.

I am guessing you have looked at SharePad’s reference to a $0.6m deficit. The accounts (note 12) show this deficit to be ‘employee benefits’ and an accrued liability for annual/long-service leave. This entry appears to be peculiar to Australian accounting and seems nothing to worry about.

I suppose LIT’s case-evaluation process will include determining the chance of the other party being unable to pay. LIT’s record to date suggests the vast majority of cases have resulted in payment, but the risk of non-payment will never be eradicated.

Your text below was a good spot and is not ideal:

“Trade receivables generally do not have a specifically defined time frame for settlement, additionally, when the receivable is due from part of the portfolio of litigation projects, the settlement of the receivable is generally made upon an additional resolution of another litigation project within the portfolio which also may not be within a specifically defined time frame”.

Some receivables are dependent on other receivables, which opens the door to a ‘domino effect’ of multiple receivables at some point not being collected.

For FY 2021, revenue of $37m versus trade debtors of $14m suggests the collection time was 4.5 months, and a similar time frame was suggested for FY 2020. But you can imagine the ‘customers’ will not be in a hurry to pay. The trade debtor level should always be monitored for reluctant payees. Sector peer Manolete agreed to a settlement where the payments would be made over ten years!

Another good point. The debt rate is not cheap at LIBOR+8% with a cap at 13%, so that 8%+ rate may be an indication the lender sees some risk. And the lender is not a mainstream bank, which may also tell you something. But in theory borrowing at c8% should be sensible if you can enjoy 100%+ ROICs on the litigation investments within three years.

I believe RBGP provides a material level of traditional legal services as well as LIT-type litigation finance.

I guess LIT is a much simpler business, given revenue is represented by a handful of formally agreed settlements where ‘recognition’ complications should be minimal. RBGP’s business in contrast involves traditional legal services and involves numerous clients and perhaps contract types, which may need more auditor time for investigation.

I can only assume some City investors like to see a dividend. But the payout makes no sense to me if these 100%+ ROICs are available!

Oh yes, that’s odd. I hope this link works: Why I think this UK Small Cap Stock will be my Next BIG Multibagger! - YouTube

Ah, I note his last Patreon update occurred in July: Funky Finance is creating Multibagger Madness! | Patreon

And his Twitter has gone all Covid, too: https://twitter.com/FinanceFunky

For background he is a late-20s ex-portfolio/wealth manager but made good with ‘lockdown winners’ BOTB, Argo Blockchain and others last year and became a full-time investment Youtuber earlier this year. I get the impression recent market conditions have not been so funky :frowning:

Maynard

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Hi Maynard + Others

Thanks for the write-up and all the comments.

I do hold LIT (and Burford) and actually topped up the former earlier this week.
My rationale for doing so was as follows:

  • The confirmed Gross Profit so far in H1 is $16.3m.
    This came from 2 cases only.

  • Cash inflows from those 2 case wins will be $24m, which will cover the $16m admin costs I’m expecting this year (up from $14m last year.)

  • This already leaves $8m available for further case investment.

  • For perspective these 2 cases cost $7.7m to fund, and there were $135m of investments deployed in cases at the year end (June, 2021 - includes $40m of 3rd party investments) - that leaves $127.3m of investments in cases yet to conclude.


A couple more points:

  1. Operating Profit in the 10 months to October 2021 was $AUD 22m (£12m)
    The current market cap is £120m, so the company doesn’t seem overly expensive.

  2. 3rd party fund management is actually a drain on profits at the moment (see image below), so is masking the true profitability of the underlying business.


If there was one risk on my mind, it’s that admin costs are too low.

As I’ve seen with Burford the return on investment within litigation finance is fantastic, but profits have not been growing because admin costs have risen so materially too. I’m still waiting for these to slow down so that operating leverage kicks in, but I remain wary when I see disclosures of new employee profit-sharing agreements appear in their accounts.

If I start to see LIT’s admin costs increasing materially, I will be more concerned.

Cheers
A

image

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Hi abtan,

Many thanks for the comment. I’d only take issue with this:

Is it wise assessing LIT on a profit basis? I effectively view litigation funders as ‘investment portfolios’, and surely their inherent value is linked to the eventual NAV of their litigation cases. I don’t think anyone would value a share portfolio on its annual gains.

Yes, not a surprise that the workforce – who can generate 100%+ ROICs within 3 years – are ready to take a greater share of the pie. As the cases/potential settlements become larger, no doubt the number of staff (and the incentives required to keep them all on!) will become larger, too.

Not quite sure there is amazing potential for operational gearing here. I am guessing the employees can handle only so many cases before new staff will be needed.

Maynard

Hi Maynard

Thanks for taking the time to respond.

Is it wise assessing LIT on a profit basis? I effectively view litigation funders as ‘investment portfolios’, and surely their inherent value is linked to the eventual NAV of their litigation cases. I don’t think anyone would value a share portfolio on its annual gains.

I’d probably say that both are important:

  • current profitability/cash generation ensures that costs are covered and that there’s enough to invest in growth.

  • the core assets/deployments ensure that there’s a business in the future too.

With LIT:

  • making £12m of operating profit, which is of course after all their operating expenses, and;
  • having a valuation of £120m

then that’s a good sign for me; it highlights past actions achieving positive results today.

If the Operating Profit was zero I would be more concerned at their ability to generate future excess returns and would assign less value to the c£70m ($127.3AUD) of cash currently deployed in cases, irrespective of the implied high IRR.


I’m actually not against management taking a cut of the profits. However, with Burford I’ve seen this profit share % rise from 4% to 9%. At what point will it slow down/stop?


I actually think operating gearing will kick in at some point as funders get better at identifying cash-generative cases.

Burford said as much last month and provided some insight into their increased use of data and rise in “Claim Families”, high conviction groups of cases.

Here are some screenshots from that presentation.

image

On a similar note, Burford also made a material commitment of $276.9m in H1 2021 - I believe this was the highest amount committed to a single case and a brand new matter (so not part of a claim family), but conviction gained from experience (their words not mine) implied a high chance of success.

It’s of course all words until results start coming through, but I do like the model and the commentary makes sense.

Given how successful LIT have been so far, one hopes that they will follow a similar trajectory in due course. In the meantime I think the risk is reduced given the returns being achieved today.

I hope so anyway.

Cheers
A

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Hi abtan,

Ah, ok, I meant to write to “Is it wise valuing LIT on a profit basis”. Sorry about that. Just that I have seen investors value LIT, BUR etc on profits and I am not convinced that is the correct approach.

Yes, the commentary from BUR is useful on this subject and in particular the mention of “replicable” litigation matters. I have to admit BUR was too complicated for me so I sold out years ago at well below today’s price! I could not really correlate the quoted IRRs with the accounting.

Not ideal news from LIT today:

Litigation Capital Management Limited (AIM:LIT), a leading international alternate asset manager of disputes financing solutions, advises that the employment of Nick Rowles-Davies by the Company’s subsidiary, LCM Corporate Services Pty Ltd, has been terminated on the grounds of gross misconduct effective 17 December 2021.

The decision to terminate Mr. Rowles-Davies’ employment follows the identification of certain expenses claims which have been made in contravention of LCM’s Global Expense Guidelines and Policy.

I guess the legal outcomes of the current litigation portfolio will not be affected by this departure, but I am not sure how important Mr Rowles-Davies was to attracting/assessing new claims.

Maynard

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For me, this is one of the understated metrics. Investors have to trust the people running the company of which they own a share. I have seen directors essentially bankroll their lifestyle on company expenses but this was in large companies where the level of expenses was not material at the EBIT level. For someone to get thrown out for abusing expenses at a £95m company… Should we trust him with our money?

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