Burford (BUR) – The Napo Mysteries

Preface

I am neither long nor short Burford and had not looked into them (beyond identifying some immediately apparent red flags) before Wednesday. Accordingly I am coming into this from a cold start and it may well be I am not the first to have uncovered the answers to some loose ends in Muddy Waters’ report.

Mysteries

The core of the Muddy Waters report lists seven ways they claim Burford have manipulated their performance metrics. It seems a reasonable assumption that they led with their strongest example and so I have concentrated on the Napo case (search for “#1” in the report).

MW’s first complaint, and the first mystery, is that this case was categorised as “concluded” (for a profit) before it reached a verdict (of a total loss).

They then talk about how the investment becomes a debt owed by Napo to Burford (later to be “bailed out” by an associate of Neil Woodford). This doesn’t make much sense as the entire purpose of litigation finance is that repayment is only required in the case of a win. MW explicitly admit that they can’t explain how Napo came to owe Burford money in the accompanying video.

The final mystery is how/why the debt amount (and therefore profit) increased from £15.4 to £21.3m in 2014.

Solved?

In Burford’s last annual report they say:

We have consistently used concluded investments and investment recoveries as terms to refer to those investments where there is no longer any litigation risk remaining.

They then give examples of what this definition encompasses, but they do not say they are exhaustive. The last one concludes with “and there is no longer any litigation risk involved in the investment“.

Taking this information and reviewing the annual reports I suggest the sequence of events could have been as follows:

• During 2011 Burford take on the case with the expectation of winning
• Late in 2013 the case seems to be progressing well, perhaps there’s even an offer of a settlement. Napo decides to buy the case back from Burford for £15.8m in order to obtain 100% of the remaining upside. [Edit: Burford today seem to be explicitly refuting this theory, instead claiming that it related to a different legal matter] This theory is supported by the fact that the cost of the investment / litigation (to Burford) remains at £7.4m in the following years even though litigation itself is ongoing.
• At this point Burford understandably categorises the litigation investment as “concluded”. Certainly, using their own words, they now have “no litigation risk involved in the investment” – in its place they have a receivable from Napo, win or lose. It seems that the timetable for this receivable is in excess of one year since in the 2013 Annual Report, only the “Non-current” “Due from settlement of litigation-related investments” could contain such an amount.
• The following is pure speculation: Perhaps part of Burford’s motivation in agreeing to the transaction is to reduce their “risk capital” thus reducing equity or debt funding costs. MW might claim they did it to flatter their FY2013 figures as they go on to claim Burford did with other mark-to-market exercises just before year-ends. Perhaps Napo privately reasoned that due to their other debts (including those to other law firms) if they didn’t win the case then they wouldn’t survive and so had nothing to lose by taking on the liability. Some seasoned investors might detect what Charlie Munger calls “incentive-cause bias” (search here, or listen here) in the accuracy of Burford’s assessment of Napo’s ability to pay.
• In 2014 a jury verdict finds against Napo.
• Later in the year Napo defaults on their debt to Burford. As part of debt forbearance Napo have to pay penalty fees, bringing the receivable value (conceivably after some impairment) up to £21.3m. This increase is one component in the unusually high “Interest and other income on due from settlement of litigation-related investments” of £13,318 in their 2014 Annual Report.

Notes

I have nothing further to add to the remainder of the MW’s story, except that:

• Impairment of receivables was never identified as a key audit matter.
• The timing of the debt to equity swap occurred 5 months before the start date of IFRS 9 which might otherwise have required an impairment to be declared.
• I confirm that the traces of the debt to equity conversion can be found on BUR’s financial statements.
• Although Burford boast about how they recently added details of each investment to their website, prior to 2016 much of this information was found found directly in the annual report.
• From MW’s perspective as a short seller, the involvement of the UK investment world’s Number 1 Supervillain seems almost too good to be true, but the Woodford connection seems indisputable.
• Although I found evidence that a jury indeed found against Nabo in 2014, apparently this was not the end of the story. A 2016 settlement indicates that Nabo did eventually receive some consideration in respect of the case. Although it is by no means clear that this consideration had any value, this does give more support to judgements that Nabo’s case had merit and/or Nabo had some value than MW gives credit for.
• Finally: None of what I have described as fraudulent as I understand the law.