Litigation Finance, Litigators, Money

Lessons From The Burford-Gerchen Keller Deal

What might have motivated this major deal in the litigation financing space?

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Handshake merger money financeLast week, Burford Capital announced the $160 million acquisition of Gerchen Keller Capital. That deal included $94 million of Burford’s own cash, $44 million in notes, and $23 million in Burford shares. The principals of GKC could also earn an additional $15 million over time.

From a benchmarking standpoint, the deal is enormously interesting. GKC has roughly $1.3 billion in assets under management (“AUM”), plus roughly $300 million in new funds thatare currently being raised. Those figures are actually quite small in the investment world and speak to how far litigation finance still has to go to catch up with mainstream finance.

To put it in perspective, I’m an outside advisor sitting on investment committees for two different asset managers that are virtually unknown by the broader public; one of those asset managers has $3 billion in AUM, and the other has $8 billion in AUM. By these types of measures, GKC was not a large firm. Yet GKC was one of the best-known firms in the litigation finance space, which in turn suggests just how far the industry still has to go.

GKC’s profit’s picture was also surprising. On that $1.3 billion in AUM, GKC earned $15.4 million in income in 2016 and operating profit of $9.1 million, according to the press release. That’s a net income after expenses of roughly 70 basis points on assets – a surprisingly low figure for a high-flying asset class aimed at sophisticated investors. Successful hedge funds generally have better margins – the reason for this low level of profit is the way that GKC is structured.

Gerchen Keller used a structure that attempts to mitigate investor governance concerns by not giving GKC any performance fees until fund investors have recouped their entire capital investment. That is very much out of the ordinary in finance. Management fees of 1-2% annually and performance fees of 15%-50% are on par with what one might expect. Hedge funds famously charge 2% and 20%, with top-tier players like Renaissance Tech charging 4% and 40%. The higher fees at GKC compared with top hedge funds like RenTech (which has achieved a 79% internal rate of return (“IRR”) for 24 years running for its top fund) are likely driven by the delay of performance fees to GKC. So GKC’s fees are reasonable in comparison to the broader universe.

Perhaps the most important aspect of the Burford deal is what is left unsaid, though. The fact that Burford is buying GKC raises the possibilities that (1) Burford may be facing a dearth of attractive available ways to deploy their own capital at this stage, and (2) the industry still has a lot to learn about attracting institutional investors.

Burford is paying roughly 20x 2016 earnings for GKC (assuming full earn-out in the deal) – that’s expensive, but not as crazy as other deals I have seen in finance. Still, it is not consistent with a business where Burford can deploy capital and earn 30%+ IRRs. Maybe Burford simply has more capital than it can deploy effectively, maybe GKC opens up new connections to deals and investors, or maybe this year’s GKC earnings are artificially low.

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The most likely explanation for Burford’s willingness to pay a premium for GKC is that the acquisition is an aqui-hire deal typical of the type seen regularly in Silicon Valley. Litigation funding is still in its infancy, and there are relatively few experienced litigators that want to move into the space. By the same token, because the space is dominated by attorneys, it’s hard to bring experienced alternative-finance experts in.

The acquisition helps Burford with talent on the legal side, but probably ignores the most important issue in the industry – gaining institutional acceptance. Burford has roughly 60 employees pre-deal, and GKC has 20 – of those 80 total, 40 are attorneys. The remaining 40 are going to be a mix of different functional areas. It’s clear then that GKC and Burford are heavily oriented towards a legal perspective of the industry rather than a financial perspective.

Lawyers and financial analysts are both smart groups of folks who have value, but they think about the world in completely different ways. And most major institutional investors are dominated by finance people, not attorneys. Corporate finance verticals are the same way, of course. This dichotomy – attorneys asking finance people for investments and asset sales – explains why the litigation funding industry has not attracted more institutional interest yet.

I spoke with an investment manager at a large alternatives manager last week that confirmed my view – litigation funding firms right now simply do not know how to talk to institutional investors. Institutions want to talk about laddered durations in case portfolios, cross-case outcome correlations, and quantitative methods of case selection. These are the kinds of concepts that completely outside the wheelhouse of attorneys.

The point here is that finance and accounting people speak a different language than attorneys, and until litigation finance firms learn to operate in both worlds, they will be missing out on the true level of growth potential in the field.

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These are merely my opinions as an outside observer of litigation finance. If you work in this field and have information or insight to share with me, please don’t hesitate to email me; I’d love to hear from you.

Earlier: A Major Merger In Litigation Finance Means A Giant Payday For Three Young Lawyers

Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at M.McDonald@MorningInvestmentsCT.com.

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