IMF

The markets are back at or close to all-time highs and selecting investments at this point is becoming quite tricky, especially for a fundamentalist and contrarian investor, like me.

Also, trying to follow the macro tourists into which sector is poised to go up can prove itself a very difficult task – or, as experience shows us, equivalent to flipping a coin. But I believe I have stumbled onto something that could be a real opportunity at the moment: IMF – and I am not talking about the one led by Christine Lagarde.

IMF Bentham is a litigation funding company providing funding to plaintiffs in Australia, New Zealand, Hong Kong, Singapore, United States and Canada. The name stands for Insolvency Management Fund and it is related to its initial target – insolvency-related issues.

The company has its origins at the beginning of this century, did a back-door listing in Australia and it is traded now on ASX under the ticker IMF. IMF has been in the ASX top 300 companies since 2009. They simply finance litigation cases and do not provide investment advice.

Up until 2015, the company used to invest its own money on the litigations it funded. This brought some idiosyncratic risk that the Board decided to diversify away from. Also, the earnings were a bit lumpy and the company was restrained by its own capital to grow.

Hence, from 2016 onwards, the company changed its business plan and decided to raise funds, in which it also invests, alongside investors, to finance growth and diversify risk. So, in February 2017, the first fund, focused on the US, was launched. Soon after, in October 2017, the second fund, for the rest of the world, was launched.

Today the company is already launching its 5th fund (the 4th fund is already closed and it was a success in terms of capital raising) and it is already oversubscribed. The due diligence process of the investors is still going on, but commitments have been made. Both the 4th (focused on the US) and the 5th fund (rest of the world) will be a US$500 million fund each.

IMF is transacting from a risky venture to a more asset management company venture, with a little spice (it invests in its own funds 20% of the fund’s target capital raising) and still has a few investments on its balance sheet. This explains why the company holds so much cash on hand. Once fully invested, IMF has to put US$200 million of its own capital on its 4th and 5th funds, not accounting for the option they have to double the size of these funds.

The funds are similar to private equity funds, with capital calls and management fees and performance fees (which varies according to the IRR).

Fund 1 still needs to make commitments and Fund 2 & 3 have only 10% of capacity left. Fund 4 is already being invested and Fund 5 should close by July 2019. Funds 4 & 5 are considered to be “new generation” funds, and they charge a quarterly management fee and performance fee. Funds 4 & 5 have an option to raise another US$500 million, so after investing 75% of the proceeds of the funds, IMF will most likely exercise the option to raise series II and double the size of the funds.

IMF has 50 investment managers that are litigation specialists. The cases are brought to them and these investment managers select the ones they really like. From there, they sign a non-binding term sheet which gives IMF exclusivity for 30-45 days so they can go through their due diligence process.

Then, after the due diligence, the case is brought to the CIO of the country in question who then, if approved, raises it to the investment committee – there are two, one in the US and one for the rest of the world. Both committees are formed by IMF people and non-IMF people.

Once the case is brought to the Investment Committee, its chances of getting approved rise substantially, with an average 2 out of 3 cases getting the green light. In any case, anyone in the Committee has a veto power.

Having said that, the company has a conversion rate of only 4-5%, meaning that from 1,000 cases that are offered to IMF, only 40-50 are accepted. This shows how the due diligence process is really thorough. Each case, from start to getting approved, takes approximately 4-6 weeks.

Unfortunately, litigation cases do not have a specific date to come to an end. Processes can take different turns, be delayed for much longer than people expect and costs may mount. Funding litigation could be an enormous bottomless pit and it is important to have some rules in place to avoid being dragged into endless battles that consume cash – and hence reduce profitability.

The way IMF takes care of these situations is two-fold: one for the US side and one to Australia. In the case of the US, they operate by a fixed budget and IMF co-invests with other partners, rarely taking 100% of a case by itself. When it comes to Australia, IMF splits its costs with the lawyers, paying 75% of hourly-rates up to the budget and only 50% of hourly-rates above budget. This helps keep lawyers more focused in solving the problem, instead of billing them.

IMF can also advance capital to law firms (minimum of 3 cases, due to US regulation) and participate in the gains together with them.

The staff has grown from 35 to 100 today and IMF has 14 offices in 6 countries. Still, they want a footprint in Europe and they are looking into starting an operation there or buying out an existing company. This should be very valuable to IMF, if done right.

IMF has made 92 investments and have invested US$350 million, for a portfolio of US$7 billion. From these cases, 23 were made using its own balance sheet and the balance through the fund structure. They do not give forward-looking statements and it makes sense, as the outcomes are normally binary and consists of illiquid investments.

Capital is not invested front-end, but over time. The cost of litigation is exponential as the trial date gets closer – hence the importance of having a cap on costs and dividing the risks of each case with different companies. One could say that in the beginning the odds of a favourable result are higher, as the company invests a lot of time and experienced litigators to assess the cases. But their chances of success diminish as the trial date approaches, moving closer to 50%.

IMF’s track record is fantastic. In its 17 years of operation, they have lost only 17 cases out of 175 invested and completed

Below is a comparative between the US and the rest of the world:

                                                            USA                RoW

IRR                                                      90%                 68%

IRR (after overheads)                    68%                 50%

Success rate                                       73%                 60%+

Duration                                            1.8 years         3 years

The breakdown of cases is 50% US, 50% row, which is where they want to be. The success rate is measured after a case is won or settled. The ROIC is 1.5x, which translates into an IRR of above 40% per annum – definitely an impressive number. Almost half of IMF’s investment portfolio is expected to be completed in the next few months – this can become an extraordinary opportunity for a savvy investor.

Talking about numbers, theirs are very conservative and IMF accounts for its investments at cost as intangible assets, instead of at fair market value (whatever it means in a litigation case). This definitely impacts its balance sheet and may discourage an analyst to look further, but when one looks into the company in more detail, the picture gets rosier. This way of accounting for investments can cause an explosion in earnings once cases are settled or won, leaving very little downside (cost of case) exposed.

The conservativeness of IMF’s accounting does not impress an investor in the first moment, but it definitely hides a gem. Besides, I personally like a firm that errs on the side of conservativeness and is willing to sacrifice short-term profitability for sustained long-term growth.

Some of IMF’s key investments are yet to achieve a resolution, but two of those are very important and large cases, named Wivenhoe and Westgem. They are both on its balance sheet – not in a fund structure – and a decision is expected soon.

Wivenhoe case concerns people who suffered losses in the Brisbane floods of 2011, and these people allege that the increase in flooding was caused by the negligence of the Dam operators. The Westgem case concerns a property developer alleging improper conduct in relation to loans for a property development by a bank.

I estimate that if IMF is not successful in both cases, losses can run up to US$10 million (US$5 million each), which is more than covered by its large cash position on the balance sheet of almost AUD200 million. But if successful, IMF should receive circa US$95 million just for Wivenhoe. As the outcome is almost binary (win or lose) – and I say almost because there can be a settlement before a sentence – I really don’t see a better risk x return relationship for a case. Most of the negatives are already priced in, but none of the positives are.

So, the market capitalization of the company is AUD560 million, or US$420 million approximately. The company is trading today at almost the same level it was in 2015, 4 years ago. Besides, IMF has de-risked its portfolio through the fund structure and actually is becoming more of an asset management company, with a few key differences, of course.

As an investor, one of the points I like the most about this company is that it is not correlated with markets, interest rates or the growth of the economy. After 10 years of uninterrupted growth in the financial markets, risks are increasing and finding something which has an incredible upside potential with low risk and even lower correlation is definitely a gem.

Apart from the risks of the business itself, it is worth mentioning the key staff and new entrants. On the positive, there is a strong background and solid track record, potential M&A (both ways), unique business model and the fact that the new fund structure can pave the way for value creation.

As it is nearly impossible to predict the outcomes of lawsuits,I used their track record as a proxy and discount it. Obviously, I had to make various assumptions towards the valuation, but at least it gives us an idea of where it should be trading now. IMF is not an easy company to evaluate, because the nature of the business and the structure of the investments, part using the company’s balance sheet, part using the fund structure.

It is even complicated to compare IMF to others in the sector, like Burford Capital. But if we try, we would be positively surprised: IMF looks cheaper in pretty much every single metric we came up with.

I did a back of the envelope calculation using SOTP (sum of the parts), meaning that each fund is a part of the company and applying a 20% discount to IMF’s track record. Also, Funds 4 & 5 can reach US$1 billion each, but I am only considering US$500 million. On top of that, I am not considering the 23 cases that IMF has on its balance sheet, that can have a significant impact on the upside.

IMF’s model includes higher profitability and a few tailwinds. There is a potential for gains in the sector, as big institutions are starting to allocate funds to this kind of strategy and diversify away from the risks in the markets. The early bird gets the worm.

After all these conservative assumptions, in my opinion, one could project the value of this company and I believe the price now is an absolute bargain, with the risk x return relationship extremely skewed to the investor.

I believe the market’s lack of knowledge of the sector, the size of the company and the nonexistence of marketing strategies to spread the name around presents an opportunity to the savvy investor.

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