Thursday, August 22nd, 2019
Australian global litigation funder IMF Bentham (ASX:IMF) was a recent Small Cap addition to the ASX Model Portfolio.
Clime last held IMF over 2016 and 2017, and we believe now is a good time to hold again.
IMF is a company we consider as a “niche leader” in its field, and one with strong prospects, a high calibre staff, and more than adequate capital resources to fuel its growth strategies.
At inception in 2001 IMF was a first mover in Australia in the third-party dispute funding space. Out of the approximately 200 cases funded to completion, IMF has achieved a 90% success rate and generated an average return on invested capital (ROIC) of 144%. The average time to case completion is 2.6 years. These are strong economics.
Historically, the downside to the business, however, was the unpredictability and lumpiness of its earnings as a result of the size and timing of big case judgements and settlements.
The main change in recent years is IMF’s strategy to shift funding for litigation cases from its own balance sheet to Fund vehicles, which it will co-invest in and manage. Generally, IMF will co-invest in the funds to approximately 20% of capital, instead of 100% previously, and charge management and performances fees in addition to earning a profit share as co-investor. Ultimately, the new structure should improve IMF’s ROIC.
Equally as important, the strategy means IMF can significantly diversify and grow its business, in terms of geographic footprint and the cases it invests in. Over time this should yield both higher and more consistent revenues and earnings, potentially solving the main issue with old business model.
IMF has also concentrated on diversification by dispute type. Starting out in insolvency funding, IMF grew its operations across several investment categories, including class actions, arbitration, law firm portfolios, and various types of commercial disputes. Historically IMF focused on asymmetric ‘David versus Goliath’ cases, but more recently it has pursued funding for corporates as a new business avenue.
The Funds strategy was announced in 2015 but it wasn’t until 2017 that IMF launched what management calls the “first generation funds”. These funds included Fund 1, which invests in disputes in the US, and Funds 2 & 3, which invest Rest of World (RoW – Australia, Asia, Europe). IMF’s balance sheet investments went into run-off following the launch of Fund 3 in October 2017. At today’s exchange rate, the capacity of these funds totals A$425m.
The launch of the first-generation funds was an early sign of execution by IMF. Recall the average time to case completion is generally 2 to 3 years, so they are only now bearing fruit.
Over FY19 IMF ramped-up the funds strategy with the launch of Fund 4 (US) in November 2018, and Fund 5 (RoW) in June 2019. Both funds each have capacity of US$500m, and both carry options to increase capacity to US$1bn. We also believe these “second-generation” funds are on improved terms for IMF in terms of profitability.
In our view, successful execution of Funds 4 & 5 should yield a very healthy payoff to the prevailing share price of $3.30. This, however, assumes funds are fully deployed and historical returns on invested capital are maintained. It is also worth keeping in mind the lag in the time from capital deployment to case completion; we likely won’t see the second-generation funds maturing until 2023.
However, IMF has near term catalysts from maturing balance sheet investments and cases held in Funds 1 -3. As a rough guide to the value of potential judgements and settlements, management provide Estimated Portfolio Value (EPV), as well as their expectations of EPV over the next 4 years to FY23. EPV as at 30 June 2019 is summarised below. This is interesting, because expected EPV indicates a potentially very large revenue step-change across FY20 and FY21.
Figure 1: EPV by investment vehicle
It should be noted that the Balance sheet investments include two particularly large cases in Australia, Westgem and Wivenhoe, both of which await judgement. Although IMF doesn’t split out EPV by individual case, we believe the EPV of these cases could be up to A$665m, as both are included in the FY14 and earlier vintage shown below. The two cases represent up to $100m of gross case income.
Figure 2: Balance sheet investment EPV by vintage
In summary, IMF’s weak financial performance in recent years belies its future earnings power. This is perhaps best illustrated by the following chart which shows rapid growth of case investments (blue) during a period of falling case income.
Figure 3: Case investment vs Net case income
Weighing the risk and reward we have introduced IMF at a relatively low initial weight in the Clime Direct Model Portfolio. This gives us some room to top-up on further positive execution.