Manolete Partners (AIM:MANO) – a litigation finance microcap
Share Price: $6.11 (USD) (490p)
Shares Outstanding: 43.5mm
Market Cap: $263mm (USD)
Enterprise Value: $236mm
This is going to be a shorter post as I continue to do some due diligence, but wanted to highlight an interesting microcap in the litigation finance space. While studying the litigation finance industry, I’ve come across a number of UK companies raising capital to attack different segments of litigation finance. I may post a longer write-up at some point in the future, but for now I’m putting this one on hold. Disclosure: no position.
Manolete Partners (pronounced Man-O-Lay) is a litigation finance business, and the leading insolvency litigation funder in the UK.
Manolete deals primarily with funding insolvency or bankruptcy cases – a bit of a niche business in the litigation funding space (Burford Capital for example, funds any and all types of cases – aside from individual lawsuits and class action – on which they deem to be able to earn a decent return).
When a company files for bankruptcy, a ton of claims arise, and Manolete either provides funding for stakeholders to pursue legal action, or buys a particular claim outright, pays for the legal fees, takes a return, and then gives 50% of the return back to the creditors who presumably have lost everything during the bankruptcy process.
MANO also has a personal bankruptcy arm, dealing with those who attempt to take advantage of the bankruptcy process by eliminating assets and leaving creditors high and dry. Manolete will fund the bankruptcy trustee to recover those assets.
Unit economics are pretty straightforward. Using a $2mm funded case as an example, MANO is able to earn a $420k recovery fee on a 50/50 split with the creditors and insolvent company after receiving their initial investment back from the gross proceeds.
I describe this in more below, but the value prop for insolvency practitioner firms (‘IPs’) and bankrupt companies is enormous, as both are attempting to a.) recover everything they can to pay off debts/recover assets and b.) stay out of court. Manolete provides an alternative to expensive, IP-involved litigation and has a strong track record of successful recoveries.
I’ll back up for a second to provide a high level (and very simplistic) overview of the litigation finance industry and what is driving the increased demand for funding over the past decade or so.
Although there are different types of litigation funding with different risks and rewards, regulations and economics, the basic idea is that litigation funders exist to finance legal claims on behalf of individuals and corporations in exchange for a fee, and/or a portion of the legal settlement.
Because funding is non-recourse, there’s also a large value proposition delivered to the party seeking funding, as corporations and law firms get to offload legal costs (which they would have to expense for the duration of a case) and remove any risk from their balance sheets, freeing up capital for more productive things while still being able to pursue legal action. Think about it like this; if a corporation takes out a loan to fight a legal battle, they’re still obligated to repay the debt whether the outcome of the case is favorable or not.
While its difficult to calculate the size of the industry as well as the TAM given the lack of public data, the industry is massive and growing, giving the impression that many of these businesses are just scratching the surface of their TAM. I’d estimate the industry size to be around $400-600 billion, estimated by using the amount of litigation awards issued each year, as well as global legal fees charged around the world. What’s more is that the litigation finance industry is in its infancy, as the industry (from a large scale standpoint) was formed about a decade ago.
In terms of the opportunity for MANO, the company outlines an addressable market of 2,300 UK insolvency cases annually, with a $1 billion (pounds) headline claim value, $500 million of which may actually be recovered. MANO feels that $130mm of that is potential recoveries to chase (net of costs), resulting in an additional $50mm revenue opportunity and $40mm in EBIT. These are estimated per year figures very likely to be wrong, but at least gives you an overview of the opportunity set.
Alright, now back to Manolete. In the UK over the past 10 years, there have been somewhere in the neighborhood of 14,000-15,000 corporate bankruptcies per year, and over 40,000 personal bankruptcies. Manolete is currently funding 76 cases, making the growth runway and ability to capture additional share quite long. The demand for a firm like Manolete comes from the above number of corporate and personal bankruptcies, but also from an unfavorable way of pursuing insolvency litigation in the UK, called the ‘CFA Model’.
Under the CFA model, insolvency litigation cases are conducted on a ‘no win, no fee’ basis + after the event insurance model. I don’t need to get into the details of the actual model other than to say that favorable UK law changes have opened up the door to increased litigation funding being used, as its now more risky for IP firms to pursue recoveries on their own. In April 2016, the UK government ended the exemption for insolvency litigation from LASPO’s abolition of recoverable success fees and insurance premiums in conditional fee cases. That was a ridiculous sentence so I’ll try explain.
CFA stands for ‘conditional fee agreement’. Before 2016, in the UK, all insolvency litigation was exempt from something called LASPO, or the Legal Aid, Sentencing and Punishment of Offenders Act. Basically, the exemption allowed parties pursuing the litigation to recover certain success fees and insurance premiums in certain cases where the fee arrangement was conditional (no win, no fee type of thing). The idea behind the law change argues that conditional fee agreement (CFA) attorneys do not provide much benefit to insolvency practitioners (or those required to collect the debts). The law change doesn’t ban the collection of fees altogether, but doesn’t allow CFAs to collect fees from defendants anymore. Hopefully I didn’t lose you there.
So, enter Manolete. Due to the law changes, insolvency practitioners will now have the option of selling the litigation to a third party funder, who will have no prior connection to the litigation but will agree to finance all or part of the legal costs in return for a fee payable from the proceeds recovered. This works out well for insolvency practitioners, generally risk averse, who can seek out an established, nationwide brand with a long track record of success. During the past eight years, MANO has won 87% of total cases funded or bought, with the other 12.5% voluntarily ceased, and only one actual loss. MANO CEO Steve Cooklin said that this law change has helped considerably, as regulators changed their guidance to recommend that IPs use third-party funding instead of CFAs. So there are some serious industry tailwinds for Manolete. These favorable tailwinds have resulted in increased profits every year since 2012, a nearly doubling of pre-tax earnings YoY (in addition to a 3-year EBIT CAGR of 49%), and new case inquiries growing at a 40%+ clip. Revenues eclipsed $13mm for 2019, with EBIT coming in at $7.7mm.
Manolete IPO’d specifically to explore international opportunities outside the UK. To date, MANO has funded over 279 cases, growing at a rate of 40%+, around 200 of which have been completed. The average case duration is 11 months, far eclipsing any other litigation finance provider, and MANO has been able to earn ridiculous ROIs of 180% on the total number of cases funded, and 394% (!) IRRs. MANO has invested a total of just under $10mm, recovering over $33mm, and getting to keep as gains $11mm of that number (50% or so goes to the insolvency practitioners). To further illustrate the demand picture, it took six years for MANO to reach 100 cases in which they invested, but then just two years to hit 200.
Of Manolete’s addressable market, only 7% of the 2,300 insolvency litigation cases per year in the UK are currently using financing. It’s become clear that Manolete’s work so far has provided the industry with abnormally quick recovery periods with better returns than the traditional model of slow to recover, fee paying arrangements. Now, insolvency practitioners contact Manolete directly, speeding up the process and reducing the need for consultants or brokers. I’ll get into this more below, but MANO’s growing reputation has allowed them to build strong relationships with hundreds of UK insolvency firms, become the ‘preferred brand’ for IP firms seeking recoveries.
Moving forward, MANO will be focusing on increasing the number of new case inquiries, rolling out their regional networks across the UK to increase density, and deploying recently raised capital of around $30mm.
Competitive Landscape and Competitive Advantages
It’s no secret that the litigation finance space is incredibly competitive, with pretty low barriers to entry. There are plenty of recoveries and legal fees to chase for each firm, and returns on these cases can often be multiples of what a third party invested at the outset. This has led to a dearth of capital entering the space over the past decade, from small firms to large, public to private. However, there are only a few with size and scale, and fewer who used a head start in the space to gain strong footholds within the industry. This includes Manolete.
MANO has a few built in competitive advantages earned over the last ten years, including their size, scale and access to capital, their first mover advantage resulting in the build out of their large referral network of over 280 IP firms, and their brand or reputation.
These advantages have resulted in a nice recurring referral network of IP firms, where each IP firm that has worked with Manolete before has returned with repeat business. Currently over 60% of invested cases have come from repeat IP firms. MANO is now the preferred third party funder for insolvency practitioners, resulting in increased business wins, a better track record, increased profits and even more repeat business. In addition, deep relationships with IP firms are very hard to replicate from scratch, even if a third party comes along with plenty of capital. The reason is because there is an incredible amount of risk in funding an insolvency case – outcome to lead to zero recoveries – and IP firms are generally risk averse. This leads to the selection of the preeminent brand in litigation financing, removing the risk for IPs, and leading to more frequent, higher value cases for Manolete.
I’ve noticed throughout the litigation finance space, that once this sort of recurring network is built, it becomes somewhat of a flywheel (I apologize as I hate that term) that is incredibly difficult for competitors to slow down, and can result in very attractive economics for the firm able to capture these network effects. Manolete’s competitive advantage will widen as they take on new business and help generate successful recoveries. In addition, there is an incredible amount of operating leverage inherent in these models, with low fixed costs and limited number of staffers required to handle business operations, driving 55%+ EBIT margins that will most likely expand with greater scale.
In line with most of the litigation finance businesses I’ve looked at, large portions of Manolete’s revenues and gross profit comes in the form of what’s called unrealized gains. How this works is that MANO will fund or purchase a case on which they expect to earn ‘X’ amount as a return, and over time, leading up to the conclusion of the case, incremental revenues are realized depending on the current status of the case. So as cases settle each year, MANO will report those revenues, but also the unrealized gains from not-yet-concluded cases as described above.
The nature of litigation finance and the uncertainty surrounding the timing of each case requires this abnormal approach to reporting results. I’m not a huge fan of how Manolete has chosen to report. A look at the financials reveals that they report a total revenue and total gross profit number (and the corresponding YoY percentage increases), even though unrealized gains make up a large portion of both. If one were to exclude unrealized gains from their calculations of revenue and gross profit growth, the percentages would be much lower then currently being reported.
Of note, MANO isn’t hiding anything. It’s all there in the annual report, and you can do the basic math pretty easily. I’m just not a fan of this approach. The only reason it’s probably fine in the long run is that MANO has historically had an average case duration of less than one year, which is the fastest I’ve seen from all litigation finance businesses, as well as a very high success rate. This either speaks to the quality and speed of their work, or the nature of the insolvency process.
Burford’s model for example includes realizing the majority of unrealized gains within one year of case conclusion, indicating a conservative approach. In addition, historical results show that nearly 100% of Burford’s unrealized gains have become cash at some point in the future.
Management and the Board
In terms of high powered shareholders, Manolete has one of the most interesting ownership groups (majority shareholders) I’ve seen in a long time.
Float amounts to around 28%, with 18% owned by CEO Steven Cooklin, and 12% owned by George Soros’ firm SFM UK Management. Jon Moulton is one of the most successful and well-known private equity investors in the UK. To be fair, Soros and Moulton have been financing MANO long before the IPO, but it’s clear some very smart and experienced groups believe in the potential of the business. In addition, Dr. Stephen Baister sits on the board, a 20 year+ bankruptcy judge in the High Court of the UK, and former chief bankruptcy registrar.
Interests appear to be aligned, and there are some very smart and very experienced people involved with this business.
Like Burford Capital, this is a complex business that will most likely prove difficult to model and value given the complex accounting and use of realized and unrealized gains in calculating revenues and profits. With that said, it’s clear that the current valuation is very pricey at over 7x book value and around 30x pre-tax profit. Based on what I’ve seen around the industry, litigation finance businesses can trade anywhere from 2.5x book (on the cheaper side) to 5x book (the expensive side). Shares of MANO are up over 100% in the past six months alone, making it clear that the market sees some serious growth potential for the foreseeable future.
With revenues growing 30% YoY and operating income up 85% YoY, maybe the multiple gets cheap when looking a few years out. With that said, I don’t have a position because of the expensive looking price, but there are a lot of really attractive aspects here including the balance sheet, management team, large shareholders, widening competitive advantage, and long runway for growth.
MANO also pays a small dividend of 1.49 pence per share, but it’s immaterial at this stage. I’m going to do some more work and will add any further details as they come up.
Accounting is gimmicky – large percentage of revenues and profits are made up of unrealized gains
Rush to IPO – hopefully because capital was needed due to increased demand
Valuation – a lot is baked into the future of this business
Additional capital entering the space drives up the cost for purchased cases
Multiple re-rating/missed growth expectations
Not as much case diversification
One large case loss may have an adverse affect on the entire year
Steven Cooklin Interview: