Today I’m very excited about this latest idea. Manolete Partners Plc is a rapidly growing specialist insolvency litigation financing company (42% 5Yr CAGR), which I believe to be undervalued by 40% – 80%.
The company earns revenues by financing (20%) or purchasing (80%) legal claims associated with insolvent companies and has an excellent track record with its cases with an average ROI of 168% and an average case completion length of only 11.1 months.
It currently maintains a 67% share of the Third Party Financing (‘TPF’) segment (up from 52% in 2016). TPF is a growing segment which remains only 14% of the overall insolvency litigation market (up from 7% in 2016) following legal changes in 2016 which made alternative financing options less attractive, providing significant room for further growth.
In the COVID-19 pandemic, despite widespread financial difficulties for masses of companies, temporary restrictions on wind up orders and statutory demands in the UK, not to mention other government support schemes such as furlough, have artificially suppressed insolvency levels to the lowest level in over 20 years. I believe the current share price is depressed by this temporary issue, and once insolvencies inevitably unwind the company should be able to continue on its strong trajectory.
The business model
Manolete Partners Plc (AIM:MANO) is a specialist insolvency litigation company, based in the UK and listed on the alternative investment market. The company earns its revenues buy either funding or outright purchasing legal claims related to business insolvency (i.e., where businesses fail and there are disputes between various parties as to who owes whom what).
Essentially the company seeks to identify legal claims that have a high probability of success before taking an interest in the claim by either buying it outright or through a funding arrangement. The company therefore invests in legal claims, bearing the risk that the claim is unsuccessful, and seeks to earn a return on these investments through successful claims & case settlements. As such the company is essentially an investment company. Insolvency cases are the only kind of claims that can be purchased by a third party due to a specific exemption in the law.
This a kind of business activity is unfamiliar to most, so it is worth going through how these cases work step by step. The company provides quite comprehensive examples and explanations of how these claims work on the company website: https://www.manolete-partners.com/, however to sum it up in a few words:
Manolete works in a three-way partnership with insolvency practitioners (‘IPs’) and the lawyers of the IPs. The role of the IP is to oversee the bankrupt business, and attempt to recover as much as possible for the various creditors of the company. Part of this process sometimes involves making legal claims against counterparties to recover funds or assets. As an example, a company may have unlawfully transferred assets to an external entity prior to bankruptcy (for example, inappropriate loans to directors, transferring of property to another entity on non-commercial terms, etc).
The IP will seek to make a claim on behalf of the company to recover funds from the relevant counterparty, however this requires upfront investment to realise the recovery (e.g. expensive legal costs). This is where Manolete comes in. Manolete will either purchase the legal claim outright or provide funding of the claim, taking a share of the gains from successful claims.
In terms of the chronology of a case:
- An IP or Lawyer, with whom Mano have built relationships, will discuss a potential case with Mano;
- Mano will assess the potential case on a cost vs benefit basis, with the investment committee approving any new cases. As such Mano has staff with experience and knowledge in the area to determine which cases are worth pursuing;
- Purchase or funding agreement is made;
- The case is pursued, with the case being settled out of court in many cases, but taken to court for judgement if necessary;
- If the case is successful, Mano will receive it’s share of the net proceeds. If the case is unsuccessful, Mano will receive nothing, and any costs incurred in the case will be absorbed as an expense.
Market leader in the growing TPF market segment
In the litigation funding market, there are three primary options for those looking to fund their claim:
- Conditional Fee Agreement (‘CFA’). This is commonly referred to as ‘no win no fee’, where the fee charge by the relevant solicitor is dependent on the outcome of the case.
- After The Event (‘ATE’) insurance. ATE insurance is a type of legal expenses insurance policy that provides cover for the legal costs incurred in the pursuit or defence of the litigation and arbitration.
- Third Party Funding (‘TPF’). This is the type of funding which is offered by Mano, where funding or outright purchase of legal claims occurs.
Mano does not use any CFA or ATE agreements in its cases (this is due to the high costs involved), and as such Mano bears 100% of the costs associated with all of its cases. This is the primary risk that the company therefore faces.
Manolete partners currently has a market share in the TPF market of 67% (up from 52% in 2016), and is therefore the market leader in the segment. Despite this, TPF still only makes up a small minority (14%) of the total litigation market of c.£1.5bn in claims (and c.£750m in recoveries) each year (up by 50% in the last 5 years), and therefore there is clear scope for further growth.
In 2016 a change in the law with respect to legal costs came into effect for insolvency litigation cases. The Jackson Reforms (https://hsfnotes.com/litigation/jackson-reforms/conditional-fee-agreements-cfas-after-the-event-ate-insurance/) effectively reduced the amount of legal costs which can be recovered from the opposing party in CFA/ATE agreements. The new rules came into play for most types of litigation in 2013 but these only became active for insolvency cases in 2016:
“Since 1 April 2013, where parties fund their litigation via conditional fee agreements (CFAs) and/or after-the-event (ATE) insurance, the CFA success fee and ATE premium are no longer recoverable from the losing opponent if the case is successful. Parties can still enter into CFAs and take out ATE insurance to fund their litigation, but have to bear the additional costs of doing so.
Parties can enter into a CFA with their lawyer, where the lawyer is paid up to double the normal fee if the case is won and nothing, or sometimes a discounted fee, if the case is lost. The uplifted fee is called a success fee, and it is capped at 100%.
Parties can also take out ATE insurance to cover their risk of having to pay the opponent’s costs, as well as their own disbursements, if they lose the case. ATE policies are sometimes available with “deferred and self-insured” premiums, meaning the insured party does not have to pay the premium until the end of the case, and does not have to pay it at all if the case is lost – ie the insurance kicks in to cover the cost of the premium itself as well as the adverse costs if the case is lost.
The crucial feature of this system as it applied before 1 April 2013 was that both the CFA success fee and the ATE premium were recoverable from the opponent if the case was successful. As recommended by Lord Justice Jackson, that is no longer the case for CFAs entered into and ATE policies taken out on or after 1 April 2013.”
As a result of this, the financial incentive for taking up CFA or ATE arrangements has significantly reduced, and relatively this makes the TPF option much more attractive. On the back of this the TPF share of the market share has doubled from c. 7% in 2016 to approximately c. 14% in 2021. The most recent research on the market is summarised in the following slide from the 2020 annual results presentation:
Mano’s growth in the last few years has been exceptional, revenue growing from c.£5m in 2016 up to c.£27m in 2021, but if the trend towards TPF continues and if Mano can continue to expand it’s share of the TPF market, then there is plenty of growth potential remaining. This will form the basis of my DCF model which I shall discuss later on.
Excellent profitable track record
As noted earlier, the key risk for Mano is that it must pick the right cases in order to earn a good return, because it is responsible for 100% of the costs incurred in each case it purchases. It should provide real comfort then that Mano has achieved consistently high returns on investment on its claims.
Since Mano purchases over 80% of it’s claims outright, this gives it greater control over the cases and ultimately allows it to ensure a higher return is achieved. The following table, published in the FY21 year end results presentation, shows the long running track record of successful claims:
In turn this has translated into impressive growth in earnings, however it is worth noting that a significant part of reported revenue (and earnings) comes from unrealized gains on cases which are measured at fair value (never trust accountants). However even looking at cash receipts over the years it is clear to see that cash receipts are truing up reported earnings:
Temporary Adversity
“Experience teaches that the time to buy stocks is when their price is unduly depressed by temporary adversity. In other words, they should be bought on a bargain basis or not at all.” – Benjamin Graham
I know I used this exact same quote for my last piece, but I make no apology for this, because again I believe that temporary problems are being reflected as permanent in the share price, providing a golden opportunity.
If I said to you, what impact do you think COVID-19 would have on insolvencies and by extension insolvency litigation, there is a good chance you would think that insolvencies and litigation for insolvencies are on the rise. After all, how can it be that GDP drops by over 20% in the UK in one quarter and whole industries are forced to close for extended periods of time, but insolvencies don’t rise?
The answer is the government. In the UK there has been significant restrictions put into place which limit winding up order (compulsory liquidation). In addition, temporary financial support in the form of government backed loan schemes and the furlough scheme have also been introduced. As a result, the level of bankruptcies in 2020 has actually fallen to the lowest level in over 20 years:
UK Bankruptcies per quarter:
As such in the next couple of years this will have a knock-on effect on insolvency litigation and therefore revenue for Manolete, however the consensus is that insolvencies will bounce back sharply once these restrictions are eased (currently due to end in September 2021). I believe this is holding back the share price when this is a very temporary disruption and common sense tells us that economic downturns ought to increase bankruptcies.
UK Bankruptcies forecast per quarter:
The above forecasts will factor into my revenue forecasts later (with peak bankruptcies at 5,800 per quarter), but my view on this is that the level of bankruptcies to come may be far higher than this, considering the level of build up that has surely occurred whilst these restrictions have been in place, and considering that the level of bankruptcies after the 2008 GFC reached 7000 per quarter and only declined gradually. This is not to mention the heightened level of company fraud which is likely to occur when government support is on offer.
Incidentally this also highlights one of my favourite traits about this company, which is that it’s financial performance should be uncorrelated, or perhaps negatively correlated, with the performance of most businesses in the economy. This in turn provides genuine diversification for potential investors.
Bargain pricing
DCF Model
In order to value the company, I have put together a standard DCF model based on enterprise level cashflows, and based on my view of a reasonable mid case.
Revenue forecasts are based on the assumption that Mano can achieve a 75% share of the TPF market by 2026 (as compared to 67% currently, and 52% in 2016), that TPF makes up 20% of all insolvency litigation by 2026 (as compared to 14% currently, up from 7% in 2016), adjusted for the expected level of bankruptcies forecast by trading economics, trending down to the long term average.
Gross profit margin is assumed to converge towards 60% which is below the long term average achieved but above that achieved in FY21. Operating costs have been modelled using a regression against revenue with a high R^2 (0.97).
Incremental increases in net working capital have been factored into the cashflow, which is relevant for Mano as significant investment outlay is required to increase revenue through higher case volume.
Beyond FY26 cashflows I have calculated a terminal value based on the Gordon Growth Model with terminal growth of 2%, in line with UK target inflation, which therefore (conservatively) assumes that no further market share can be gained after the forecast period.
I’ve estimate Ke at between 9.2% – 10.8% using the CAPM model, considering observed betas across the market, though this is difficult with highly limited available peers. I’ve also included a considerable small cap premium which you could argue it not that applicable with an (albeit niche) market leader.
Cost of debt applied is 2.95% in line with the disclosed interest rate on the company RCF of maximum 2.9% above SONIA. It is worth noting that in 2021 the company agreed an extension to its RCF facility of £25m for at least 3 years, providing significant headroom above current usage and therefore good stability for the business (31 March 2021 net debt: 8.4m).
Calculated WACC applied is between 8.0% and 9.3%.
This has been used to discount expected free cashflow to the firm before the application of the Gordon Growth Model at 2% terminal growth as noted.
The resultant calculation gives an equity value range of between £153m and £189m, or between £3.35 and £4.18 per share, significantly higher than the current price level of £2.37 per share. Moreover, my sensitivities show that the applied WACC would need to rise to 12% for the equity value of Mano to be equal to the current share price.
This results in an implied current year EV/EBIT of between 15x to 25x, reflecting the level of growth which is expected. I would normally seek to compare multiple with peers, but there simply isn’t any sufficiently comparable listed companies out there.
Conclusion
Overall, Manolete Partners Plc represents a rare opportunity of a growth potential share at a very fair price, with the added bonus of offering genuine diversification with performance uncorrelated (or perhaps negatively correlated) with the performance of the wider economy.
Target price: £3.35. Conclusion: bargain share. Bought at £2.37.
Eddie Lloyd Investment Research 