A class action is where individuals with common interests launch legal action against a company for an alleged wrong. Generally, class actions allow any "aggrieved persons" to join a matter and have their claim heard with every other individual that has a "substantially similar" claim ("the Class"). If the court rules in favour of the class, all individuals in that matter are entitled to a share of the proceeds. If the court rules against the class, all members of the case are liable for a portion of the cost of litigation and automatically waive their right to sue the wrongdoer.
The role of a litigation funder is to provide money for such class actions; litigation funding is a fickle business as the funder agrees to bear the cost of losing in return for a slice of the proceeds if the action is successful. IMF Bentham Ltd (ASX: IMF) is the biggest litigation funder in Australia, and the recent retreat in its share price presents a great opportunity to buy a growing business.
A strong track record
IMF started funding cases in Australia in 2002. It has been the financial backer of some of the largest class actions in Australia, including cases against the directors of ABC Learning, Forge Group, Treasury Wines Estates Ltd (ASX: TWE) and more recently, Australia and New Zealand Banking Group (ASX: ANZ) for its penalty fees on credit cards.
IMF agrees to take on cases and pay for the costs of litigation, on the condition that it receives a portion of the payout if the matter is successful. The business model is similar to a managed fund, given IMF needs to pick which cases it will fund.
The process requires meticulous case selection, which IMF has demonstrated over the years. To date, IMF has funded over 175 cases and has only lost 10 of them, indicating management's selective and level-headed approach is working.
A stable pipeline
As at 30 June 2015, IMF had $89.1 million in cash and a net tangible asset backing of $1.11 per share. The value of current cases was estimated to be worth $2.03 billion, with IMF's share being approximately $650 million over the next three years (if successful).
Although every case may not result in a win, IMF's strategy is driven by statistics as it assesses each case on its merits (based on potential payout and costs) and then selectively funds cases which provide a positive risk-weighted return. That is, IMF only 'invests' in cases where the legal probability of winning/settlement is higher than the cost of funding the matter (on a dollar-for-dollar basis). This stringent approach is how IMF averaged a return on investment of 158% during the 2015 financial year.
Accordingly, IMF's portfolio of cases is generally weighted to provide a positive return based on the expected payout of each case and thus any investment by IMF is, in the long term, likely to be accretive to earnings per share.
A solid income stream
Whilst earnings can be volatile in the short term, given the timing of case wins, IMF has resolved to provide an ongoing, semi-annual, fully-franked dividend of 5 cents per share. This represents a modest payout ratio of 40%, leaving the company well capitalised to fund new cases.
As current cases finalise, IMF expects the dividend to increase to 14 cents per share per annum in 2016, representing a forward yield of 9.3% if that eventuates.
Foolish takeaway
Despite the challenges involved in litigation funding, IMF Bentham appears to have mastered the business with a strong track record and solid pipeline of cases, making it, in my opinion, a buy at today's prices.
