Innovation in Legal Finance (Part 2)
What is “Event Driven Litigation Centric” Investing & Why Should Investors Care?
Executive Summary
EDLC Investing is a relatively new, niche market requiring highly specialized skills
EDLC has many advantages over CLF investing, although it is not a directly comparable investment strategy due to its application to publicly traded markets
EDLC investing requires investors to have more of a buy/hold mentality than a ‘trader’ mentality due to the ‘fundamental’ risk being assumed
Despite EDLC ‘events’ being non-correlated, the publicly listed security aspects of their portfolios add some level of correlation which will impact fund performance, both positively and negatively
Slingshot Insights:
There are many benefits and few drawbacks to EDLC investing as compared to CLF
The scalability of EDLC investing is only limited to the number of dispute events
The ability to control and take advantage of risks, including the ability to influence litigation, in EDLC investing makes this an overall superior asset class in my opinion
The tools open to EDLC managers to mitigate risk or enhance returns (hedging, changing position sizes, trading during the investment period, liquidity) provide a number of benefits to securing better risk adjusted outcomes and allows them to avoid complete losses, although they come with a cost
EDLC investors may also have the ability to undertake CLF investing within their mandates
In Part 1 of this article, I introduced the concept of Event Driven Litigation Centric (EDLC) investing and started exploring some of the ways in which it differs from Commercial Litigation Finance (CLF) investing. In this article we will dive deeper into some case studies and discuss some of the relative benefits and the return attributes of the asset class.
Case Studies
In order to make the concept more tangible, I reached out to a successful and influential investor in the EDLC market to provide some case studies of events in which they had invested along with some insight into how these investments were structured and the returns they produced.
Case Study #1 - Indivior PLC (Ticker: INDV.L)
Indivior touches on many of the themes at the center of EDLC investing. Indivior Plc (“Indivior”) pioneered the use of buprenorphine for the treatment of opioid use disorder (“OUD”), including for the abuse of heroin and oxycontin. For the past two decades, Indivior has dominated the OUD treatment market by virtue of its strong patent portfolio and continued improvements and refinement of its drugs. However, in 2018, the company was hit with a criminal indictment in Virginia by the Department of Justice (the “DOJ”) for its aggressive marketing activities. This led to a massive drop in the company’s public securities (bonds and equity), driving a once £3.6 billion market cap company to the point where the equities were trading down to the average of 41 pence during the first quarter of 2020, effectively liquidation levels. It was at that point that the EDLC manager began its analysis, starting with researching the DOJ’s legal allegations. This was supplemented with FOIA requests to the FDA, CDC and DEA, agencies that supervise and regulate Indivior. Finally, the EDLC manager attended hearings in an obscure courthouse in Abington, Virginia where they were the only observer in the courtroom. These due diligence steps, amongst others, led to the strong conclusion Indivior would settle the DOJ case for a fraction of the damages sought after and once resolved, the strength of the underlying business would be appreciated by the market. These conclusions led the EDLC manager to make a significant investment at the then depressed stock price levels. In July 2020, the DOJ and Indivior settled and the equity securities materially appreciated, trading at 120 pence at the time of the settlement. Notably, this opportunity existed only for EDLC investors as there was no opportunity for investment by CLF investors. Indivior’s stock price currently trades around 1,800 pence, which translates to 360 pence prior to the reverse stock split as a comparison to the 120 pence price at time of settlement and the 41 pence price when the investment was made or 9 times appreciation in value from trough to current market values.
This is a notable example because not only did value get created through the valuation dislocation related to the event, but the underlying thesis of the strength of Indivior’s business provided further upside as the company continued to capitalize on their product pipeline and expand market share.
Case Study #2 – Hertz Global Holdings Inc. (formerly Hertz Corporation) (New Ticker: HTZ)
Where Indivior presented a mispriced security arising from a claim against a company, Hertz equity was mispriced based on the market believing that the Hertz bankruptcy process would extinguish pre-emergence equity holders. The EDLC manager had prior experience in bankruptcy equity situations and believed Hertz equity holders were entitled to a recovery in the bankruptcy case, a view no one in the market believed as reflected by Hertz equity trading as low as $0.50. Based on prior experience in bankruptcy equity situations, the manager assembled the appropriate advisors and like-minded hedge funds, the Hertz Ad Hoc Equity Steerco (the “Steerco”), to litigate in the bankruptcy case for a recovery. The Steerco, partnering with a private equity team consisting of Apollo, Knighthead and Certares (the “AKC Team”), succeeded in convincing the court to hold an auction to bid for the assets of Hertz, as opposed to allowing the creditors to take control. The AKC Team succeeded in winning the auction and, as a result of their involvement, the manager had the opportunity to invest an outsized proportion of capital in what was one of the most successful restructurings in 2021. As an EDLC investor, it was able to increase and decrease its position throughout the bankruptcy case as new facts arose, an option most CLF investors do not have. Equally important was the manager’s ability to drive the litigation (unlike CLF investors who are passive) to enhance recoveries for their specific Ad Hoc Equity group. And finally, due to their deep involvement in the process and partnership with the private equity sponsors (Apollo and Certares), the Manager developed a deep appreciation of the underlying business which provided a competitive advantage well after Hertz’s emergence from bankruptcy. In the month following Hertz’ emergence from bankruptcy on July 1, 2021, the average value of the assets received per share of pre-reorganized equity was $8.95, and further increased in the months to follow. From trough to peak an EDLC investor could have stood to earn 18X their investment.
Investment Scale
One of the drawbacks of the CLF market is a lack of scale. The average single case funding contract is $4.3MM, according to Westfleet’s 2022 Litigation Finance Market Report. There are larger single case and portfolio financing investments available, but fewer in numbers. So, if you are an investment manager that is looking to achieve economies of scale for your own fund and manage significant amounts of money for large institutional investors, scale is a critical success factor that is not inherent in the CLF market (while portfolio financings do allow you to increase scale they are also limited in number and the large single case investments are few and far between which is why Burford, the world’s largest litigation finance company, mainly focuses on portfolio financings).
Conversely, EDLC investing is only limited by the size of the publicly listed entities that are impacted by the event. In the context of the public markets, this is a massive potential marketplace estimated at $119 trillion and $46 trillion for the Global and American bond markets, respectively. Global and American equity markets add another $100 trillion and $40 trillion, respectively. Accordingly, the scale for EDLC is only limited by the number and size of companies that are impacted by a litigation or similar event at any given point in time.
EDLC investors can take as large or as small a position in the debt and equity of companies as they want based on what is appropriate in the context of the risk inherent in the transaction and their portfolio construction parameters as well as any limitations therein. Further, EDLC investors are not only limited to investing long, they can also take short positions, where available. We will discuss more about short sales when we review the benefits of hedging.
Another benefit of scale is that the transaction costs related to EDLC investments can be amortized over a much larger investment and so they are relatively less meaningful to the outcome of the investment as compared to the single case CLF market where the average case size is much lower and therefore the transaction costs (funding contracts, diligence, expert opinions, etc.) have a much more significant negative impact (or ‘drag’) to the net return on investment.
Return Timelines
Most independent EDLC investors are structured in the form of a hedge fund. Hedge funds typically get compensated annually for their performance, making them a relatively short-term type of investment strategy. While the EDLC manager has the option to invest in longer duration investments, they know full well how they will be measured by their investors.
Conversely, CLF managers have no choice but to invest in and get judged on longer-term performance, similar to many private equity (“PE”) managers. However, unlike PE managers I would content it is impossible to value single case investments whereas it is easier to value enterprise value of operating companies (less so for earlier stage ventures) and so the CLF manager loses the ability to mark-to-market their investments the way PE does. Therefore, it is not uncommon for CLF managers to run negative returns in their funds (in part due to the J-curve effect and in part due to the fact that investments are held at cost until a write-down or realization event) for the first few years of the fund’s life as they deploy their commitments and their early investments start to progress (although invariably CLF managers will have some strong early unexpected wins).
So, if you are an investor in these strategies you will naturally favour the manager that can produce positive short-term returns over one that may ultimately produce good returns but only after a significant portion of the portfolio (think > 75%, depending on fund concentration) of the portfolio has been realized (which is not to say this is the appropriate way in which to measure performance, it’s just a reflection of investor bias). Suffice it to say, comparing the two strategies in terms of short-term performance will yield dramatically different results and you may only find out your CLF investor is good after 5, 6, or 7 years, which is too long for most investors. For foundations, endowments and pension plans that have longer-term investment horizons they are more apt to give the CLF manager the benefit of the doubt. For most other investors, they will want to see performance manifest fairly quickly and so EDLC investment will probably be more in alignment with their expectations.
Liquidity & Duration
While investors typically speak of duration and liquidity as two separate and distinct concepts, for commercial litigation finance investors the two are intertwined. For a CLF investor, their ability to obtain liquidity on their investment is typically limited to obtaining co-investors or attracting a secondary purchaser if they can find one, potentially assisted with the application of insurance. For EDLC investors, they are inherently investing (although not exclusively) in the public markets which means their investments are as liquid as it gets (perhaps less so for Rule 144 Debt, which is a less liquid market).
The availability of liquidity has a direct consequence for duration. For example, if a litigation funder enters into a funding contract their main avenue for liquidity stems from the proceeds (or not) that result from the outcome of the case and the collection of the proceeds, which can take anywhere from a few months to a few years. In certain circumstances and typically for very large cases there exists a ‘secondary’ market that will allow a funder to sell all or a portion of their interests in the case as the case becomes de-risked through the litigation process. A prime example of this are the secondary sales Burford Capital had arranged for its interest in the ‘Peterson’ claims, which allowed them to book significant gains and obtain cashflow even though the litigation had not been decided. Although, for litigation funders, this source of liquidity is a bit of an anomaly and mainly available to the largest of the cases.
EDLC investors on the other hand, because they are typically investing in liquid markets to begin with, have the ultimate power over when to liquidate their positions, how much to liquidate (it doesn’t have to be all or nothing as it is with most litigation funding contracts), and how much to hedge their gains (or losses) if they are in a gain (or loss) position. In essence, the EDLC investor is, subject to the vagaries of the markets, in control of their duration. Although one could argue that the EDLC investor does require the event to occur in order to maximize their investment and so the ideal duration may be governed by the timing of the event. The significant benefit associated with liquidity cannot be understated. Other than binary risk, the single biggest risk inherent in financing litigation is duration and generally the longer the duration inherent in an investment, the lower the internal rates of return that investment can create because there is typically a limit to the quantum of proceeds or multiples of capital they can charge.
A related point is that CLF requires continued funding for appeals and remands. Litigation duration is unpredictable and CLF managers may be forced to fund until final resolution/settlement. EDLC Investors often realize the appreciation in their investment upon a positive decision, allowing the EDLC fund to exit without the risk of getting over-turned on appeal.
Taxation
There has been much written about the taxation of litigation funding contracts and the use of prepaid forward contracts as a method to ensure capital gains treatment for US tax purposes. Unfortunately, there is very little in terms of precedent that exists to give CLF investors comfort that the outcome of funding contracts will in fact be taxed as capital gains for US tax purposes. The same uncertainty exists in many other jurisdictions.
One of the benefits of EDLC investing is that it mainly involved investing in “securities” and it has been well established that gains/loss on securities are capital in nature. In the US there are differences in taxation between long-term and short-term capital gains but there is 100% certainty that gains and losses on securities are capital in nature. Accordingly, the certainty inherent in the taxation of EDLC gains is a significant benefit for investors that can save time and money as compared to assuming tax risk associated with CLF investing.
Enough about theory, what about returns?
Having been involved in the litigation finance market and being privy to a variety of fund managers’ results, the vast majority of which are for funds that have not been completely realized (an inherent limitation in assessing performance), I can tell you that from my perspective the industry in general is likely under-performing investors’ expectations, on average. However, I would also tell you that the experience is very manager specific with some investors content with their returns and others ecstatic. In other words, as with many asset classes manager selection is critical to performance.
On average, the CLF industry wins cases about 70% of the time and hence loses the remaining 30% (whether via outright loss, partial loss or withdrawals of financing commitments). That 30% loss ratio places a lot of pressure on the remaining winning cases to perform, which would be fine if managers could control duration. But they can’t! The combination of binary risk and duration risk makes this a very challenging asset class. In addition, I am finding many managers do not understand how to build properly diversified portfolios and hence many of the portfolios I see are far too concentrated which makes it difficult to manage the inherent volatility of a portfolio with binary risk characteristics, especially when you marry that volatility with duration risk.
When I look at the performance of EDLC investing, it is difficult to draw conclusions on performance simply because there are so few managers that pursue this strategy in a way that dominates their portfolios and even then much of this information is private. What I can say is that the EDLC Manager with whom I have invested has produced approximately 52.84% returns since inception (29 months), but the returns are somewhat a mixture of realized and unrealized returns (i.e. they have yet to exit their investment but the underlying investments have gone up or down in value due to the volatility inherent in the public markets). As I have referenced in the section below, the issue with an EDLC manager’s performance is that it combines realized and unrealized returns in any given period and so while you have invested in the manager to produce returns through their investment hold periods, the mark-to-market that occurs within the portfolio during the interim tends to muddy the return profile. In ‘bull markets’, it will make the results look better than they actually are and in ‘bear markets’, such as those we are currently in right now, it can tend to make the results appear worse. Ironically, it is the current markets that make the best buying opportunities for EDLC managers as it is times of stress that contribute to more litigation and regulatory events and hence more and better opportunities as stock prices are also generally depressed, but such periods may add some duration risk.
If you strip out the unrealized returns and focus on the realized returns, then the picture will more closely reflect the reality of the strategy. One way to do this is to look at Special Purpose Vehicles (“SPVs”) that may be set up for specific investments where the size of the investment opportunity exceeds the fund’s concentration limits and review the performance of these SPVs which focus on a single investment thesis. On this metric, the EDLC Manager in which I have invested has had some exceptional returns across a number of investments which have exceeded 50% IRRs. Of course, not every investment is successful, but I do like the fact that there are very few circumstances where the EDLC investor suffers a complete loss which is a meaningful statistical difference between the two strategies’ risk/reward profiles. In addition, you need to be very careful in extrapolating the outcomes of a handful of investments as statistically they will not be representative of the performance of a broader portfolio over a longer period of time. It is not uncommon and some might say it is necessary for CLF managers to book high IRR realizations early on in the life of the portfolio, but these early wins typically have low MOICs and are ultimately necessary to offset the losses that statistically occur in most portfolios.
Having said that, the EDLC manager with whom I have invested produced +11.04% return in 2022, a year in which S&P 500, Dow Jones Industrial Average and the Russell 2000 returned -18.01%, -8.78% and -21.56%, respectively. Accordingly, the EDLC investor produced strong non-correlated returns despite the portfolio being exposed to correlation, which I believe speaks volumes of the ability of this asset class to produce significant alpha. The alpha is essentially driven through material public information, but one needs to be aware that the information is available and know where to look to find it and interpret it, which is the ‘secret sauce’ to exceptional returns in the EDLC space.
Too Good to be True?
If you are a CLF manager or investor, this is probably sounding almost too good to be true, right? Well, there are some downsides to EDLC investing. One of them is that EDLC returns are ultimately subject to the volatility of the markets as their investments are typically valued daily by the markets, which may, but more than likely do not, possess the same level of material public information as the EDLC investor. So, while an EDLC investor may be right, the stock market may decide otherwise at least until the date of the event that is causing the mispricing is reached and the resulting event information is disseminated through the public markets.
Now, if we look at the larger publicly-listed litigation finance firms (Burford, Omni Bridgeway and LCM), we will also see that their stock prices are somewhat correlated despite investing in an otherwise non-correlated asset class. So, they suffer some of the same correlation risks as an EDLC investor might although I suspect if one did the technical analysis they might find that EDLC portfolios are probably more highly correlated to the markets than the publicly listed litigation finance managers, in part because their investment positions are poorly understood by the market which is the reason for the investment to begin with and in part because their portfolios are almost entirely publicly listed companies with price transparency. In the case of a pure play CLF fund their returns will be as uncorrelated as one can find in financial markets, which is a strong benefit for investors looking to offset their correlation exposures.
However, I think what is important is to have the right perspective and time horizon when making any such investments involving “events”, be they litigation or anything else. In the case of both EDLC and CLF, your investment thesis is based on the intended outcome that the manager is underwriting and not the variability inherent in the positions taken to affect those investments. The following theoretical stock chart illustrates the point that you need to be invested for the right period of time to allow the outcome underlying the investment to realize or you may suffer as a consequence. If your hold period is too short, you may suffer from the volatility of the markets and what would otherwise be a great investment if you held from A to B, the point of the realization of the underlying event (i.e. a 35% gain), becomes a poor investment because you decided to exit the fund at C (i.e. a 55.5% loss).
As an investor, you really need to provide the EDLC manager with adequate time to prove out their thesis and judge their performance on the sum total of the outcomes (i.e. when they close their positions) of their various investments as opposed to the market’s view of their value in the periods in between when the investment is made and the event occurs and even then it may take another quarter or two before the market fully understands and properly values the impact of the event’s economic impact on the security. And to a certain extent EDLC is perhaps best invested in through a private equity fund type structure where the investor does not have the option to obtain liquidity for a fixed period of time so that they don’t make the same mistake that many public market investors do, which is to let emotion overtake rational thought and sell out of their investment at the worst possible time. Interestingly, the volatility illustrated in the chart above also presents an opportunity for the EDLC manager to take advantage of this volatility by increasing their position as the stock price moves toward C and decrease their position to lock in gains as the stock price heads toward B. In other words, they can double down on their strong conviction investments if the market continues to get it wrong.
All this to say whereas CLF is about as non-correlated an investment strategy as you can get, there is an element of correlation that EDLC investors have to contend with during the manager’s hold period. Conversely, CLF managers don’t have the same price transparency for their investments as they derive their value from the contractual terms of the funding contract, which are ultimately driven by the outcome of the litigation, and hence it is virtualy impossible to value litigation (although IFRS is going to make the publicly-listed entities attempt to do just that - it may work in the context of valuing a portfolio, but likely not in the context of a single case). Although, I would contend that this is a small price to pay for all of the inherent benefits accorded the EDLC investing strategy relative to CLF investing and is no worse than the illiquidity afforded CLF investing.
Fundamental Risk
The other significant difference between the two strategies is the fact that an EDLC investor is assuming “fundamental” or company risk when they invest directly in debt or equity securities, whereas CLF investing is investing in a financial contract tied to litigation outcome. Accordingly, an EDLC investor could be 100% correct about the undervalued nature of a given security in light of the litigation, yet their returns may suffer either due to correlation, as discussed above, or due to the fundamental risk inherent in the positions they acquire as they are direct investors in the company and a derivative investor in the claim. If a company wins its litigation event, but has to take a write-down in its operations or misses its revenue expectations then the EDLC investor may still lose overall. However, it is very unlikely they will lose their entire investment which is a real risk in CLF investing.
Of course, the opposite is also true and one could argue that the fundamental risk can also serve as a hedge for the litigation. For example, the other scenario that could arise is that the manager was wrong on the outcome of the litigation but right on the fundamentals of the business which would allow the losses of one to offset the gains of the other, acting as an imperfect hedge. So, the inherent assumption of fundamental risk associated with EDLC investing can serve as an amplifier of returns, positive or negative, or it can serve as a hedge against the outcome of the litigation event.
So, why isn’t EDLC investing a massive market?
Simply put, it’s not an easy discipline to master and it does come with some uncontrollable variables. Understanding litigation and the potential outcomes thereof is very difficult to master. Understanding financial valuation is difficult as well as being complex, uncertain and varying with the markets. Understanding commercial operations of an operating business and its industry dynamics takes managers a lifetime to master. Finding all of those specialties in one place, is very rare. To be fair, no one can be an expert in all of those areas effectively and so there is an element of EDLC investing which involves leveraging other experts and effectively operating as a ‘quarter-back’ to make the ‘plays’ happen. But as we all know, finding a Tom Brady or Peyton Manning doesn’t happen very often!
Slingshot Insights
As you will see from my disclosure below, I like the strategy so much I became an investor and this strategy now represents my largest investment in legal finance related strategies. In my opinion it provides all of the same exposures as those of litigation finance, but does so in a way that mitigates downside risk and maximizes upside potential. It adds an element of flexibility for the manager that can’t be found in CLF investing, in my experience. The clear taxation treatment removes an area of lingering concern for me as it relates to the CLF marketplace. As long as you have an appropriate investing horizon and are prepared to deal with some mark correlation while the investment thesis plays out, this appears to me to be a significantly better approach to obtaining exposure to idiosyncratic risks to create a portfolio of uncorrelated outcomes.
As always, I welcome your comments and counter-points to those raised in this article.
Edward Truant is the founder of Slingshot Capital Inc. and an investor in the consumer and commercial litigation finance industry. Slingshot Capital inc. is involved in the origination and design of unique opportunities in legal finance markets, globally, advising and investing with and alongside institutional investors.
Disclosure: An entity controlled by the author is an investor in investing vehicles managed by the EDLC Manager referred to herein.