Investor – Beware Outliers!
Is commercial litigation finance really a venture capital asset class?
EXECUTIVE SUMMARY
Commercial litigation finance does not have the same investor model as venture capital
Win rates in the commercial litigation finance industry are approximately 70%, globally
Investors need to assess outliers very carefully, as there is much to be learned from their contribution to portfolio returns
Outlier outcomes may enhance returns, but should not be counted on as the main contributor to returns
INVESTOR INSIGHTS
Investors should assess unrealized and realized cases in making their determination about fund manager performance
A good manager will understand how to avoid/minimize outlier risk and focus on creating diversified, well-balanced portfolios to deal with the various unknowns inherent in the asset class
Having reviewed over 100 different fund offerings in the commercial litigation finance space over the last five years, I have gained a certain level of insight into the spectrum of results that fund managers have been able to generate through their portfolios (some fully realized, but many more partially realized portfolios). In the past, I have written about the importance of diversification, the applicability of portfolio theory (articles one, two & three), and the perils of fund concentration; but I also believe that investors in the asset class should understand the perils of relying on outliers to drive fund performance.
In the context of a portfolio of litigation finance cases, an outlier can be defined as a case outcome that sits outside a probabilistic range of acceptable (and preferably defined) outcomes within, say, (approximately) 2 standard deviations of (mean - average) expectations. That is to say, if you target a portfolio of cases with basic value distribution characteristics (such as minimum and maximum values), such a portfolio will produce an average (a mean) and a standard deviation (a dispersion around the mean)1. Therefore, for a normal bell-shaped distribution (with no skewness / heavy tail), you can assume that those results that sit beyond two standard deviations should be considered outliers in that they don’t represent what you would typically anticipate to see in such a portfolio, because the result would be outside of a 5% - 95% confidence interval (i.e., the range within which you would expect most case values to fall, on both sides of the average).
However, one also needs to be cognizant that for litigation finance portfolios, it is not unusual to see a concentration of lower end cases (those with values well below the average), while outliers on the high end are quite uncommon. Expressed differently, a probability of low end outliers (both for individual cases, and in aggregate) is greater than a probability of high value outcomes. In this context, assuming a normal bell-shaped distribution of values is an overly-simplistic assumption. In reality, it is rare that an accumulation of below-average cases is more than offset by a big win; although still a possibility. Practically speaking, portfolio construction should not be based on the assumption of (exaggerated) high values materializing.
The other way to think about litigation finance, is that the dataset can be bifurcated into two subsets – there are the losers, which are typically (but not always) complete write-offs, and there are the winners, which can have a wide spectrum of outcomes, as described above. In the aggregate, this bifurcated data set makes it difficult to utilize traditional statistic methodologies to apply to the asset class, because the losers skew the averages and the standard deviations, but not as much as the winners do, because the winners have a larger dispersion of results. Accordingly, one must be careful in applying statistics to commercial litigation finance asset class.
The one asset class where similar dynamics exist is the insurance industry, specifically, in the analysis of catastrophic events, and re-insurance and insurance-linked securities. Investors with an insurance background would be used to dealing with investments that have similar outcome profiles, and to the extent they are working for a large insurer, they have the added advantage of being privy to settlement outcomes where their insurance company was involved in settling the claim. A competitive advantage indeed!
Is Commercial Litigation Finance akin to Venture Capital?
Some have described the commercial litigation finance asset class as having a “venture capital” type risk/reward profile, a contention with which I strongly disagree. The typical venture capital portfolio model is highly skewed, the outcomes of which can be illustrated as follows:
Shared by Benedict Evans: (https://twitter.com/BenedictEvans/status/1008038770396942336)
As one can see from the above chart, 6% of the deals within a VC portfolio produce 60% of the returns. In essence, this is a model that is dependent on outliers to drive returns. So, what’s wrong with that? Well, the problem is that if you don’t get an outlier in your VC portfolio, the manager will not likely survive to live another day, which is a difficult way for a manager to run a business on a long-term basis. It also means that for investors, it is difficult to select managers that can replicate outliers on a regular basis, as they are essentially statistical anomalies. This also explains the relatively high failure rate of fund managers in the venture capital industry. Coincidently, those VC managers that produce high end outliers frequently claim to produce high alpha returns (sometimes calling it a “secret sauce”) - while, in reality, their success may have more to do with “luck” than a systemic outcome - but that’s perhaps a topic for another article.
So, why do I think this is not an appropriate analogy for the commercial litigation finance asset class? The numbers just don’t support it. I have been privy to over 1,000 litigation finance case outcomes in different case types, different sizes, different durations, different legal jurisdictions, and different defendants, and the reality across jurisdictions is that cases win (i.e. the manager makes a profit on its investment) approximately 70% of the time, and hence lose about 30% of the time. This stands in stark contrast to the Venture Capital model where the VC manager is losing over 50% of the time and making less than 2X its investment 70% of the time. So, whereas Venture Capitalists need to count on having outliers in their portfolio to create sufficient returns, a well-diversified litigation finance fund should not rely on outliers to produce returns, as there should be sufficient wins in their core portfolios (net of losses) to produce acceptable overall returns for investors, given the underlying risk profile of litigation finance portfolios (that are more akin to insurable exposures). If a manager believes that outliers are necessary to produce returns, then I believe that manager does not understand the benefits of applying portfolio theory to the asset class, and the investor is taking unnecessary risk, because the stark reality is that no manager can tell you which case is going to be a home run case, and hence does not have the ability to include one in their portfolio.
While outliers in commercial litigation finance can enhance returns (albeit infrequently due to the low probability of such being the case), investors should not count on outliers for contributing to the majority of the fund’s returns, because the particular case that gave rise to the outlier event could have very easily ‘gone the other way’, especially if the outcome resulted from a judicial/arbitral decision, which are inherently binary outcomes.
The ‘Math’
The basic math of commercial litigation finance, although it rarely works out exactly this way, is that managers generally (emphasis added) underwrite to a 3X multiple of invested capital (“MOIC”), and managers win approximately 70% of their cases on average, hence the portfolio should theoretically produce a gross return of 3 X 70% = 2.1 X MOIC, which gets whittled down to say 1.75 x MOIC after management and performance fees and fund operating expenditures. Internal rates of return will then be derived based on the timing of funds deployed and the overall case duration of the portfolio. Some case types having longer duration but a higher probability of outlier returns, and other case types having shorter duration and generally lower potential for outlier returns. In other words, if a high value outlier is obtained, it’s IRR is likely “diluted” by a (much) longer than average case duration, thereby, its impact on the portfolio’s IRR is diminished.
In this context, when investors are assessing investing in a commercial litigation finance managers’ portfolio, especially one that mainly consists of single case investments, they should analyze the portfolio from two different perspectives: (i) determine how the fund would have performed if that outlier was not in the portfolio; and (ii) determine how the fund would have performed if that outlier resulted in a loss. These are “incremental impact” analyses that are designed to capture a true value of such outliers. The first analysis will provide the investor with a perspective on how the fund performed without the benefit of the outlier event. If the fund still maintained respectable performance, this may illustrate that the outlier event was not significant to the performance of the fund, which tells the investor that the manager was very thoughtful about the construction of a balanced portfolio, which is exactly what you want in a long-term oriented manager. The second analysis enhances the first analysis by answering the question “Did the manager get lucky?” If the second analysis shows that the opposite outcome would have decimated the fund returns, then it buttresses the first analysis and also indicates that perhaps the fund was too concentrated in terms of its deployed capital (which can be very different from its committed capital, as I have addressed in a previous article).
Corporate and Law Firm Portfolios
Fund managers investing in corporate portfolios or law firm portfolios provide yet another layer of complexity. In the case of corporate portfolios, these portfolios are groups of single cases that have a common plaintiff. In the case of law firm portfolios, these portfolios are with law firms that have a contingent interest in a group of cases. By their very construct, portfolio investments are inherently less risky than single cases because the portfolios are generally cross-collateralized, so the risk of having an outlier event within the sub-portfolio is that much more remote. Nevertheless, investors should assess the component parts of the sub-portfolio’s results, because if the sub-portfolios themselves are generating returns through an outlier event, then the exact same risk exists as a manager that focuses on single cases within their portfolio. The key difference is that a fund manager that invests in a series of sub-portfolios will have more chances to make errors than one that focuses on a portfolio of single cases.
Other Considerations
The other thing to consider, is that not all cases and case types are alike. Each case has its own idiosyncrasies and each case type has its own unique risk/reward profile. Accordingly, an investor cannot look at a portfolio of single cases and assume that each of the cases within the portfolio has similar risk / reward characteristics. So, when an investor assesses the outcomes of cases, it is not only important to look at the outliers, but also to look at, among other attributes, (a) the types of cases, (b) the life cycle of the cases (important for determining duration), and (c) how the outcomes of the case were derived (judicial/arbitral outcomes vs. settlements) and the derivation’s effect on returns (a portfolio that derives most of its results from settlements (non-binary) is far superior to a portfolio that derives its results from 3rd party decision makers (binary), but this risk also varies by case type and venue).
Portfolio Theory plays a significant role in investing in the commercial litigation finance market, and so investors need to be aware of its application and the various permutations that can arise in the construction of a portfolio, which generally starts with an investment in a ‘blind pool’ type fund. More active investors can eliminate the risk inherent in a blind pool by selecting individual case or portfolio exposures, but they generally need to have internal resources to appropriately assess risk, or be prepared to incur the cost to outsource those underwriting activities.
Equally important is the selection of a business model under which a portfolio is sourced, evaluated, and constructed. A manager philosophy that equates litigation finance investing with venture capital investments can be misguided and possibly result in unrealistic assumptions and faulty portfolio construction that can produce real results quite distinct from the manager’s intentions.
1 Standard deviation is the measure of dispersion of a set of data from its mean. It measures the absolute variability of a distribution; the higher the dispersion or variability, the greater the standard deviation and the greater will be the magnitude of the deviation of the values from their mean.
Investor Insights
For investors, I strongly advise diving deep into both realized and unrealized cases within the portfolio to get a better understanding of the manager’s appreciation for portfolio construction and their appetite for risk. While it may be cost prohibitive to do deep diligence on every case in the portfolio, analyzing high level data about the nature of the various case exposures can bring an investor a long way to understanding the risks inherent in the portfolio and the manager’s approach to investing. For the realized subset of the portfolio, understanding the dynamics at play within the case and its contribution to overall fund performance is critical to assessing a fund manager’s ability to replicate results (termed persistency in private equity), which is critical to long-term investing in the space.
I don’t believe this is a venture capital asset class, and a manager that tries to convince an investor otherwise is either taking unnecessary risk, or does not understand how the asset class benefits from portfolio theory.
As always, I welcome your comments and counter-points to those raised in this article.
About The Author
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, investing with and alongside institutional investors.