Investor Evolution in Commercial Litigation Finance
EXECUTIVE SUMMARY
The investor base in litigation finance continues to evolve
The asset class is becoming more institutional as it produces more data and enhances transparency
Litigation finance is entering its institutional capital phase
INVESTOR INSIGHTS
Restrictive capital sources will be replaced by less restrictive capital sources
Fund managers must ensure their equity value is not impaired through their fundraising decisions
Investors should monitor supply / demand characteristics of the asset class to ensure pricing is not eroded through excess capital supply
As with any new industry, there is much risk and trepidation with respect to whether (i) the concept will work, (ii) the concept will be profitable, (iii) the concept will be scalable and (iv) the concept will attract investment support. Oh, and in the case of litigation finance, (v) whether the concept is in fact legal.
Let’s tackle legality first. Without going into a long dissertation on champerty, maintenance and barratry, justice systems around the world have understood the stark reality of the construct of their respective modern day justice systems. That is to say, the playing field is in no way even – it is markedly tilted in favour of those parties with deep pockets that can afford some of the best lawyers in the world. Recognizing the inequality of their own systems, the fact that litigation costs are increasing at more than three times the rate of inflation (about 9% per annum in the US), and the fact that litigation is being used as a business tool to extract advantage, justice systems globally have been increasingly receptive to a third party providing financing to support “David” in his fight against “Goliath”. The outcome of this global judicial reform (mainly driven by precedent, but in some cases by legislation) is that the little guy is fighting back and now stands a chance at winning against the large corporation which has much more time, money and resources at its disposal.
The trend is strong and increasing, so much so that it has become a political issue in certain jurisdictions (as evidenced by Australia’s recent ruling to force funders to become licensed), and has attracted regulation in both consumer and commercial segments of the market. One could cite efforts by many funders, including Omni Bridgeway (formerly IMF Bentham) in Australia (and recently in Canada – Bluberi) and Burford Capital in the USA, for funding cases that ultimately went on to create an environment in which litigation finance has flourished. And the industry is just getting started.
As it relates to the first three concerns about whether the concept will work, will it be profitable and is it scalable, empirical results indicate that the answer has been a resounding “YES!” to all three. So, let’s take a deeper look at how the industry got to the point where it was able to validate litigation finance as an asset class, how the investor base has evolved over time, and what the implications are for the investors of the future.
Humble Beginnings
Risky strategies attract risky money. In the early days of most litigation finance funds, fund managers are selling a concept and their own capabilities, but not much else. When the risk level is that high, it attracts a certain type of capital. On the one hand, it attracts high net worth individual capital that has been created by those who have taken a certain degree of risk in creating their own nest eggs and are very comfortable assuming similar risks. These investors tend to start off taking a bit of a “flyer” on investing in single cases where the risk/reward dynamic is asymmetrical, meaning the probability weighted upside is much lower than the probability-weighted downside. Let’s put some numbers around this concept to illustrate:
Assume I have a case that requires $1MM in financing and would pay out as much as $10MM to the funder if the case is successful. If the probability of winning is 50% and the probability of losing is 50% (as is the case with most trial outcomes), then the probability weighted outcomes are as follows:
Losing: 50% * $1,000,000 = $500,000 probability-weighted loss
Winning: 50% * $10,000,000 = $5,000,000 probability-weighted win
Investors would view these outcomes as asymmetrical meaning the gain that would be generated in a win scenario is multiples of the loss that could get experienced.
On the other hand, asymmetric investments are also very attractive to sophisticated hedge funds who get paid to take risk, but in a methodical and calculated way (at least that is the theory).
Accordingly, if you look at the early days of the larger fund managers in the asset class, many of them started off by raising capital initially for single cases and eventually for portfolios of investments, as this asset class is particularly well-suited to portfolio theory (as discussed in my three-part series on portfolio theory). In particular, those hedge funds that had a distressed credit background and who were accustomed to investing in sticky situations involving litigation were particularly comfortable with and attracted to the asset class.
While I don’t view the asset class as a “credit” based strategy due to the non-recourse nature of the investments (that is “equity” in my mind), it has nonetheless attracted credit hedge funds. Then there are hedge funds that have more discretion as to what they can invest in, and some of those fund managers invest in debt and equity of public companies where the outcome of a litigation has a significant impact on the value of the underlying securities. So, while they are investing in publicly-listed securities, they are ultimately making a call on the outcome of the underlying litigation, which is a natural investor for litigation finance given the similarity of the risk/reward profile and their understanding of litigation.
Public Markets
An interesting dynamic was at play in the early days of litigation finance in the public markets, specifically the UK markets. Typically, you don’t see business in new industries being established in the public markets (although Canada’s cannabis market would prove me wrong), other than perhaps venture exchanges or through reverse take-overs which create a ‘liquid currency’ (freely tradable shares) to help raise capital, provide investors with liquidity to sell their shares if the thesis was flawed and to use as acquisition currency where an acquisition strategy was relevant.
In the UK, litigation finance took a non-conventional path. First to ‘go public’ was Juridica through a closed-end fund structure. In speaking with Tim Scrantom, a founder of Juridica and a pioneer in the litigation finance industry, the public vehicle structure was a condition of raising capital from wealth management firms, specifically Neil Woodsford’s Invesco Perpetual fund which could not invest in private structures at the time, but loved the idea behind the litigation finance industry. With Neil, who was described as the ‘Warren Buffet of the UK’ at the time, the rest of the market followed to the point where Juridica was able to raise a significant amount of capital in a very short period of time, all with the condition that the vehicle be publicly listed to ensure investor liquidity. With Juridica paving the way for a public listing, and with all of the hype around the opening of the UK litigation finance space, Burford was soon to follow with a more traditional common stock offering.
On the other hand, many fund managers who were raising money through private vehicles found it frustrating to raise capital from private individuals as it invariably took a lot of time and attention away from running the operations of the business, and they would ultimately churn through their investors, especially if they didn’t produce sufficient cashflow before their next tranche of investments required capital. In order to solve the problem of constantly fundraising while scaling their operations, some groups decided to raise permanent capital through public markets. First to list publicly was Omni Bridgeway in 2001 (formerly IMF Bentham) in Australia, then Juridica in 2008 and Burford Capital in 2009, as previously referenced, and most recently LCM Finance, which originally listed in Australia and then moved executive offices and its listing to the UK markets. Accordingly, I would suggest there are a disproportionate number of fund managers in litigation finance that are publicly listed in relation to the nascency of the asset class.
Many other alternative asset classes have ultimately made their way into public markets, but typically have only sought a public listing when their enterprises approached a sufficient scale such that there was a dependable cycle to their financial results and cashflows and sufficient diversification in their portfolios. Some litigation finance managers ‘grew up’ in the public markets, which is not always the most comfortable training ground for companies. Nevertheless, the public market participants have so far been successful with a few bumps along the way. The speed at which litigation finance has tapped the public markets was always a surprise to me, but having undertaken fundraising in the past, I clearly see the benefits of a permanent capital vehicle. The issue of whether or not litigation finance is an asset class well suited for public markets is a topic for another day, as there is a certain non-recurring nature to the underlying cases and volatility in cashflows that make it a bit of a misfit, but then the attractiveness stems from the non-correlated nature of the investments. Oddly, being publicly listed adds an element of correlation to an otherwise non-correlated investment. Let’s not even talk about the issue of ‘marking-to-market’ litigation investments, also a topic for another article.
The other benefit of having a public vehicle is that it has allowed these managers to issue relatively inexpensive public debt to reduce their overall cost of capital (this issue will be revisited when we speak to the next wave of investors), which would be difficult to impossible in the private markets. Lastly, most managers have since raised private partnership vehicles to leverage (not in the debt sense of the term) their public equity and to smooth out their earnings, although recently, and surprisingly, some managers are foregoing management fees in exchange for greater upside participation through an enhanced carried interest in the outcomes of their portfolios (which eliminates one of the benefits of using management fees to smooth earnings).
The ability for fund managers to raise public capital was also an important evolution for the industry as it brought litigation funding to the forefront within the investment community, and by virtue of their financial disclosure requirements, provided a level of transparency that other litigation funding companies could leverage to raise their own private funds. Never underestimate the value of data when raising capital. The industry owes a debt of gratitude to the pioneers that broke new ground and laid the foundation for the rest of the industry.
Institutional Investors
A key part of the evolution of the asset class has also been the active participation of family offices who have made a meaningful impact to the industry. Some of these family offices, like those that created Vannin and Woodsford, have made a significant investment to the industry by starting and investing in their own litigation finance companies. Others have decided to construct their own portfolio across a number of different funds and/or managers and strategies to achieve different objectives, with the overarching interest of being exposed to a non-correlated investment strategy that produces strong risk-adjusted returns. Private equity groups are also actively investing in the sector, either as passive LPs in “blind pool” funds or investing directly into new managers.
Endowments and Foundations
Within the endowment and foundation world, there is a bifurcation between those groups that are early entrants and those that follow the broader market. In the litigation finance space, endowments like Yale, Harvard and Columbia, moved decisively a number of years ago to make significant investments in a number of litigation finance managers and continue to invest to this day, which speaks volumes of their experience with the asset class (although it may still be ‘early days’ in terms of fully realized portfolios).
Many endowments and foundations have been sitting on the sidelines with good reason. While the industry has been in existence for upwards of two decades, depending on the jurisdiction, there are few fund managers that have more than one fully realized portfolio (beware duration risk) and many fund managers market their funds off of a handful (or fewer) of case realizations. Having been on the reviewing side of the ledger, I know enough to know that a few cases does not a fully realized portfolio make. These investors have been patiently learning and investigating what the asset class is all about and waiting for the best entry point. I expect to see a whole new series of entrants from the endowment and foundation space as more data is produced by the industry and more comfort is gained from the consistency of returns and manager’s ability to replicate their initial performance (termed “persistency” in private equity circles).
Pension Plans and Sovereign Wealth Funds
Until recently, it was felt that the industry was not large enough to be attractive to large sovereign wealth funds and pension plans that typically have minimum investment allocations in the hundreds of millions. However, as Burford and Omni Bridgeway have recently launched funds in the $500 million to $1 billion range, we are starting to see interest from this part of the market. In fact, a sovereign wealth fund, is a single investor in a $667 million separately managed account managed by Burford pursuant to its recent capital raise. Many of the top five sovereign wealth funds in the world are rumoured to be actively looking at investing in the litigation finance market. While I expect continued interest, the industry is not so large as to allow for many large sovereign wealth funds and pension plans, and so I don’t expect this to be a large segment of the investing market, as measured by number of investor (but it will be, as measured by dollars). Of course, the concern with attracting large amounts of capital is that it forces managers to accept larger amounts of capital than they can responsibly invest, which creates distorted incentives and a misalignment between investors and managers. I hope the industry continues to maintain its discipline in this regard, but I know some will succumb to the lure of larger amounts of capital at their own peril.
Beware Conflicts
One of the very early entrants into litigation finance in Germany was Allianz, a large German insurance company with over $100 billion in gross written premiums (at the time). It stands to reason that an insurance company would be an early mover in the marketplace as there is no entity better placed than an insurance company to have a significant depth of data about case outcomes upon which they can analyze risk and reward. The following excerpts are from an article written by Christian Stuerwald of Calunius Capital LLP in January 2012 which aptly describes the reasons for their exit:
“The business grew, quickly became profitable and expanded into other jurisdictions, mainly Switzerland, Austria and the UK….
“…, with time and growing market penetration and acceptance the cases became bigger; as claim values grew, so did the size of the defendants,” …”that meant that more and more often cases would be directed against large corporate entities.” “This is really where the problems began, because most corporate entities, certainly the ones that are domiciled in Germany, are customers of Allianz, typically of course in the insurance sector.”
“Because of the nature and sheer size of the organisation it was not always easy to detect potential business embarrassment risks in time, as the checks needed to be done on a global basis. This led to some instances where a litigation funding agreement was entered into when it was discovered that the case was directed against a long standing corporate client, who declared himself not amused when the fact of funding was disclosed.”
Which lead to the conclusion:
“…it was decided to keep the business and place it into run off.”
The same phenomenon applies to hedge funds that have many similar relationship conflicts. Hedge fund conflict checks have presented significant issues for certain funders who have spent time analyzing cases only to find out at the last minute that the case presents a conflict for their main investor, with many of these investors having veto rights to avoid this very situation. For funders, this is a bit of a double whammy, as not only are they prevented from making a good investment, but they also suffer reputationally with the law firm that brought them the case, which may have longer term implications for origination.
It is my opinion that anyone that imposes investment restrictions on their fund managers will not be long for the world of investing in litigation finance funds, as there will be many new investors that do not impose the same restrictions on their fund managers. As a fund manager, I would never accept specific case restrictions (other than concentration limits) as they would interfere with my ability to produce returns, foster relationships within the legal community and ultimately make me uncompetitive.
I further believe that the investors who invest in hedge funds should not be concerned with the specific contents of the hedge funds’ litigation finance portfolio. Rather, they should take the enlightened perspective of their investment as a financial hedge against any other pieces of litigation in which they otherwise find themselves (i.e. they may lose their case, but their hedge fund investment just increased in value because it won another litigation). I think it is naïve to believe a case with good merits will not get funded if one hedge fund does not provide the funding due to a conflict, as meritorious claims are the very reason the industry exists, and so relationship-based restrictions are not effective in the context of the industry. Nevertheless, capital will chase away restrictions in time, it always does.
More Investors are Better
The other aspect of the litigation finance community that I have found a bit perplexing is that certain managers, presumably in an effort to expedite their fundraising efforts, have accepted significant investments from one or two large investors, typically hedge funds.
On the upside, it makes for a more efficient fundraise – a few meetings and you are done (believe me, I understand the allure). On the downside, those investors now control your business and have a significant influence on the Management company’s equity value.
It has long been known in private equity that you never want a limited partner to ‘own the GP’. I am not referring to ownership in the traditional sense, although that occurs too. Rather, in the sense that if you have one or two meaningful investors and they decide to stop funding your business plan, you are then scrambling to find a replacement with a big question mark hanging over the managers’ head – “why did your prior investor stop investing?”.
Instead, if you have a broad-based set of investors in your fund (with no single investor providing more than, say, 15% of your capital), you can easily explain why a specific investor exited. The persistency in capital raising and fund performance is what gives rise to equity value for the GP. If you don’t have one of the two under your control, the equity value of the GP is significantly impaired.
So, my advice to litigation finance managers is to ensure diversification in your investor base as well as your investment portfolio. Of course, I appreciate that in the early days of a fund manager’s evolution, they may have to accept some investor concentration to establish the business. This is perfectly acceptable as long as the capital doesn’t have too many conditions that limit your ability to raise capital from others in the future.
Investors of the future?
In the current Covid environment, I would expect to see hedge funds that have increasingly played a role in litigation finance pivot out of litigation finance to chase their more typical distressed credit opportunities that may provide a superior potential return profile. While this dynamic may not last long, it does remove one competitor type from the litigation finance community which should benefit all other litigation finance funders. For now, I view this as a short-term phenomenon.
The more significant trend, I believe, will be the emergence of the pension plans fueled by their relatively low cost of capital. For pension plans whose cost of capital is dependent on the discount rate applied to their pension liabilities to determine the return profile necessary to ensure the plan remains well capitalized and preferably growing, litigation finance has not been an active investment to date. However, as more and more data is produced and the level of transparency becomes elevated, pension plans will apply their deep analytical skills to the industry and make the decision that this is a viable asset class in which to invest and has the benefit of non-correlation which may be a very important characteristic depending on the specific plan’s life cycle.
I would also expect to see continued strong interest from the endowment, foundation, family office and hedge fund markets as the industry becomes more transparent and data-centric, and the investors that heretofore have been educating themselves about the market start to allocate capital. I would also not be surprised to see sizable asset managers (think Blackstone, KKR, Apollo, etc.) and sovereign wealth funds enter the market and perhaps even make a move to take some of the publicly listed companies private and internalize the operation so they can not only invest a significant amount of their own money in the platform itself, but also as a permanent vehicle to continue to recycle and compound the returns they are achieving, perhaps at the exclusion of other investors or perhaps as a platform from which to scale further.
Of course, technology has traditionally proven to ‘throw a wrench in the works’ by disintermediating many industries, and I expect litigation finance will be no different. As an example, crowd funding is nascent but becoming a popular investor platform that appears to be attracted to litigation finance. I say this because I think we need to be open about the possibilities for sources of financing in the future. I would also look to the private equity markets for guidance in terms of alternative avenues for fundraising as they are some of the more sophisticated alternative investors in the world (in the words of Wayne Gretzky “…skate where the puck is going…”).
Investor Insights
It perhaps goes without saying that the litigation finance asset class is here to stay. While there may be challenges, regulatory, judicial and otherwise, the asset class has shown to prevail against formidable challengers to date because the asset class is both efficacious and beneficial for society. As I have written before, this is an Impact Investing asset class.
As the asset class gains scale and awareness, the investor base will change and the changes may be dramatic. Fund managers who will be raising money should be aware of these changes so they can anticipate and adapt and position their fund offerings to maximize success. As always, diversification is critical to prudent investing in the asset class, whether from the perspective of fundraising or case investing. Accordingly, fund managers should be thinking somewhat selfishly about their own equity value when fundraising and investing their capital.