Investor Watch-Outs in the Commercial Litigation Finance Asset Class. Beware gross case returns as an indicator of manager performance
EXECUTIVE SUMMARY
Gross Returns Net Returns in this asset class and the differences can be material
Tail risk is more pronounced in litigation finance, misleading to infer performance from early results
Nascent and transparent market puts the onus on investors to dedicate time to understanding the asset class
Single litigation investments are impossible to value accurately, don’t rely on fair value estimates for performance measurement
INVESTOR INSIGHTS
Investors need to dedicate resources (internal or external) to a deep dive before allocating capital
Managers need to ensure transparency and alignment of interests in order to attract long-term capital partners
Managers need to be very careful in the figures they provide to potential investors and ensure they disclose net fund returns if they are going to disclose gross case returns.
I recently moderated Litigation Finance Journal’s digital conference entitled Investor Insights into Litigation Funding, and the panelists delivered a clear message that the asset class needs to be more transparent. Accordingly, I decided to pen this article to explore the more opaque aspects of the asset class and the reasons underlying that opacity, and what this means for investors, as well as provide some “watch-outs” for those looking to invest in the industry.
Clearly, the conference left the impression that the investor community is savvy to the fundamental economics of commercial litigation finance, despite the relative nascency of the industry. While many investors have made investments in the asset class over the last five years, those same investors would say, when it comes to concluding about the overall merits of the asset class, that “the jury is still out” (pardon the litigation pun). After having spent several years investing, reviewing troves of litigation finance realization data, I have come to the conclusion that it is a fundamentally strong asset class that has the extra benefits of being (i) non-correlated and (ii) ESG compliant. However, investors should be aware that the application of portfolio theory (I have explored these concepts in-depth in a three-part series, here, here and here) and manager selection are both critical elements (emphasis added) to successfully investing long-term in the asset class.
So, why is it that after decades of investing experience, the investor community still has some trepidation about the asset class? The answer lies in a few fundamental truths about the asset class, along with a lack of transparency—which panelists called for an increase in, and is core to the litigation finance articles I write for the industry.
Let’s start by exploring the cold hard truth about the asset class based on what we know today. It is important to note that this article makes specific reference to commercial litigation finance as distinct from the consumer side of the asset class (personal injury, divorce, inheritance/estate, etc.), which exhibits some very different characteristics as it relates to the risks highlighted below. This article also mainly deals with portfolios of pre-settlement single case risks, as later stage cases and portfolio financings also exhibit very different risk profiles compared to those discussed herein.
Gross ≠ Net
Perhaps one of the biggest mistakes that fund managers make is not specifically referencing net returns in their fund documentation. And one of the biggest mistakes investors make is assuming that strong gross case returns will lead to strong net fund returns.
Every single manager presentation deck in litigation finance I have reviewed, with perhaps one or two exceptions, has focused solely on gross case returns. Now, in many asset classes, there is a relatively high correlation between gross investment returns and net fund returns, and investors can extrapolate with a great degree of certainty from the gross return what the likely net fund return will be, and rules of thumb have even been developed to estimate that relationship. This is not the case in commercial litigation finance. Indeed, managers that market their gross case IRRs and MOICs without also referencing their net fund IRRs and MOICs are misleading investors, and this may have ramifications for their fundraising efforts and the extent to which they are in breach of securities regulations. Managers should seek the advice of securities counsel (and perhaps litigation counsel) prior to communicating any results to potential investors, and ensure that counsel understands how the proposed data was calculated and what it does and doesn’t include.
The differences between gross case and net fund returns in commercial litigation finance are far greater than those in other asset classes, and the differences can transform high positive gross case internal rates of return (“IRR”s) into negative fund IRRs, depending on when the returns are being measured relative to the fund’s life.
So, let’s explore why this discrepancy exists.
Deployment Risk
In the commercial litigation finance asset class, there are two levels of deployment risk. The first is the common risk among many alternative asset classes, which is the risk of whether or not the manager will be able to allocate investors’ commitments during the proposed investment period. If not, investors will be stuck paying fees on a commitment that is not capable of being allocated in a timely manner, thereby making their effective fee drag much greater than anticipated (a concept I explore in a two-part article that can be found here and here), which I will refer to as Deployment Allocation Risk. To a large extent, Deployment Allocation risk can be somewhat controlled by the activities of the manager, in the sense that they are responsible for their fund’s origination efforts.
The second deployment risk emerges once the manager has allocated (or committed) its monies to a case: What is the risk that the commitment will not be fully drawn upon? I will refer to this form of deployment risk as Deployment Draw Risk. The real problem with Deployment Draw risk is that it is largely uncontrollable by the manager, and can have a significant effect on effective management fees. The other issue with Deployment Draw Risk is that it can have a meaningful impact on the diversification of the overall fund and thereby add volatility to a fund’s return profile.
The lack of controllability stems from the fact that once the manager has decided to invest in the case, the case is generally beyond the control of the funder, as many jurisdictions prohibit the concept of “wanton or officious intermeddling”, which would put the funder offside legal doctrines of “maintenance”. As a result, some investors view the asset class as “passive” in that once the investment is made, the manager (and hence the investor) is simply ‘along for the ride’. While true to a degree, the degree of passivity is dependent on the jurisdiction in question, with certain jurisdictions being more permissive with respect to the influence the funder can have on determining the outcome of settlement negotiations.
In addition to the effective management fee issue, the other problem with Deployment Draw Risk is that it can have a profound impact on the diversification of a portfolio when viewed on a drawn basis as compared to a committed basis. Take, for example, a portfolio of ten equal sized commitments where five of the commitments only draw on 50% of the commitment, and the other five draw on 100% of the commitment. This means that the portfolio will contain five cases with 13% exposure each, and five cases with 6.5% exposure each, which means that five cases represent 67% of the drawn capital of the fund (assuming no other fund expenses). When you then apply an overall industry win rate of 70%, you quickly see that the ultimate outcome of the fund will largely depend on whether one of five large cases is a winner or a loser (i.e. will those five have a 60% win rate (three wins) or 80% win rate (four wins), because you can’t win half of a case, and the difference is material). This is far too much quasi-binary risk for my liking, which is why I believe a more appropriate concentration limit for this asset class is one based on 5% of capital available for commitment (after deducting a provision for management fees and operating expenses of the fund). Unfortunately, concentration limits of 10-15% of a fund’s committed capital (not available capital), which have been borrowed from other asset classes, are more common in litigation finance funds, which is a mismatch given the risk profile of the asset class.
Duration Risk
The other non-controllable feature of litigation finance is duration risk, which is the risk that particular cases take a longer time to settle, or obtain an arbitral/trial decision than that which was underwritten. Why is this an issue? The reason is that many times there are caps or limits on the upside available to litigation funders, because while the plaintiffs are willing to reward the funder for the risk they assume, there is a limit to their generosity which often comes in the form of economic caps on the funder’s return. When gross dollar profits are limited, IRRs are negatively correlated with case duration, although multiples of invested capital (“MOIC”) are not impacted, unless there is also an IRR limit contained in the funding agreement (which is also common).
‘Tail’ Risk
In commercial litigation finance, tail risk can be significant. According to Investopedia, “tail risk is a form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution. Tail risks include events that have a small probability of occurring, and occur at both ends of a normal distribution curve.”
Applying this to litigation finance, the tail is influenced by both duration risk, outlined above, as well as case returns. Since litigation finance has what I refer to as ‘quasi-binary’ outcomes (if not settled pre-trial, the longer the case goes and the further it moves down the path of a trial, the more binary it becomes), a normal distribution curve is not very applicable. This is because the data set becomes bifurcated into winners and losers, hence, the concept of using a normal (bell shape) distribution to capture underlying portfolio dynamics (via mean and variance) is likely not appropriate, especially when infrequent but "extreme outcomes" materialize.
In litigation finance, managers can definitely find themselves in situations where they obtain favourable outcomes in the portfolio relatively quickly after the funder makes the commitment, which generally leads to strong IRRs but relatively low MOICs.
On the other end of the spectrum, a portfolio of litigation exposures, especially large ones or ones with specific attributes (international arbitration or patent), will contain cases that have longer durations, and have required more capital and have a higher propensity for a binary outcome. In addition, time is generally not your friend in litigation, as length of case duration indicates that either (i) the issue at hand is so significant or meaningful to the defendant (financially &/or operationally) that they may not have a choice but to fight until the bitter end, or (ii) the defense may be stronger (financially, counsel or case merits) than originally thought by the plaintiff.
These are the ‘tails’ of litigation finance! While a manager may not mind having a few on the front-end (early settlements), those will not likely materially contribute to your fund’s overall MOICs, but they sure make the fund’s early results seem (emphasis added) strong. This is a strong watch-out, as one should never conclude that a fund will ultimately perform consistent with its early returns, as there is no correlation of results within a fund, since each case has its own idiosyncratic risks. In fact, I would venture to say that an investor should not get comfortable with a well-diversified fund’s performance until it is about 85% realized. Why? Because the back-end of the tail is much riskier for the reasons articulated above, and can be very punitive to overall fund returns if the results don’t mimic those of the remainder of the fund. It is conceivable that a fund trending toward a mid-teens IRR can ultimately turn negative, depending on the outcome of the performance of the tail if those investments are significant in size. As an investor, if you committed to the first fund and then made another commitment to the second fund before the tail realized, you could be caught in a long tenure, double loss situation.
Portfolio Concentration
The application of portfolio theory is critical to successful investing in this asset class. As discussed previously, due to Deployment Draw Risk, estimating portfolio concentration on a drawn capital basis is inherently difficult and beyond the control of the manager.
Unfortunately, many managers don’t take this into consideration when building their portfolios, or believe that concentration limits in the 10-15% (of fund committed capital) range are more than adequate to create a diversified portfolio. They’re not! Due to quasi-binary risk and Deployment Draw Risk, managers find it difficult to create diversified portfolios for this asset class, which means lower concentration limits than other asset classes are appropriate to protect the investor. This was one of the main reasons for the design of the fund-of-funds I managed.
“Mark-to-Market” or “Fair Value” Accounting
It is very common and sometimes required for accounting purposes for many asset classes to mark-to-market or fair value account for their investments. The reasons for this request are simply because investors want an accurate estimate of the carrying value of their investment, so they can judge manager performance and concentration within their own portfolios, and to serve as an early warning system for avoiding future bad allocation/funding decisions. Investors may also require this to judge their own performance internally.
In certain asset classes there is sufficient and current data available to undertake this exercise with some degree of certainty. However, in the litigation finance asset class, each case has its own idiosyncratic risk, and there is an element of bias in any decision-making process that makes it impossible to accurately determine outcome or damages, and hence value a piece of litigation (especially commercial litigation). Investors should also be aware of valuations established by secondary sales in the marketplace as they do not necessarily establish credible value for a case, but rather are more likely a reflection of a fund manager’s ability to convince others that the case has a higher probability of success and collection (i.e. I wouldn’t want to borrow against that value).
As investors consider investing in the asset class, while they should look at the fair value figures provided by managers as part of their overall assessment, they should focus their decision-making on cash-on-cash returns, and understand that fair value calculations cannot be relied upon (portfolio financings have different characteristics which may make fair value less risky in this regard, as long as the portfolio is cross-collateralized and diversified).
Managers need to be very careful using fair value accounting as their basis of investor reporting, as they may assume liability in the event the portfolio’s ultimate performance does not coincide with the fair value estimates. My suggestion is that if the manager insists on providing fair value accounting estimates, they also provide cash-on-cash returns for the realized portion of the portfolio, along with associated fund fees and expenses.
Asset Class Nascency & Transparency
For those of you who have been toiling in the asset class since inception, you may have come to the conclusion that the asset class is maturing, and have gotten quite comfortable with the risk/reward profile. However, for many investors who have been investing for the last five years, they still have yet to experience fully realized fund returns from their investing efforts, and while they have made a significant dedication to the asset class (kudos to them for believing), they are data-driven organizations that require data to make sound long-term investment decisions. In this regard, the entire industry is very nascent in terms of having produced fully realized funds – I can only think of a handful of managers who have done so, and as I have articulated above, an investor cannot infer returns from early fund results.
However, the nascency of the industry has been aided by the transparency of the publicly-listed managers that operate in the industry (Burford, Omni, LCM, etc.). Accordingly, the entire industry owes a debt of gratitude to the public players who have paved the way for the private players by ensuring a degree of transparency is disseminated in the market, as a result of their regulatory disclosure requirements. Were it not for those players making their results public out of necessity, the industry would likely not have attracted the level of interest it has, and definitely not as quickly. However, we must remember that the publicly-listed companies mainly invest from their permanent capital, and do not have fund horizons or fund management fees, performance fees and operating expenses to factor into their results (or at least they get buried within their own profit and loss statements, which are co-mingled with the costs of managing a portfolio). Accordingly, the gross returns we see from the publicly-listed players need to be proforma’d for the expenses associated with running private funds, and those expenses are not immaterial.
In a nascent and opaque asset class with a relatively small number of managers, manager selection becomes critical. Investors who are considering investing in the asset class need to spend the upfront time to take a deep dive in the global manager community, so they can ultimately select the best stewards of their capital. This is something I have done over the last five years, and I can definitively say it has expanded my knowledge immensely and provided me with an enhanced perspective that has served my investors well.
Investor Insights
For investors, the asset class presents a unique opportunity to add an asset that has true non-correlation, along with inherent ESG attributes. This makes litigation finance a very attractive asset class. However, an investor needs to do their homework prior to executing an investment, and needs to think about this asset class in a very different way than others in which they may have invested. If the investor doesn’t have the internal capabilities to devote to the effort, they should consider hiring an advisor to guide their decision making, or selecting a lower risk vehicle to ‘dip their toe in the water’.
For fund managers, transparency is critical to attracting significant comittments from institutional investors. The more data you can provide, and the more upfront you are about your net returns, the more success you will likely achieve. Managers that address the risks inherent in the asset class through their fund structures and decision-making processes will likely be more successful. Aligning your fund economics as closely as possible to those of your investors will lead to long-term successful partnerships that may take managers in directions never contemplated during the early stages of the fund.
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 litigation finance industry (consumer and commercial). Ed is currently designing a new fund focused on institutional investors who are seeking to make allocations to the commercial litigation finance asset class.