‘Secondary’ Investing in Litigation Finance (Part 2 of 2)
Why, why now, and how to approach investing in Lit Fin Secondaries
EXECUTIVE SUMMARY
Evolution of Litigation Finance necessitates the need for a secondary market
Investing in Litigation Finance secondaries is much more difficult than other forms of private equity due to the inherent difficulty in valuing the ‘tail’
Experts should be utilized to assess case merits and valuation
Life cycle of litigation finance suggests timing is right for secondaries
INVESTOR INSIGHTS
Investing in the ‘tail’ of a portfolio, where most secondary transactions will take place, can be more difficult than primary investing
Dynamics of the ‘tail’ of a portfolio are inherently riskier than a whole portfolio, which is partially offset by enhanced information related to the underlying cases
Secondary portfolios are best reviewed by experts in the field and each significant investment should be reviewed extensively
Derive little comfort from portfolios that have been marked-to-market by the underlying manager
Investing in secondaries requires a discount to market value to offset the implied volatility associated with the tail
In part 1 of this article I explored some of the basic concepts of secondary investing, specifically in the context of the commercial litigation finance asset class. This article continues the discussion and explores some of the unique aspects and characteristic of the ‘tail’ of a litigation finance portfolio, why now is a particularly good time for secondary transactions and other investment considerations with respect to secondary investing.
Investing in the ‘tail’
In a prior article, I made reference to three phases of risk in the context of litigation (there are more but let’s keep it simple for now). As a case evolves, it moves from a phase where the case is “De-Risking” because more information is flowing to the point where both parties have an abundance of, and equal information about, the litigation (yet still have different perspectives based on subjective value judgments), which moves the case into something I referred to as the zone of “Optimal Resolution” (credit to John Rossos at Bridgepoint Financial who developed this ‘three phases of risk’ analogy). Optimal Resolution is a period of time where both parties understand what information the other party has, the legal precedents being referenced, and perhaps some insights into how similar cases would have been judged in the past. With an abundance of information, the two parties should come together to form a conclusion around a reasonable settlement and bring the case to an end. However, if they fail to do so, the case starts to enter into the “Re-Risk” stage where the parties typically commence with a trial or arbitration, at which stage both sides may get more entrenched in their positions and if they do the outcome ultimately becomes binary, as it will be decided by a third party (i.e., judge, arbitrator or a jury) without a vested economic interest in the outcome. Any good litigator will tell you to avoid a binary outcome if at all possible, as these outcomes are quite unpredictable (i.e. your odds of winning may be better in Vegas).
I make reference to these three phases because the ‘tail’ tends to capture the Re-Risk stage of litigation/arbitration, which is the riskiest part of the litigation process. So, when investors are looking at a secondary portfolio of single case investments, they are almost by definition investing at the riskiest part of the lifecycle of the case. Of course, that is not always the case, and it depends whether you are the plaintiff or the defendant. If you are a plaintiff, you may have a number of interim procedural wins and so you may believe there is a stronger possibility of success as compared to when the manager first under-wrote the case. Therefore, you may be feeling relatively good about your prospects. However, while one would think justice is equitable, consistent and repeatable, that is rarely the case, which makes this stage of the litigation process the most dangerous, as the plaintiff may be lulled into a false sense of security based on some procedural wins and damning evidence against the defendant.
The fact that these cases are in the tail of the portfolio firmly suggests that (i) they have been going on for a long time, which means that (ii) you may have two entrenched, deep pocketed parties who are not likely to give in soon, which means that (iii) the outcome will more likely than not end up in a binary decision. Of course, it may also mean that it is closer to resolution, as many cases have been settled on the ‘court room steps’.
Accordingly, the risks are different than those of investing into a ‘blind pool’ portfolio where the cases have yet to be picked. In a nutshell, the investor in a secondary does not get the benefit of the early wins and relatively more attractive IRRs to offset the more binary characteristics of the tail, which likely includes bigger losses (if for no other reason than a loss in the tail means the original capital commitment has likely been fully consumed). Since the secondary investor has to make his or her returns from the more binary portion of the portfolio, which means higher volatility as the probability of a loss is higher in the tail segment of the distribution (a well-known statistical characteristic), ultimately, it would be dangerous for a new investor to pay a premium, and conversely, it is likelier the investor will need to buy at a discount.
But discount to what – original cost or current fair market value? Discounting to cost is a fairly easy exercise, but may not be meaningful. Discounting to fair market value is pretty challenging in the context of a tail comprised of single case investments, each of which is more likely than not in the Re-Risking stage of the investment life cycle. Nevertheless, it is only logical that a secondary investor should treat the investment as though it was a new portfolio and underwrite every significant investment in the portfolio from scratch, to do otherwise would be reckless. A “diligence light” approach is not acceptable given the potentially higher risks inherent in the tail and so as much, if not more, time should be spent underwriting secondary portfolios as compared to primary portfolios. Also recognize that when selling secondary portfolios the seller and their advisors are in ‘sell mode’, and so a second set of sober and skeptical eyes is probably the best way to value these assets. An astute investor can also structure the investment by limiting its downside by negotiating a lower entry price in exchange for a sharing of the upside with the exiting investor, so that it becomes a ‘win-win’ transaction with the secondary investor getting some downside protection, and the exiting investor retaining some upside.
A positive aspect of investing in the tail is that the majority of the legal spend has taken place and so your deployment risk is probably low, which essentially means that if you win, your ROI will likely be a multiple of a higher known number as compared to when the investment was originally underwritten. That’s IF you win! It also means that you have the ability to determine the impact of fees on expected returns based on when the fees were charged in relation to when the cash was invested, which may help with the gross-to-net return spread issue that can be significant in litigation finance. There is also the potential that these cases may settle relatively early in the life cycle of the secondary investor’s ownership period, which will likely generate stronger IRRs and MOICs, and hopefully minimize the ‘fee drag’ (the impact fees have on net investor returns).
Why now?
There has been much recent chatter in the litigation finance sector about secondary opportunities, so why now?
Well, it’s mainly reflective of the extent of time the industry has been in existence. The commercial litigation finance industry started in earnest between five and ten years ago in the US. Accordingly, a meaningful amount of capital has been raised and a sufficient amount of time has passed to allow for the conditions necessary for secondaries – namely supply. The supply mainly stems from a confluence of investor interest in liquidity for their longer dated investments, and GP interest in ‘putting some points on the board’, meaning they need to show some track record so they can raise a subsequent fund. Simply, the timing seems right, and when an institution needs a way to achieve liquidity for its portfolio, it will find a way to do so.
How best to approach investing in secondary transactions?
Different from other forms of private equity, acquiring litigation finance investments in the secondary market requires the expertise of a litigation finance fund manager. I say this because of the risks inherent in the tail end of the portfolio, and the expertise required to assess this tail is the same expertise required to underwrite new investments. It would be a mistake to confuse investing in secondary transactions in litigation finance with other private equity sectors like leveraged buy-out or venture capital, where the valuation metrics and approach to valuation are much more transparent and well accepted. Valuation in litigation finance is much more in the realm of ‘beauty is in the eye of the beholder’ (aka “a subjective value judgment”), with one group seeing much more value in a case than another based on their biases and experiences. Managers that invest in secondaries should be prepared to do extensive diligence on a large part of the portfolio, and certainly those investments in the portfolio that appear riskier and disproportionately large relative to the average case size in the portfolio.
The other important element is to ensure that you have a diversified portfolio. If you are purchasing a tail portfolio, then it likely means there are fewer investments than what was present in the original portfolio earlier in its investment cycle; hence, there will be a higher degree of volatility, in statistical terms. Since there are now fewer investments in the tail portfolio and the early resolutions likely provided strong returns, the remainder of the tail has to stand on its own merit and so it will be important to ensure the tail portfolio is large enough to be diversified in its own right. To the extent it is not well diversified, I would consider spreading your overall secondary allocations across more than one portfolio, until you get a desired (target) degree of diversification (case types, case sizes, geographies, defendants, law firms, etc.) with a limited concentration risk within the portfolio. A portfolio with 50 cases might seem diversified, but if three of those cases represent 30% of the capital and they all turn out to be losers (which is statistically a very real potential outcome), then it puts a lot of pressure on the remaining portfolio to both offset the large losses while simultaneously producing target returns for the portfolio as a whole.
Lastly, I would consider putting in place an insurance wrapper for ‘first loss’ insurance. This type of insurance can be expensive, and so you need to be prudent and careful not to over-insure. You have to look at the risk of loss probabilistically, and such an analysis could show that you don’t likely have to insure 100% of the principal, but probably just a fraction of the principal, and preferably through first-loss coverage, where the insurer takes the obligation for the loss on the first, say, 20% - 30% of the portfolio (the riskiest portion, statistically speaking), and the investor is exposed for the remaining 70% - 80% (the decreasingly less risky portion).
I think most secondary portfolios should be valued at a significant discount to market value with a range of probability-sequenced outcomes to triangulate to a valuation. The valuator should not lose sight of the fact that approximately 30% of litigation finance backed cases lose, and so this should be a starting point for the analysis of the potential value of the portfolio, and stress-tested from there to reflect the higher risk inherent in the ‘tail’. However, there can also be specific investment opportunities which through the process of de-risking may represent better opportunities than they did before the de-risking process and the investor may be able to justify or may be forced to accept a higher valuation in order to be able to transact.
In situations where the litigation is so significant that it can actually have an impact on a defendant’s publicly traded securities, you could also use options on the publicly traded securities of your counterparty to hedge your investment such that if you lose the case you make money on the hedge, and if you win the case, the cost of unravelling the hedge becomes the cost of an otherwise successful transaction. Of course, any hedge will be imperfect as the stock price of the defendant can be influenced by a number of factors in addition to the outcome of the litigation, the very outcome you are trying to hedge.
David Ross, Managing Director & Head of Private Credit at Northleaf Capital Partners notes: "We approach secondary transactions in a prudent and judicious manner with thorough analysis on concentration risk, deep dive on case merits and outcomes, as well as comprehensive financial diligence and modeling. We tend to mitigate investment risk by way of conservative structuring and cautious underlying assumptions that provide significant cushion for the investment."
It is only through a cautious approach that one can successfully invest in commercial litigation finance secondaries. Other areas of litigation finance (consumer, law firm lending, etc.) will likely have different risks and portfolio characteristics that allow for less extensive diligence on the portfolio, which may be a consideration for some investors.
Slingshot Insights
For those investors interested in the litigation finance secondary market, I think it is important to approach the investment with caution and a high level of expert diligence to offset the implied volatility that the ‘tail’ of the portfolio offers. It is also important to understand the motivations of the seller – a manager looking to create a track record will have different motivations than an investor who needs liquidity. The seller’s motivations may also offer insight into the extent price can be negotiated. It is important not to lose sight of the typical loss rate of the industry and the fact that the tail should exhibit enhanced volatility (more losses) as compared to a whole portfolio, and so an investor should model their returns, and hence their entry price, accordingly. Should you choose to make a secondary investment, consider a variety of options to de-risk the investment by sharing risks and rewards with others (i.e. insurance providers or the vendor of the asset). Above all else, make sure your secondaries are diversified or part of a larger diversified pool of assets.
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.