Valuing Indemnity Protection Investment Performance in Litigation Finance
Executive Summary
Indemnities are not costless instruments
They are akin to securities options, but without a stated option value
Approaches to determining cost of indemnity
Probability weighted outcome approach
Opportunity Cost Approach
Approach based on empirical evidence
Implications for Portfolio Returns
Improper assessment of indemnity returns may materially skew return results of a portfolio
Investor Insights
Indemnities have a cost and their cost should be used to determine investor returns
Depending on how indemnity performance is measured, it has the ability to skew portfolio performance
The interesting aspect of Indemnities is in trying to estimate the returns inherent in providing the protection. Different than most traditional litigation finance which requires the funder to finance hard costs (legal counsel, court costs, expert witness costs, etc.), Indemnities only pay out once a case is lost by the plaintiff and subject to the court determining whether adverse costs apply and to what extent. In the event the plaintiff is successful, the indemnity provider shares in the contingent proceeds and does not pay out any money. In the event the defendant is successful, the indemnity provider will have to pay out the indemnity amount without any related proceeds. Accordingly, in a normal rate of return calculation where you have a numerator (i.e. gains or proceeds) and a denominator (dollars deployed to finance costs) to determine a Return on Invested Capital (“ROIC”) or Multiple of Invested Capital (“MOIC”), with indemnities you have no denominator in the event the plaintiff wins the case and hence there is no “cost”. Or is there?
I think most people in finance would argue strongly and rightly so that there is indeed a cost. I liken the analysis to that of a securities option. In the context of a securities option (a put or call option, for example) you pay an amount upfront (i.e. the option price) to give you the right to benefit in either the decline or increase in the underlying stock price. The value of the option is based on the market’s view of the weighted average probability of the event happening (i.e. achieving the strike price in a given period of time).
In the case of an Indemnitee, there is no cost of providing the indemnity (other than out of-pocket contracting costs) even though the opportunity has value to the indemnity provider. The value is inherent in the economics they will receive and the likelihood of paying out under the indemnity. Essentially, it is a costless option. Upside produces infinite returns and downside produces a total loss.
“However, as we all know nothing is “costless”. Instead, I would suggest that an investor in an indemnity needs to determine a theoretical cost for that investment.”
One approach would be to look at the litigation funder’s underwriting report and economic analysis to determine the various probabilities associated with various negative outcomes pertaining to the case and probability-weight the negative outcomes to determine a theoretical cost of capital. Of course, these need to be looked at in the context of the risks of the various case type in the relevant jurisdiction in addition to the risks of the case and through the various stages of the case as adverse costs can have multiple pay-out points throughout the case. As an example, securities class actions in Australia and Canada, when certified by a court, have an extremely high success rate (meaning that they typically settle quickly after the certification).
Another approach might be to look at the alternative to utilizing that same capital in an investment with similar risk profile where the potential outcome could be the same and the risk of loss is similar. As an example, if the opportunity cost of providing an indemnity was to buy a securities option with a similar risk profile, then you could use the market cost of the option as a proxy for the cost of the indemnity.
Yet another alternative would be to study the outcomes of a large sample of identical indemnities to try and determine the probability of a negative outcome and apply it to the indemnity amount to determine a notional cost. Unfortunately, much of this information remains in the private domain as most cases which use indemnity protection tend to settle.
While approaches will differ by fund manager and investor, the important point is to not conclude that an indemnity is a costless financial instrument as to do so would skew the results inherent in a fund manager’s track record where Indemnities are an important part of their strategy. These same result can also happen in more traditional litigation finance cases where there is a settlement shortly after the funding contract has been entered which did not necessitate the drawing of capital.
Investor Insights
When assessing the rates of return on an indemnity, my approach is to determine a weighted average probability of loss outcomes and apply them to the Indemnity amount in order to determine a notional cost for the indemnity. This analysis becomes extremely important when assessing portfolio performance because most often fund managers do not assign a notional cost to their Indemnities when providing their investment track records and hence positive indemnity outcomes make their overall portfolio performance seem better than one might otherwise assess. A simplified example to illustrate the potential for an indemnity to skew the performance of a portfolio depending on the approach taken follows:
