Credit or equity: the new economics of litigation finance funds

October 2023 | SPOTLIGHT | LITIGATION & DISPUTE RESOLUTION

Financier Worldwide Magazine

October 2023 Issue

As traditional merger and acquisition, real estate and corporate deal flow slows due to economic fears and recessionary pressures, litigation will become a greater revenue generator, albeit a lagging one, for most large law firms. This trend, coupled with rising interest rates over the past 24 months, will result in more litigation finance funds extending credit facilities to law firms.

Such facilities will enable law firms to grow their litigation practices at a faster pace, thus mitigating the ‘gap’ between transactional practice slowdown and litigation uptick. This confluence of practice area shift for law firms and rising interest rates may make litigation finance more desirable to institutional investors that see credit opportunities as offering more traditional, as opposed to outsized, returns with a concomitant lower risk profile.

In order to understand the interplay between market forces, inflation, credit products and litigation funding, one must first understand the byzantine economics of large law firms. Unlike most modern businesses (including many professional services organisations), large law firms, by and large, are still organised as limited partnerships and distribute all earnings to equity partners, as opposed to retaining earnings, on an annual basis.

A savvy managing partner of an AmLaw 50 firm once analogised this practice to an old ‘mom and pop’ convenience store where profits are deposited in a cigar box and paid out to the owners at the end of the year, leaving an empty box at the start of the new year. This practice of distributing earnings to partners means that law firms start each fiscal year from scratch.

No matter how good the prior year’s earnings, such largesse is not used as a hedge against a down year. This results in enormous pressure on law firms to meet or exceed ever-increasing budgets so that equity partners can realise a year-over-year increase in compensation. In this system, there is little room for error when a practice area experiences a downturn unless the slack can be immediately tightened-up by an upturn in a different group within the firm.

Not surprisingly, the incessant economic pressure of these firms is passed through to the partners, and, indeed, all lawyers and revenue generators, in the firm. Every big law firm lawyer knows the stomach-clenching sensation as his or her economic metrics shift to zero on day one of a new fiscal year (often helpfully highlighted on the firm’s home intranet page). The lifeblood of a practicing lawyer’s metrics – origination, billable hours, collected fees, leverage and profitability – must be replenished every year in order to maintain one’s compensation or equity stake in the partnership.

Worse still, merely replicating prior year performances is not satisfactory as budgeting mandates demand a year-over-year increase in profitability; effectively, this means either higher billing rates, more hours worked, greater origination, more efficiency or, in all likelihood, a combination of all these factors. Thus, there is little incentive for lawyers in these firms to make developmental or time investments for the future beyond the current fiscal year.

The confluence of law firm economics with those of individual lawyers makes large law firms especially vulnerable when macroeconomic factors negatively impact a practice area, such as a real estate downturn, a financial sector failure, an adverse regulatory development in the technology or healthcare fields, and so on.

When these calamities strike, the firm has little time to recover and shift resources into other, countercyclical, practice areas, such as insolvency and litigation, resulting in a loss of revenue potentially over multiple fiscal years. This, in turn, reduces the profits of equity partners and puts pressure on revenue generators to quickly make up the difference.

If revenue is not replaced promptly enough, there is a concern that the highest performers may leave to join other firms. One way in which law firms can quickly increase the pipeline of insolvency and litigation matters is to enter into alternative fee agreements with their clients, specifically contingency or success fee agreements. The problem with this ‘solution’ is that these arrangements go against the law firm economic model of billing and collecting in the current fiscal year. While the firm may, ultimately, make a large return on such cases, it can often take years before those outsized returns are realised through monetisation of the cases, either through settlement or collection.

Into this breach steps litigation finance credit products. Many may be familiar with traditional litigation funding in which a funder makes a one-off ‘equity’ investment into a case. In those instances, the funder’s counterparty is typically the claimant in the case, and the investment is used to cover legal fees, costs and litigation expenses. The funder’s return is measured in multiples of invested capital (following a return of capital) or a percentage of the monetised amounts, depending upon the jurisdiction.

This model results in outsized returns and attracts investors who desire maximum upside and are prepared to weather the associated litigation risk. A trend in recent years, however, has been a shift to litigation funding credit products made available to law firms. In these products, the funder’s counterparty is the law firm itself which creates a pool of contingency or success fee cases originated by the firm.

The economics of these cases is governed by the law firm’s engagement letter with each claimant and typically provide that the firm receives a percentage of monetised proceeds, or a multiple of the value of the time committed to the case, instead of billing and collecting on a monthly basis. On their own, these cases do not ameliorate the economic pressures noted above because the firm may not see the (albeit enhanced) revenue from those cases for years. By partnering with a litigation funder offering a credit solution, however, a law firm can create liquidity and leverage in its investment of time.

Although the proverbial devil is in the detail, most litigation credit products work in a similar fashion. The law firm creates a pool of alternative fee cases which are subject to due diligence by the litigation funder. Once vetted, the funder makes a credit line available to the law firm, which can range up to several hundred million dollars. While this may seem like a large figure, it is helpful to remember that many large complex cases now routinely require legal fee outlays between $10m and $20m, if not more.

In a pool of 10 or 20 such cases, combined budgeted fees quickly approach $500m. The credit line is non-recourse to the firm or the partners and is secured only by the potential monetisation of the cases in the pool. As lawyers bill time working on these cases, the law firm has the ability to draw down on the credit line to pay a portion of those bills on a monthly basis, in the same way as if the firm had a billable hour fee agreement with the claimants.

In this way, the firm is able to create liquidity in any given fiscal year, by essentially advancing contingency or success fees to itself over the course of a case. This results in a win-win for the law firm and the claimant. The claimant does not have to pay legal fees except upon success and the law firm is able to mould alternative fee arrangements into a traditional monthly billing and collection model better suited to its fiscal year deadlines.

In exchange for making the credit line available, the funder receives traditional fees associated with credit products as well as a healthy interest rate on the funds that are drawn, commensurate with the non-recourse risk borne by the funder. As cases monetise, the credit line may be replenished. Further, the law firm can add cases to the collateral pool, thus increasing the number of cases for which the credit line can be used while simultaneously reducing the risk profile for the funder by broadening the potential collateral.

In addition to providing immediate revenue generation for alternative fee cases during transactional practice downturns, this product also helps law firms leverage the number and size of contingency or success fee cases it can handle. This is true regardless of the economic environment and can enhance a large law firm’s competitiveness vis-à-vis more specialised, or boutique, firms. Specifically, credit facilities allow large law firms to grow, develop or attract practice areas that rely upon contingency or success fee arrangements, without disincentivising its partners from participating in such cases due to outdated law firm economic and compensation paradigms.

It is not difficult to see the allure of litigation funding products to institutional investors. As interest rates rise, more investors are drawn to credit products which can provide a higher rate of return. For investors seeking these newly enhanced credit returns, a growing financier tranche given the uptick in interest rates over the past two years, litigation credit funds may provide a risk-appropriate investment return in an uncertain economic environment.

Moreover, if the collateral pool of cases is deep enough, and the diligence handled properly, the default risk should be relatively low. As a result, institutional investors, who in the past may have been hesitant to invest in litigation funding vehicles due to higher perceived risk, can now obtain access to the same asset class only with credit-like return structures and a higher level of diversification. When utilised appropriately, litigation finance credit vehicles should create an alignment of interests between law firms, funders and investors allowing all parties to benefit even during down markets and in an era of rising inflation and interest rates.

Jonathan Sablone is a managing director at Delta Capital Partners. He can be contacted on +1 (617) 460 2591 or by email: jsablone@deltacph.com.

Jonathan Sablone

Delta Capital Partners