Private equity and litigation finance: a maturing market

September 2021 | SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2021 Issue

Litigation financing has matured from a not very well-known boutique investment product into an asset class desired by private equity (PE) investors. The combination of attractive investment returns, shorter investment periods relative to typical buyout funds, and lack of correlation to the broader financial markets and benchmarks like the S&P 500, has turned this once obscure financial product into an appealing PE investment opportunity for institutional investors.

While litigation finance has been around for decades, it has only gained broader acceptance as an asset class in the past few years. Thus, it is not uncommon for even sophisticated investors to be unfamiliar with opportunities presented by litigation finance funds. Put simply, litigation finance is a way for an unrelated party to invest into litigation and share in the proceeds. If the lawsuit is successful (for example the claimant wins or settles on favourable terms), then the investor receives a return of its invested capital plus a multiple thereon or a percentage of the remaining proceeds from the settlement or judgment.

In the US, this arrangement has been compared to law firms taking cases on ‘contingency’, meaning that the lawyers invest their time and services without charging by the hour, and, instead, agree to take a percentage of the recovery if the client prevails (and get nothing if the client loses). Litigation financing differs from contingency cases, however, in that a third-party funder pays the legal fees and costs in exchange for an agreed-upon return negotiated with the claimant as part of a waterfall of proceeds in a funding agreement.

The early days of litigation finance saw relatively small investments into single cases and were funded largely by high-net-worth individuals or asset managers deploying ‘friends and family’ capital. While those arrangements still exist today, the industry has matured and now has greater appeal to a broader market. Many litigation finance funds are now set up as either PE or hedge funds, with two primary functions: the raising of capital and the deployment of that capital into the asset class.

With the assistance of private fund investment vehicles, funders have been raising much larger amounts of capital. Billion-dollar litigation finance funds are no longer rare, and most mainstream funders have, at least, several hundred million dollars of capital to deploy. This level of capital has transformed the industry from, primarily, one-off funding of litigation matters to larger portfolio investments.

For example, a funder may work with a sophisticated global law firm to fund a portfolio of cases in a specific practice area, such as commercial arbitration or patent infringement. Rather than cover the legal fees for one specific case, large sums of money, typically tens of millions of dollars, can be deployed to cover multiple existing matters and even future matters.

In many instances, the portfolio of funded cases will be cross-collateralised so that investors are protected from the risk of one or more cases not monetising. This type of arrangement is often a ‘win-win’ for all involved: the claimants receive funding for their cases, the law firms are able to diligently pursue cases while getting paid in whole or in part for their services irrespective of the outcome, and investors are more likely to see enhanced returns while minimising the downside risk of a loss.

Some funders even offer credit solutions to such law firms, extending credit based upon a collateralised group of cases, rather than making an equity investment. The result for investors is a high-performing credit deal with minimised risk of default or loss given the value of the secured assets relative to the credit extended. Institutional investors are the newest entrants to the litigation finance model, typically contributing significant capital to litigation finance funds. These types of investments tick many of the boxes that investors seek when allocating capital to alternative asset classes.

First, and most importantly, the potential returns could be significant compared to the S&P 500 or similar benchmarks. The New York Times has reported industry returns in the 30 percent range, with some funders reporting returns double that figure and more. Second, and almost as important, litigation finance funds do not suffer the same liquidity problems as some alternative investment portfolios. Since the underlying assets are tied to the litigation lifespan, typically averaging 24 to 36 months, capital is not usually frozen for longer lengths of time as would be the case in a typical buyout fund. Third, there is less volatility associated with the asset class because litigation viability and performance are case dependent and not subject to the whims of the market. Finally, litigation finance has a lack of correlation to the broader financial markets. Whether or not a lawsuit succeeds, and an asset monetises, depends entirely upon the merits of the case and the collection efforts (if necessary), thus eliminating exposure to broader financial concerns tied to the economy or market performance. Given the above, it is not surprising that institutional investors have deployed billions of dollars into this asset class over the past several years. This includes fiduciary asset managers for pension funds, charities and endowments, including, reportedly, Harvard University’s endowment fund.

Like all private fund investments, not all funds are created equal. Before committing capital to an investment fund, investors should proceed with their usual due diligence checklist for alternative investment strategies. Unique to this asset class, however, investors should also spend significant time and resources performing diligence on the fund’s origination and diligence teams. Choosing which lawsuits to invest capital into is not the same as picking an equity or debt investment. Each litigation matter is unique and presents bespoke issues for the litigation fund’s diligence team. Picking winners and losers with respect to litigation requires attorneys with sophisticated pedigrees and experience because, in the end, the assets in the fund are only as good as the team’s ability to find and approve high-value litigation opportunities.

Equally important is the funder’s ability to monitor the assets through monetisation. The best funders employ inside and outside counsel and investigators to ensure that a case is proceeding along the desired track and moving toward monetisation within the expected time frame. In this regard, funders operate less like asset managers and more like business partners that can offer practical assistance to litigants and their lawyers throughout the lifecycle of cases.

Given the billions of dollars deployed into litigation finance funds, it is clear that this is an asset class that has evolved from its infancy into a mainstream investment that will have significant staying power. The question is no longer whether large institutional investors should deploy capital into this asset class, but, rather with whom they should invest and how much.

Driven by the combination of attractive returns over shorter periods of time compared to traditional buyout funds, less volatility and lack of market correlation, litigation finance has become a mainstream alternative asset class in its own right. The influx of institutional capital demonstrates an industry that has successfully evolved from a niche product into a growing and respected marketplace.

Jonathan Sablone is global director of originations at Delta Capital Partners Management LLC. He can be contacted on +1 (312) 414 0856 or by email: jsablone@deltacph.com.

Jonathan Sablone

Delta Capital Partners Management LLC