What is litigation finance?
Litigation finance is the provision of funds by a third party to a plaintiff in exchange for part of a legal settlement. It can also involve directly financing attorneys and plaintiffs to pursue cases against large defendants. The investor typically receives a specific multiple of the initial investment or a percentage of the settlement for a successful case.
Litigation finance was once a niche investment, but it has evolved into a multi-billion dollar industry. Attorneys increasingly work on a contingency basis, and they need to reduce the risks associated with individual cases.
Why should investors be interested?
Returns from litigation finance have been quite high, but more importantly uncorrelated with the broader market and other asset classes. The returns for litigation finance depend on the outcomes of particular court cases, which are unaffected by movements in the stock market. What is more, legal decisions are generally uncorrelated with each other.
A diversified portfolio including multiple cases can produce much more predictable returns. Litigation finance is still a relatively new asset class with room for growth. Cases frequently take three to five years to reach a settlement, and the secondary market is still developing. Litigation finance remains an extremely illiquid asset class, and “being paid to wait” is an important component of the return profile.
What are the expected returns?
In general, the illiquidity of litigation finance implies higher returns. Ibbotson and Kim showed that low liquidity stocks outperformed the stock market by over two percentage points per year. Litigation funding is less liquid than any stock, so theoretically returns should be even higher.
In actual practice, the expected returns to litigation finance vary dramatically based on the type of investment. In a recent Financial Times article, a sample of settlements that had been purchased from claimants, had returned roughly 10x what the claimant received at the time of funding.
Litigation finance “fundings”, in our opinion, perform much like distressed debt combined with venture capital. Some cases will exceed the litigation funders expectations, while some will be total losses, and others will come in closer to the ex-ante expected return.
Many of the cases that are purchased by investors have not been settled at the time of investment. Thus, the risk profile for individual cases is similar to out of the money options.
As the case plays out and headlines are publicly announced in the media, and as judgments are reached, the “implied value” of the investment increases as market participants gain more visibility into the possible outcome. For prudent portfolio managers, it’s possible to create portfolios with defined risk because cases are uncorrelated with each other.
Who should invest in litigation finance?
Litigation finance is most appropriate for institutional investors and high-net-worth individuals because of its lack of liquidity and complex nature of modeling the variables that will make up the return, including size and timing of the settlement, and assessing the ability for the defendant to pay. Litigation finance is for sophisticated long-term investors like hedge funds and family offices.
What are the risks?
Litigation finance is considered high-risk because the investor will typically lose the entire initial investment if the plaintiff loses the case. Cases can also take much longer to play out than investors originally anticipate, which lowers the internal rate of return.
Additionally, being able to verify and value potential assets available for recovery is also challenging for most investors. Idiosyncratic risk, conflicts of interest, lack of liquidity, and regulatory uncertainty are some of the risks associated with litigation finance. The high idiosyncratic risk of any specific case is the main reason that attorneys seek litigation funding.
How can the risks be minimized?
Risks can be reduced through underwriting, structuring, oversight, choice of attorneys, diversification, and choice of jurisdictions. Proper underwriting protects investors from adverse selection and moral hazard by selecting only sound cases for investment purposes. Structuring and oversight also minimize conflicts of interest.
Attorneys with histories of acting in good faith in the litigation finance industry are even more important. Experienced attorneys with good access and relationships with regulators is also an edge that can help to improve returns.
Long time horizons and diversified portfolios can help investors to decrease risks related to low liquidity. Diversification also reduces the high idiosyncratic risk of individual cases. We recommend investing in a dozen or more cases to achieve diversification. Finally, legal uncertainty can be minimized by investing where the status of litigation finance is better established, and where frameworks for the ultimate case recoveries are well defined.
How We Create Value
Ashton Global can help your organization locate appropriate litigation finance investments. We use a network of fraud examiners, hedge fund managers, journalists, forensic accountants, and attorneys to find exceptional litigation funding opportunities. Please contact us at +1 212 514 8953 or email firstname.lastname@example.org to learn more about investing in case settlements.