Finance Comes To the World of Litigation
The term litigation finance may not mean much to many people, including some attorneys yet, but that is likely to change over the next few years. Litigation finance is one of the fastest growing areas in the financial field whether measured by objective metrics like assets under management in the space, or investment returns.
The field is also taking on an increasingly public role as it grows – for evidence of that, one need look no further than the recent front page Wall Street Journal article featuring one of the goliaths of the space, Burford Capital. Outside of Burford, barely a week goes by when I am not contacted by an investor or fund manager interested in investing in the space.
So why is litigation finance becoming so popular so quickly and what does its rise portend for the future of the legal field? The answers lie not in the litigation side, but in the finance side.
There are three major changes likely to influence the legal field as litigation finance grows.
Finance is simply a means to an end.
The field of finance does not exist to provide a consumable good or because anyone enjoys the service. Finance is in economic terms, an intermediate good (or in this case service). Whether we are talking about financing for aircraft people fly on, companies entrepreneurs start, or houses bought by consumers, finance’s only role is to enable other industries to function better.
The same thing holds true of finance’s role in the legal field. Litigation finance exists because some lawsuits are simply too expensive and too risky for plaintiffs to fund on their own, or for lawyers to take on contingency. The VW suits over diesel emissions illustrate this in Europe; with no ability to form class action suits as in the US, European consumers have fewer options for suing VW. Finance helps to fill that gap, assuming the risk in exchange for a return.
In the US, this same principle applies in a variety of settings; corporate disputes, class action cases, medical injury cases, and many others. Litigation funding exists to fill a void left by traditional banks and other legal channels. While many attorneys will take certain cases on contingency, the lawyer’s purpose is not to be a source of funding, but to argue a case well. The financier’s purpose to is to absorb the risks in exchange for a return on invested capital.
Of course, not all jurisdictions approve of litigation finance or value the risk mitigation that such a service provides. The problem of usury has long been a difficult issue in finance especially in high risk areas, of which litigation finance is certainly one. To get around this issue, litigation finance is generally structured as the equivalent of a contingent rights offering rather than a loan.
Hostility to litigation finance creates artificial barriers to cases beyond what the law prescribes. In states where litigation finance is made more difficult by regulation, plaintiffs and defendents have fewer options to enforce their legal rights. While different litigation funders are more or less willing to invest in different states, Roni Elias of litigation finance firm TownCenter Partners cites Alabama, Colorado, Kentucky, and Pennsylvania as being particularly tough to fund cases in.
Elias of TownCenter Partners says that for his firm, litigants residing in hostile states have to “agree to both choice-of-law and choice-of-forum clauses that would put the agreement under the jurisdiction of a state that is friendly to litigation financing.”
Finance sees value in diversification
One of the benefits of modern finance is the ability to achieve reduced risk through diversification. Returns in litigation finance are generally fantastic comparatively speaking, perhaps because the space is still in its infancy.
To understand returns in the space, we need to think about litigation finance as being similar to a bond. Like all fixed income products, litigation finance essentially has two ways of measuring cost, and these two are inversely related – yield and price. The more money a litigation finance firm advances against a claim upfront, the higher the price and the lower the expected yield on the investment. Alternatively, lower yields or multiples imply either a higher amount of money advanced upfront or a lower backend repayment.
In the fixed income world right now, annual yields are generally anywhere from 3% to 7%, with the latter being only for very risky deals. While a decade ago it was easy to find junk bonds yielding north of 10%, today there is virtually nothing in the way of performing debt in that bucket.
Litigation finance is the exception. Litigation finance deals today generally carry multiples on invested capital (MOIC) of anywhere from 2.2 on the low end to 4.5 on the high end depending on the structure and complexity of the deal. While the exact yield depends on the time frame involved, virtually all litigation finance funds are offering investors expected returns of somewhere between 12% to 24%, with a select few offering more.
As the litigation finance area develops though, the key is to avoid taking big risks. Early investors in the space from large firms like Burford to boutiques like Town Center Partners have initially faced a dearth of investment opportunities. Today the litigation finance world has grown enough that a portfolio can be effectively diversified. British funder Augusta and US firm Oasis appear to have understood the value of diversification early on.
Simply holding investments in a large number of cases is not sufficient for diversification purposes. Instead the key is to identify cases that are uncorrelated both in terms of their outcomes and in terms of the portfolio characteristics. An attractive portfolio should offer the financier a ladder of expected case maturities with minimal risk from black swan events (e.g. tort reform), and broad geographic exposure. Finance has long focused on these types of issues, but they are outside the purview of the traditional legal field. Indeed, financial firms have significant experience dealing with artificial regulatory barriers to finance from usury regulations to the restrictions on paying any interest at all in many Middle Eastern nations.
Finance is focused on objective value, not morality.
The creation of regulation around litigation finance brings up an important distinction between finance and the law. While the legal field is set up around specific concepts of morality and right and wrong, finance has no such subjective concepts. The bounds in finance are driven by law; report earnings using a distortion of GAAP (Generally Accepted Account Principles – the legal standard for earnings reports by the SEC), and you are in violation of the law.
Finance, like economics or accounting, is not a morality play.
The law is very much about morality. And that sense of morality – the idea that we have too many lawsuits, or that the law helps to hold the powerful in check, is often impressed onto matters of litigation finance. That’s not sustainable in the long run. Effective finance of litigation is not about funding righteous matters or heling to correct in justices. Instead financing legal matters simply requires a cold and hardnosed assessment of risk and the return necessary to make the average investment profitable.
The concept of litigation finance divorced from morality has taken a while to set in. Initially many litigation finance firms were run by attorneys, and those attorneys saw finance as a way to carry out the ethos of the law. That is starting to shift as more and more individuals with finance backgrounds move into the space. Software providers like Mighty are already helping to provide objective investment decisions to funders in the space, and such software is fast becoming standard for investment management and reporting in the field.
None of this is to say that the legal field does not have an important role to play in litigation finance; that would be an absurd proposition. But specialization does play an important role in developing expertise, and the reality is that litigation finance as a field needs to draw on the lessons of finance to continue its meteoric rise.