Litigation Finance: A Silver Bullet?
Enigmatic, murky, and even daunting are some words that we, finance professionals, may immediately associate with the global $713B a year legal services market.
Litigation, which is the process of taking legal action, knows no boundaries. It is like an expanding universe, with themes covering intellectual property theft, tax disputes, and fraud, while covering different geographic scopes, claim sizes, and stages. No legal case is the same.
Largely lurking in the dark, Litigation Finance, however, is evolving and marching towards the limelight as an emerging asset class to service the legal industry.
In the United States, unbeknownst to most, litigation finance started to gain traction for investors during the 2007-2008 Global Financial Crisis. Nevertheless, despite its significant growth over recent years, litigation finance today remains a small and niche asset that has yet to be discovered by many.
Litigation Finance, which is also known as alternative litigation financing or legal funding, at its core, is purely all about risk distribution for the legal team and clients seeking this arrangement. To put it simply, litigation finance is a type of transaction in which a third party provides capital to a law firm or plaintiff for a legal claim in exchange for monetary interests in the outcome of the case. Thus, clients do not need to carry the monetary risk of funding their own cases, especially for cases that require an exorbitant amount of capital to undertake.
The edge of this unique asset class is its uncorrelated nature to the broad financial markets. In these days of high inflation, rising rates, market downturns, and high volatility, this rare asset class could prove precious for an investor’s portfolio.
Historically, the act of financing another person’s litigation costs was often considered illegal in many jurisdictions. The reason was that such financial arrangements had long been considered crimes in courtrooms that applied the esoteric concepts of maintenance and champerty.
Think of maintenance as the action taken by a third party who is funding a legal case in which it has no personal connection and is also seeking no return. Champerty is simply maintenance, but in this case, the third party is seeking a return. While these principles were largely intended to preserve the independence and integrity of the legal proceedings, certain jurisdictions began changing their perspective in seeing the potential benefits that litigation finance may create.
The United Kingdom, for example, first allowed an early form of Litigation Finance when it passed the 1967 Criminal Law Act. This Act raised the suitability of Litigation Finance only for certain situations, but its applicability remained a grey area for decades. It was not until the 1990’s when the UK experienced a wave of judicial reforms seeking to abolish Maintenance and Champerty as crimes. Laws were then enacted to spare the legal costs that many seeking justice could simply not afford while also enabling litigants to earn a fee for success. In essence, it became a tool to level the field.
Australia also experienced a number of developments in the 1990s that placed the country in pole position for innovation in the Litigation Finance space. Similar to the UK, such developments included abolishing bans on champerty and maintenance, which to the benefit of Litigation Finance, resulted in ambiguity around its use. The Australian legalization of domestic class action lawsuits also buoyed the need for Litigation Finance. Perhaps the most important development happened towards the end of the decade when Australia passed legislation allowing insolvency practitioners to seek third-party funding. This meant that companies undergoing bankruptcy who were unable to finance a legal case by themselves could seek financial assistance from a third party to pursue their preexisting claims.
In the United States, it was the 2007-2008 Global Financial Crisis that gave rise to Litigation Finance. This was when this new asset class experienced lift-off. In the subsequent years, it was the United States that became the largest market, with the UK trotting behind. As of the spring of 2022, less than 5% of the US litigation market, however, was funded by external investors.
Further growth in the Litigation Finance industry is anticipated to rise 6.7% thru 2026, raking in an estimated $20B per year. The image below could shed some light on the potential of this asset class:
Global Litigation Finance Markets Are Still Immature
How it Works
Legal battles are often settled by way of a court judgment or, in many cases, out-of-court arbitration. Litigation finance covers both litigation, as its name suggests, and arbitration.
In its most basic form, Litigation Finance essentially is a transaction that occurs when a third party identifies a legal claim as a potential winner and decides to commit capital to cover the costs the claimant is seeking to cover. As we all know, legal fees are quite steep, and those seeking justice are sometimes unable to self-fund these. In return, the party funding the case seeks a return on invested capital, typically 2X or 3X. The caveat, as there is always, is that this repayment is contingent on a successful outcome. The funder may lose all of the invested capital if the case turns out to be a loser. For that reason, funders typically seek to diversify risks across a portfolio of cases, where losses can be offset by the gains of winners.
It is important to note that these financing arrangements are individually negotiated amongst the parties. The parties typically include the end client, the law firm, and the funder. After all, no case is the same, and the risks and odds of success differ widely. Experienced funders, though, with thousands of investments under their belts, may have developed analytics that allows them to select the best deals.
In the case of a successful outcome, investors will have priority rights to distributions. It is typical that the financier’s interests are the first to be paid out. As in many other investments, Litigation Finance is subject to Waterfall provisions. Often, it is these provisions, which are defined in term sheets, that may make one funder more attractive than another. Let’s walk through an example.
First, the investment amount should be zeroed in. In real life, however, the total investment amount could be subject to change. For this analysis, as an example, assume that the following data is correct and the funder is responsible for 100% of the total investment amount:
The end client may incur some costs but will typically seek the funder to cover the bulk of it or, in some cases, the entire sum. Terms will tend to vary case by case. For our analysis, let’s assume the following return structure:
Term sheets differ widely, but it may be typical for the funder to be the first in line to recoup its deployed capital plus a minimum acceptable return pursuant to the funding agreement. If the law firm made any advances, then this firm will receive distributions pro rata. The end client will then receive what is left of the settlement. Keep in mind, though, that cases can settle well below everyone’s expectations, and sometimes some parties may not be able to play catch up.
Assuming the settlement in our example is $3,000,000.00, the funder will receive the first money out, which in this case was $750,000.00. Once the funder recovers its share of the settlement, the litigation firm, which is typically paid in 50% at this point, is next in line for distributions, so on and so forth. In this oversimplified example, the funder made a profitable investment netting a MOIC of 2.41X but that is not always the case. To be clear, please note that waterfalls can be structured in many ways and some results are less favorable than others.
The market for this industry is composed of three segments. There is the commercial, which alludes to corporations seeking legal action, and perhaps is the most exciting category for investors. Mass tort is another category, which is essentially your typical class action lawsuit. The third is personal litigation, which for example, could be individuals seeking compensation for injuries.
Each category has different durations, risks, and returns, which are connected to the different characteristics of each legal claim. Portfolio engineering can take many shapes as these funders seek to satisfy distinct investor appetites. Commercial litigation is typically the heavyweight category; therefore, the rest of this report will be focused on it.
U.S. Commercial Litigation Finance Industry
Industry Size & Recent Growth
In the U.S., litigation funders can be divided into three types, dedicated funders, multi-strategy funders, and ad hoc funders.
Dedicated Funders are fully specialized in litigation finance and account for most of the deals and capital available in the industry. Multi-strategy funders are usually hedge funds that invest in multiple asset classes and have developed their own litigation finance desk. Ad hoc funders include entities like family offices that have no specific litigation finance desk but may opt to participate in deals, most will not publicize their participation.
In the U.S., the average portfolio deal size in 2021 was estimated to be $8.5m. 59% of the commitments in 2021 were allocated to portfolio deals. Patent Litigation has been reported to be attracting a considerable amount of attention, absorbing 29% of the total commitments in 2021. Most importantly for the industry is the anticipated embrace by Big Law, the largest 200 US law firms, with 41% of the total commitments being allocated to Big Law in 2021. This is a significant 46% increase from 2020.
Although performance data of this unique class is not easy to find, some public data strongly suggest IRRs can exceed 20%, with no systematic risk whatsoever. In these golden days of high inflation, rising rates, market downturns, and high volatility, this rare asset class could prove precious for an investor’s portfolio.
As we all know, settling lawsuits can take time. Downsides, therefore, include significant illiquidity and elevated risk. After all, the cases these managers invest in must be winners to rake in returns. However, the investment period is typically shorter relative to the typical PE Buyout funds and coupled with attractive returns and an uncorrelated nature to the broader financial markets, Litigation Finance can prove to be an appealing investment opportunity.
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- The Hedge Fund Journal, June 2013. “The Emerging Market for Litigation Funding”
- The Journal of Alternative Investments, Spring 2022. “Litigation Finance Investing: Alternative Investment Returns in the Presence of Information Asymmetry”
- The Practice Harvard Law School. “A Brief History of Litigation Finance”
- Alts.co, May 2022. “Investing in Litigation Finance”
- Business Insider, May 2021. “The bankers, brokers, and big money transforming litigation finance from a lawyer’s hustle to a multibillion-dollar asset class”
- Validity. “What’s in a Term Sheet: Understanding Waterfalls”
- Westfleet Advisors, March 2022. “2021 Litigation Finance Market Report”
- Financier Worldwide, September 2021. “Private equity and litigation finance: a maturing market”