Given the volatility experienced by institutional and high-net worth investors alike in the stock market, many are clamoring for alternative investment ideas that will optimize their portfolios on a risk-adjusted basis.
And there are certainly no shortage of asset classes- from collectibles and commodities to farmland and water rights.
But there’s another profitable, yet controversial, addition to the group- litigation financing.
What is Litigation Financing?
Litigation financing (also known as litigation funding or third party funding) is the process where a third party provides capital for legal costs to one side in a lawsuit in exchange for a return from a successful settlement. Funding is usually reserved for plaintiff firms but can also be used to fund the defense side. Litigation finance companies operate on a non-recourse basis, so if the result of the case is unfavorable, the financing company loses the entire ‘investment’.1 Given the inherent risks involved, it behooves the financiers to prescreen cases it believes are winnable. Compensation arrangements vary but many litigation firms receive a cut of the recovered settlement, often between 25% and 33%.
Advocates of litigation funding call it a way for the little guy to challenge, large deep-pocketed corporations who can often grind down resource challenged adversaries. Critics call it unsavory and contend litigation funding will increase frivolous lawsuits, increasing costs for many companies.
The allowance of third party investments in lawsuits is relatively new in the United States, where bar associations have historically forbade, citing conflicts of interest. There are 30 jurisdictions that allow for litigation finance (including New York and Florida), 13 that strictly prohibit it (including Washington D.C.) while the rest have no relevant case law for or against it.2 There are generally two types of litigation funding-consumer and commercial.
A popular area for third party financing of consumer lawsuits has been personal injury and especially divorce cases. Financers typically fund the plaintiff spouse to even the playing field against the other, deeper-pocketed spouse who would often drag out costly legal proceedings, forcing the plaintiff to concede due to lack of resources. Today, these battles are sometimes backed by commercial funding from investors.
One headline grabbing example of this is in the divorce case between former hedge fund magnate Steven Cohen and his first wife, Patricia Cohen. According to Forbes, Mr. Cohen is a billionaire, so he presumably has the financial resources to outlast his ex-wife in legal fees. Ms. Cohen turned to litigation funding and has reportedly obtained financial backing by Balance Point Funding and Asta Funding, who agree to share in the proceeds of successful legal recoveries for their clients.3
While consumer lawsuit financing has been around for decades (divorces, personal injury), larger scale commercial litigation funding is relatively new. Commercial practice can be traced back to 2006 with the creation of the Credit Suisse Litigation Risk Strategies unit.4 Commercial litigation funding typically works like this, a plaintiff (often a large corporation or an attorney) has a case it believes it can win but doesn’t possess, or want to commit, the financial resources to take on the case. The litigation funding company advances capital to the plaintiff for legal expenses and general corporate purposes and if they win the case, the financing company gets a cut of the settlement.
Corporate America is littered with litigation so there’s no shortage of cases to back. But plaintiff companies don’t always want to commit the resources necessary to win long, dragged out court battles. Instead, they want to focus on their core businesses that earn revenues.
Depending on the level of flexibility, litigation funders can invest capital early on in the process or come in later in the case. This results in different costs of capital for the funding company and different returns from the settlement.
For example, it’s more expensive to begin financing from the earlier stages and throughout the case, so they may demand more of a venture or equity-style return, based on a percentage of a successful settlement. Sometimes, litigation firms put up all the capital from the start, resulting in essentially a no-lose proposition for the plaintiff firm. Or the firm may come in late to the case and provide funding more along the lines of a high-interest loan, not contingent upon the outcome.
Litigation Funding as an Investment
Litigation financing is an alternative investment that’s generally not economically linked-lawsuits appear in both good economic times and bad. There are two ways to invest in litigation funding-direct investing or through an investment fund.
A direct investment in a particular case is very high risk. Institutional investors, typically private equity funds, provide the capital used by the litigation funders for this type of investment. Direct litigation financing is very illiquid, sometimes tying up capital for three years or more, so it’s probably not appropriate for individuals or even some hedge funds because of some liquidity needs in meeting redemptions.5
Most investors, institutional and individuals alike, choose to invest in private funds consisting of several different cases. Accredited individual investors, family offices, private equity and hedge funds have participated in such investments.
The Wall Street Journal reports that Emanuel Friedman’s hedge fund, EJF Capital, is ready to lend hundreds of millions of dollars to law firms in pursuit of injury class actions suits, targeting cases including transvaginal mesh complications and a schizophrenia drug.6
The nation’s largest commercial litigation finance firm is Gerchen Keller Capital LLC with over $1.4 billion in assets under management.7 Speaking to the growth and profitability of the industry, the average size of their investments in a new case was roughly $10.7 million last year up from $3.7 million in just 2013.8
The nation’s largest commercial litigation finance firm is Gerchen Keller Capital LLC with over $1.4 billion in assets under management.7
Other noteworthy players in litigation financing include Burford Capital Ltd., IMF Bentham, Juris Capital, BBL Churchill and Juridica Investments. Burford has reportedly formed a joint venture with law firm Hauseld LLP to bring claims against German car manufacturer Volkswagen amidst their emissions testing debacle.9 A 2015 Bloomberg article reported that Burford Capital had made a total of 32 investments resulting in $209 million in gross recoveries and $78 million net of invested capital.10
The returns from litigation funding are high, often outperforming equity indexes. From 2006-2011, cash-on-cash returns from litigation financing funds were 15%-18% annually.11 Some report even higher returns, like Juris Capital who reported returns exceeding 25% annually on a portfolio basis.12 IMF Bentham boasts an astounding 65% historical annual return on investment, blowing away most other investments.13
This is mainly an asset class for institutions and sophisticated investors. But mom and pops can also invest indirectly in this type of business and potentially benefit from their success. The aforementioned Asta Funding is a Nasdaq-listed stock and Juridica is a closed-end fund tradable on the London Stock Exchange. Of course, these examples are for informational purposes only and any investor should consult with their financial advisor to determine suitability for their individual situation.
Risks for Litigation Financing
But there are risks to litigation financing. Sometimes the seemingly symbiotic relationship between litigation funders and law firms can get messy when they don’t win the case. The American Lawyer reported that last December, U.K.-based law firm Clifford Chance agreed to pay a confidential settlement to an unnamed hedge fund that had helped fund an unsuccessful case.14
The growth in litigation financing has also caught the attention of the U.S. Chamber of Commerce. It has been classified as “a sophisticated scheme for gambling on litigation” by Lisa Rickard, president of the chamber’s Institute for Legal Reform.15 Still, a March 2016 legal update from law firm Dechert LLP summarized a March 9th decision by a Delaware Superior Court, permitting the use of litigation financing.16 The court denied a motion to dismiss an action based on the claim the financing constituted ‘unlawful champerty and maintenance’. The court ruled that Burford did not itself maintain the action on its own or any control over the claim.17
Barring any groundbreaking ruling, we would expect the litigation financing area to continue. And with the investment returns in litigation financing being what they are, competition is sure to increase. The takeaway is that alternative investment classes continue to thrive in a low interest rate environment and that a career in finance can come from very different paths.