Litigation Finance: A recession-proof asset class

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Investors are facing a challenging market environment. High commodity prices, supply chain disruptions, as well as the loss of credibility of central banks after their sluggish reactions to inflation spikes, mean the inflationary pressures will not fade away quickly. The tightening cycle might be interrupted temporarily due to recession concerns, but it is unlikely to end unless we have a sharp recession.

In this uncertain market situation, traditional portfolios will remain volatile unless investors diversify into alternative asset classes. Commodities and some hedge fund strategies, such as managed futures, might provide an interesting hedge against further inflationary pressures and tail risks. Even so, these asset classes are highly volatile and, therefore, negatively affect the risk budget of investors.

One of the most attractive alternative investments is litigation finance, which is a fast-growing asset class that is still widely overlooked by investors. This niche area has proven to be recession-proof and offers truly uncorrelated returns, which makes it particularly interesting in the current economic environment.

Litigation finance generally means that a third party—a litigation funding firm—provides financial resources to support a claimant in a legal dispute, which enables litigation or arbitration cases to proceed. In return, if the case is won, the litigation funding firm receives an agreed share of the proceeds of the claim. Litigation finance offers the prospect of higher returns than traditional asset classes and returns that are truly uncorrelated to equity markets, which is particularly attractive during times of financial crisis, market downturn and volatility.

Litigation finance has its roots in antiquity. Historians cite the example of Apollodorus, a wealthy Athenian banker’s son, who purchased an interest in a current claim in ancient Greece. Nevertheless, until relatively recently, funding or investing in litigation was commonly known as the legal doctrine of “Champerty”, which was long seen as an unlawful taboo. This is mainly because ancient legal systems were susceptible to abuse by men of status and influence. In modern times, this is clearly no longer the case, especially in developed countries with strong rules of law. In fact, if a claimant with a meritorious claim lacks the financial resources to seek justice and thus law becomes a luxury, it is probably a greater injustice for society. Litigation finance, in its modern form, originated in Australia in the mid-1990s, quickly spreading to the UK, the US and other jurisdictions. However, the legal and regulatory framework remained relatively unclear until very recently. In the UK, for example, there has been widespread recognition that litigation finance promotes access to justice by enabling litigants to manage their exposure to costs, when the Jackson reforms of English commercial litigation came into force on 1 April 2013.

The benefits of litigation finance are manifold. It enables smaller companies and individuals to get access to higher quality counsel against oftentimes powerful counterparties. It also helps to reduce the pressure to settle prematurely, free up working capital during litigation, and de-risk positions with another shareholder. At the same time, the economics for funders are highly attractive. In the UK, for example, litigation funding firms typically find cases where potential compensation is roughly 10 times the legal costs. On average, there is a probability of success of almost exactly 50%, and funders tend to receive around 25% to 35% of the potential benefit plus recovery of the legal costs if the case is won. For example, if a funder finances 10 cases, with a cost of GBP 100’000 each (so a total investment of 1’000’000), a reasonable scenario would be that he recovers between 1’750’000 and 2’250’000.

Assuming a duration of 2 to 4 years, the annual expected gross return of such an investment vehicle would be between 15% and 50%.

Despite the attractive returns, litigation finance remains overlooked by many investors, given the investment vehicles’ relatively small size and high complexity. There is no central database on the litigation market, but there are estimates that value its size between USD 50 billion and USD 100 billion, with an annual growth rate of around 40% over the last 10 years. In a 2019 survey of more than 500 senior finance professionals from US, UK and Canadian companies conducted by the litigation finance firm Burford Capital, three-quarters report their company has increased their use of litigation finance services in the past two years. This, together with rising investors’ appetite indicates that the litigation finance boom is far from over. While demand is growing fast, many specialized litigation funding firms should be well-positioned to take advantage of the strong returns.

There are several factors that investors need to take into account when selecting the best investment vehicle to answer specific opportunities. Jurisdiction and the legal framework are very important. The US market tends to be overcrowded with more regulatory challenges, which makes the risk/return less attractive compared to the UK, for example. In addition, investors should focus on opportunities where they get enough diversification through a large number of claims. Investing in a few cases can be risky due to the binary outcome of returns.

Statistic studies teach us that only portfolios with a sufficiently large number of cases can lead to a normal distribution of return, eliminating the binary risk. Litigation funding firms that focus on smaller claims tend to be more diversified. Finally, investors should focus on specialized Litigation funding firms that offer privileged access to a large number of valid legal cases with low credit risks, for example, claims against large financial institutions or quasi-government entities. Oftentimes, winning the case is easy, but collecting the benefits can be hard to achieve if the counterparty is in financial distress.

Katch focuses on niche areas that offer attractive yields with strong downside protection, for example by providing loans to law firms. The loans are typically protected by legal claims, the counterparties’ balance sheet, the After The Event (ATE) Insurance and other guarantees, counting on the group’s strong experience in senior-secured lending and loan structuring. In addition, the group’s focus is on a large number of small claims with strong case law that typically settle in a short period of time.

In uncertain economic times, it is important that investors can count on trusted partners to broaden their reach to invest in new alternatives with specific investment vehicles. Litigation finance offers truly uncorrelated returns that improve risk-adjusted returns of traditional portfolios considerably, providing a new source of diversification.

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