Litigation Finance: The attractiveness of truly uncorrelated returns
So far, 2020 has been an extremely challenging year for investors. It has been characterized by high levels of volatility and uncertainties. Many investors, financial advisors and fund managers were caught wrongfooted twice. First, stock market were hit by the sudden economic paralysis caused by the Covid-19 epidemic. Second, few investors expected an unprecedented monetary and fiscal stimulus that would cause such a sharp rebound, particularly in large-cap technology stocks. After the rebound, investors are facing a dilemma of high equity valuations and extremely low returns in traditional fixed income portfolios. Clearly, there are still plenty of economic and political uncertainties around the globe, and it is fair to assume that stock markets will remain extremely volatile. What is more, investors and analysts will continue to struggle to anticipate future corrections.
Therefore, investors would be well-advised to review their asset allocation. Traditional asset classes like equities and bonds appear overvalued with limited upside potential and low yields. At the same time, there are plenty of opportunities in private markets that have not been inflated by monetary stimulus and that offer high, uncorrelated. One of the most attractive areas is litigation finance, which is a fast-growing asset class that is still widely overlooked by investors. Litigation finance generally means that a third party 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 funder receives an agreed share of the proceeds of the claim. Litigation funding 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 funding 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 rule 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 a society. Litigation funding, 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 funding 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 funding 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, to free up working capital during litigation and to de-risk positions with another shareholder. At the same time, the economics for funders are highly attractive. In the UK, for example, litigation funders 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 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 would be between 15% and 50%.
Despite the attractive returns, the litigation market remains overlooked by many investors, given its still 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 fund managers should be well-positioned to take advantage of the strong returns.
There are a number of factors that investors need to take into account when selecting the best opportunities. Jurisdiction and the legal framework are very important. The US market tends 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 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 funds that focus on smaller claims tend to be more diversified. Finally, investors should focus on specialized managers 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, wining the case is easy, but colleting the benefits can be hard to achieve if the counterparty is in financial distress.
In uncertain economic times, it is important that investors can count on trusted partners to broaden their reach to invest in new alternatives. Litigation finance offers truly uncorrelated returns that improve risk-adjusted returns of traditional portfolios considerably, providing a new source of diversification.