A week ago, I had the pleasure of moderating an expert panel at the LF Dealmakers Forum in NYC. The panel was tasked with answering the “tough questions” in litigation finance, and we entertained inquiries from all of the industry stakeholders – investors, funders, and law firms seeking financing. For those who couldn’t attend the conference (which was sold out), I’ve briefly summarized the answers our panel gave to five of the most pressing questions raised. I’ve also listed a provocative sixth question for extra credit.
Our three panelists were: Aaron Katz, a 13-year veteran of the industry who now helps lead Parabellum Capital; David Jang, who is with Bardin Hill Investment Partners and has worked at several of the leading hedge funds and law firms; and Michael Kelley, who is one of the premier advisors and transactional attorneys in litigation finance, now with the Parker Poe firm.
As I mentioned in introducing the panel, the answers to these questions are naturally messy -- as by definition these hard questions defy easy answers. That said, as our industry matures, we need to struggle with these questions – even if the answers are incomplete, or perhaps not necessarily the answers we’d like to hear.
1. How big is the litigation finance market?
This is the question most frequently asked by investors – and the question most difficult to answer. Difficult because most funders are private and don’t report the number and size of their investments. And difficult because the market is fluid, with hundreds of millions of new dollars entering each year and market penetration continuing to grow among those taking up litigation finance. Our panel concerned itself with the traditional commercial litigation finance market in the U.S. We started by recalling that a panelist earlier in the day had suggested that there are $4 billion in investment opportunities currently available on the U.S. market – a figure for which we were generally skeptical. Our panel eschewed the common technique of top-down market sizing based on a percentage of the total litigation spend in the U.S. We also set aside survey data as often skewed by self-selection among respondents. Instead, looking at the number of deals done by public companies, and based on our own industry knowledge, we estimated that the major pure play commercial funders are typically closing 12-20 deals a year in the U.S., at a blended investment size of $9 million (blended between single case financing and portfolios financing). This would mean major funders are committing an average of $100-180 million a year. Assuming a rough aggregate of 10 major funders in the U.S., this would mean a market size of between $1 billion and 1.8 billion a year. While not precise, the panel agreed this range was directionally on target. Significantly, this figure does not include mass tort portfolios, which can reach $50 million and more apiece, but which are usually financed on an interest rate basis and often with recourse.
2. What effect will increased competition have on pricing for counterparties and returns for investors?
We agreed that pricing for litigation finance remains generally stable, despite the increased capital entering the market. We surmised that this is the result of the 20-30% IRR returns that funders have pledge to their investors – in short, such funders can’t lower their prices and still deliver the required results. We also agreed that 20-30% IRRs appear to be a reasonable target for funders in the current environment – as opposed to the stratospheric figures reported by some of the publicly listed entities. We also noted that it is still relatively
early days for the industry, and that the difficulty of finding and securing quality investments will continue as the number of market participants increases. This is especially true as more multi-strategy hedge funds expand their distressed portfolios to include large single cases and portfolios. (It was noted that competition for smaller and medium size investments will likely not be of interest to these hedge funds.) Interestingly, there was also support for the notion that should a fund be raised that promised investors a lower, but still enticing IRR (such as 15%), that this could lower market pricing for some sorts of funding. While obviously lowering returns for investors, the upside of such a development would be an expanded market of those willing to seek financing.
3. Does the industry need to form a trade association or other organization to deal with calls for regulation and/or to increase the trust that counterparties place in funders?
On both days of the conference, funders bemoaned the prospect of industry regulation. The particular concern was regulation that didn’t understand the specifics of commercial litigation finance, and thus would burden the industry with inappropriate rules or measures. (One example was last year’s New York City Bar Association opinion on fee sharing, which was generally deemed to be well off-the-mark.) The conference also showcased a report on the considerable state-by-state legislative “reform” efforts currently underway – often targeting the consumer side of litigation finance, but threatening to spill over into the commercial practice. (Hat-tip, Eric Schuller.) As a result, there was consensus on the panel – and even more vocally in the audience – that the industry needs to find its voice through some sort of trade association. Such an organization could not only deflect inappropriate regulations, but would bring a level of trust to the market by ensuring a guarantee of proper conduct by members (akin to the U.K.’s self-regulating body, which addresses issues of control, capital adequacy, and dispute resolution. See here.) The question left hanging, of course, is which funder – or collection of funders, more likely – will step up to this task?
4. What can be done to make the process of obtaining financing – specifically the often lengthy underwriting process – more efficient for counterparties?
Obtaining finance can be very difficult, and the path to a successful deal is typically arduous. According to industry stats, some 90%+ of those seeking financing from a given funder fail. What can be done? The panel had a few thoughts. First, it was suggested that the use of an experience broker can be enormously valuable. (This wasn’t my comment, but I am more than happy to endorse the idea as it has the virtue of truth). Second, the use of a break fees, as an alternative to periods of exclusivity for due diligence – during which funders effectively “own” their counterparties and can alter deal terms – is also helpful. (This one was, in fact, my contribution.) Third, counterparties would do well to understand that some funders have
a dual approval process – in short, these funders require that their deals first be approved by their own staff, and then subsequently approved by the funder’s source of capital (i.e., global PE shop, hedge fund, etc.). These capital sources are often removed from the underwriting process, and can thus delay and occasionally misunderstand an investment. Fourth, in fairness, it was pointed out that the often complained of “delay” in underwriting is actually the result of the counterparty’s failure to respond to requests for information in a timely fashion. Fair point, indeed (see need for broker above).
5. Will the threat of public disclosure of funding deter a funder from making an otherwise valuable investment? And – as a related matter - has the industry done enough to educate jurists on the process and value of funding?
Over the past few years, the “ethics” debate in litigation finance has move from an existential threat (should funding be allowed?) to a question of transparency (should funding be disclosed?). Our panel started by noting that disclosure comes in many forms (fact of funding? name of funder? amount of funding? funding terms? funding agreement?) and contexts (in camera? to the opposing party? to the jury? to the public?). All of this said, when pressed, the panelists declared that while disclosure is an inconvenience – most notably as it may opening the door to typically fruitless but expensive satellite litigation – it would not deter them from making an otherwise valuable investment. It was noted that several years ago the funder Gerchen Keller went the “full monty” in the now well-known MagCorp investment (due to the requirements of bankruptcy court procedure). An excellent question from the audience raised a related question: what, if anything, is the industry doing to educate jurists on the basics of funding? The answer appears to be – despite occasional efforts, especially in the MDL space – perhaps not enough.
6. EXTRA CREDIT. Two well-known funders have been in the news recently. What do Burford’s and Vannin’s recent difficulties mean for the market?
Our audience was clearly primed for a discussion of recent funders in the headlines, and in response our panel gamely provided their thoughts on the topic. Regarding Burford’s recent brouhaha, it was quickly pointed out that the issues raised in Muddy Water’s attack on the firm have little or nothing to do with litigation finance – rather they involve governance and accounting issues, which are actively being addressed by Burford. Aside from increasing investors' scrutiny of some accounting practices, the panel had seen little impact on the funding industry as a whole. Regarding Vannin’s recent acquisition by Fortress Investment Group, the panel agreed that this situation is far more relevant to the business of funding. After noting the lack of public insight into the situation, the panel nevertheless suggested that Vannin’s inability to remain independent may become Exhibit A for the notion that litigation finance is not all sweetness and light (as is sometime suggested), but actually rather difficult to get right. To succeed, funders need a sound economic structure (any debt ratios should be watched carefully), good process (avoid delay), excellent underwriting (to state the obvious) – and proper pricing (which is necessary even when cases are winners). The panel generally anticipated a continued shake out in the industry as portfolios ripen and competition increases – all of which is part and parcel of a growing industry.
All in all, a very productive and insightful discussion was had – which continued into the cocktail hour which immediately followed the panel.
Many thanks to my three outstanding panelists (and Wendy Chou and the folks at LF Dealmakers). If you’d like to continue a discussion of any of the questions above, feel free to reach out to me directly at andrew.langhoff@redbridgesadvisors.com.
- Andrew Langhoff, September 25, 2019
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