The following is an article contributed by Ed Truant, founder of Slingshot Capital,
Executive Summary
- Gross v. Net return dispersion needs to be considered by investors & fund managers
- While present in many private equity classes, managers that can limit dispersion can attract more capital for a given return profile
- Wide dispersion prevents many institutional investors from considering investing in the asset class
Slingshot Insights:
- Fund performance reporting can help address the appearance of wide dispersion in gross to net returns
- The valuation of litigation assets is very difficult due to a combination of idiosyncratic case risk and binary outcome risk
- Fund managers need to ensure that they are obtaining returns on their undrawn capital to reflect the opportunity cost of undrawn capital
In my recent set of articles, I discussed the concept of managing duration risk as this is often a topic that comes up in conversation with institutional investors. The other topic that invariably comes up in discussions is the common case of wide dispersion between gross and net returns in commercial litigation finance (this is not typically an issue within consumer litigation finance). It’s a problem that is somewhat unavoidable and somewhat explainable!
I have been privy to fund manager returns that start off with cases that have gross internal rates of return in the hundreds to thousands of percent range that ultimately turn into negative IRRs at the fund level (albeit in the first few years of the fund) – hence the gross v. net return dispersion dilemma. The problem with this dynamic for fund managers is that it undermines the entire investment thesis because it leaves the investor wondering how such a high performing strategy at the case level ultimately yields low net returns at the fund level as the same does not necessarily hold true for many other alternative asset classes. In turn, this dissuades investors from investing in the asset class because the return profile does not match the risk profile or, in other words, they can either get better returns for the same risk profile or commensurate returns with a lower risk profile, so why invest in commercial litigation finance?
Let’s start with the basics. The term ‘gross’ typically refers to the raw return of a given investment or portfolio of investments. Simply, this is the rate of return that was produced on the realization of the investment (i.e. money received) for a given dollar of investment (i.e. money invested or drawn), whether expressed as a Multiple of Invested Capital (“MOIC”) or as an Internal Rate of Return (“IRR”) before considering any of the costs of the manager (management fees, expenses or carried interest) or the investment vehicle (administrative costs for legal, audit and reporting) (collectively, the “Costs”). It is very common for commercial litigation finance managers to refer to the gross returns of their realized cases and these, sometimes sexy, returns have been used to generate interest in the asset class and the manager, but it may not all be as it seems.
Conversely, most other private equity asset classes (Leveraged Buy Out (“LBO”), Venture Capital (“VC”), Private Credit, Real Estate, etc.) refer to the valuation of their entire portfolio when they refer to gross returns. The problem with referring to returns that stem from only the realized portion of the portfolio in commercial litigation finance is that it is often the case that the early cases produce strong IRRs and few losses which means that they represent an overly optimistic view relative to the reality of the entire portfolio. Investors can expect that a typical commercial litigation finance fund will ultimately have a few losses (20-40%) and a few cases with longer durations, depending on the nature of its strategy, both of which have a significant negative impact on the portfolio’s overall return profile.
The challenge that litigation finance has when valuing its entire portfolio is that it is extreme difficulty to establish credible valuations (so called ‘fair value’ or ‘mark-to-market’ valuations) for the unrealized portion of their portfolio. Other private equity asset classes have the benefit of being able to point to well defined and accepted valuation methodologies and metrics (Enterprise Value (EV) / Earnings Before Interest Taxes & Amortization (EBITA) in the case of LBO and multiples of Annual Recurring Revenue (ARR) in the cases of ‘Software-as-a-Service” VC investments). These well-defined and accepted metrics allow managers to publish credible fair value estimates on a quarterly basis and, while not perfect, the investor can then adjust the valuations based on their perspective on market valuations as the industry metrics are fairly transparent and available. The same cannot be said for litigation finance investments as each case has its own idiosyncratic characteristics and risks and each dispute has its own unique resolution, which are two variables that I would argue are virtually impossible to value with any accuracy. I will agree though that it may be possible to come up with a reasonable estimate of the value of a portfolio of investments but to estimate a single case with reasonable accuracy is nearly impossible. Further, any portfolio estimate would only be possible if the portfolio was relatively diversified and had a number of equal weighted investments which is also nearly impossible to create due to single case deployment risk. Portfolios of cross-collateralized law firm portfolios or corporate portfolios would be good candidates for this approach.
The term ‘net’ typically refers to the returns that the investors in the fund will receive after taking into consideration all of the Costs involved in producing those returns which applies equally to MOIC and IRR. While some investors like to focus on MOIC as it gives them a sense of the multiplier effect of the investment, I think a better measure in this asset class is to focus on IRR as duration risk is real in this asset class and this is a metric on which most investors get measured and compensated.
The other critically important concept to understand is what has been termed the “J-Curve” effect as this can have a significant impact in commercial litigation finance, especially in the early years of a fund. The J-Curve effect is a description of the tendency of net returns to first decline in the early years of an investment fund’s life when costs are high and valuation are relatively stagnant and then strongly produce returns (or so investors hope) as the fund matures and when value creation within the portfolio is at its peak. When you plot time and returns on a chart, the curve resembles a “J”, hence the term. The reason this happens is that in the early days of a fund’s life, there is money being spent to originate opportunities and make investments, including ‘broken deal’ costs associated with the failure to secure investments after investing some diligence capital to pursue the opportunity. In addition, the investments that have been made will take some time to start producing a return that more than compensates for the costs incurred. In short, the fund produces a negative return in its early years which brings the return curve into negative territory before it rebounds into positive territory as the fund matures.
However, keep in mind that the J-Curve is and should be a temporary phenomenon the effect of which will dissipate with time as the portfolio produces returns and so it tends to explain large differences between gross and net returns in the early years of the fund. If you don’t have the benefit of fair valuing your portfolio, the J-curve effect will likely last longer which is the case in litigation finance. If the J-Curve is still having a significant negative impact after three to four years then there are likely larger issues at play and probably some unhappy investors.
What is different about Commercial Litigation Finance as regards Gross v. Net?
Double Deployment Risk & ‘Effective’ Management Fees
In most private equity asset classes, a ‘2/20’ fee model is fairly common, although it is increasingly under pressure. The “2” is a reference to the management fee of two-percent that gets charged on committed capital and the “20” is a reference to the twenty-percent carried interest that accrues to the General Partner, typically once the investors’ principal and hurdle have been achieved. In most private equity asset classes, there is a lag between when the commitment is made by the investor and when the fund manager invests the committed capital during the investment period (usually two to three years) and this similarly holds true for commercial litigation finance.
However, in commercial litigation finance there is a second deployment risk in that the commitments fund managers make to cases or portfolios of cases may not ultimately get drawn which means that if the manager is not able to recycle and redeploy those same committed (but undrawn) dollars, then the effective cost of management fees will be higher than what is found in other private equity funds, which in turn represents a larger drag on returns and increases the gap between gross and net returns. Accordingly, fund managers can find themselves in a position where the overall costs of a fund that was designed to deploy say $100 million in fact only deploys say $67 million which then distorts the effective management fee cost. For example, the 2% management fee on $100 million commitment becomes a 3% management fee on a fund that only deployed $67 million, which negatively impact returns and increases the gross to net return differential.
For this reason, fund managers need to start obtaining a return on any unused capital commitment in order to help bridge the gap between gross and net, but this can only be achieved by educating their customers that there is an opportunity cost of not utilizing their capital for which they must obtain a de minimis return. The fact that competing managers are not separately factoring in their cost of undrawn capital makes it difficult to achieve in a competitive environment, but my view is that the industry needs to reflect this cost separately in their funding agreements to drive home the message that their capital, whether drawn or not, comes with a cost. Similarly, the fund manager would be justified in obtaining a minimum level of overall economics in cases where the resolution happens much quicker than anyone expected and so there should be a floor to the economics a fund manager receives to compensate them for time spent on diligence and approvals.
The other fee related phenomenon I have been noticing that also helps to address the gross to net dispersion is having the management fees applied to deployed capital and not committed capital. Some fund managers are choosing, likely under pressure from their investors, to structure their management fees in part based on committed fund capital and in part based on either deployed capital or capital committed to underlying investments. This will help reduce the drag that management fees have on net returns, but it goes without saying this means less upfront economics to fund managers to run their funds and may only be relevant for larger fund managers.
Litigation Capital Management (“LCM”), has gone one step further and has eliminated management fees entirely in lieu of a larger carried interest. On the one hand, this illustrates to investors their confidence in their ability to generate returns in excess of their hurdle rate (and they have done so handily) and on the other hand they will get compensated handsomely for foregoing those early management fees. It is a very good example of strong alignment of interests between the investor and the manager and the investor generally doesn’t mind giving up more on the back-end because they feel that the manager has earned it by assuming risk on the front-end. This has the side benefit of not contributing to the J-Curve effect, although a higher carry will not help with the gross to net dispersion but then investors don’t mind when the dispersion is created through performance. Of course, having an entity (publicly listed in the case of LCM) with its own balance sheet to fund the operations is necessary to propose this type of economic structure.
Portfolio Valuation
In a typical LBO fund, the manager will make say 5 investments during a 3-year investment period and then exit those investments around the 5-year hold period for each investment. Assuming the investing happens evenly over the 3-year investment period, the first 3 years will see a high level of Costs. Yet, the portfolio will not have had enough time to produce sufficient returns to offset all of the costs despite the fact that LBO fund managers typically revalue their investments on a quarterly basis (with a possible exception of the first year) to reflect their estimations of the fair market value of their investments.
However, the same cannot be said for the portfolios of most litigation funders who typically hold their investments at the lesser of realizable value and cost unless they have received proceeds from a realization or recognized a write-off. The reason they do so is in part due to a lack of accepted valuation methodologies for litigation assets, which is in turn a reflection of the difficulty inherent in valuing a piece of litigation that has idiosyncratic risks and a quasi-binary outcome. While recent efforts have been made by Burford Capital in conjunction with the Securities and Exchange Commission to create an accepted valuation methodology under Accounting Standards Codification 820 for litigation assets, this is mainly for the purposes of publicly listed companies that utilize a certain set of reporting standards. One would think that if the standards are good enough for retail investors, they should be sufficient for investors in private litigation finance funds, but for right now it seems that investors are more comfortable holding investments at lesser of cost and market until there is either a realization that suggests otherwise (i.e. a receipt of proceeds, or a write-off).
So, what does this have to do with litigation finance returns? Well, if you don’t have the ability to mark your investments to fair market value (assuming the portfolio is increasing in value), the impact of all of those Costs that are incurred early in the fund’s life are going to more negatively impact the fund’s early returns unless the fund was lucky enough to have some significant realizations. Even with early litigation finance fund returns, while they can tend to create very strong IRRs, they typically are not meaningful to the overall fund because they tend not to draw a lot of capital and when your returns are predicated on a return on drawn capital, they end up being not meaningful in terms of their dollar impact on cashflows and hence not meaningful contributors to overall returns. In short, unless the fund had an investment that drew a large commitment and then had a realization shortly after the launch of the fund, the early realizations tend not to contribute strongly to offsetting the J-Curve effect and any early losses exacerbate the J-Curve effect.
As an example, if you raised a $100 million litigation finance fund and it had 2 investments that realized in the first year and each of those investments drew $1 million of their $5 million commitment and then doubled in value at the end of the year, you would have created $2 million in gains in the fund in the first year but that would only offset the $2 million in fund management fees you charged your investors and so you would still be in a loss position when you factor in your other operating costs. So, your gross results at the case level would look great at 100% IRR, but the J Curve would cause your net returns to be negative because the dollar value of those gains was not material relative to the costs that have been incurred. This dynamic is especially true for the early stage part of a commercial litigation finance fund’s life cycle.
Loss Profile of Litigation Finance
The loss profile of litigation finance also doesn’t help matters. In LBO investing, a manager would typically target to generate no losses in their portfolio. Sometimes LBO funds can see up to 20% of their portfolio creating losses but they may not always be complete losses – equity value is not binary (although it can be when too much leverage is applied). In litigation finance, the average fund manager loses about 30% of their cases and unfortunately with litigation finance the loss is usually complete (although it is possible to have a partial loss). With complete losses, you are now counting on the remaining 70% of the portfolio to not only generate a return for its own capital but it also has to generate a return on the portion of the portfolio that suffered losses. This is why despite litigation funding contracts having funding terms that might yield 3+ times their investment, the actual math when you factor in the losses results in fund multiples closer to 2 times and then you have situations which either over-perform or underperform the underwritten expectations and so most of the completed funds I have seen (of which there are surprisingly few on a global basis) produce multiples that range anywhere from 1.4 to 2.5 times. You can then have outliers that result in very large MOICs, but they are few and far between and as an investor you can’t rely on outliers to recur, and so they are dismissed even when the investor benefits from them. Some people have likened litigation finance to venture capital investing because of the loss profile, but I disagree with that characterization (VC losses are much higher, but they also have the ability to create huge returns to carry the fund which is generally missing in commercial litigation finance), and I think the reality is that it sits somewhere between LBO and VC in terms of its loss profile but significantly different in terms of its overall return profile.
As a consequence of the loss profile inherent in litigation finance and the fact that the losses tend to be complete losses, there is a significant negative impact on net returns especially if the losses tend to happen at the end of the life of the portfolio. If the losses happen later in the life of the fund, they can also be larger because more time has elapsed to draw down larger amounts of capital with more invested dollars to lose and thus have a more significant impact on the portfolio.
Fixed(ish) Returns
In LBO and VC investing your returns aren’t fixed. If your business grows beyond your wildest dreams your upside is almost unlimited (just ask the early backers of Google). In litigation finance, your upside tends to be capped or tied to time. For example, many funding contracts will cap returns at 3 times their investment in 3 years, 4 times in 4 years and 5 times in excess of 4 years. The reason for capping returns is to ensure there is economic alignment of interests between the funder and the plaintiff (and the lawyer if they are working on a contingent basis) so that all parties remain motivated throughout the case as their involvement may be critical to the outcome of the case. The implication of the somewhat fixed return profile means that you cannot expect that really well performing cases will translate into strong returns for investors and thus the overall return profile of the asset class is somewhat muted (Industry participants may point to Burford’s ‘Petersen’ case as an example of unlimited upside but my experience is that this type of outcome is a statistical outlier in the litigation finance market). Accordingly, with a somewhat fixed return profile time tends to work against commercial litigation finance fund managers in that it reduces their net IRRs thereby increasing the gross v. net return spread.
Implications for Measuring Management Performance
For investors the question remains, “if all of this noise is in the numbers and there are different ways to present returns with wildly different outcomes how do I know if my fund manager is performing and whether I should keep allocating to the sector?”. For fund managers, the question is “how do I present my results in a way that balances the reality of my investments without being overly optimistic or overly pessimistic and thereby give investors a reasonable estimate of their expected returns so they can rely on the return estimates?”.
First, you can’t manipulate cash-on-cash results. So, the safest route for an investor is to assess performance based on IRRs that use cash-in and cash-out (this includes the realized investments and the actual Costs incurred) as the measurement mechanism, but this is only really appropriate for fully realized funds. Of course, this approach is the most conservative but it may inadvertently penalize the fund manager as discussed earlier, especially if applied to funds that have many unrealized positions in their portfolios and some upfront losses.
In the absence of a fully realized fund, the default then becomes assessing the performance of realized cases and ensuring that the unrealized cases should not otherwise be written off (managers love to hold on to their ‘losers’ to avoid the inevitable write-off so you will have to diligence whether a dated unrealized case continues to have value). In this scenario, trying to develop a methodology that is reasonably accurate to assess value of the unrealized portion of the portfolio is critical.
Fund managers and investors alike may want to interpolate how the remainder of the fund could perform based on the performance of the realized portion of the fund or the manager’s past performance in other funds, although each fund and fund manager is unique and each case has its own idiosyncrasies and binary outcome risk. So, instead of looking at a discrete outcome, I would assess a probability weighted range of outcomes. Although one needs to keep in mind that the tail of any commercial litigation finance fund will certainly perform differently than the front-end of the fund and so adjustment will need to be made accordingly if you are using interim results as a basis to forecast full fund performance.
For investors, another valuation methodology would be to approach valuation from a macro perspective. This might entail accumulating as much data as possible about realized transactions and fund performance in the commercial litigation finance industry, apply the relevant data to the strategy of the manager (for example, data that includes small financings in plain vanilla commercial disputes would be irrelevant for a manager that focuses exclusively on patent disputes), incorporate the data of the manager’s performance to date in predecessor funds (if available) and develop your own model on how you believe this fund should perform in a few different scenarios (involving differing rates of return and durations) to try and triangulate to a series of potential fund returns and then determine whether the series of outcomes fits with the risk/reward profile of the investment. This approach could also be relevant for fund managers, especially those that are either new to the industry or have yet to establish a sufficient track record although it may be more difficult for fund managers to get data about their competitors’ returns.
I would also be cautious about attributing realized results that come from secondary transactions to the manager under consideration. Just because the manager was able to convince a third party of the value doesn’t mean that is how the portfolio will necessarily perform had the manager kept those investments on their books until they realized and ultimately that is what you are trying to underwrite as an investor because you can’t count on secondaries as an exit. Reliance on secondary transaction values in commercial litigation finance is different than other areas of private equity where it is easier to more accurately determine fair market value using accepted methodologies and metrics. Litigation Finance valuations for secondary transactions will always be theoretical in nature and ultimately dependent on some form of probability weighting to estimate values which may not bear any resemblance to the ultimate reality and could be fraught with bias. This is not to say that you don’t give any credit to a manager that sells into the secondary market as that may be the best outcome for their fund and they can be viewed as astute capital allocators by deciding that the best outcome for their investors is to de-risk their investors at a decent return rather than continue to assume the risk. A prime example of an astute secondary sale is the multiple secondary sales that Burford undertook of its ‘Petersen’ case which allowed it to realize hundreds of millions in profits, even though the case had significant litigation risk at the time of the secondaries and it continues to have significant enforcement/collection risk.
The promise of a valuation methodology blessed by the SEC is potentially an interesting development, but ‘the devil is in the details’ and I hope to explore those details in an upcoming article concerning valuation in litigation finance.
Slingshot Insights
Commercial litigation finance is one of the more difficult private equity asset classes in which to perform well, consistently. The reason for this difficulty lies in a great degree of subjectivity in the issues in dispute, the people that dispute and resolve them, and the judiciary that decides the case, if necessary. The loss ratio coupled with the relatively fixed nature of damages and the need for a fair sharing of proceeds across multiple parties also presents issues in terms of maximizing returns for investors that ultimately places a ceiling on returns (relative to other asset classes). The average single case size is USD$4.3 million according to Westfleet Advisors’ most recent survey, and so this means that it is also a difficult asset class to scale as there are relatively few cases requiring large amounts of financing which in turn means that the manager requires more people to originate and underwrite cases as compared to other private equity asset classes which also means managers need full management fees to fund their operations. All of this results in an asset class that will inherently have a higher-than-average gross to net return spread, especially in the earlier years of the fund’s life. Managers would be well advised to not only report their returns based on a conservative cash-on-cash basis, but also look to alternative approaches (including ASC 820) to provide investors with a view as to the likely fund returns if even by illustrating a matrix with several potential return outcomes. After all, investing is nothing if not uncertain.
I also firmly believe that the litigation finance industry really needs to start charging appropriately for its capital, specifically the portion of their undrawn capital that has been committed and set aside for potential deployment – there is a cost to having this capital on the sidelines and it should be factored into the terms of the funding agreement. Similarly, quick realizations require a minimum return on capital that should be factored into the terms of their litigation funding agreements.
As always, I welcome your comments and counterpoints to those raised in this article.
Edward Truant is the founder of Slingshot Capital Inc. and an investor in the consumer and commercial litigation finance industry. Slingshot Capital inc. is involved in the origination and design of unique opportunities in legal finance markets, globally, advising and investing with and alongside institutional investors.
