Currency Considerations for Litigation Fund Managers and Investors

By John Freund |

The following article is part of an ongoing column titled ‘Investor Insights.’ 

Brought to you by Ed Truant, founder and content manager of Slingshot Capital, ‘Investor Insights’ will provide thoughtful and engaging perspectives on all aspects of investing in litigation finance. 


  • There has been an unprecedented & swift fluctuation in currency markets globally
  • Currency fluctuations can have a significant impact on litigation finance funds with currency exposures
  • Impartial currency advisors will provide market transparency and specific solutions geared towards your specific situation


  • Currency hedging is an important risk mitigation strategy to consider for portfolios exposed to multi-currencies without hedging
  • Hedging cannot eliminate currency risk entirely but can mitigate its impact
  • When assessing manager returns, ensure the effects of currency gains/losses are removed to understand the actual return profile of the portfolio

Editor’s note– the following contribution appears with illustrative graphs and charts here

The recent unprecedented and rapid strengthening in the US dollar has created a significant 8% swing in currency rates in a matter of days.

Such abrupt swings can have significant implications for businesses or financial instruments that are exposed to currency.  As an example, in 2014, the owners of the famous ‘Gherkin’ building in the city of London were forced to sell the building, which was 99% occupied and performing exceptionally well. The only problem was, the debt the owners had used to acquire the building was denominated in multiple currencies, including Swiss francs.  As a consequence of the financial crisis of 2008, the Swiss Franc appreciated against the British pound by almost 60% over a few years, which increased the debt by £100 million.  This was compounded by interest rate swaps that ended up £140 million out of the money. Consequently, the owners were forced to sell their investment in order to repay the higher level of debt, as expressed in British pounds.

Similarly, there are global concerns related to the domestic currency obligations of US dollar denominated debt of developing countries (US bond holders did not want to accept currency risk and insisted on US dollar denominated bonds).  These developing countries have seen their dollars depreciate relative to an appreciating US Dollar, which makes their US dollar denominated debt that much more expensive in terms of their domestic currency, exacerbating their debt obligations in the middle of a global financial crisis.

All of that is to say that currency fluctuations can happen quickly, and have a material impact on the value of the underlying instrument to which they relate.

Implications for Litigation Finance Investing

In a previous article, I made reference to the fact that the commercial litigation finance marketplace has quickly become a global marketplace.  Typically, we would see alternative asset managers toil away in their backyards for a number of years until they achieve sufficient scale to justify replicating infrastructure worldwide, in order to expand operations into less familiar but potentially less efficient markets – ‘pursuing greener pastures’ one might say. Commercial litigation finance, on the other hand, has been a rather global marketplace right from its origins. Some of the larger funders, including hedge funds, have been focused on major opportunities that have taken them into international markets for specific cases (international arbitration, investor-state arbitration, intellectual property or class action cases) with sufficient size to justify their due diligence efforts and costs.  Other funders have specialized in particular case types (e.g. intellectual property) which have enabled them to apply their expertise and networks into vast geographic locales.

The globalization of the industry has implications for the return profile of those managers that invest globally in multiple currencies.  Some fund managers, like Omni Bridgeway (formerly IMF Bentham), have raised country-specific private partnership funds which directly address the currency issue.  As an example, Omni Bridgeway has a US private partnership that was denominated in US dollars and only invests in US cases, thereby negating the impact of currency fluctuations on returns.  Other funders have decided that the currency fluctuations are either immaterial relative to their expected returns, or are too difficult or too expensive to effectively hedge, and hence have left investors with the exposure.

As an investor in a fund, it is easy to enter into currency hedges to deal with currency fluctuations inherent in a portfolio of homogeneous currencies relative to one’s reference currency. However, the problem becomes difficult to solve when the fund manager invests across multiple geographies (and hence multiple currencies) within a portfolio.  In those instances, it is virtually impossible to perfectly hedge the underlying currency exposure unless one is privy to information regarding the date the commitment was provided, the dates of the various funding contract draws, and the amount and date of the expected outcome.  Of course, if I knew the answer to these questions on a case-by-case basis, I probably wouldn’t need to hedge (although I may choose to do so to maximize my profits).

As if the quantum of case proceeds wasn’t difficult enough, litigation finance is equally uncertain as it relates to case duration, due to the high degree of variability between the date of the commitment and the date of receipt of the ultimate settlement/award, if any.

So, in order to shed some light on the issues inherent in currencies, as well as potential solutions as relates to the commercial litigation finance asset class, I have reached out to a large, publicly-listed currency management solutions expert with the following questions:

Questions and Answers:

Q1. Is currency hedging fairly common in the alternative investment asset market?

Market volatility since 2009 has heightened peoples’ awareness on hedging currency risk, with downturns in sentiment seemingly occurring on a more frequent basis. Currency hedging has certainly been more common in assets classes with lower expectations on IRR, such as the private credit market where volatility can remove the return expectations entirely, but in comparison, the unknown exit dates of Private Equity or Real Estate assets have meant hedging currency risk is far less common. However, as mentioned before, volatility from events such as Brexit, the US/China trade war, and now the COVID-19 Pandemic, has meant an increasing number of enquiries about hedging across all asset classes, including Litigation Finance.

Q2. What advice do you have for fund managers who invest their funds across multiple currencies?

I think the most important thing to consider is whether the GP is undertaking a non-biased opinion on whether to hedge or not. Using an advisor or non-bank allows a GP further insight into hedging risk, where they perhaps haven’t looked, ensuring LP’s are receiving the best possible product or strategy in the fund. Often, a banking counter-party will offer a product to solve an issue, without understanding/knowing the risks behind that problem. A non-bank counterparty has teams of analysts who work with industry-focused partners on fully exploring all risks within each investment fund, not to mention what the competition is doing. The one piece of advice I would give, is to not follow confirmation bias on hedging, and instead explore all avenues to ensure the best policy is being implemented by the GP.

Q3. Given that managers typically raise capital on a ‘blind pool’ basis and may invest across multiple-currencies, what are some of the currency management strategies that managers should be thinking about?

A3.  The four key risk areas where we engage with our clients on currency management strategies are:

  • Deployment and Exit Risk
  • Portfolio Risk
  • Share-Class Hedging – it is becoming more common for fund managers to offer currency nominated sleeves to attract a wider investor base.
  • Fee Income Risk – if the base currency of the fund differs from the main operating countries of the GP, it may be prudent to look into hedging FX risk on forecastable income.

Q4. Instead of trying to eliminate all currency movements, is there a way to offset ‘black swan’ situations related to large currency fluctuations (similar to what we have seen with the GBP volatility in the context of Brexit), using perhaps a ‘collar’ type strategy?

A collar allows you to participate up to a certain level, however, if the market exceeds that level, you may not be able to participate. It is important to get the best advice on an option if you feel that is the best strategy for your requirement. Again, utilising a non-bank counter-party is key to ensuring your LPs receive the most effective strategy for the fund to which they are committing.

Q5. Can you comment on the cost of hedging and how those costs can vary based on the solutions applied (options vs. forward purchases vs. other)?

Q5.  The present interest rate environment across most G10 countries allows for a significantly reduced cost in hedging risk both on the forward and options market. This means funds can now actively hedge tenures of 5yrs+ via relatively low-cost hedging solutions, where previously they could not, particularly against USD and EM currencies. The cost of hedging differs per the product used, of course. And one thing that’s important to note, is an advisor will not only ensure you receive transparent pricing, but will also allow you to explore unique solutions, which in turn could reduce cash drag to the fund.

To the extent readers of this article would like to be connected with the currency management solutions provider referenced above, please email me and I will make an introduction.

Investor Insights

For investors that are invested in the sector or considering making an investment in the litigation finance market, currency may be an important consideration in risk assessment.  Litigation Finance managers may hedge at the fund level, which would be the most appropriate level at which to hedge, given their direct knowledge of the underlying cases and their cashflow requirements, duration and the expected returns. However, it is also possible to hedge at the investor level (albeit less accurately). Given the heightened level of volatility in currency markets, hedging is more appropriate now than ever before, and in certain jurisdictions where there is country specific risks (i.e. UK – Brexit), it remains important.  In assessing a manager’s portfolio that invests in various currencies, you must remove the effects of currency when assessing returns, as currency-driven returns lack persistence (positive and negative) to determine the true return profile of the fund.

Edward Truant is the founder of Slingshot Capital Inc., and an investor in the consumer and commercial litigation finance industry.


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Gross v. Net Return Dispersion in Commercial Litigation Finance

By John Freund |
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.
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Managing Duration Risk in Litigation Finance (Part 2 of 2)

By John Freund |
The following is the second of a two-part series (Part 1 can be found here), contributed by Ed Truant, founder of Slingshot Capital, Executive Summary
  • Duration risk is one of the top risks in litigation finance
  • Duration is impossible to determine, even for litigation experts
  • Risk management tools are available and investors should make themselves aware of the tools and their costs prior to making their first investment
  • Diversification is critical in litigation finance
Slingshot Insights:
  • Duration management begins prior to making an investment by determining which areas of litigation finance have attractive duration risks
  • Avoidance can be more powerful than management when it comes to duration in litigation finance
  • There is likely a correlation between duration risk and binary risk (i.e. the longer a case proceeds, the higher the likelihood of binary risk associated with a judicial/arbitral outcome)
In the first article of this two-part series, I provided an overview of some of the issues related to duration in the litigation finance asset class.  In this article, I discuss some of the ways in which investors can manage duration risk, both before they invest and after they have invested. Managing Duration Risk The good news is that there are many ways to manage duration risk in litigation finance and you can use the various alternatives in combination to create your own portfolio to mitigate the risk. Before we look at how we can manage duration through an exit of an investment, let’s first explore how we can avoid duration risk before we even start investing.  That is to say which investments have lower levels of duration risk to begin with so we can avoid duration risk going into an investment. Case Type Selection On the commercial side, post-settlement cases have a low degree of duration risk as the litigation risk has mainly been dealt with through the settlement agreement and the resulting risks relate to procedural (generally timing) and collection risk.  Similarly, appeals finance is generally involved with cases that have less litigation risk as the issue at play is usually a specific point of law and the timeline for appeals tends to be relatively certain and short while the costs are fairly well defined. Consumer litigation cases (think personal injury cases, other than mass torts) tend to have relatively dependable timelines and so this can be a very attractive area in which to invest with less duration uncertainty, but it does come with some ‘headline’ and regulatory risk.  Mass tort cases, which technically are consumer cases, have different dynamics because of the sheer size of the claims and the complexity of the multi-jurisdictional process which require test cases to prove out the merits and values of the cases.  So, I would view these as being similar to large commercial cases in terms of their dynamics with respect to duration. Other case types such as international arbitration and intellectual property disputes tend to have much longer durations in general and so avoiding these case types is a way to mitigate duration risk within a portfolio. Case Sizes Based on some statistical analysis I had prepared from funder results (my demarcation point between small and large was based on one million in financing) and on review of a large number of case outcomes of different sizes, there appears to be some correlation between the size of the financing and the duration of the case. Smaller financings (and presumably, but not necessarily, smaller cases) tend to have shorter durations than larger financings.  The correlation could result from the fact that litigation finance is more effective in smaller cases or that there is generally less at risk in smaller cases and hence rational parties tend to resolve things more quickly when there is less to squabble over.  The exact reason will never be known, but there does appear to be some statistical correlation to support the finding.  Accordingly, one way to manage duration risk would be to focus on smaller sized cases. Case Jurisdiction Selection Not all jurisdictions are created equal in terms of speed to resolution.  Accordingly, one might want to investigate the best venue for their cases given their portfolio attributes to ensure they are in jurisdictions where duration risk is lower than others.  Of course, jurisdictions don’t offer duration risk in isolation and so you will need to know what you are trading off by investing in cases in jurisdictions with a faster resolution mechanism as there will likely be trade-offs with economic consequences.  This could involve different countries, different states within a given country, and different judicial venues (arbitration vs. court).  There are even certain judges that progress through cases at a quicker clip and are less prone to allow for unnecessary delays.  Of course, you may not be able to pick your judge and even if you can there is no guarantee you will end up with the same one you started. Case Entry Point  If you are a fund manager, another way to manage duration risk on the front end, aside from case type selection, is to focus on those cases that are already in progress and therefore should have a shorter life cycle because you are entering them later in their life cycle.  While this doesn’t deal with the situation where the case goes on longer than anticipated, it does decrease the overall length of the case by deciding to enter it at a later stage, but then you don’t always have a choice when you enter a case as it may be presented to you at a particular point in time and then you may never get the opportunity to invest in it again.  In this sense you could suffer from adverse selection if you only selected late-stage cases as you are only investing into a subset of the broader market of available cases. Liquid Investments Another way to mitigate duration risk is to focus on a liquid alternative that provides similar exposure through the publicly-listed markets, which is a topic I covered recently in a two-part article which can be found here and here under the heading of Event Driven Litigation Centric (“EDLC”) investing.  EDLC has the distinct advantage of being liquid through a hedge fund structure that provides redemption rights which allows the investor to somewhat control duration although ultimate duration is typically dictated by the timing of the event itself.  Of course, as investors move into the public markets, they start to add correlation to their portfolio which may be at odds with your duration/liquidity objectives. While it is beneficial to deal with duration risk on the front end through the case selection options outlined above, once an investor has concluded their investments, there are some options still available to deal with duration risk as outlined below. Secondary Sales  As the litigation finance industry has evolved, so to have the number of solutions in the marketplace.  While secondaries have been taking place informally for years (hedge funds, litigation funders, family offices, etc.) there has only recently been a formalizing of the secondary market and I am very keen to see how the early market entrant, Gerchen Capital, ultimately performs. Nevertheless, for managers and investors seeking liquidity and an end to duration risk entering into a secondary transaction may be a very viable solution. I believe it will be more economically viable in the context of a portfolio sale than a single case investment, but I am sure there will be some level of appetite and valuation for both.  It may be the case that the investor does not obtain 100% liquidity for their position but rather risk shares alongside another investor who doesn’t want to suffer from adverse selection and thus makes it a condition of their secondary offer that the primary investor retain an ownership position.  Other situations may allow for complete liquidity, but that will likely come at an economic cost.  And there are even other times when the case is moving along exactly as planned and the primary investor is able to sell a portion of its investment at such a high valuation that it produces a return on its entire investment, which is the case with Burford and its Petersen/Eton Park claims, despite the fact that no money has exchanged hands between the plaintiff and the defendant and there is still no clear path to liquidity. While selling a portion of an investment allows the manager to obtain some liquidity for its investors, it also serves to validate the value of the investment/portfolio to its own investors, which may in turn allow that manager to write-up its portfolio to the value inherent in the secondary sale transaction (again, this assumes that the transaction is completed with a third party investor).  As an investor, you really need to assess whether any secondary transaction is being undertaken for the intended purpose (liquidity or duration management) or whether there are alternative motivations at play (i.e. for the manager to post good return numbers to allow them to increase their chances of success at raising another fund).  And while third party validation may be comforting, too much comfort should not be derived by someone’s ability to sell an investment to another party, it could have more to do with sales acumen than the value of the underlying investment. Insurance Any discussion regarding litigation finance wouldn’t be complete without mentioning its close cousin, insurance.  In the early days of applying insurance to litigation finance, the focus was more on offsetting the risk of loss.  While that is still true today, there is an increasing focus being put on insurance as a way to deal with duration.  The thinking is that investors don’t want to get stuck in funds that take years beyond their original term to pay out and so they are prepared to accept the duration risk if there is a safety valve in place. The safety valve is the insurance which will pay out at the end of a defined term, which provides the investor with assurances that they will at the very least get their original principal repaid (and possibly a nominal return).  In essence, the insurance functions as a risk transfer mechanism between investor and insurer until the case is finally resolved. While it is more common to put insurance in place on making the investment, one could place insurance after the fact as well. Slingshot Insights   Duration management in litigation finance is almost as critical as manager selection and case selection.  I believe duration management starts prior to making any investments by pairing your investment strategy and its inherent duration expectations with the duration characteristics of your investments.  From there, you should ensure your portfolio is diversified and you should be actively assessing duration and liquidity throughout your hold period.  You should also assess the various tools available to you both on entry and along the hold period to determine your optimum exit point. 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.
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Managing Duration Risk in Litigation Finance (Pt. 1 of 2)

By John Freund |
The following is the first of a two-part series, contributed by Ed Truant, founder of Slingshot Capital, Executive Summary
  • Duration risk is one of the top risks in litigation finance
  • Duration is impossible to determine, even for litigation experts
  • Risk management tools are available and investors should make themselves aware of the tools and their costs prior to making their first investment
  • Diversification is critical in litigation finance
Slingshot Insights:
  • Duration management begins prior to making an investment by determining which areas of litigation finance have attractive duration risks
  • Avoidance can be more powerful than management when it comes to duration in litigation finance
  • There is likely a correlation between duration risk and binary risk (i.e. the longer a case proceeds, the higher the likelihood of binary risk associated with a judicial/arbitral outcome)
When you are speaking to an institutional investor about litigation, it doesn’t take long until the concept of “duration risk” enters the discussion.  Everyone seems to have a story about that one piece of patent litigation or commercial dispute that went on for over a decade that seems to have marked them for life even though they weren’t in any way involved. Yet, it’s a real risk.  Thankfully, it’s not a real risk for a well-constructed portfolio of different case types in different jurisdictions, which is one of the reasons that prompted me to raise a commercial litigation finance fund-of-funds in 2016 – it will ultimately serve as a very good proxy or index for how the industry performs. The whole concept of duration risk is critically important for investors in legal finance to understand, including ways in which duration risk can be managed in this specialized asset class. Private alternative asset classes, such as litigation finance, always need to deal with duration as part of their fundraising pitch to investors as the investments are inherently illiquid investments.  This means that in order for investors to obtain their liquidity, their needs to be a mechanism to allow for that to happen.  Within most private equity sub-classes (venture capital, growth equity, leveraged buy-out, real estate, etc.) the exit is typically a sale of the business.  An argument is often made that there is always a clearing price for any private company and the path to liquidity is generally through an investment bank or intermediary that canvasses the market to search for the best price for that asset at any given point in time.  However, with litigation finance, the pool of capital providers is relatively small, the complexity is very high and the nascency of the market means that beyond the settlement of the case (either through negotiation or a court/arbitral decision) there are not many options. But that is changing… Duration Risk Let’s start by defining duration risk for purposes of litigation finance investing, as the risk that the time horizon of a given investment is different than that which was originally underwritten without a commensurate increase in economics. Most Litigation Funding Agreements (or “LFA”s) have provisions to deal with duration risk such that the negotiated economics increase as time progresses, but often this ultimately gets capped as the claimant is concerned that the funder can end up with the lion’s share of the settlement amount.  Similarly, the funder does not want to put itself in a position where the claimant is not participating in the economic outcome of the claim, otherwise the claimant is wasting their time and effort (and stress). The two opposing forces work to keep each other “in check”. And while the LFA is typically structured to mitigate this risk, there is the potential that the case simply takes much longer than originally thought and investors want to get their money back to redeploy into another, perhaps slightly more liquid, investment.  And this is where many investors, individual and institutional, who poured into the space since 2015 find themselves today. Now, the duration risk inherent in commercial litigation is not to suggest they will rival Myra Clark Gaines (the longest-running civil lawsuit in the US at 57 years), but the difference between 5 years and 10 years can make a meaningful difference to an investor’s return profile if the economic benefits are not commensurate with the timeline extension.  While many funders quote an average hold period of 30+- months, one needs to be careful of the use of averages in litigation finance.  Many of those averages have been derived from the average length of settled cases only, which inherently ignore the duration of the unsettled cases, which is obviously not reflective of reality. Since there are very few fully realized funds in existence globally, it is difficult to determine an actual industry average for litigation finance but I would confidently say that the average will in fact be greater than the 30-month time period often quoted.  The other thing to consider is that any average should be weighted based on dollars invested to ensure that the early settlements, which by definition would likely have fewer invested dollars, do not contribute disproportionately to the average.  The reality is that funders rely on the relatively early case wins to produce strong IRRs (albeit lower MOICs) in order to offset the IRR drag of those cases that are not successful and that exceed the average duration. If we look at a case where the LFA calls for 3X multiple (200% return on investment) during the 3-year period and a 5X multiple (400% return on investment) thereafter, then the IRRs would look as follows for different durations:
Original InvestmentProceeds ReceivedDurationInternal Rate of Return
The first two data points illustrate that where the cap on the proceeds move in lock-step with timing, it has little effect on IRRs. However, the last three data points illustrate the punitive impact that duration has on internal rates of return. When duration moves from 5 to 10 years for a fixed outcome the internal rate of return decreases by approximately half. In addition to the duration necessary to get to a decision (after the potential for an appeal), you may then get caught up in additional enforcement and collection timelines which could add years and additional investment to the original investment proposition.  A good example of this is the “Petersen” & “Eton Park” claims that Burford invested in involving a claimant that is fighting Argentina & YPF over the privatization of energy assets without due compensation. The Implications of Time on the Value of Litigation  In a prior article written about the value of litigation, I describe how a piece of pre-settlement litigation starts off at the risky end of the spectrum due to a lack of information about the various parties’ positions, it then starts to de-risk as each side goes through discovery (approaching the optimal zone of resolution) and then the it starts to re-risk as each side becomes entrenched in their positions and pushes on to a third party decision.  This then leads to a bifurcation in value because the more the outcome of a case is dependent on the outcome of a disinterested third party (a judge, jury or arbitral panel) the more binary the outcome becomes as displayed in the chart below. This of course begs the question, if the timeline of a lawsuit extends beyond its original timeline, what does this say about the value of the case itself? Is it that the case is seen as a win by both sides and therefore each side ‘digs in’ to ensure the other side loses (hence a more binary outcome), or is this just a reflection of healthy sparring between parties to delay the inevitable and increase the friction costs to force the claimant to drop its case? Sadly, because every case has its idiosyncrasies and different personalities involved, we will never know the answer.  But what we do know is that any case that does get decided by a third party results in a binary outcome and as an investor “binary” doesn’t make for a good night’s sleep. I have written about this issue in an article about secondary investing, and in that article I make the argument that secondaries, if not valued properly, likely have a higher risk profile then the rest of the portfolio in which they reside because they are moving into the re-risk zone which inherently has a higher level of binary risk attached thereto.  I think this is important for investors to understand because it suggests that if you are concerned about duration in a litigation finance investment, it is probably (although not always) in your best interest to get out earlier than later.  Of course, the counter-argument is that the longer the case has elapsed the more you know about its merits and how the other side has conducted itself during the case and so your case may in fact be less risky than when it started. However, in these cases you are going to be asking the secondary investor for a premium to reflect that fact and that means you need to convince them of the merits, the likely duration and any credit/collection risks, which is a difficult task by any measure. We must also not lose sight of the fact that the longer a case proceeds, depending on the size and financial capacity of the defendant, the risk of collection may increase due to the financial condition of the defendant especially those with multiple lawsuits or those whose fortunes (profits and cashflow) are tied to more cyclical industries.  What looked like a good credit risk five years ago when the case commenced may look very different coming out of a recession or a commodity cycle.  Similarly, if the plaintiff is not of sound financial condition, the risk that the plaintiff runs out of money or interest in pursuing the case is also a risk that you are implicitly assuming. Given that the secondary industry is in its infancy and there is very little in terms of empirical results on secondaries, it remains to be seen how secondary portfolios will perform but if I were an investor in the sector I would go in with ‘eyes wide open’ and a deep value mindset.  The reality of most litigation finance is that the economic benefits tend to be somewhat capped, and so whatever premium is paid on a secondary, it means it reduces the overall economics available to the secondary investor. Dissimilar to private equity where a secondary investor can still benefit from growth in the value of the underlying company it acquires, the same does not generally hold for litigation finance investments and in fact the risk is to the downside with most LFAs. In the second article of this two-part series, we will look at the various ways in which investors can manage duration risk, both before they start investing and after they have invested. Slingshot Insights Duration management in litigation finance is almost as critical as manager selection and case selection.  I believe duration management starts prior to making any investments by pairing your investment strategy and its inherent duration expectations with the duration characteristics of your investments.  From there, you should ensure your portfolio is diversified and you should be actively assessing duration and liquidity throughout your hold period.  You should also assess the various tools available to you both on entry and along the hold period to determine your optimum exit point. 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.
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