The Importance of Diversification in Commercial Litigation Finance (pt. 2 of 2)

Investors’ Corner

Presented by Balmoral Wood | Litigation Finance

In part 1 of this article, we examined the legal and counterparty risks inherent in commercial litigation finance, in order to better understand why diversification is so critical to the asset class. In part 2, we continue our examination by assessing judiciary and plaintiff risk, as well as deployed vs. committed capital. And of course, ‘where there is risk, there is always reward’ – and commercial litigation finance is no different. We’ll finish up by taking a look at the reason firms are so eager to absorb all of that outsized risk… there must be a reason, right?    

Judiciary Risk

Judiciary risk is simply the risk that despite a meritorious claim with ample supporting evidence, the judiciary will make an unpredictable or incorrect decision that results in a loss to the plaintiff.  This risk will differ depending on the nature of the forum (court or arbitration) and the nature of the judiciary (judge, jury or panel), not to mention the individual making the decision. The only remedy in this situation is success through an appeal, but that option may not be available, and typically the chances of a successful appeal are less than 50%.

Judiciary risk encourages many to believe that litigation risk is “binary”, which is to say that a plaintiff will either win or lose its case, but rarely is there a judicial outcome somewhere in the middle.  I would argue that the asset class, when viewed through the lens of a large diversified portfolio, possesses “quasi-binary” risk, as described below.

During the earlier stages of a case, there is uncertainty on either side of the dispute because a lack of disclosure has taken place, and so the counter-parties’ confidence in their respective cases relies solely on what they know about the case (both sides, of course, appreciate that there may be much they do not know). When you look at two parties in a dispute that have equivalent economic resources, the parties quickly turn their attention to focus on the merits of the case and the probability weighted potential outcomes of the case if it were to proceed to a judicial process. This uncertainty, married with the concept promoted by litigation finance of ‘level the playing field,’ creates a breeding ground for settlement. When you consider the large variety of potential outcomes in the context of a negotiated settlement, the possibilities are infinite. It is this series of potential outcomes that make a piece of litigation much less binary during the pre-trial period.

The reality of litigation is that the lion’s share of resolutions is derived through settlement (90-98%, depending on the data source). Hence, a commercial litigation finance portfolio is not as binary as one might think.  However, in the context of a single piece of litigation, there is the possibility that it gets resolved through a judicial decision and hence there is an element of binary risk inherent in any single piece of litigation. Since most commercial litigation is settled, and since there is binary risk associated with a single piece of litigation that reaches the judiciary, the application of portfolio theory decreases the binary risk inherent in a portfolio of cases.

Plaintiff Risk

Most jurisdictions prevent a third party from influencing the plaintiff with respect to their case.  “Officious intermeddling” is a reference to a third party interfering with the plaintiff’s decision, and is a component of the definition of the legal doctrine of ‘champerty’, which is still relevant in many jurisdictions.  Accordingly, when a litigation funder takes on a case, they must ensure that the plaintiff will be an economically reasonable decision-maker, which is difficult to assess, as the injured party typically wants to exact revenge for the damage done to them. There are ways in which a litigation funder can construct its funding contract to make the plaintiff act economically rational, but the provisions are more ‘guard rails’ than a ‘podium’.  Good litigation funders will spend time with the plaintiff to assess their economic rationality, but ultimately the funder is adopting an element of plaintiff risk when funding a new case.

Commitment vs. Deployment 

In addition to the risks outlined above, the other characteristic of the commercial litigation finance asset class that merits comment relates to deployment rates. In this asset class, there is a distinction between the amount the litigation funder ‘commits’ to a case, and the amount they ‘deploy’.  The former is the amount that the financier is willing to commit to fund based on a set of assumptions, milestones and limitations. The latter is the amount that is actually funded.

Since litigation funders cannot possibly know (particularly in early stage cases) how much of their commitment they will ultimately deploy, it becomes that much more difficult for fund managers to design diversified portfolios.  As an example, if I manage a fund with a 15% concentration limit based on aggregate committed capital, and my entire fund deploys 75% of its aggregate committed capital throughout its term, then my concentration limit is effectively 20% (15%/75%) of deployed capital.  If that same fund has 2 investments that have hit the fund concentration limit, then the returns of the fund will mainly be dictated by 2 cases representing 40% of the deployed capital.  When you layer on single case binary risk, you quickly come to understand how inappropriate the concentration limit is for the fund, and how difficult it can be for a fund to overcome a loss related to 1 large case investment and still produce strong absolute returns.

The Reward

Given that many of these risks exist in a single piece of litigation, the economic return must be significant to justify assuming these risks, which is why the industry has the perception of being an expensive source of capital. In addition, the industry does have the potential to achieve outsized returns depending on the funding contract and timelines, but these are typically driven by single cases and are extremely difficult to underwrite and predict. While the industry risks are numerous, many of them are manageable and diluted in the context of a diversified portfolio, and many investors believe the rewards are well worth the risk.

So, when an investor looks at the risks and rewards of a single piece of litigation in the context of a large diversified portfolio, it is easy to conclude that the application of portfolio theory (i.e. diversification) is necessary to achieve appropriate risk adjusted returns. Diversification can take many forms (fund managers, geography, case size, case type, counterparty, industry and legal representation) and it is important to have a mix of each within the portfolio to reduce risk, while obtaining the overall benefits of the absolute returns inherent in the asset class.

 

About the Author: Edward Truant is a principal of Balmoral Wood Litigation Finance, a litigation finance fund manager based in Toronto, Canada.  The author can be reached at edwardt@balmoralwood.com.

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