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Commercial Slingshot Capital Special Features

Litigation Finance – Lessons Learned from Manager Under-Performance (part 1 of 2)

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. 

Executive Summary

  • Business under-performance in the commercial litigation finance market has typically stemmed from 3 main causes
  • Business partner selection is critical to success & corporate culture
  • Portfolio Construction is critical to success and longevity in commercial litigation finance
  • The application of debt is generally not appropriate in the commercial litigation finance asset class, with some exceptions, but may be appropriate in other areas of legal finance

Slingshot Insights:

  • Spend the time to determine whether your partners are additive to what you are trying to achieve and understand their motivations
  • Debt is a magnifying glass on both ends
  • Portfolio concentration – even when you win, you lose

A number of years have passed since the commercial litigation finance industry was established in the UK, USA & Australia (the more mature markets of the global industry), and so I thought it appropriate to reflect on some of the lessons learned within the industry to extract insights both for investors and fund managers.  Some of these lessons resulted in the wind-down of funders, some resulted in restructurings of the management company and their funds, some represent a “failure to launch,” and some resulted in changes in ownership. Some of the failures have been more public in nature, whereas others have resulted in restructurings and new ownerships (reluctantly) behind the scenes, and while they may now appear to be healthy funders, they underwent some restructuring to get there.

This article will not name the specific companies that have failed or faced significant adversity (they know who they are), but through a fair amount of rumour, press and feedback from former employees, one can start to assemble a story around the cause of fund failures related to a number of fund managers in various countries. Sometimes, the pioneers in an industry are those that make the biggest sacrifice for the good of those who follow in their footsteps (assuming they learn, which is why this article has been written). Marius Nasta of Redress Solutions PLC previously wrote an article entitled “Why do litigation funders fail?’ and this is an attempt to take a deeper look into the causes, and extract insights for fund managers and investors.

This article will not touch on the various frauds that may have occurred in the industry as those are beyond the scope of this article, but bear scrutiny nonetheless.  For edification, some of the articles that cover those frauds can be found below. Interestingly, a recent case in the UK ended in a fourteen-year jail sentence for one of the founders of Axiom.

Commercial Litigation Finance

Axiom Legal Finance

Argentum

Consumer Litigation Finance

Cash4Cases

LawBuck$ and MFL Case Funding

As I reviewed the various fund managers’ experiences in the industry with a focus on distressed situations, some themes started to arise which I have classified into various categories, as outlined below.  Sometimes, the cause is singular in nature and sometimes it is a combination of issues that result in an unexpected outcome resulting in a business setback, which can be fatal.  In any event, I think the following insights are ones that all fund managers and investors should take into consideration as they operate, diligence and invest in the commercial litigation finance market.

Insight #1 – Pick Your Partners Slowly & Carefully & Don’t be Afraid to Walk Away

There is an adage in human resources, “hire slowly and fire quickly”. The same holds true for any business where partnerships are involved, although the ‘firing’ aspect is much more difficult.  There is another adage that says you don’t really know your partners until you either start working together or until money is involved, and that is true of any venture where partners come together to form a business.

In the early days of any asset class, there is a fervor and an anxiousness to ‘get on with it’ in order to capitalize on the opportunity before others beat you to it. As a consequence, partnerships are formed all too quickly and with the wrong partners, and typically among people that have never worked together before.  The first few months can be exhilarating and then reality sets in and eventually people’s ‘true colours’ start to show (both good and bad).  It is important in the early days of assessing the merits of a business partnership to have an open dialogue about business goals and expectations, roles and responsibilities, individual strengths and weaknesses, relative motivations and incentives, distractions (i.e. is one partner independently wealthy and the other living ‘paycheck to paycheck’, as these economic differences will surely result in motivational differences and likely impact the amount of time and effort each will spend on the business), and generally what each party is looking to get out of the business.  As this is a finance business, there are requirements around investor relations and fundraising to consider beyond the business of marketing, originating and deploying capital, and you need to be very clear what the expectations are of the partners in this regard, as it tends to be an ‘all hands on deck’ situation in the early days of establishing a business and some partners may not be comfortable with the fundraising role.

Fund managers should be under no illusions, it’s extremely difficult to raise a new fund in a new market with limited liquidity, unknown duration and quasi-binary outcomes …. and all with no track record to show for it.  In fact, if you were to consult the investor playbook, these are often characteristics most investors absolutely avoid.  This is the task at hand for any new manager looking to establish themselves in the litigation finance sector. But the allure of big multiple payouts is often hard for investors to ignore, and that is in essence what has allowed this industry to grow and prosper (hope is a powerful aphrodisiac).

Accordingly, the early days of forming a business can be very telling about how the business will perform and where tensions will arise.  In the field of litigation finance, your pool of experienced talent from which to hire is very limited, as the industry has not been around for a long time.  My observation is that some of the best funding teams in the world have a combination of partners with different business backgrounds and experiences. While litigation experience is clearly a desirable skill set to invest in litigation finance opportunities, finance experience is equally critical to the success of a litigation finance fund.  The important thing for partners is to recognize their strengths and weaknesses, and partner up with someone that fills the voids.  Of course, this all means that people need to be self-aware, and that can often be a challenge, especially with individuals who have had some success in their field and who have never been told of their ‘blind spots’ by their peers.

The strongest and most effective teams I have come across in the industry have a combination of experience in litigation and finance. The value add of those with litigation experience is self-evident, although many litigators come with their own biases based on their experience which require balancing via a different perspective.  The value of those with finance experience is not only as a second set of eyes on the merits of the case (i.e. keep the biases in check), but perhaps more important are the structural benefits they can bring to the construction of the funding contract and their focus on risk mitigation. This is a subsector of specialty finance, after all.

Nevertheless, a business partnership may under-perform for any number of reasons.  At that point, your options are quite limited. Generally, you have four options:

  • you can attempt to restructure your internal operations and economic allocations around the reality of people’s efforts and value they bring to the partnership, so that there are appropriate incentives and procedures in place to deal with issues (good luck with that one),
  • you can exit and start from scratch, with the appropriate exit agreements in place which may make it more difficult to start a new business for the exiting partner in the short term (while more difficult, this may ultimately be the most rewarding (financially and ‘spiritually’) if it can be done successfully),
  • Status Quo – you can attempt to make it work, although the issue is that this may ultimately result in significant resentment, which in turn makes it extremely difficult to create an environment to attract top talent, and generally results in a sub-par business. In essence, you’re just delaying the inevitable, and potentially degrading the value of the business in the interim.

Of course, if one of those three doesn’t work, there is always the nuclear option – blow it up & start over, separately.  This tends to be the ‘scorched earth’ option where the partners decide that if they all aren’t going to benefit, then no one will benefit. While this does nothing for reputations and personal brands, it can be immensely satisfying (albeit short lived) for the partner that has suffered the most. Generally, people should try to avoid this option, if at all possible.

Selecting partners (and hiring employees in general) is the single most important value driver for equity creation in the fund management business (secular trends also help, a lot!) yet it is constantly the area where business owners spend the least time and attention. I encourage those looking to form a business to over-invest their time on the people side of the equation early on to avoid missteps. Just like marriages, business partnerships can be difficult even when they are working well.

Insight #2 – Concentration is a Killer – Diversify, Diversify, Diversify

One of the easiest errors to make in commercial litigation finance is to be inadequately diversified; and diversification should be multi-faceted.  I have covered the benefits of portfolio diversification in a prior article, but for this article, let’s talk about some of the challenges in creating a diversified business.

Manager Bias…or Wishful Thinking

The first challenge to creating a diversified portfolio is eliminating bias.  I have often heard fund managers refer to cases as “slam dunk cases”, only to be proven otherwise by a judicial decision.  I have also personally reviewed many cases where I thought the balance of probabilities outweighed the plaintiff over the defendant, only to be shown otherwise by a judicial outcome.  In short, no one knows.  What I do know, based on the extensive data I have reviewed, is that litigation finance is successful about 70% of the time (where “success” = profit), across geographies.  With a 70% success rate, I can figure out an appropriate portfolio construction (size, concentration, number of investments, case types, etc.) but if I allow my bias to enter into my decision making, I may make the mistake of putting too much of the fund in one transaction or case type (see below), and this one mistake may be fatal, as it could determine the overall outcome of the fund’s returns, and hence impact that manager’s ability to raise another fund.

As your fund grows, you can then look to address bias through attracting different human capital to the business, each of whom will have different experiences (and biases) which will hopefully provide different perspectives that will result in superior decision making. The networks of these additional people will also add a different origination source to the business, which will further serve to diversify the portfolio through other case types, law firms, case sizes, case jurisdictions, etc.  All should serve to diversify and strengthen the business, if executed well.

Deployment Risk 

The second challenge is portfolio concentration relative to deployment risk.  In an asset class that has double deployment risk, the first level of deployment risk is the risk associated with whether the manager will invest the commitments. The second layer of deployment risk in litigation finance is whether the commitments made by the manager will draw 100% of the commitment, and this layer of risk is almost impossible to quantify, although there are ways to mitigate it.

In commercial litigation finance it can be extremely difficult to create a diversified portfolio on a ‘dollars deployed’ basis, simply because you don’t know how much of your fund commitments will ultimately be deployed.  I have seen many limited partnership agreements that have 10% concentration limits.  Those concentration limits are based on funds committed, so on a funds deployed basis, those concentration limits could be well in excess of 10%.  With a 10% concentration limit, as goes those investments, so goes the fund, which is an overly risky position for a fund manager and investor to take.  We also can’t lose sight of the fact that for any given fund, about 15-25% (depending on your management fees & operating costs) of the fund’s commitments will be consumed by management fees and operating expenses, and so the fund manager is really investing seventy-five to eighty-five cent dollars, which makes portfolio concentration even riskier.

Accordingly, fund managers should target fund concentration limits in the 5% range (5% of dollars deployed, that is), which would result in about 20 investments in any given fund, thereby giving the manager a reasonable chance at success, statistically speaking.  But, in order to achieve 5% concentration on a dollars deployed basis, they should really be looking at about fifty to seventy-five percent of that rate on a dollar committed basis.  Said differently, the fund manager should be targeting about a 2.5-3.5% concentration limit on a ‘dollars committed’ basis that may ultimately result in something closer to 5% on a dollars deployed basis for some of the investments in the portfolio (the same math does not hold true for managers that focus on investing in portfolio investments, which by their nature are diversified and cross-collateralized). 

In part two of this two-part series, we further delve into portfolio construction issues, and then discuss the appropriateness of utilizing debt within the context of commercial litigation finance.

 

Slingshot Insights

Much can be learned from the misfortune of others, and this is what I have attempted to summarize in the article.  To be fair, in the early days of an asset class, establishing a business is much more difficult than in more mature asset classes.  The learning curve, both for managers and investors, is steep, and those that came before were pioneers. There are a lot of unknown unknowns in commercial litigation finance, and things don’t often end up going the way people thought they would go, but we learn from the benefit of hindsight.  In short, establishing a new asset class is very difficult, and everyone can learn from the missteps of others as they build their own successful organizations.  Coupled with the difficulty inherent in establishing a new asset class is the fact that this asset class is unique with many risks that only come to light with the benefit of time – idiosyncratic case risk, double deployment risk, duration risk, quasi-binary risk, etc. Accordingly, the industry owes a debt of gratitude to those that came before as we are now smarter for their experiences. But beware!

Those who fail to learn from history are doomed to repeat it!
                                                              – Winston Churchill (derived from a quote from George Santayana)

As always, I welcome your comments and counter-points 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. provides capital advisory services to fund managers and institutional investors and is involved in the origination and design of unique opportunities in legal finance markets, globally.

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Commercial Special Features

Key Highlights from the Inaugural LF Dealmakers European Edition

By John Freund |

Last week, the LFJ team attended the inaugural LF Dealmakers European Edition, held across two days at the Royal Lancaster in London. Building on the longstanding success of Dealmakers’ New York event, the first edition of the European conference brought together an impressive selection of leaders from across the industry.

Spread across two days, LF Dealmakers featured an agenda packed with insightful conversations between some of the most prominent thought leaders in the European litigation finance market. An array of panel discussions covered everything from the looming potential of regulation to the increasing corporate adoption of third-party funding, with these sessions bolstered by a keynote interview between two of the key figures in the Post Office Horizon litigation.

A long road to justice for the postmasters

In a conference that managed to fill every single panel discussion with speakers engaged in some of the largest and most influential funded disputes taking place in Europe, the standout session of the two days provided unparalleled insight into one of the most famous cases of recent years. The keynote interview on ‘The Future of Litigation Funding in the Wake of the Post Office Horizon Scandal’ saw James Hartley, Partner and National Head of Dispute Resolution Freeths, and Neil Purslow, Founder & CIO, Therium, offer up a behind-the-scenes tale of the sub-postmasters campaign for justice.

Going back to their first involvement with the case, James Hartley reminded attendees that whilst those looking at the case post-judgement “might think it was a slam dunk”, this was not the viewpoint of the lawyers and funders who first agreed to lead the fight against the Post Office. As Hartley described it, this was a situation where you had “a government owned entity who would fight to the end”, with a multitude of potential issues facing the claimants, including the existence of criminal convictions, the limited amounts of documented evidence, and the fact that the Post Office was the party that had ninety percent of the data, documents, and evidence.

Hartley also offered his own perspective on the legal strategy adopted by the Post Office and its lawyers, noting that at every stage of the litigation, “every single issue was fought hard.” He went on to explain that whilst he was “not critical” of the defendant’s strategy in principle, there remains the underlying issue that “the arguments they made were not consistent with the evidence we were seeing.” Hartley used this particular point to illuminate the issues around defendant strategies in the face of meritorious litigation that is being funded. He summarised the core issue by saying: “There is nothing wrong with fighting hard, but it’s got to be within the rules, and in a way that helps the court get to a just outcome.”

Offering praise for the support provided by Purslow and the team at Therium to finance the case, Hartley stated plainly that “without Therium’s funding it would not have gone anywhere, it would not have even got off the ground.” Both Purslow and Hartley also used the case to highlight problems around the lack of recoverability for funding costs and how that incentivises defendants such as the Post Office to prolong litigation and inflate legal costs. Hartley said that he would welcome a change to rules that would allow such recoverability, arguing that in this case “it would have neutralised the Post Office’s strategy to just keep driving up costs on the claimants side.”

What problem is regulation solving?

It was unsurprising to find that questions around the future of regulation for the litigation funding industry were a regular occurrence at LF Dealmakers, with the event taking place only a few days on from the House of Lords’ debate on the Litigation Funding Agreements (Enforceability) bill. From the opening panel to conversations held in networking breaks between sessions, speakers and attendees alike discussed the mounting pressure from government and corporate opponents of third-party funding.

The view from the majority of executives at the event seemed to revolve around one question, which was succinctly put by Ben Moss from Orchard Global: “What are the specific issues that require regulation, and what is the evidence to support those issues?”

This question became somewhat of a rallying cry throughout the conference, with suggestions of increased scrutiny and oversight being turned back on the industry’s critics who make claims of impropriety without citing evidence to back up these claims. Whilst several speakers referenced the recent LFJ poll that found a broad majority are open to the potential for new regulation, Ben Knowles from Clyde & Co described a lot of the discourse around the issue as “a fairly partisan debate.”

Among the few speakers in attendance who offered a contrasting view on regulation, Linklaters’ Harriet Ellis argued that “regulation done right would be good for the industry.” However, even Ellis acknowledged that any rules would have to be carefully crafted to provide a framework that would work across the wide variety of funded disputes, saying that a “one size fits all approach does raise issues.”

Regarding the government’s own approach to the issue through the draft legislation making its way through parliament, all of the executives in attendance praised lawmakers’ attempts to find a solution quickly. Alongside these government-led efforts, there was also a feeling among legal industry leaders that funders and law firms have to be part of the solution by promoting more education and understanding about how litigation finance works in practice. Richard Healey from Gately emphasised the need for firms to engage in “hearts and minds work” to change wider perceptions, whilst Harbour’s Maurice MacSweeney emphasised the need to “create the environment where law firms and funders can flourish.”

Innovation through collaboration

Outside of the narrow debate around legislation and regulation, much of the conference was focused on the speed at which litigation finance continues to evolve and create new solutions to meet complex demands from the legal industry. This was perhaps best represented in the way speakers from a variety of organisations discussed the need for a collaborative approach, with executives from funders, insurers, law firms, investors and brokers, all discussing how the industry can foster best working practices.

The interplay between the insurance and funding industry was one area that offered plenty of opportunity for insightful discussions around innovation. Andrew Mutter from CAC Speciality noted that even though “insurers are not known for being the fastest and moving the most nimbly,” within the world of litigation risk “the insurance markets are surprisingly innovative.” This idea of an agile and responsive insurance market was backed up by the variety of off the shelf and bespoke products that were discussed during the conference, from the staples of After-The-Event and Judgement Preservation Insurance to niche solutions like Arbitration Default Insurance.

Delving into the increasingly bespoke and tailored approach that insurers can take when working with funders and law firms, Jamie Molloy from Ignite Speciality Risk, described how there are now “very few limits on what can be done by litigation insurers to de-risk.” Whilst there is sometimes a perception that insurers are competing with funders and lawyers for client business, Tamar Katamade at Mosaic Insurance offered the view that it is “more like collaboration and synergy” where all these parties can work together “to help the claimant and improve their cost of capital and reduce duration risk.”

Class action fervour across Europe

Throughout both days of the LF Dealmakers conference, the volume and variety of class actions taking place across the European continent was another hot topic. However, in contrast to an event focused on the American litigation finance market, the common theme at last week’s forum was the wideranging differences between large group claims across individual European jurisdictions. In one of the most insightful panels, the audience were treated to an array of perspectives from thought leaders practicing across the UK, Spain, and the Netherlands.

The example of Spanish class actions provided an incredibly useful view into the nuances of European claims, as a country that is still in the process of implementing legislation to comply with the EU’s collective actions directive, but has already evolved routes for these types of actions over the last decade. Paul Hitchings of Hitchings & Co. described how the initiative to innovate has come “more from the private sector than the legislature”, with domestic law firms having become “experienced with running massive numbers of parallel claims” as an inefficient, yet workable solution. Hitchings contrasted Spain’s situation with its neighbouring jurisdiction of Portugal, which he argued has been comparatively forward thinking due to the country’s popular action law.

Speaking to the Dutch class actions environment, Quirijn Bongaerts from Birkway, argued that the “biggest game changer” in the country was the introduction of a real class actions regime in 2020. Bongaerts explained that the introduction of this system allowed for “one procedure that fits all types of claims”, which allows not only claims for damages, “but also works for more idealistic cases such as environmental cases and ESG cases.”

LFJ would like to extend our thanks to the entire Dealmakers team for hosting such an engaging and insightful event, which not only offered attendees a view into the latest developments in litigation finance, but also created a plethora of networking opportunities throughout both days. LFJ has no doubt that after the success of the inaugural LF Dealmakers European edition, a return to London in 2025 will cement the conference as a must-attend feature in the litigation funding events calendar.

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Commercial Regulatory Issues

The Dangers of Retrospective Legislation in Litigation Funding

By John Freund |

The debate around whether the Litigation Funding Agreements (Enforceability) Bill should be retrospective is a complex one, with valid arguments on both sides. A recent op-ed makes the case that retrospectivity poses significant dangers and unfairness.

Writing in LegalFutures, Jeremy Marshall, Chief Investment Officer of Winward UK, argues that the core issue is whether it is unfair to allow litigation funders to rely on contractual agreements that were freely entered into by both parties, even if those agreements were based on a mistake of law.

Marshall claims that the common law right to recover money paid under a mistake only applies when the mistake led to one party receiving an unintended benefit. In the case of litigation funding, the only benefit that has accrued is the one that was explicitly drafted into the contract. Allowing retrospectivity would open the door to satellite litigation and unreal counterfactuals, according to Marshall.

Claimants who have already received funding and won their cases are now arguing for the "right" to renegotiate and keep all the proceeds for themselves. But what about the funders' arguments that cases may have gone on longer or become more expensive than intended? Fairness demands that both sides' positions be considered.

Marshall insists that the true drawback in retrospectivity is the inherent danger of prejudicing one party to the exclusion of the other, or conferring an unexpected benefit to one party at the expense of the other. Ironically, this is precisely what those challenging the bill are attempting to do. So while the debate is a complex one, one can make a compelling case that retrospectivity in litigation funding poses significant dangers and unfairness.

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Commercial Regulatory Issues

The CJC’s Review of Litigation Funding Will Have Far-Reaching Effects

By John Freund |

The following is a contributed piece by Tom Webster, Chief Commercial Officer at Sentry Funding.

Reform is on its way for the UK’s litigation funding sector, with the Civil Justice Council firing the starting gun on its review of litigation funding on 23 April.

The advisory body set out the terms of reference for its review, commissioned by lord chancellor Alex Chalk, and revealed the members of its core working group.

The review is working to an ambitious timetable with the aim of publishing an interim report by this summer, and a full report by summer 2025. It will be based on the CJC’s function of making civil justice ‘more accessible, fair and efficient’.

The CJC said it will set out ‘clear recommendations’ for reform in some areas. This includes consideration of a number of issues that could prove very significant for funders and clients. These include:

  • Whether the sector should be regulated, and if so, how and by whom;
  • Whether funders’ returns should be subject to a cap; and if so, to what extent;
  • The relationship between third party funding and litigation costs;
  • The court’s role in controlling the conduct of funded litigation, including the protection of claimants and ‘the interaction between pre-action and post-commencement funding of disputes’;
  • Duties relating to the provision of funding, including potential conflicts of interest between funders, lawyers and clients;
  • Whether funding encourages ‘specific litigation behaviour’ such as collective action.

The review’s core working group will be co-chaired by CJC members Mr Justice Simon Picken, a Commercial Court judge, and barrister Dr John Sorabji. The four other members are:

  • High Court judge Mrs Justice Sara Cockerill, who was judge in charge of the commercial court 2020 – 2022, and who is currently involved in a project on third party funding for the European Law Institute;
  • Academic and former City lawyer Prof Chris Hodges, chair of independent body the Regulatory Horizons Council which was set up to ensure that UK regulation keeps pace with innovation;
  • Lucy Castledine, Director of Consumer Investments at the Financial Conduct Authority; and
  • Nick Bacon KC, a prominent barrister and funding expert who acts for both claimants and defendants

The CJC had said that it may also bring in a consumer representative, as well as a solicitor experienced in group litigation.

In a sign that the review seeks to be informed by a wide range of views, the CJC has also extended an invitation for experts to join a broader consultation group, which will directly inform the work of the review and provide a larger forum for expert discussion. Meanwhile the advisory body has said there will also be further chance ‘for all to engage formally with this review’ later this year.

Given the broad remit of the review and significant impact that its recommendations may have on the litigation funding industry, litigation funders, lawyers and clients would be well advised to make the most of these opportunities to contribute to the review.

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