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
- Article draws comparisons between commercial litigation finance and private equity (leverage buy-out) asset classes
- Similarities and differences exist between private equity and litigation finance operating costs, but there are some significant jurisdictional differences to consider
- Value creation is front-end loaded in litigation finance vs. back-end loaded in private equity
- Litigation finance can be a difficult investment to scale while ensuring the benefits of portfolio theory
INVESTOR INSIGHTS
- The ‘2 and 20’ model is an appropriate baseline to apply to litigation finance, but investors need to understand the potential for misalignment of interests
- As with most asset classes, scale plays an important role in fund operating costs
- Deployment risk and tail risk are not insignificant in this asset class
- Investor should be aware of potential differences in the reconciliation of gross case returns to net fund returns
- Up-front management fees may have implications for long-term manager solvency
In Part 1 of this two-part series, I compared litigation finance to private equity (i.e. leveraged buy-out) and the deployment problem endemic to litigation finance and the impact it has on the effective cost of management fees. In Part 2, I drill deeper into the operating costs inherent in running a litigation finance strategy.
Fees
The “2 and 20” model in the private equity asset class was established early on in its development, and for the most part it has not materially changed since inception (after decades). Sure, there are some managers that charge less of a management fee and more of a performance fee, but the industry generally operates from a compensation perspective, as it has since its inception. There have been many reasonable arguments suggesting that as a fund scales and the manager’s Assets Under Management (“AUM”) increases, the management fee as a percentage of AUM should decrease because of (i) economies of scale, and (ii) the amortization of management costs over multiple funds being managed simultaneously. Despite these well-reasoned arguments, limited partners (LPs) have not been overly successful in moving managers off of the compensation model other than those LPs who have been able to use their scale to their advantage by making large commitments in exchange for lower management fees. In addition, some large PE fund managers recognize the scale inherent in investing billions of dollars, and have accepted lower levels of management fees accordingly, but this dynamic is not currently relevant given the scale of most fund managers in the litigation finance market.
Why has fee compression been absent in private equity? Because the performance of private equity has justified the fee structure, although Ludovic Phalippou’s recent research entitled “An Inconvenient Fact: Private Equity Returns and the Billionaire Factory” may contribute to changing that sentiment. Then again, private equity can always turn the page on institutional investors and ‘pivot’ to the trillions available in the 401(k) market, which has recently become more accessible. At present, I don’t see a compelling reason for the existing compensation models changing, as private equity is a much more management-intensive asset class than public equities, and does require some unique skill sets given the breadth and depth of issues inherent in managing a private business, even if only at the board level.
And while the “2 and 20” model is also prevalent in litigation finance, there have been some marked exceptions. First, let’s take a look at the publicly-listed fund managers who also run private partnerships.
Publicly Listed Managers
In the private equity world, there are a number of managers that are currently publicly-listed. These managers typically became publicly-listed not out of business necessity, but more so out of a necessity to monetize their shareholders’ investments in their private equity firms for the benefit of departing partners who contributed to the success of their organizations over decades, and also as part of their succession strategy. Alternatively, they may have floated once they created a certain level of scale in the private equity business, to justify attracting investor capital in the public markets in order to scale their already sizable organizations in a variety of different asset classes (credit, distressed, real estate, etc.). However, one thing never changed – their fee structures. I would argue that the reason their fee structures never changed is due to the fact that such structures were at the heart of their business models since inception – 2% management fee ‘keeps the lights on’, and the 20% performance fee creates wealth (if the manager performs). Arguably, for those that have achieved scale, both the 2% and the 20% have contributed significantly to their wealth and continue to do so. We are even at a point in time of the lifecycle of the PE asset class that fund managers have been able to monetize their excess management fees and performance fees by selling minority interests in their PE firms to the very same institutions that pay their excess management fees & performance fees to begin with – talk about double dipping!
Conversely, the publicly-listed litigation finance managers did not always start off with a strong private partnership model, but were forced to look to the public markets for capital (see my recent article entitled “Investor Evolution in the Context of Litigation Finance” which explains why). Instead, they ran a business off of their own balance sheets and they didn’t have to live within the confines of a 2% management fee model to finance their operations, as they could rely on funding from their balance sheets, although they ultimately had to deliver profits to their investors which forces a different type of discipline. This had the benefit of allowing managers to expand more quickly than they could in a private partnership context, but perhaps did not have the same level of financial discipline, as the case outcome results were co-mingled with the expenses, and the investor could not necessarily bifurcate the results.
More recently, certain publicly-listed litigation finance managers have decided to forego management fees in exchange for a bigger percentage of the contingent profit of the portfolio, which appears to be unique to this asset class. When I originally contemplated publicly-listed managers raising money through private partnerships, my thought was that they would do so to ‘smooth out earnings’ by generating consistent and recurring management fees to offset their operating expenses, and thereby contribute to producing more consistent operating profits on which their equity would be valued with less inherent volatility. In essence, their share price would appreciate solely due to the mitigation of earnings volatility. However, given their openness to foregoing management fees, perhaps their philosophy is that having covered off the operating costs through the public balance sheet, they should ‘leverage’ their balance sheets by maximizing their performance fee and thereby enhance their return on equity for the benefit of public investors (i.e. forget the management fees, we prefer higher performance fees). Both approaches are equally supportable, although I would tend to favour a strategy that promotes earnings stability in an asset class than can otherwise be relatively volatile, although I also recognizine that it would take a significant amount of AUM in order to generate sufficient fees to make a meaningful difference.
As a private partnership investor, I would view the low/no management fee approach as quite attractive, because it’s almost as if the operations are being ‘subsidized’ by the public balance sheet, from which I would benefit. I am more than happy to give up some extra fees on the ‘back-end,’ as those fees are paid out of contingent profits as opposed to up-front principal, plus it selfishly helps my own cash-on-cash returns. More recently, I have heard rumours that a private fund manager that runs multiple funds has taken the same approach – presumably the prior funds’ management fees are paying to ‘keep the lights on,’ and so they are more apt to forego current fees for a larger share of the back-end. Of course, this might make prior fund investors wonder whether their management fees were too high if they can carry the subsequent fund’s operating expenses, in addition to covering the operations of the fund in which they invested.
The issue that foregoing management fees for additional performance fees may present, is whether this affords the publicly-listed fund managers a competitive advantage from a fundraising perspective, since most of the private fund managers don’t have the luxury of being able to forego management fees, as they rely on them to ‘pay the bills’ while they invest. One could argue that the publicly-listed managers’ compensation systems distort the marketplace, but then again, they are obtaining a higher share of profits than a private fund manager would with a ‘2 and 20’ model, and so one could say that the difference is simply a trade-off between ongoing cashflow from management fees and deferred performance payments with incremental risk. I think given the relatively early stage of industry development, there is enough room for multiple manager compensation models, and one will not necessarily compete with the other. After all, the only basis on which performance should be measured is net returns. However, we are at a stage of the industry’s development where many newer managers can’t show empirical results to prove out net fund returns to investors, which may ultimately result in term modifications to established compensation norms, in order to address the inherent risk of uncertainty associated with younger managers.
Management Fee Logistics
Not all management fees are created equal, and not all management fees are as transparent as a 2% annual fee, paid quarterly. Some fund managers have decided to charge the plaintiffs an origination fee, which may ultimately get capitalized as part of the investment in the case, but is funded by the fund investors through a larger draw, as contrasted with the draw required without an origination fee. This origination fee construct comes with the benefit of providing the investor with a return on their origination fee, but arguably this is inherent in all management fees, as there is typically a hurdle return to investors for all capital called as part of the proceeds waterfall.
The negative aspect of an origination fee is that the fee is charged and funded upfront, and so it represents an incremental ‘drag’ on Internal Rates of Return (“IRRs”). Conversely, it may not show as an operating cost of the fund if the fee is capitalized as part of the investment, and thus may help with the J-curve effect in the early years of the fund’s performance. However, the difference is rooted in ‘playing with numbers’. My one caution to investors on the topic of upfront origination fees is that the manager is effectively front-loading management fees that would otherwise be charged and earned over time by the fund manager. The implication is that an investor needs to take a closer look at the long-term solvency of the fund manager when considering an investment in their fund offering, because if the manager’s returns fail to persist, they may not be able to generate sufficient fee income to run-off the remainder of the portfolio, which potentially leaves the investor in a precarious position. Ideally, upfront fee income would be put into escrow and released to the manager over time to prevent future liquidity issues, although I have never seen this proposed (and this concept may cause “dry income” to the manager, which is taxable income for which there is no corresponding cashflow).
Other Operating Costs:
Different than some other asset classes, an investor in the litigation finance asset class has more than management fees to consider when assessing the returns inherent in the asset class, but these costs can be jurisdiction-specific.
Adverse Costs
Perhaps the most extensive cost is that of investing in jurisdictions that levy adverse costs (also known as “loser pays” rules) against plaintiffs who lose their case, which effectively makes the plaintiff responsible for the costs of the defendant’s litigation costs. Adverse costs can be found in Australia, Canada and the UK among other jurisdictions, but they are not generally found in the US market. These adverse costs can either be covered through an indemnity by the plaintiff, an indemnity from the litigation funder, or through the use of an After-The-Event (“ATE”) insurance policy. It should also be noted that some judges have found the litigation funder to be ultimately responsible for adverse costs even if an indemnity for such costs was specifically excluded from the funding agreement (this is the ‘ability to bear’ principle at work, rightly or wrongly), so this should factor into your manager diligence.
Some litigation funders will put in place individual insurance policies on a case-by-case basis, and others will put in place a blanket policy at the fund level to cover all adverse costs throughout the fund. Depending on how these costs are accounted, they could represent an upfront cost (insurance premiums are generally paid upfront) at the fund level or on a case-by-case basis, or they could be capitalized to the individual investments which would be appropriate as they are in fact a benefit to the investment. Regardless of the manager’s approach to ATE, they represent incremental costs, and since they are funded upfront, they represent a drag on IRRs and may contribute to a more substantial J-Curve effect for the fund in its initial years (assuming they are expensed currently). While there are many financial differences between legal jurisdictions, this is certainly one significant cost that investors who invest globally should be aware of when assessing manager performance in different jurisdictions. I would also encourage fund managers who put in place blanket policies, to ensure the costs of such policies are being incorporated into the economics of the funding agreements and passed along to the plaintiff, as there is a significant cost and benefit attached to the existence of the policy which should be recognized as a pass-through benefit. ATE policy protection is really a plaintiff benefit, as the funder typically considers it a defensive measure, knowing that the courts have sought adverse costs protections from the funder in cases where the plaintiff does not have the financial resources to indemnify.
External Diligence Costs
The other cost which does not vary jurisdictionally that investors should be cognizant of, is the extent to which a fund manager uses external parties to diligence their cases vs. internal resources and how these costs are accounted for – expensed or capitalized as part of their investment (the more typical treatment). It would be unreasonable to expect a fund manager to be able to perform 100% of their diligence internally, as much of litigation is nuanced and requires the input of professionals (lawyers, experts, etc.) to obtain a realistic and informed opinion of the risk associated with a particular legal or technical issue. Some managers employ an outsourced model, while others conduct most of their diligence in-house, and the costs associated with each can influence the operating costs of the fund.
The larger litigation finance fund managers have economies of scale to their advantage, and are more likely to employ litigators and executives with specific expertise in a variety of areas, and so they are less likely to employ third parties to provide these services. With these managers, the diligence expertise is contained within their operations team, which is funded by their management fees (and may be funded by balance sheets for the publicly-listed funders). Smaller fund managers, lacking economies of scale, would be more apt to use external parties for diligence. The question then is how are they accounting for these costs? Are they being run through the operating expenses of the fund, are they being capitalized to the cost of the investment or are they applying a hybrid approach?
The other issue is how are “broken deal costs” accounted for, and who is responsible for picking up the external costs of undertaking diligence, only to walk away from the investment (the General Partner or the limited partners or a combination of both), perhaps as a result of the insight gained from the external party. These costs are typically included as part of operating expenses of the fund, but not exclusively. From this perspective, litigation finance is superior to private equity as an asset class, because PE firms tend to spend hundreds of thousands to millions of dollars in external deal costs, whereas litigation finance tends to limit these to the tens of thousands of dollars (although in either case they are directly influenced by the size of the investment), as much of their diligence expertise remains in-house. This dynamic could justify a relatively higher compensation model for litigation financiers, because those costs are effectively funded through the management fees, whereas the comparable costs in private equity are funded by the limited partners through fund operating expenses, or capitalized to the cost of the investment.
Net-Net?
When I assess a litigation finance manager for potential investment, my baseline is to look at their compensation system relative to a “2 and 20” model, with the devil being in the details in terms of how those items are defined. For small managers, of which the majority of litigation finance managers would be classified, it is difficult to make anything other than “2 and 20” work from a cashflow perspective. For most managers, I don’t believe there is a lot of excess profit inherent in the management fees found in a “2 and 20” model, but it should be sufficient enough to hire strong people and execute on the business plan, generate solid returns if done correctly, and if management pays proper attention to portfolio construction. Compensation should also be predicated on the fund manager deploying a high percentage of its committed capital (85-100%). Where the manager does not meet its deployment targets, perhaps there should be a ‘claw back’ of management fees.
The issue of excess compensation starts to become significant as any manager scales its operations into the hundreds of millions and billions of AUM. This phenomenon is no different for litigation finance, but it is much more acute given the deployment issue highlighted previously. Also, relative to other asset classes, the litigation finance asset class suffers a bit from a lack of available data that would provide comfort to investors in the absence of having data to confirm that completed portfolios of litigation finance investments produce a level of return commensurate with the risk.
I have been investing in the industry for the better part of five years, and I have yet to see more than a handful of examples of fully realized net fund returns globally, which forces investors to be cautious on fees to minimize the downside risk. There is a sufficient amount of ‘tail risk’ inherent in any portfolio, and even more in litigation finance, and so the quicker the industry can produce and disseminate data on completed portfolios, the quicker this risk can be mitigated and the industry can be viewed as a true private equity asset class with perhaps less pressure on compensation models. Conversely, this data will also provide fund managers with additional confidence to consider different compensation models so that they can put more of their own money at risk and benefit from enhanced performance fees, which is the approach that has been taken by some of the larger publicly-listed managers who have the benefit of realization data to justify putting their fees at risk.
Investors should focus not only on management fees, but on the entire operational model, of which manager compensation may be one significant cost factor. Certain jurisdictions and legal systems come with other costs that also need to be factored into the equation. Certain case types and strategies may also be more resource-intensive and need to be factored into the overall risk/reward characteristics of the investment (i.e. if you had to pay more people to generate a more diversified portfolio in order to reduce portfolio risk, perhaps the investor will be satisfied with a lower overall return which is reflective of the de-risked nature of the investment). No different than litigation finance itself, investing is a form of risk-sharing. Managers and investors who recognize the symbiotic relationship between investor and manager will soon come to appreciate the benefits of transparency and fairness that will serve as the foundation for a long-term business relationship.
Investor Insights
Any fund operating model needs to be designed taking into consideration all of the operating costs inherent in the manager’s operational model in the context of expected returns and timing thereof. Investors care about being treated fairly, sharing risk and sharing the upside performance in order to foster long-term relationships that reflect positively on their organizations’ ability to perpetuate returns. Professional investors rely on data to make decisions, and in the absence of data which might get them comfortable with a manager’s performance, they will default to mitigating risk. Tail risk in this asset class is not insignificant, which makes investing that much more difficult. A performing manager that does a good job of sharing risk and reward with investors will have created a sustainable fund management business that will ultimately create equity value for its shareholders beyond the gains inherent in its performance fees.
Edward Truant is the founder of Slingshot Capital Inc., and an investor in the litigation finance industry (consumer and commercial). Ed is currently designing a new fund focused on institutional investors who are seeking to make allocations to the commercial litigation finance asset class.
