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Commercial Slingshot Capital Special Features

Portfolio Theory in the Context of Litigation Finance (pt. 2 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. 

In part one of this two part series, which can be found here, I explored a variety of portfolio theories and applied them to the litigation finance asset class. This second article continues the application to commercial litigation finance and discusses implications for portfolio construction.

Executive Summary

  • Modern Portfolio Theory (MPT) – a mathematical framework based on the “mean-variance” analysis – argues that it’s possible to construct an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk
  • MPT states that assets (such as stocks) face both “systematic risks” – market risks such as interest rates – as well as “unsystematic risks” – mostly uncorrelated exposures that are characteristic to each asset, including management changes or poor sales resulting from unforeseen events
  • Post-modern Portfolio Theory (PMPT) adds a layer of refinement to the definition of risk
  • Diversification of a portfolio can mitigate the impact of unsystematic risks on portfolio performance – although, it depends on its composition of assets
  • Behavioural Finance (BF) introduces a suggestion that psychological influences and biases affect the financial behaviors of investors and financial practitioners, also applicable to litigation finance

Slingshot Insights:

  • Portfolio theory is important to the commercial litigation finance asset class due to its inherently high level of unsystematic risks
  • Slingshot’s Rule of Thumb: a portfolio should contain no less than 20 investments in order to provide the benefits associated with portfolio theory
  • Diversification is critical for every fund manager
  • Specialty fund managers may play a positive role in a comprehensive litigation finance investing strategy by assisting with meeting a particular performance objective when defined in the context of acceptable “mean-variance” targets
  • Diversification provides optionality for an under-performing manager to ‘live to fight another day’ if their first fund achieved sub-par performance
  • Portfolio theory is applicable to consumer litigation finance

How Big is Big Enough?

There are many theories about how large a portfolio should be to meaningfully benefit from the application of portfolio theory, with analysts suggesting anywhere from 20 to over 100 investments (typically in relation to public equities).  While I have yet to conduct a study to determine a more finite range applicable to litigation finance, I will say that there are a few elements that are critical to consider, which are specific to litigation finance.

First, litigation finance is by its very nature uncertain in terms of the amount of commitment the fund manager will ultimately deploy in relation to its financial commitment to a single case (i.e. while a manager may commit $5 million to a case, the legal team may only deploy $2MM by the time the case settles). Capital deployment (both quantum and timing) is an uncontrollable variable that makes portfolio theory difficult to apply, because portfolio theory assumes the dollars deployed in each investment are (i) known and (ii) of equal size (although weightings can be assigned).  Accordingly, in order to ensure that the portfolio is diversified on a dollars deployed basis, the portfolio needs to be sufficiently large to ensure that on a committed basis it is not skewed by a few cases which have deployed 100% or more of their initial commitment relative to those cases that have deployed less than 100%.  It is also not uncommon for managers to deploy nil or very little against their commitment as a result of an early settlement (perhaps brought on by the existence of litigation finance itself, or by virtue of the investment being in the form of adverse costs indemnity protection), which adds another element of complexity as relates to the application of portfolio theory.

Second, diversification in the context of litigation finance is not only a mathematical exercise of ensuring no one case represents a disproportionate amount of the fund, it also covers the types and extent of case exposures in the portfolio.  If one is investing only in a single manager, one wouldn’t necessarily want a fund that invests solely in Intellectual Property cases, as an example, because a Systematic risk that effects that sector (for example, litigation reform such as Inter Partes Reviews in patent litigation, or an important case precedent with broad implications) will likely effect all cases in the portfolio and hence diversification will not aid at all in terms of addressing the Systematic risk. Case types, defendants, jurisdictions, judges, plaintiff counsel, defense counsel, case inter-dependencies (where the outcome of one case has a direct impact on the likely outcome of another case in the same portfolio) are all important variables that a manager should consider when creating their portfolio.

Third, litigation finance portfolio financings (the concept of a funder investing in a portfolio of law firm or corporate cases) are, by their very nature, benefitting from the application of portfolio theory. Therefore, in constructing one’s portfolio, one should consider whether the committed capital is being invested in single case portfolios, cross-collateralized portfolio financings or a combination thereof, each of which having different risk-reward profiles.

When we take all of the above into consideration, especially the uncertainty inherent in capital deployment, my general rule of thumb is for managers to target a minimum of 20 equally sized litigation finance case commitments within a portfolio. From there, I adjust based on a variety of factors including case types, financing sizes, jurisdictions, currencies, etc.  Other investors may have a different perspective.  Of course, the portfolio will never be comprised of 20 equally-sized cases due to deployment uncertainty, so I view this as a baseline. If the portfolio is made up of cases with a higher inherent volatility (class actions, intellectual property, international arbitration or large cases), then a larger portfolio would be more appropriate, such that the higher loss ratio in the portfolio – which is inherent in higher risk portfolios – will not disproportionately contribute to the portfolio’s overall performance.

Applicability to Consumer Litigation Finance

Portfolio theory suggests that diversification is exceptionally good at reducing Unsystematic risk; hence, it comes as no surprise that MPT should be more frequently applicable to the commercial litigation finance asset class given the high level of idiosyncratic case risk.  The consumer litigation finance market also exhibits similar idiosyncratic case risk, but I believe it has more Systematic risks related to defendants (usually, insurance companies with a common approach), regulation, and established case precedent where the damages are much more prescribed.  Accordingly, while portfolio theory may not be as critical in this segment of litigation finance, as an investor in the asset class I believe it remains an important value driver for the consumer litigation finance market, especially since the return profile of a single piece of consumer litigation finance is generally not as strong as those inherent in commercial litigation finance due to risk and regulatory differences.

Fund Managers’ Perspective

As an investor experienced with managing capital, deploying capital and portfolio construction, I offer a few observations for consideration.

First, don’t fall in love with your investments (i.e. don’t get caught with personal biases working into your portfolio construction).  It is easy for a fund manager to be attracted to certain cases thinking the particular case is a ‘no brainer’ (perhaps due to personal experience and/or comfort with the merits of the case) and allocate a disproportionate amount of the portfolio to finance that case. However, in the context of an asset class with binary and idiosyncratic risk, the portfolio manager would be taking on a disproportionate amount of risk in doing so.  Once a manager has determined that the case meets their rigid underwriting criteria, her or she must change their mindset to one of portfolio allocator and take a dispassionate view of the case to ensure the portfolio is optimized.  In fact, I would suggest splitting the functional role of underwriting and portfolio construction to ensure the underwriting doesn’t influence portfolio allocation decisions!

Second, do not insist on exceptions to concentration limits.  I have seen a number of fund documents where the manager has carved out exceptions to concentration limits (many of which are not appropriate for this asset class (10%, 15%, 20%) and have been derived from other PE asset classes with completely different risk profiles). By doing so, the manager is adding a lot of risk (and bias) to the portfolio that is both unnecessary and risky to the longevity of the fund, not to mention investor returns.  In my mind, the equation is quite simple: if one creates a diversified set of investments of relatively equal size, and one maintains a sound underwriting methodology, industry data suggests that one’s investment thesis should work. So why jeopardize a sound strategy?

Third, fund managers will live and die by their portfolio results, so why take unnecessary risk in haphazardly allocating capital?

To illustrate the second and third points, let’s consider four potential portfolio outcomes: (i) non-diversified portfolio with poor performance, (ii) non-diversified portfolio with exceptional performance, (iii) diversified portfolio with good performance and (iv) diversified portfolio with poor performance.

As an investor, I would look at situations (i) and (ii) and say “as a fund manager you are ‘dead in the water’”. Why? Situation (i) is self-explanatory: poor underwriting which impacts fund performance, and is buttressed by the fact that the fund manager isn’t astute enough to diversify the portfolio. Situation (ii) communicates the exact same thing, but in a different way. It tells an investor that the fund manager was ultimately successful, but in a way that was risky (in other words, the manager ‘got lucky’) and not likely repeatable (because fund performance was dependent on too few outcomes), which is not what attracts most investors who are looking for a measure of conservatism and persistence in their managers’ return profiles. I contend that this asset class should exhibit a return profile closer to that of growth or leveraged buy-out private equity (strong returns across the portfolio with a few losers for an overall strong return profile) and not venture capital (mostly losers with some exceptionally strong performers which contribute disproportionately to the overall portfolio return, which may be positive or negative).  Recent shifts toward portfolio financings by Burford and other private fund managers, suggest that there is a consensus as to the benefit of diversification on the volatility of portfolio returns.

On the other hand, situation (iii) is an ideal one, where the manager was prudent and the results illustrate underwriting and portfolio construction acumen, with portfolio returns not being disproportionately impacted by a few cases. Situation (iv) is interesting because it is a scenario where a manager can potentially ‘live to fight another day,’ since he or she was prudent with capital allocation, but perhaps something went awry with underwriting, or the portfolio was negatively impacted by a Systematic risk which was beyond the manager’s control. Every fund manager should ask themselves, “why take the risk” in creating a non-diversified portfolio, because it is a lose-lose scenario?  Diversification will always provide the optionality of raising a subsequent fund, even if returns are sub-par.

As we live in a dynamic world with a myriad of financial innovations being developed daily, managers should remain aware of new approaches to reducing risk in their portfolio (i.e. insurance, co-investing, risk-sharing with law firms), which may allow them to invest a smaller amount without taking on undue case concentration risk.  Of course, any instrument that reduces risk incurs a cost, and so one will need to assess the overall risk-reward equation to determine whether it is appropriate for both the manager and the investor.

Diversification is in the eye of the Investor

Managers should also keep in mind that each investor is different.  A manager may have one investor that has decided to maintain a single exposure to litigation finance through the manager, in which case the investor is likely counting on that manager to ensure application of portfolio theory.  On the other hand, an investor may be looking for specific exposures to complement his or her numerous allocations within the litigation finance sector, and so the investor is expected to apply portfolio theory to the various allocations within their portfolio and are less reliant on the fund manager for doing so in their specific fund.

What is critical for managers is that they deploy capital in a responsible manner and not acquiesce to the demands of a given investor with respect to their perspective on portfolio construction and portfolio theory. We are all here to create sustainable long-term businesses, and a given investor may have different objectives that could derail the manager’s own goals.

Slingshot Insights

Investing in a nascent asset class like litigation finance is mainly about investing in people.  Most managers simply don’t have the track record of a fully realized portfolio on which investors can base their investment decision.  Accordingly, much time and attention is spent on understanding how managers think about building their business and in particular their first portfolio.  In addition to the underwriting process, one of the most important considerations for investors to understand is how managers think about portfolio construction and diversification. Portfolio theory plays an integral role in terms of how managers should be thinking about constructing their portfolios from the perspective of the number of cases in the portfolio, but managers should also ensure their own personal bias is not entering into the portfolio and that they have thought about all of the systematic risks that can affect like cases. My general rule of thumb is that most first time managers should be targeting a portfolio of at least 20 equal sized commitments, appreciating that it is almost impossible to achieve equal sized deployments due to deployment risk. It is also not in the manager’s best long-term interest to take a short-cut on diversification for expediency sake (i.e. to raise the next larger fund) and to do so may be interpreted as poor judgment from an investor’s perspective!

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.

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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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