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‘Secondary’ Investing in Litigation Finance (part 2): Why, why now, and how to approach investing in Lit Fin Secondaries

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

  • Evolution of Litigation Finance necessitates the need for a secondary market
  • Investing in Litigation Finance secondaries is much more difficult than other forms of private equity due to the inherent difficulty in valuing the ‘tail’
  • Experts should be utilized to assess case merits and valuation
  • Life cycle of litigation finance suggests timing is right for secondaries

Slingshot Insights:

  • Investing in the ‘tail’ of a portfolio, where most secondary transactions will take place, can be more difficult than primary investing
  • Dynamics of the ‘tail’ of a portfolio are inherently riskier than a whole portfolio, which is partially offset by enhanced information related to the underlying cases
  • Secondary portfolios are best reviewed by experts in the field and each significant investment should be reviewed extensively
  • Derive little comfort from portfolios that have been marked-to-market by the underlying manager
  • Investing in secondaries requires a discount to market value to offset the implied volatility associated with the tail

In part 1 of this article, I explored some of the basic concepts of secondary investing, specifically in the context of the commercial litigation finance asset class.  This article continues the discussion and explores some of the unique aspects and characteristic of the ‘tail’ of a litigation finance portfolio, why now is a particularly good time for secondary transactions and other investment considerations with respect to secondary investing.

Investing in the ‘tail’

In a prior article, I made reference to three phases of risk in the context of litigation (there are more but let’s keep it simple for now).  As a case evolves, it moves from a phase where the case is “De-Risking” because more information is flowing to the point where both parties have an abundance of, and equal information about, the litigation (yet still have different perspectives based on subjective value judgments), which moves the case into something I referred to as the zone of “Optimal Resolution” (credit to John Rossos at Bridgepoint Financial who developed this ‘three phases of risk’ analogy). Optimal Resolution is a period of time where both parties understand what information the other party has, the legal precedents being referenced, and perhaps some insights into how similar cases would have been judged in the past.  With an abundance of information, the two parties should come together to form a conclusion around a reasonable settlement and bring the case to an end.  However, if they fail to do so, the case starts to enter into the “Re-Risk” stage where the parties typically commence with a trial or arbitration, at which stage both sides may get more entrenched in their positions and if they do the outcome ultimately becomes binary, as it will be decided by a third party (i.e., judge, arbitrator or a jury) without a vested economic interest in the outcome.  Any good litigator will tell you to avoid a binary outcome if at all possible, as these outcomes are quite unpredictable (i.e. your odds of winning may be better in Vegas).

I make reference to these three phases because the ‘tail’ tends to capture the Re-Risk stage of litigation/arbitration, which is the riskiest part of the litigation process.  So, when investors are looking at a secondary portfolio of single case investments, they are almost by definition investing at the riskiest part of the lifecycle of the case.  Of course, that is not always the case, and it depends whether you are the plaintiff or the defendant.  If you are a plaintiff, you may have a number of interim procedural wins and so you may believe there is a stronger possibility of success as compared to when the manager first under-wrote the case.  Therefore, you may be feeling relatively good about your prospects. However, while one would think justice is equitable, consistent and repeatable, that is rarely the case, which makes this stage of the litigation process the most dangerous, as the plaintiff may be lulled into a false sense of security based on some procedural wins and damning evidence against the defendant.

The fact that these cases are in the tail of the portfolio firmly suggests that (i) they have been going on for a long time, which means that (ii) you may have two entrenched, deep pocketed parties who are not likely to give in soon, which means that (iii) the outcome will more likely than not end up in a binary decision.  Of course, it may also mean that it is closer to resolution, as many cases have been settled on the ‘court room steps’.

Accordingly, the risks are different than those of investing into a ‘blind pool’ portfolio where the cases have yet to be picked. In a nutshell, the investor in a secondary does not get the benefit of the early wins and relatively more attractive IRRs to offset the more binary characteristics of the tail, which likely includes bigger losses (if for no other reason than a loss in the tail means the original capital commitment has likely been fully consumed).  Since the secondary investor has to make his or her returns from the more binary portion of the portfolio, which means higher volatility as the probability of a loss is higher in the tail segment of the distribution (a well-known statistical characteristic), ultimately, it would be dangerous for a new investor to pay a premium, and conversely, it is likelier the investor will need to buy at a discount.

But discount to what – original cost or current fair market value?  Discounting to cost is a fairly easy exercise, but may not be meaningful.  Discounting to fair market value is pretty challenging in the context of a tail comprised of single case investments, each of which is more likely than not in the Re-Risking stage of the investment life cycle.  Nevertheless, it is only logical that a secondary investor should treat the investment as though it was a new portfolio and underwrite every significant investment in the portfolio from scratch, to do otherwise would be reckless.  A “diligence light” approach is not acceptable given the potentially higher risks inherent in the tail and so as much, if not more, time should be spent underwriting secondary portfolios as compared to primary portfolios. Also recognize that when selling secondary portfolios the seller and their advisors are in ‘sell mode’, and so a second set of sober and skeptical eyes is probably the best way to value these assets.  An astute investor can also structure the investment by limiting its downside by negotiating a lower entry price in exchange for a sharing of the upside with the exiting investor, so that it becomes a ‘win-win’ transaction with the secondary investor getting some downside protection, and the exiting investor retaining some upside.

A positive aspect of investing in the tail is that the majority of the legal spend has taken place and so your deployment risk is probably low, which essentially means that if you win, your ROI will likely be a multiple of a higher known number as compared to when the investment was originally underwritten. That’s IF you win!  It also means that you have the ability to determine the impact of fees on expected returns based on when the fees were charged in relation to when the cash was invested, which may help with the gross-to-net return spread issue that can be significant in litigation finance.  There is also the potential that these cases may settle relatively early in the life cycle of the secondary investor’s ownership period, which will likely generate stronger IRRs and MOICs, and hopefully minimize the ‘fee drag’ (the impact fees have on net investor returns).

Why now?

There has been much recent chatter in the litigation finance sector about secondary opportunities, so why now?

Well, it’s mainly reflective of the extent of time the industry has been in existence.  The commercial litigation finance industry started in earnest between five and ten years ago in the US.  Accordingly, a meaningful amount of capital has been raised and a sufficient amount of time has passed to allow for the conditions necessary for secondaries – namely supply.  The supply mainly stems from a confluence of investor interest in liquidity for their longer dated investments, and GP interest in ‘putting some points on the board’, meaning they need to show some track record so they can raise a subsequent fund. Simply, the timing seems right, and when an institution needs a way to achieve liquidity for its portfolio, it will find a way to do so.

How best to approach investing in secondary transactions?

Different from other forms of private equity, acquiring litigation finance investments in the secondary market requires the expertise of a litigation finance fund manager.  I say this because of the risks inherent in the tail end of the portfolio, and the expertise required to assess this tail is the same expertise required to underwrite new investments.  It would be a mistake to confuse investing in secondary transactions in litigation finance with other private equity sectors like leveraged buy-out or venture capital, where the valuation metrics and approach to valuation are much more transparent and well accepted. Valuation in litigation finance is much more in the realm of ‘beauty is in the eye of the beholder’ (aka “a subjective value judgment”), with one group seeing much more value in a case than another based on their biases and experiences.  Managers that invest in secondaries should be prepared to do extensive diligence on a large part of the portfolio, and certainly those investments in the portfolio that appear riskier and disproportionately large relative to the average case size in the portfolio.

The other important element is to ensure that you have a diversified portfolio.  If you are purchasing a tail portfolio, then it likely means there are fewer investments than what was present in the original portfolio earlier in its investment cycle; hence, there will be a higher degree of volatility, in statistical terms.  Since there are now fewer investments in the tail portfolio and the early resolutions likely provided strong returns, the remainder of the tail has to stand on its own merit and so it will be important to ensure the tail portfolio is large enough to be diversified in its own right.  To the extent it is not well diversified, I would consider spreading your overall secondary allocations across more than one portfolio, until you get a desired (target) degree of diversification (case types, case sizes, geographies, defendants, law firms, etc.) with a limited concentration risk within the portfolio.  A portfolio with 50 cases might seem diversified, but if three of those cases represent 30% of the capital and they all turn out to be losers (which is statistically a very real potential outcome), then it puts a lot of pressure on the remaining portfolio to both offset the large losses while simultaneously producing target returns for the portfolio as a whole.

Lastly, I would consider putting in place an insurance wrapper for ‘first loss’ insurance.  This type of insurance can be expensive, and so you need to be prudent and careful not to over-insure.  You have to look at the risk of loss probabilistically, and such an analysis could show that you don’t likely have to insure 100% of the principal, but probably just a fraction of the principal, and preferably through first-loss coverage, where the insurer takes the obligation for the loss on the first, say, 20% – 30% of the portfolio (the riskiest portion, statistically speaking), and the investor is exposed for the remaining 70% – 80% (the decreasingly less risky portion).

I think most secondary portfolios should be valued at a significant discount to market value with a range of probability-sequenced outcomes to triangulate to a valuation. The valuator should not lose sight of the fact that approximately 30% of litigation finance backed cases lose, and so this should be a starting point for the analysis of the potential value of the portfolio, and stress-tested from there to reflect the higher risk inherent in the ‘tail’.  However, there can also be specific investment opportunities which through the process of de-risking may represent better opportunities than they did before the de-risking process and the investor may be able to justify or may be forced to accept a higher valuation in order to be able to transact.

In situations where the litigation is so significant that it can actually have an impact on a defendant’s publicly traded securities, you could also use options on the publicly traded securities of your counter-party to hedge your investment such that if you lose the case you make money on the hedge, and if you win the case, the cost of unravelling the hedge becomes the cost of an otherwise successful transaction.  Of course, any hedge will be imperfect as the stock price of the defendant can be influenced by a number of factors in addition to the outcome of the litigation, the very outcome you are trying to hedge.

David Ross, Managing Director & Head of Private Credit at Northleaf Capital Partners notes: “We approach secondary transactions in a prudent and judicious manner with thorough analysis on concentration risk, deep dive on case merits and outcomes, as well as comprehensive financial diligence and modeling. We tend to mitigate investment risk by way of conservative structuring and cautious underlying assumptions that provide significant cushion for the investment.”

It is only through a cautious approach that one can successfully invest in commercial litigation finance secondaries.  Other areas of litigation finance (consumer, law firm lending, etc.) will likely have different risks and portfolio characteristics that allow for less extensive diligence on the portfolio, which may be a consideration for some investors.

Slingshot Insights

For those investors interested in the litigation finance secondary market, I think it is important to approach the investment with caution and a high level of expert diligence to offset the implied volatility that the ‘tail’ of the portfolio offers.  It is also important to understand the motivations of the seller – a manager looking to create a track record will have different motivations than an investor who needs liquidity.  The seller’s motivations may also offer insight into the extent price can be negotiated. It is important not to lose sight of the typical loss rate of the industry and the fact that the tail should exhibit enhanced volatility (more losses) as compared to a whole portfolio, and so an investor should model their returns, and hence their entry price, accordingly. Should you choose to make a secondary investment, consider a variety of options to de-risk the investment by sharing risks and rewards with others (i.e. insurance providers or the vendor of the asset). Above all else, make sure your secondaries are diversified or part of a larger diversified pool of assets.

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. is involved in the origination and design of unique opportunities in legal finance markets, globally, investing with and alongside institutional investors.

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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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