Commercial Litigation Finance: How big is this thing?
Executive Summary
The chart above summarizes the results of quantifying the size of the most mature markets for litigation finance. If you were to attempt to do the same analysis 3 years ago, I suspect you would find that the industry was less than half its current size. Accordingly, it is a dynamic and growing market that should be on most investors’ radar screens if you are interested in non-correlated exposures.
Investor Insights
Growing, dynamic market
Relatively few managers with long track records; ‘tall risk’ can be significant
Diversification is critical
New investors should focus on a small subset of experienced managers
Approach and Limitation of Sizing
I am often asked about the size of the commercial litigation finance market by individual and institutional investors alike, whether relative to the US market or other large global markets. I often hesitate to answer the question as the answer is dependent on an element of transparency not currently inherent in the industry itself. Nevertheless, I think it is important for all stakeholders to understand the size of an industry so that investors can determine whether it has the scale and growth attributes necessary to justify a long-term approach to investing in the sector.
However, before I describe the approaches taken, I think it is important to recognize the limitations of attempting to size the industry as past estimates have varied wildly.
Limitation #1: Dedicated Funds vs. Opaque Capital Pools vs. Non-Organized Capital Pools
While there are many dedicated litigation funders (“Funders”) servicing the global marketplace, both private and publicly-traded, they only represent a portion of the available financing for the industry (especially in the US). Even the Funders that service the market are relatively private about the amount of capital they have available and the amount of capital they deploy annually (not to mention committed capital vs. drawn capital). On the odd occasion you will have a funder trumpet their latest close size, but it is often just a headline number and you are left wondering exactly what it means as it could be inclusive of co-invest capacity, side cars, discretionary separately managed accounts, etc.
Then, there are the Opaque Capital Pools. These are the hedge funds, the multi-strategy funds with a sliver of their fund dedicated to litigation finance, merchant banks, credit funds, etc. Even PIMCO, the world’s largest bond fund, has an allocation that has invested in one of the UK funders (a tiny allocation for PIMCO, but perhaps that is the ‘thin edge of the wedge’ if they achieve success). The problem from a data perspective is that many of these funding sources don’t disclose how much of their capital has been allocated to litigation finance as they don’t necessarily want the world, or their competitors, to know where they are investing.
Finally, there is a host of other financiers in the marketplace, which I will refer to as Unorganized Capital Pools. These are the lawyers, the law firms, the High Net Worth (HNW) and Ultra HNW (UHNW) individual investors, family offices and the like that have decided they want exposure to single case risks or portfolios thereof. Investors who have not dedicated a lot of time and attention to the asset class are probably best served by investing in a series of funds as opposed to going direct with one manager or a series of individual cases.
Often times, the second and third categories are what I will call flexible pools of capital, meaning that if they have achieved good success in investing they will allocate more capital and if they don’t have a good experience they will retreat and ‘run-off’ their remaining investments and “chalk that one up to experience”. The Opaque Capital Pools and Unorganized Capital Pools are what I refer to as “Non-Fund Investors”. Accordingly, due to the flexibility and private nature of the Opaque and Unorganized Capital Pools, it is difficult to determine the exact amount of capital they represent at any given point in time.
Limitation #2: Financing Fees vs. Financing Out of Pockets
There is a distinction in the industry between financing legal fees (which is not always possible in all jurisdictions) and financing out-of-pocket expenses (court costs, discovery costs, expert reports, etc.). There is also a third bucket where financiers will provide “working capital” as part of their litigation finance commitment. Funds which provide working capital are grounded in a belief by the Funder that the piece of litigation has value and if the value exceeds the various costs necessary to pursue the case, then they are comfortable providing any excess to the business for working capital purposes. The other aspect to working capital is that the litigation funder does not want to find itself in the middle of litigation with an insolvent enterprise with the management team no longer focused on the litigation prize and so they argue it is in their best interest to keep the company solvent while the litigation is being pursued. Arguably, working capital loans belong in the world of specialty finance, not litigation finance, but in this case the underlying security is the outcome of the litigation.
The reason I draw the first distinction is because it could be argued that a large segment of litigation finance is already being provided through contingent fee arrangements, which have been in existence for decades in the US but have been the sole purview of lawyers. Should these contingent fees count towards the industry sizing? I think a logical argument can be made that they should be included as these are funds that could or would otherwise be provided by a third-party litigation funder, but then again, they will never be funded by Funders. Some people believe that law firms are taking the best cases for themselves and the litigation funding industry is fighting for the cast-offs (termed ‘adverse selection risk’). I don’t necessarily subscribe to this theory as the high success rates in the Litigation Finance industry supports a lot of good cases being undertaken by third party funders.
Interestingly, one of the world’s largest law firms, Kirkland & Ellis, recently announced that they are going to double down on their contingent fee arrangements through the establishment of a plaintiff side litigation group, which was previously the sole purview of scrappy plaintiff side lawyers (many of whom have achieved tremendous financial success in so doing). Perhaps the grass is greener…
For the purpose of this article, I have assumed that contingent fees are not included in the industry sizing exercise.
Limitation #3: It’s Getting Global
A few years ago, the various funders were entrenched in their local jurisdictions and happy to toil away in their own back yards. Then something interesting happened. It got global, fast! Over the last 3-5 years, the industry saw litigation funders move outside of their home base and do so in a significant way. UK funders were moving into the US, Australian funders were moving into the US and UK, UK funders were moving into Australia and more recently some funders figured my host country, Canada, was also an interesting opportunity. Is this a reflection of their local markets being saturated or is this a global ‘land grab’? I point this out because when you analyze pools of capital by litigation funder, you cannot solely look at where that funder is domiciled and conclude their capital is solely dedicated to their home country. Some funders, like IMF Bentham, have set up dedicated pools to service the US and other pools to service Rest of World (i.e. ex-US). Other funders do not have dedicated pools but look for the best risk-adjusted opportunities around the globe or in specific markets in which they are comfortable investing (typically other English common law or common law derived markets, but not necessarily so). I say this because the available data forces one to look at global litigation funding sizing, as it is difficult to know where the funder will deploy its capital. This doesn’t even consider foreign exchange rate fluctuations and their effect on industry sizing – the Brexit impact on the GBP would have had a significant impact on the USD equivalent alone.
Limitation #4: Cultural Differences and Punitive Damages
There is no arguing that the US is a much more permissive culture in terms of utilizing litigation as a way to settle differences – ‘nothin’ like a good gun fight to settle a dispute’, one might say. This means that while the size of the litigation industry is much larger, one could argue that you have to separate through the less meritorious claims to find the jewels that litigation finance would support – their money is not frivolous and so the cases they fund are also not frivolous. Accordingly, when you look at the size of the entire industry you will have to assign a lower litigation funding applicability rate in the US because of the aggressive nature of the claim environment (i.e. while the US legal market is much larger because the culture is more permissive, there are a smaller percentage of claims that would attract litigation finance).
The second, and more important issue, is the relative extent of punitive damages in the American civil justice system vs other civil justice systems. There is no doubt and it has been well documented through empirical evidence that awards are larger in the US. Accordingly, this would suggest that comparing data from other jurisdictions and applying it to try and size the US market, or any other market for that matter, is somewhat limiting.
In addition, each market has its own nuances and peculiarities and so it is very difficult to compare different jurisdictions and draw solid conclusions. All of the aforementioned would suggest the industry is difficult to size with any degree of accuracy. I think there is some truth to that supposition.
Limitation #5 – What is included in “Commercial”?
While the commercial litigation finance market is generally defined to include financing of litigation involving two corporate entities, the funders involved in the space have expanded the definition to include, amongst others, Investor-State, product class action and insolvency cases where there is typically not another commercial entity on the other side of the dispute, but rather a sovereign, a set of consumers or an individual (director or shareholder), respectively. Accordingly, the commercial litigation finance funders have expanded the definition of what gets included in the market by including large, complex cases involving non-commercial entities. Nevertheless, these cases are typically financed by commercial litigation finance funders and should be captured in the size estimates.
So, with all of the limitations above, I have tried to approach industry sizing using a couple of different approaches: micro and macro.
Macro Perspective:
When looking at it from a macro perspective, I like to focus on one of the more mature markets for litigation finance and draw inferences – that market being Australia. Australia is a common law market; it has been utilizing litigation finance for close to two decades and therefore is one of the more mature markets which suggests market penetration for Litigation Finance is relatively high. The one limitation of using Australia as a benchmark is that they generally do not allow contingent fees and so, arguably, litigation finance levels are higher because lawyers are not able to put their fees at risk and hence their fees are financed by Funders. I also believe Australia has fewer of the other Non-Funder investors as compared to the United States and so we can likely draw better conclusions about the size of their market by looking at the active funders in the market. The following chart attempts to put the relative markets into perspective.
So, if one considers the Dedicated Funds in Australia and tries to estimate the amount of capital they have dedicated to the local industry and compare that to the overall size of the litigation market (a number that is fairly well tracked), we can see that the Australian market is approximately AUS$200-300MM in annual commitments and has commitment capacity of about 2-3 times that, or $500-750MM (using the mid-point). This would suggest that litigation finance in terms of annual commitments represents about 1 to 1.5% of their $21B legal market (where the “legal market” is the market for all legal services, not just those dedicated to litigation).
Applying the same methodology to the UK market and adjusting for the fact that contingent fees are more prevalent in the UK, one could argue that the UK market, being younger than the Australian market, should be less penetrated and less capital is required due to contingent fees, perhaps the litigation finance market is closer to 1% of the legal market or approximately £290MM and commitment capacity of 2-3 times that amount of £600-900MM.
Extending this logic to the US market, and allowing for a strong punitive damage system, strong contingent fee usage and a low relative penetration rate might suggest the market is similarly close to 1% of the size of its legal market, or $4B in annual commitments with commitment capacity of 2-3 times that or $8-12B.
Micro Perspective:
The other way to look at the market is to build up the annual commitments and the commitment capacity on an investor-by-investor basis. Westfleet Advisors has recently published a “Buyer’s Guide” to estimate the size of the US market using this approach and their results seem to correlate with the approach I have used below. The difference in results between our two approaches has to do with the size of the non-fund sources of capital, and my approach is admittedly a best guess estimate. Nevertheless, I have used the following assumptions to try and triangulate the market sizes. I took my knowledge of the various funders’ commitment capacity in each of the jurisdictions to determine the total commitment capacity of the market and then I interpolated the size of the total market by estimating what percent of funding is represented by these Dedicated Funds.
Conclusion
The two approaches seem to triangulate fairly well and are buttressed by the micro analysis done by WestFleet in the US market. Accordingly, I think the two approaches provide a high level view of the amount of capital available and annual commitments for the various jurisdictions. While I would not rely on the exact figures, I believe the numbers are directionally correct and give investors an order of magnitude assessment of the current market in order to make their investment decisions as to whether this market provides sufficient scale to justify a long-term exposure to the asset class or whether they should consider it as a more opportunistic investment within one of their more niche strategies or pools of capital.
While the industry is presently not large enough to attract many large pension plans and sovereign wealth funds that typically invest no less than $100’s of million at a time, it is quickly achieving a level of scale that has become attractive to some larger investors. By example, a large sovereign wealth fund has made a US$667MM commitment to Burford’s 2019 Private Partnership through a separately managed account. The remaining external capital, aggregating $300 million, was provided by a series of small and medium sized investors rumoured to include family offices, foundations, endowments and the like. Whereas this scale of investor would not have invested in the asset class even three years ago, it appears the more aggressive of these investors have decided this is an asset class that merits serious consideration and investment and I expect more to follow.
Investor Insights
For investors interested in investing in one of the truly non-correlated asset classes, they would be best to spend the time to analyze the various managers in the sector, of which there are relatively few on a global basis that I would consider “institutional” in nature. They would also be well served to focus on those few managers with a track record that includes fully realized funds, of which there are even fewer, or be prepared to spend the time and resources to assess the unrealized portion of those managers’ portfolios as ‘tail risk’ in this industry can be significant depending on the concentration of the portfolio. As always, diversification is a key success factor to investing in this asset class as the idiosyncratic risk of cases and the binary nature of trial/arbitral awards make it particularly well suited for the application of portfolio theory.