Managing Duration Risk in Litigation Finance (Part 1)
Executive Summary
Duration risk is one of the top risks in litigation finance
Duration is impossible to determine, even for litigation experts
Risk management tools are available and investors should make themselves aware of the tools and their costs prior to making their first investment
Diversification is critical in litigation finance
Slingshot Insights:
Duration management begins prior to making an investment by determining which areas of litigation finance have attractive duration risks
Avoidance can be more powerful than management when it comes to duration in litigation finance
There is likely a correlation between duration risk and binary risk (i.e. the longer a case proceeds, the higher the likelihood of binary risk associated with a judicial/arbitral outcome)
When you are speaking to an institutional investor about litigation, it doesn’t take long until the concept of “duration risk” enters the discussion. Everyone seems to have a story about that one piece of patent litigation or commercial dispute that went on for over a decade that seems to have marked them for life even though they weren’t in any way involved.
Yet, it’s a real risk. Thankfully, it’s not a real risk for a well-constructed portfolio of different case types in different jurisdictions, which is one of the reasons that prompted me to raise a commercial litigation finance fund-of-funds in 2016 – it will ultimately serve as a very good proxy or index for how the industry performs.
The whole concept of duration risk is critically important for investors in legal finance to understand, including ways in which duration risk can be managed in this specialized asset class.
Private alternative asset classes, such as litigation finance, always need to deal with duration as part of their fundraising pitch to investors as the investments are inherently illiquid investments. This means that in order for investors to obtain their liquidity, their needs to be a mechanism to allow for that to happen. Within most private equity sub-classes (venture capital, growth equity, leveraged buy-out, real estate, etc.) the exit is typically a sale of the business. An argument is often made that there is always a clearing price for any private company and the path to liquidity is generally through an investment bank or intermediary that canvasses the market to search for the best price for that asset at any given point in time. However, with litigation finance, the pool of capital providers is relatively small, the complexity is very high and the nascency of the market means that beyond the settlement of the case (either through negotiation or a court/arbitral decision) there are not many options. But that is changing…
Duration Risk
Let’s start by defining duration risk for purposes of litigation finance investing, as the risk that the time horizon of a given investment is different than that which was originally underwritten without a commensurate increase in economics.
Most Litigation Funding Agreements (or “LFA”s) have provisions to deal with duration risk such that the negotiated economics increase as time progresses, but often this ultimately gets capped as the claimant is concerned that the funder can end up with the lion’s share of the settlement amount. Similarly, the funder does not want to put itself in a position where the claimant is not participating in the economic outcome of the claim, otherwise the claimant is wasting their time and effort (and stress). The two opposing forces work to keep each other “in check”.
And while the LFA is typically structured to mitigate this risk, there is the potential that the case simply takes much longer than originally thought and investors want to get their money back to redeploy into another, perhaps slightly more liquid, investment. And this is where many investors, individual and institutional, who poured into the space since 2015 find themselves today.
Now, the duration risk inherent in commercial litigation is not to suggest they will rival Myra Clark Gaines (the longest-running civil lawsuit in the US at 57 years), but the difference between 5 years and 10 years can make a meaningful difference to an investor’s return profile if the economic benefits are not commensurate with the timeline extension. While many funders quote an average hold period of 30+- months, one needs to be careful of the use of averages in litigation finance. Many of those averages have been derived from the average length of settled cases only, which inherently ignore the duration of the unsettled cases, which is obviously not reflective of reality.
Since there are very few fully realized funds in existence globally, it is difficult to determine an actual industry average for litigation finance but I would confidently say that the average will in fact be greater than the 30-month time period often quoted. The other thing to consider is that any average should be weighted based on dollars invested to ensure that the early settlements, which by definition would likely have fewer invested dollars, do not contribute disproportionately to the average. The reality is that funders rely on the relatively early case wins to produce strong IRRs (albeit lower MOICs) in order to offset the IRR drag of those cases that are not successful and that exceed the average duration.
If we look at a case where the LFA calls for 3X multiple (200% return on investment) during the 3-year period and a 5X multiple (400% return on investment) thereafter, then the IRRs would look as follows for different durations:
The first two data points illustrate that where the cap on the proceeds move in lock-step with timing, it has little effect on IRRs. However, the last three data points illustrate the punitive impact that duration has on internal rates of return. When duration moves from 5 to 10 years for a fixed outcome the internal rate of return decreases by approximately half.
In addition to the duration necessary to get to a decision (after the potential for an appeal), you may then get caught up in additional enforcement and collection timelines which could add years and additional investment to the original investment proposition. A good example of this is the “Petersen” & “Eton Park” claims that Burford invested in involving a claimant that is fighting Argentina & YPF over the privatization of energy assets without due compensation.
The Implications of Time on the Value of Litigation
In a prior article written about the value of litigation, I describe how a piece of pre-settlement litigation starts off at the risky end of the spectrum due to a lack of information about the various parties’ positions, it then starts to de-risk as each side goes through discovery (approaching the optimal zone of resolution) and then the it starts to re-risk as each side becomes entrenched in their positions and pushes on to a third party decision. This then leads to a bifurcation in value because the more the outcome of a case is dependent on the outcome of a disinterested third party (a judge, jury or arbitral panel) the more binary the outcome becomes as displayed in the chart below.
This of course begs the question, if the timeline of a lawsuit extends beyond its original timeline, what does this say about the value of the case itself? Is it that the case is seen as a win by both sides and therefore each side ‘digs in’ to ensure the other side loses (hence a more binary outcome), or is this just a reflection of healthy sparring between parties to delay the inevitable and increase the friction costs to force the claimant to drop its case?
Sadly, because every case has its idiosyncrasies and different personalities involved, we will never know the answer. But what we do know is that any case that does get decided by a third party results in a binary outcome and as an investor “binary” doesn’t make for a good night’s sleep.
I have written about this issue in an article about secondary investing, and in that article I make the argument that secondaries, if not valued properly, likely have a higher risk profile then the rest of the portfolio in which they reside because they are moving into the re-risk zone which inherently has a higher level of binary risk attached thereto. I think this is important for investors to understand because it suggests that if you are concerned about duration in a litigation finance investment, it is probably (although not always) in your best interest to get out earlier than later. Of course, the counter-argument is that the longer the case has elapsed the more you know about its merits and how the other side has conducted itself during the case and so your case may in fact be less risky than when it started. However, in these cases you are going to be asking the secondary investor for a premium to reflect that fact and that means you need to convince them of the merits, the likely duration and any credit/collection risks, which is a difficult task by any measure.
We must also not lose sight of the fact that the longer a case proceeds, depending on the size and financial capacity of the defendant, the risk of collection may increase due to the financial condition of the defendant especially those with multiple lawsuits or those whose fortunes (profits and cashflow) are tied to more cyclical industries. What looked like a good credit risk five years ago when the case commenced may look very different coming out of a recession or a commodity cycle. Similarly, if the plaintiff is not of sound financial condition, the risk that the plaintiff runs out of money or interest in pursuing the case is also a risk that you are implicitly assuming.
Given that the secondary industry is in its infancy and there is very little in terms of empirical results on secondaries, it remains to be seen how secondary portfolios will perform but if I were an investor in the sector I would go in with ‘eyes wide open’ and a deep value mindset. The reality of most litigation finance is that the economic benefits tend to be somewhat capped, and so whatever premium is paid on a secondary, it means it reduces the overall economics available to the secondary investor. Dissimilar to private equity where a secondary investor can still benefit from growth in the value of the underlying company it acquires, the same does not generally hold for litigation finance investments and in fact the risk is to the downside with most LFAs.
In the second article of this two-part series, we will look at the various ways in which investors can manage duration risk, both before they start investing and after they have invested.
Slingshot Insights
Duration management in litigation finance is almost as critical as manager selection and case selection. I believe duration management starts prior to making any investments by pairing your investment strategy and its inherent duration expectations with the duration characteristics of your investments. From there, you should ensure your portfolio is diversified and you should be actively assessing duration and liquidity throughout your hold period. You should also assess the various tools available to you both on entry and along the hold period to determine your optimum exit point.
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, advising and investing with and alongside institutional investors.
Disclosure: An entity controlled by the author is an investor in investing vehicles managed by the EDLC Manager referred to herein.