Managing Duration Risk in Litigation Finance (Part 2)
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)
In the first article of this two-part series, I provided an overview of some of the issues related to duration in the litigation finance asset class. In this article, I discuss some of the ways in which investors can manage duration risk, both before they invest and after they have invested.
Managing Duration Risk
The good news is that there are many ways to manage duration risk in litigation finance and you can use the various alternatives in combination to create your own portfolio to mitigate the risk.
Before we look at how we can manage duration through an exit of an investment, let’s first explore how we can avoid duration risk before we even start investing. That is to say which investments have lower levels of duration risk to begin with so we can avoid duration risk going into an investment.
Case Type Selection
On the commercial side, post-settlement cases have a low degree of duration risk as the litigation risk has mainly been dealt with through the settlement agreement and the resulting risks relate to procedural (generally timing) and collection risk. Similarly, appeals finance is generally involved with cases that have less litigation risk as the issue at play is usually a specific point of law and the timeline for appeals tends to be relatively certain and short while the costs are fairly well defined.
Consumer litigation cases (think personal injury cases, other than mass torts) tend to have relatively dependable timelines and so this can be a very attractive area in which to invest with less duration uncertainty, but it does come with some ‘headline’ and regulatory risk. Mass tort cases, which technically are consumer cases, have different dynamics because of the sheer size of the claims and the complexity of the multi-jurisdictional process which require test cases to prove out the merits and values of the cases. So, I would view these as being similar to large commercial cases in terms of their dynamics with respect to duration. Other case types such as international arbitration and intellectual property disputes tend to have much longer durations in general and so avoiding these case types is a way to mitigate duration risk within a portfolio.
Case Sizes
Based on some statistical analysis I had prepared from funder results (my demarcation point between small and large was based on one million in financing) and on review of a large number of case outcomes of different sizes, there appears to be some correlation between the size of the financing and the duration of the case. Smaller financings (and presumably, but not necessarily, smaller cases) tend to have shorter durations than larger financings. The correlation could result from the fact that litigation finance is more effective in smaller cases or that there is generally less at risk in smaller cases and hence rational parties tend to resolve things more quickly when there is less to squabble over. The exact reason will never be known, but there does appear to be some statistical correlation to support the finding. Accordingly, one way to manage duration risk would be to focus on smaller sized cases.
Case Jurisdiction Selection
Not all jurisdictions are created equal in terms of speed to resolution. Accordingly, one might want to investigate the best venue for their cases given their portfolio attributes to ensure they are in jurisdictions where duration risk is lower than others. Of course, jurisdictions don’t offer duration risk in isolation and so you will need to know what you are trading off by investing in cases in jurisdictions with a faster resolution mechanism as there will likely be trade-offs with economic consequences. This could involve different countries, different states within a given country, and different judicial venues (arbitration vs. court). There are even certain judges that progress through cases at a quicker clip and are less prone to allow for unnecessary delays. Of course, you may not be able to pick your judge and even if you can there is no guarantee you will end up with the same one you started.
Case Entry Point
If you are a fund manager, another way to manage duration risk on the front end, aside from case type selection, is to focus on those cases that are already in progress and therefore should have a shorter life cycle because you are entering them later in their life cycle. While this doesn’t deal with the situation where the case goes on longer than anticipated, it does decrease the overall length of the case by deciding to enter it at a later stage, but then you don’t always have a choice when you enter a case as it may be presented to you at a particular point in time and then you may never get the opportunity to invest in it again. In this sense you could suffer from adverse selection if you only selected late-stage cases as you are only investing into a subset of the broader market of available cases.
Liquid Investments
Another way to mitigate duration risk is to focus on a liquid alternative that provides similar exposure through the publicly-listed markets, which is a topic I covered recently in a two-part article which can be found here and here under the heading of Event Driven Litigation Centric (“EDLC”) investing. EDLC has the distinct advantage of being liquid through a hedge fund structure that provides redemption rights which allows the investor to somewhat control duration although ultimate duration is typically dictated by the timing of the event itself. Of course, as investors move into the public markets, they start to add correlation to their portfolio which may be at odds with your duration/liquidity objectives.
While it is beneficial to deal with duration risk on the front end through the case selection options outlined above, once an investor has concluded their investments, there are some options still available to deal with duration risk as outlined below.
Secondary Sales
As the litigation finance industry has evolved, so to have the number of solutions in the marketplace. While secondaries have been taking place informally for years (hedge funds, litigation funders, family offices, etc.) there has only recently been a formalizing of the secondary market and I am very keen to see how the early market entrant, Gerchen Capital, ultimately performs. Nevertheless, for managers and investors seeking liquidity and an end to duration risk entering into a secondary transaction may be a very viable solution.
I believe it will be more economically viable in the context of a portfolio sale than a single case investment, but I am sure there will be some level of appetite and valuation for both. It may be the case that the investor does not obtain 100% liquidity for their position but rather risk shares alongside another investor who doesn’t want to suffer from adverse selection and thus makes it a condition of their secondary offer that the primary investor retain an ownership position. Other situations may allow for complete liquidity, but that will likely come at an economic cost. And there are even other times when the case is moving along exactly as planned and the primary investor is able to sell a portion of its investment at such a high valuation that it produces a return on its entire investment, which is the case with Burford and its Petersen/Eton Park claims, despite the fact that no money has exchanged hands between the plaintiff and the defendant and there is still no clear path to liquidity.
While selling a portion of an investment allows the manager to obtain some liquidity for its investors, it also serves to validate the value of the investment/portfolio to its own investors, which may in turn allow that manager to write-up its portfolio to the value inherent in the secondary sale transaction (again, this assumes that the transaction is completed with a third party investor). As an investor, you really need to assess whether any secondary transaction is being undertaken for the intended purpose (liquidity or duration management) or whether there are alternative motivations at play (i.e. for the manager to post good return numbers to allow them to increase their chances of success at raising another fund). And while third party validation may be comforting, too much comfort should not be derived by someone’s ability to sell an investment to another party, it could have more to do with sales acumen than the value of the underlying investment.
Insurance
Any discussion regarding litigation finance wouldn’t be complete without mentioning its close cousin, insurance. In the early days of applying insurance to litigation finance, the focus was more on offsetting the risk of loss. While that is still true today, there is an increasing focus being put on insurance as a way to deal with duration. The thinking is that investors don’t want to get stuck in funds that take years beyond their original term to pay out and so they are prepared to accept the duration risk if there is a safety valve in place. The safety valve is the insurance which will pay out at the end of a defined term, which provides the investor with assurances that they will at the very least get their original principal repaid (and possibly a nominal return). In essence, the insurance functions as a risk transfer mechanism between investor and insurer until the case is finally resolved. While it is more common to put insurance in place on making the investment, one could place insurance after the fact as well.
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.