Portfolio Theory in the Context of Litigation Finance (2 of 2)
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
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.
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 deployedbasis, 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 fund manager 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’s portfolio, 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 similar 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.