In years to come, March 2023 may come to be remembered as the month that came closest to replaying the systemic carnage of September 2008. The collapse of Silicon Valley Bank (SVB) triggered broader concerns given its venture capital and start-up focused client base – perhaps better contextualised when one considers about 5% of VC managers control 50% of the capital in the US. Larry Fink, the legendary founder and CEO of the asset management behemoth Blackrock, wrote to investors shortly after SVB’s demise, stating that the “dominoes are starting to fall” after the changing interest rate environment had “exposed cracks in the financial system”.
Following SVB, Signature Bank quickly became the next domino, with its high-risk exposures to crypto and tech-focused lending, becoming the third largest bank failure in US history. And to prevent the next domino (First Republic Bank) from falling, 11 major US banks orchestrated a rescue package involving the injection of USD 30 billion in deposits.
If some thought of this as a contained US problem, Credit Suisse proved that concerns were spreading globally, throughout financial markets. Although one could point to Credit Suisse’s many long-standing issues, the fact that the Swiss regulators intervened to force through a sale to UBS over a frantic working weekend goes to highlight these exceptional times.
Many in the litigation funding industry have been quick to highlight how fortunate we, as an industry, are to be an “uncorrelated” asset class. After all, the last major global financial crisis of 2008 did wonders for the industry, prompting a low-yield environment, which was a key trigger to the spectacular growth of the litigation funding industry.
However, it would be a mistake to sit back and watch the mayhem with the comfort that litigation funding is uncorrelated. Correlation is not a binary measure of 0 (no correlation) or 1 (perfectly correlated), even if compared to other asset classes, it feels like 0. In financial markets, correlation has been a long-traded variable much like volatility has been via options trading. While this is not the forum to dive into the dynamics of correlation trading and how one actually trades correlation, the point is it exists. And that shouldn’t be a surprise when we live in a large, complex and inter-connected global environment where nothing is ever black or white.
How do market disruptions and downturns affect litigation investments in the negative?
Ultimate source of capital
The growth in litigation funding has been driven by the influx of significant institutional capital. 10 years ago, when many of the leading hedge funds, asset managers and fund of funds started exploring litigation funding, it was attractive because of the high return potential in what seemed like an uncorrelated asset class. But that was in the low-yield, investment-hungry context of a time that defined many an investment strategy.
The principle of context is no different today but the actual context certainly is. Portfolio composition and performance always play a big part in any investment decision; while diversification is generally perceived to be a good thing, times of chaos often trigger a flight to safety – or in investment terms, familiarity. Litigation investing sits high on the complexity scale and is therefore something less well understood in a relative sense. Therefore, times of market disruptions and downturns are more likely to discourage any investments outside core experience and expertise.
Moreover, institutional investors also have their underlying capital sources to report to. Ask a portfolio manager whether they are more likely to be dismissed for entering into a conservative but sensible investment gone wrong that everyone else did (for example, buying Credit Suisse AT1s that are now worthless), or an attractive but brave outlier trade gone wrong that few others did.
For those institutional investors with more stable capital who can be brave (of which there will be some), times of market disruptions and downturns provides yet more “distressed” or “special situations” opportunities, where they are able to arbitrage the inherent value of an investment against the lower acquisition price than would otherwise be possible in normal market conditions. This creates external competition for litigation funders looking to raise capital because it sheds a different light on their litigation investment risks.
Is this an immediate or direct impact on litigation funding? Perhaps not. But over time, if this leads to a pinch on capital raising that diminishes the influx of capital coming into the industry, might this lead to some industry consolidation, as some have been predicting?
Risk of litigation investments
There is nothing worse for a litigation funder than to invest in a case that wins at trial, only to find that the defendant is no longer solvent. In most instances, awarded costs and damages paid out would just be forced to sit in the general unsecured creditor pot.
All too often, litigation funders are presented with cases where the credit quality of the defendant has been “ticked” off on the basis of being a listed company, or a colossus with significant cash reserves or balance sheet assets. In good times that could be taken at face value as a positive first sign, but this is far from true in bad times.
While for many lawyers litigation is seen through the prism of winning or losing the case, litigation investing is about crystallising the return (hence why many argue litigation investing is in fact a financial asset class). So even in good times, every litigation funder should have considered the macro-economic environment and how any changes to the market environments might impact the litigation investment. It’s no different from a bio-tech investor considering the general trends in population health to determine the value of a new, pre-approved drug.
The point though is not that the best have Nostradamus-esque qualities but rather that there are risks, many of them unforeseen, that can materially affect the value of a litigation investment. Does the current market disruption and the nature of SVB and Signature’s activities have an impact on any claim against a crypto operator or a tech company? Will there be a devaluation in general assets (be it real estate or company valuations) that impact the viability of an insolvency, unfair prejudice or breach of contract claim? Will IP claims become worth significantly less because the use of any disputed patent will carry significantly less value in a global downturn? So, the list goes on…
Duration and the changing defendant mindsets and defence strategies
Times of market disruptions and downturns can have a material impact on defendant mindsets and strategies. In my last article, I articulated how defendants can arbitrage the time value of litigation. Take this one step further and one can see how impacted defendants may have no choice but use the favourably lengthy and slow litigation process as a financing tool.
Put another way, it would not be unreasonable to expect that the more defendants feel the brunt of any market disruption or downturn, so it is more likely to discourage settlement and encourage dragging matters out further – even if for cashflow management purposes only. For litigation funders invested in cases where the defendants are more susceptible to the overall markets, this means greater duration risk. And greater duration means diluted returns at a time when there may be more distressed market opportunities available.
And it may not just be the defendant. It’s quite one thing when a listed company drags out litigation so as to avoid any further pressures on its headline revenues, but perhaps it may also be caused by many of the large, conflicted law firms often acting on defendant cases. Market disruptions and downturns means less revenues from other commercial, M&A, employment and other legal work. To mitigate against losing litigation revenues as well, what better than to prolong litigation and increase the costs by turning up to every mediation with a dozen, rather than a handful, of fee earners on big salaries?
How do market disruptions and downturns affect litigation investments in the positive?
There are, of course, many positives for the litigation funding industry beyond the usual headline assumption that times of market disruptions and downturns lead to greater litigation opportunities.
Much like correlation, market health is not binary either. Many companies will remain profitable (with some even growing) and investing will continue because downturns are a natural part of market cycles. Disputes will also continue to happen – some will argue times of market disruption and downturns don’t materially increase or decrease the propensity for disputes to arise, while others argue otherwise – which would make the market not uncorrelated but inversely correlated.
More importantly though, during times of market disruption, many are forced into thinking how best to adapt to increasing uncertainty which is when disruptive financing solutions – including litigation funding – often see rapid periods of growth. If the first iteration of the market caught the attention of impecunious claimants seeking access to justice, it seems only logical that this iteration will help add momentum to the increasing number of corporates – whose heightened awareness over cashflow and general macro environments – that are keen to consider all financing tools; and in turn, forcing their expensive lawyers to explain how litigation funding could be utilised to add value to their overall business.
Rather than championing how litigation funding is “uncorrelated”, it is worth understanding the dynamics of correlation to illustrate both the negatives and positives that litigation funding has in times of market disruption and downturn.
