Funding is a new market. Like most new markets, it has massive potential to change as the market develops.
In the light of this, what is likely to happen in the next five years?
In Part 1, I addressed the first two of my five predictions, which are as follows:
- Law firms will become more like funders.
- In turn, funders will become more like financiers.
- Pricing will continue to become more competitive.
- Therefore, in order to maintain returns, funders will create new products.
- Courts will become more sophisticated at dealing with issues created by funding.
In this piece, I address the final three.
Three: Pricing will continue to become more competitive
The increased number of funders (including law firms with in-house facilities), plus the fact that each funder could have deeper pockets (as capital continues to flow into the sector, given the attraction of an asset class uncorrelated to the rest of the economy), means that there is very likely to come a time when pricing becomes more competitive. Good cases will get multiple offers and clients will shop around.
On the other hand, the number of funders able to commit tens of millions to a single case is not as likely to grow as quickly as the market for smaller cases; therefore, competition for the very biggest opportunities is not likely to increase as quickly as the competition in the remainder of the market.
However, the more fundamental development here could be that, as funders become more like financiers, they will become more sophisticated in their analysis of risk. In turn, that enhanced ability to analyse risk could lead to:
- The confidence to take on greater risk through reduced pricing.
- The good sense to hedge risk, by selling risk or strata of risk in a secondary market.
Funders will take more risk
As the funding market matures, track records of individual funders’ ability to invest in winning (and losing) cases will continue to develop. Those funders with strong track records may then be in a position to turn to their investors and reduce their cost of capital. The track record is likely to also allow funders to analyse what sort of factors tended to cause cases which were lost to be lost.
These developments have the potential to allow risk analysis to become more granular: risk could be analysed not just by reference to a case, but by reference to the stages of a case or even the area of law involved in particular stages of a case (for example, if a particular case had a preliminary issue to determine a particular point of law, the return on investment to a funder for capital expended to have that issue determined does not necessarily have to be the same as the return on the additional capital then required for the full merits hearing). In theory, pricing could be adapted to those stages where the risk is considered higher or lower, whether at the start (for example from a jurisdiction challenge), or at the end (for example from enforcement risk).
The next logical step, once risk is analysed in this granular way, is for different funders to finance different stages of a case: for example, in a bifurcated arbitration, one funder could finance jurisdiction and another funder could finance the merits. The return due to each funder in such a scenario would be calculated from a formula with the following inputs:
- Time (how long the capital of each funder is invested).
- Risk (the percentage chance ascribed by the legal team of success on that aspect).
- Dollar weighting (how much capital each funder is investing).
But funders will hedge that risk behind the scenes
Once funders have taken on greater risk, investors may put pressure on funders to hedge that risk. This will prompt a secondary market to develop amongst funders, in which funders will sell to each other parts of their largest investments; or parts of investments which, when taken together with other investments within a particular fund, mean that the fund has a large exposure to a particular type of risk. (Selling risk in this way has a concomitant accounting benefit in that the ability to point to a price which a third party paid to acquire a strata of risk will assist funders in persuading accountants that the value of their contingent entitlements to proceeds from cases can be revised upwards.) In time, this secondary market is likely to lead to syndication of single case investments, in which funders sell tranches of risk from a particular special purpose vehicle (SPV) to individual investors, where different tranches have different risk/reward ratios depending on individual investors’ appetite for risk.
It is also possible that the insurance market may want to access the level of returns on individual opportunities which are available to funders and, therefore, will develop new insurance products designed for the funding market. In particular, for example, the number of insurers offering capital protection insurance (a product through which funders can insure their capital invested in cases) may increase.
Four: Therefore, in order to maintain returns, funders will create new products
When pricing comes down, funders could innovate to maintain their returns by creating new products. It is difficult to predict exactly what form these new products will take, although product development efforts may likely concentrate on the provision of products other than single case funding to litigants and to law firms, and on the provision of funding in areas where it has not previously been available.
First, as to new products for litigants, many claimants who do not need funding will wish nevertheless to transfer the risk of litigation to a third-party funder. Alternatively, many claimants will recognise that whilst they may have the cash to self-fund an initial estimate of costs, such initial estimates often increase as cases hit a bump in the road, either from a security for costs application, the need to post collateral for a cross undertaking in damages, or simply from the case becoming more protracted and time-consuming than a legal team could reasonably initially anticipate.
As pricing for case funding goes down, funders will be keen to explore this market and will likely come up with a product where they offer to post cash into court (or they offer to find an insurance solution which, if it is not accepted by the court, is backed-up by the offer of cash from the funder).
Separately, funders will pitch to share in risk and return in other areas of law firms’ businesses and the legal sector. Those areas could include, for example:
- Monetising work in progress (WIP).
- Investing in a new aspect of the business, for example, opening a new office, or starting a new synergistic line of business (including a non-contentious line of business) and, in either case, potentially in a new SPV in order to separate it financially from an existing partnership.
- Investing in an entirely new business, such as a start-up law firm. This is made possible by establishing an alternative business structure; it has already been done in the UK (for example, Therium-backed Harcus Parker).
- Investing in the significant guarantees used to entice heavyweight partners to join a firm (the funder would pay out to the firm if the new partner’s billings were below a certain threshold, but the firm would pay out a percentage to the funder if billings were above that threshold).
- Continued expansion of the scale and flexibility of funders’ existing capacity to buy judgments, arbitral awards and, in the context of insolvency, claims themselves.
- De-risking the downside of businesses’ investment into certain developing countries by agreeing in advance to fund treaty arbitrations if, for example, the new business is expropriated by the political regime, in return for a pre-agreed percentage of any recoveries made.
Second, funders may become keen to fund areas where funding has not previously been available, including defences and, possibly, private criminal prosecutions.
Defence funding is most likely to be achieved through a variant of the following structure: a funder advances legal costs for a defence, and the funder and client agree on a definition of a “win” and a “loss”.
On a “loss”, the funder loses its investment. The client is therefore in a better position than it would have been had it not accepted funding, because the funder paid the legal costs.
On a “win”, the funder is repaid a multiple of its invested capital. The client is therefore in a worse position than it would have been had it not accepted funding, because the client had to pay the funder its profit as well as the legal costs.
Five: Courts are likely to become more sophisticated at dealing with issues created by funding
As courts see more funded cases, they are likely to become more sophisticated in dealing with issues created by funding, and a greater body of case law is likely to develop to guide funders. This is already happening. We saw recently in Davey v Money and others the removal of the “Arkin cap”, that is, the rule that the total liability of a funder for adverse costs should be limited to the overall maximum funding provided by the funder to the claimant.
Although funding is highly likely to face mandatory regulation in due course, before then we are likely to see the emergence of further case law to govern issues created by the increasing commonality with which funding is used.
Potential issues ripe for resolution include:
- Open questions, such as whether or not a litigant is required to disclose to the other side and to the court that funding is in place.
- Activities which funders undertake that have the potential, if not managed strictly, to create litigation; for example, if a monitoring team at a funder oversteps their remit and breaches the champerty rules.
- The delineation of boundaries as to when funding can and cannot be used, for example, whether a funder can share in returns from a private criminal prosecution.
Jack Bradley-Seddon is an associate at Bench Walk Advisors and a former litigator and solicitor-advocate in the London office of Akin Gump Strauss Hauer & Feld: firstname.lastname@example.org
With thanks to Adrian Chopin, Bench Walk Advisors, James Glaysher, Akin Gump Strauss Hauer & Feld, and Carlos Abadi, Decision Boundaries.
This blog reflects the opinions of the authors rather than the institutions with which they are associated.