Well done, everyone. We’ve done it. We’ve put litigation funding on the map. They used to call us “charlatans”, “immoral” and “seeking access to profits from others’ miseries”. But it was all worth it.
As we live through the glorious boom that is litigation funding in these otherwise depressing times, it’s easy to forget just how much the tide has turned in litigation funding in a short period of time. When Jackson LJ covered litigation funding a decade ago in his 2010 review, funders were still struggling to overcome the scorn and contempt with which the legal profession looked down on them. Even more recently in 2013, this author faced institutional investors on capital raising roadshows that called litigation funding “unethical”.
But almost overnight, the tide turned completely. Institutional investors seemed to experience a lightbulb moment, and all those industry chants of “access to justice” and “non-correlated, high returns” actually started to penetrate. Some even said that litigation funding could be considered “socially responsible investing”. And so in swept a new era in which yet another capital raise or a new funder launch was announced with such frequency and enough publicity that even my business-illiterate mother knew of the existence of litigation funding.
And that was before COVID-19. In what has otherwise been a really sad and devastating period for many, litigation funding has shone through as not only a resilient, but a truly non-correlated asset class. Litigation solicitors are busier than ever with utilisation rates exceeding 100%, translating directly to more business for funders. And that can only be good for attracting even more institutional and high-net-worth investors.
Surely, times couldn’t be better. We’ve made it. What more could we possibly do to evolve?
Well, actually quite a lot. Growth is often confused with evolution. Growth is certainly not an exclusive consequence of evolution. In fact, if we take an honest step back as an industry, the litigation funding market is truly staggering in how little it has actually evolved over time. Instead of leveraging its increasing popularity to strength business models, demand more favourable terms from investors and deliver more innovation to offer more choice and solutions for the market, everything (from business models, origination methods, deal sizes, pricing methodologies, delivery techniques, and so on) has largely stood still, much to the chagrin of the users of litigation funding.
This is not some attempt to take credit away from the longest standing funders in the market. They’ve helped to establish a market and earn the industry a credibility in a way very few could have. But much like Pan-Am in aviation, Kodak with photography and Yahoo with search engines, the world moves on and evolution, not growth, is what maintains relevance. In truth, growth will never be an issue again for litigation funding. It’s attractive enough. But it’s now time for evolution.
“How big is your fund?”
This was the most commonly asked question this author received, following the launch of LionFish Litigation Finance earlier this month. Given most litigation funders are investing on behalf of institutional investors as a fund manager (including some of the listed funders like Burford and Litigation Capital Management (LCM)), it seemed a logical question to ask. But LionFish is not a fund and is set up precisely not to be a like a fund; an idea that more than a few have struggled with to grasp.
To go back to the beginning, litigation funding started life primarily as a fund management business. A few specialist litigators got the capital of some early stage investors willing to risk capital for a sizeable share of the outcome of litigation cases. For those litigators, this was (whether intended or not) not dissimilar to a hedge fund or private equity fund manager. (If in doubt, one only need look at one of the longest standing funders in the market, Harbour, who was borne out of MKM Longboat, a pre-crisis USD 3 billion hedge fund.)
And as the market grew, so this hedge fund model became the standard. The only problem is that this hedge fund model was not built for litigation funding. Fund managers generate revenues from two sets of fees. Firstly, management fees which are usually 0.1% to 2% of assets under management (AUM). This fee helps keep the lights on. Secondly, performance fees which for hedge funds and private equity can be around 20% of returns after a certain return hurdle has been met. The extreme end of these fees (the 2/20 hedge fund model) lies behind the wealth with which hedge fund managers are often associated.
It is, however, premised on having a high ratio between AUM and operational costs. This is possible where the typical deal sizes in the underlying asset classes are substantial, like in foreign exchange, bond or equity trading. But this is not the case with litigation cases. For the more modest macro hedge fund or real estate private equity fund, managing £3 billion AUM with a core staff of less than ten is normal and manageable. Litigation funders operate to considerably smaller AUMs with considerably greater staff. And when one considers that many also outsource some of their legal work to external law firms because of the inherent complexity of the underlying litigation cases, this makes litigation fund managers a far lower margin business than many realise.
What constitutes a good margin is entirely subjective, and a funder’s operating margin is of no particular relevance to anyone. But what does matter is how this has an impact on the market it serves. Firstly, it forces an operational bias on funding large cases, where the amount deployed per man hour spent is the highest. While this helps keep margins from dipping into negative territory, this puts most litigation cases outside the “sweet spot” of most funders.
Secondly, the reliance on institutional investors for capital means that funders are really investing on their behalf, and therefore are subject to the restrictions and limitations placed on them. The biggest restriction of them all are the return expectations of these institutional investors who, buoyed by the news of phenomenal successes like Burford’s Petersen trade or Tenor’s Crystallex trade, now possibly expect even more than they did before. And this means expensive pricing for users of litigation funding.
Thirdly, a small but growing number of institutional investors are going directly into litigation funding, bypassing the platform of litigation funders to save on management and performance fees. To be clear, though, this is not some Machiavellian trend unique to litigation funding, but rather part of a drive for fund managers to eliminate fees through the value chain of investment. One only needs to look at the markets of direct lending (fund managers lending directly to corporates instead bypassing banks), exchange-traded funds (instruments enabling retail markets to access financial markets bypassing fund managers), and online pension providers (tech-enabled direct management platforms bypassing pension funds) to see the pressures facing traditional fund managers.
Many will say this is all speculation. But the overriding point is that the current market structure is ripe for evolution, and the way it evolves will ultimately be of benefit to both investors into the litigation funding market and the clients who use it.
Risk adjusted pricing in litigation funding
It is not just the evolving structure of litigation funders that will materially benefit users, but the evolution of pricing from a clunky, finger-in-the-air negotiation to a principles based, risk adjusted pricing model.
Most new entrants into litigation funding (often from a financial markets background) are baffled by the seemingly one dimensional pricing structure of funds. There is nothing wrong with a share of the award or a minimum multiple in itself; it is akin to the Series A venture capital pricing model (see here). But to apply it to all cases and all investments?
Much like a company with a capital structure of debt to equity and everything else in between, litigation has many divisible elements of risk. Depending on the case, the risk profile changes. Whether you are funding the whole case and assuming any potential third party costs order , or simply funding with capital protection insurance, the risk profiles change. Time itself affects risk profiles.
To apply the same pricing structure rigidly means that a traditional litigation funder can very easily be over-charging or under-charging on the same case. For example, the traditional pricing of the greater of (i) a 3x multiple or (ii) 30% share of the award over-charges when the matter is quite advanced with counsel’s opinion. But when the case is at a very early stage, when prospects are much harder to determine, it is under-charging.
(For pricing enthusiasts, the probability of the default approach, that Adrian Chopin excellently covers here and here, would recognise the greater risk at the earlier stages and how that directly translates to more expensive breakeven pricing, which only goes up further once the funder’s overheads are priced in (which for an early stage case will be quite substantial). It would also recognise that the same case post-issue with counsel’s opinion and defences filed will carry less risk and are therefore cheaper. Likewise, a similar parallel can be seen in real estate investing, where early stage investors who invest pre-planning permission will stand to make multiple returns, in contract to those who invest only on a post-planning permission basis.)
While under-charging is not good for funders, neither is over-charging, because, in reality, few cases actually recover their headline claim value (this can be strongly inferred from the publicly available data set of a few hundred cases). This can often lead to the same outcome as if they had under-charged. The greater irony is that this also overlooks the risk/reward profile from the litigant’s perspective, which runs the risk that conflicting outcomes can be desired at various stages of the litigation (an entire topic unto itself).
In short, pricing methodologies today are less of a science (or even art) and a crude exercise of finger licking that operates within the constraints of their funding model. As the market evolves, so should pricing methodologies into a more fluid and more flexible approach that can adapt to the requirements of each case; an approach which the next generation of funders are practising.
So what next?
Who knows how the litigation funding industry will change, but it will change one way or another because the funding model that was fit for purpose in 2010 is in need of evolution to be fit for purpose in the 2020s. The market may in fact evolve in a number of different ways where there is no one single model but a few. But this author’s view, which will be reflected in LionFish , is that funders will need to break free from the deep prejudices and biases of the legal industry and operate on the basic business principles of flexibility, fluidity and commerciality, to complement truly the opportunity of the current environment.