In the early days of litigation finance, most fund managers sold a concept and their own capabilities, but not much else. And risky strategies attracted risky investors.
For instance, litigation finance attracted high net-worth individual and family office capital from those who are very comfortable assuming risks. It also attracted sophisticated hedge funds who get paid to take risk, but in a methodical and calculated way — at least that is the theory. In the early days of the asset class, these investors would typically invest in single cases and as time progressed they started investing in portfolios of cases (either defined portfolios or blind pools).
In the U.K., litigation finance took a non-conventional path. Specifically, fund managers quickly tapped the public markets for funding. A benefit of having a public vehicle is that it has allowed managers to issue relatively inexpensive public debt to reduce their overall cost of capital, which would be difficult to impossible in the private markets in the early stages of an asset class with little in terms of empirical results on which to make a credit decision.
The ability for fund managers to raise public capital was an important evolution for the industry as it brought litigation funding to the forefront within the investment community, and by virtue of financial disclosure requirements, provided a level of transparency that other litigation funding companies could leverage to raise their own private funds.
Until recently, it was felt that the industry was not large enough to be attractive to large sovereign wealth funds and pension plans that typically have minimum investment allocations in the hundreds of millions. However, some managers have recently launched funds in the $500 million to $1 billion range and the industry is starting to see interest from institutional investors looking to make bigger investments.
Of course, the concern with attracting large amounts of capital is that it forces managers to accept larger amounts of capital than they can responsibly invest, which may create distorted incentives and a misalignment between investors and managers. I hope the litigation finance industry continues to maintain its discipline, but I know some will likely succumb to the lure of larger amounts of capital at their own peril.
In the current coronavirus environment, I would expect in the short-term to see hedge funds that have increasingly played a role in litigation finance pivot out of litigation finance to chase their more typical distressed credit opportunities.
But the more significant trend, I believe, will be the emergence of the pension plans investing in the asset class, fuelled by the relatively low cost of capital. For pension plans, whose cost of capital is dependent on the discount rate applied to pension liabilities to determine the return profile necessary to ensure the plan remains well capitalized and preferably growing, litigation finance has not been an active investment to date.
However, as more data is produced, and the level of transparency becomes elevated through the publicly traded fund managers and private managers who make their results known to prospective investors under confidentiality, pension plans will likely begin applying their deep analytical skills to the industry and make the decision that litigation finance is a viable asset class in which to invest and has the benefit of non-correlation which may be a very important characteristic depending on the specific plan’s life cycle.
Pension plans seeking to invest in the space should be prepared to study the market and the various managers therein, or leverage the work of other experts, before making a decision to invest. As only few fund managers are raising capital in any given year, the temptation is to select from the best available at the time, whereas prudence would suggest waiting until the best managers come to market and starting an investment program at that time.
Fund-of-funds, co-investment vehicles and syndications may be other ways to invest in the asset class, but few vehicles exist today and an investor must be very cognizant of diversification in the asset class due to the many unsystematic risks inherent in litigation finance that benefit from the application of portfolio theory.
For pensions plans who are reeling from the current high degree of volatility in both equity and bond markets, litigation finance represents an opportunity to achieve strong risk-adjusted returns in a non-correlated asset. As the industry’s investor base transitions from high risk money to lower risk money and as the level of transparency and degree of empirical results increase, pension plans will be well positioned to apply their deep analytic skills to determine whether litigation finance is a good strategy in which to invest for the long-term benefit of their plan members.
Edward Truant is a founder of Slingshot Capital Inc. These views are those of the author and not necessarily those of the Canadian Investment Review.