Cover Story: Investing in lawsuits

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on July 20, 2020 - July 26, 2020.
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Litigation financing, which allows investors to fund third-party legal claims in exchange for a share of any damages awarded, is becoming popular around the world. This alternative asset class was previously the domain of specialised funders and institutional investors. But now, some funding platforms are making it available to accredited investors in smaller-ticket sizes.

Also known as lawsuit funding, this asset class has gained prevalence in the legal industry as an equalising and risk-sharing tool that provides claimants and law firms with funding, explains Jay Greenberg, co-founder and CEO of US-based litigation financing platform LexShares. The funds are used to cover the typically expensive costs of litigation.  

This form of financing means that such cases, which would otherwise be hindered by a claimant’s lack of funds, can now be pursued. lt is widely seen as a solution that provides more access to the justice system for individuals and organisations of all sizes. 

The high-risk, high-return asset class is expected to grow exponentially in the coming years. According to a recent report by market research firm Absolute Market Insights, the global litigation financing investment market is expected to reach US$22.3 billion by 2027 — more than double the US$10.9 billion recorded in 2018.

Litigation financing is increasingly popular for several reasons. For starters, the asset class has a very low correlation with the capital markets. This makes it very attractive amid the current global macroeconomic risks such as the ongoing pandemic, trade tensions, oil war and other geopolitical events that are impacting the majority of the traditional asset classes, says Cormac Leech, CEO of UK-based litigation financing platform AxiaFunder. 

“There is little to no correlation between litigation financing and the broader macroeconomic market. The only way there could be a negative impact would be if the defendants suddenly had a very large drop in their net worth that they would not be able to pay for the claim.

“Normally, we pursue defendants who have a net worth that is many times higher than the claim value. Therefore, the impact of a recession would be a little over zero. In fact, an economic disruption puts a strain on contracts of all kinds, which creates opportunities for litigation financing.” 

To this point, Greenberg says the current economic downturn bears some similarity to the 2008 global financial crisis, which significantly accelerated the legal industry’s usage of litigation financing. Businesses needed capital to proceed in litigation, which the litigation financing industry was able to provide as a more specialised solution than what traditional banks and lenders were able to offer. 

“A similar trend has already emerged this year. In March, when lockdown measures were widely implemented in the US, LexShares’ inbound inquiries from attorneys and plaintiffs doubled over the subsequent three-week period,” he says. 

“We anticipate sustained demand as more companies file lawsuits related to contract disputes and business insurance claims arising from the pandemic. Many of these litigants may require capital to pursue their claims, in which case the non-recourse nature of litigation finance investments should hold particular appeal.”

Compared with other alternative asset classes, litigation financing is attractive because of its moderate investment cycle. The average civil lawsuit in the US takes about 27 months, from filing to disposition, according to Greenberg.

Some funders will only invest once a lawsuit has surpassed common litigation milestones. For example, when important new information is revealed that could increase the chances of a successful outcome. This means the time to resolution may be shorter than other alternative asset classes such as venture capital and private equity, says Greenberg. 

The median duration of LexShares’ 43 resolved investments to date is 15 months. 

“Litigation financing has a large addressable market size. The US legal industry alone is quite large. Some estimate it to be in excess of US$400 billion,” he says. 

“But commercial litigation financing is still relatively nascent, funding only a very small percentage of the market. There will continue to be deeper market penetration as more litigators become familiar with the product we provide.”

What sets litigation financing apart from other alternative asset classes is an “inevitable realisation event” for each investment, says Greenberg. “Every lawsuit will eventually resolve through settlement or adjudication. There will, with certainty, be a realisation event [either positive or negative] when investing in a legal claim. A catalyst, such as an initial public offering or sale of a private company, is not required for it to happen.”

Adding to this point, Leech says that apart from providing investors with clear economic value, litigation financing offers more certainty than other alternative asset classes as each case will lead to a binary outcome. “For example, no one can predict the price of bitcoin in the next six to 12 months. Similarly, in theory, the price of gold could go to zero if people stopped liking the yellow metal in the next year. But this is not the case for litigation financing.”

Levelling the playing field 

Prior to 2008, investments in litigation-related assets were mainly limited to specialised funders such as firms that funded litigation and dispute resolution as their core business. These funders provided loans for personal injury or small commercial lawsuits. The global financial crisis quickly changed the landscape as the ensuing liquidity crunch encouraged a greater number of companies to seek alternative financing solutions. 

As a result, there was an explosion of commercial litigation financing activities in the US post-global financial crisis, says Greenberg. The number of dedicated commercial litigation financing firms increased from just six pre-2008 to more than 30 within a very short period. 

“Most litigation financing firms manage private funds from large institutional investors such as pension funds, hedge funds, sovereign wealth funds and even university endowments. They typically deploy capital from these funds into single cases or portfolios of cases,” he says.  

“Because of the size and structure of these funds, it was hard for individual investors to access opportunities in litigation financing. I co-founded LexShares in 2014 with this in mind. We built the first dedicated online marketplace for investing in commercial litigation financing opportunities.” 

With principal offices in Boston and New York City, LexShares funds attorneys, law firms and plaintiffs with commercial lawsuits. The company has evaluated more than 825,000 cases since its inception.

Investment opportunities listed on LexShares’ platform are offered by WealthForge Securities LLC, a registered broker-dealer with the US Financial Industry Regulatory Authority and a member of the Securities Investor Protection Corporation. According to its website, LexShares assists in funding commercial cases at all stages of litigation, including anti-competitive claims, banking and insurance disputes, construction and real estate disputes, fraud as well as intellectual property and copyright infringement.

LexShares allows accredited investors to purchase an interest in litigation assets through its online marketplace. Registered investors can invest in single cases with a minimum investment amount of US$5,000. The platform is open to non-US-based investors, although additional documentation may be required. 

Investors can also invest in LexShares’ dedicated litigation financing fund — the LexShares Marketplace Fund II. Launched on June 10, the US$100 million fund gives accredited investors access to a portfolio of litigation-related assets, including all single case offerings posted on the platform, through a single fund allocation. The minimum commitment for the fund is US$250,000. 

The launch of the second fund follows the success of the LexShares Marketplace Fund I. This US$25 million fund was fully subscribed and closed in January 2018.

Echoing Greenberg, Leech says there is a growing number of platforms that allow investors with a lesser net worth to participate with a smaller amount of capital. There are a few platforms in the US and several more in the UK. 

“Having said that, the number is still very low across the globe and the asset class is at a very early stage of democratisation. On ­AxiaFunder, for example, financial institutions provide half the capital. Of our investor base, 90% are based in the UK while about 8% are from all over Europe. The remaining 2% are investors based in Hong Kong, Singapore and Latin America,” he says. 

AxiaFunder connects investors with vetted commercial litigation investment opportunities that it believes have the potential to generate attractive risk-adjusted returns. It focuses on the smaller end of the commercial litigation market in the UK and continental Europe, where there is a significant shortage of capital and many clearly viable cases. It is one of the first litigation investment companies in the UK. 

Why should investors participate in these platforms, instead of privately funding the cases themselves, if they have the necessary capital? Greenberg says accredited investors, even those with strong legal backgrounds, rely on dedicated litigation financing firms over directly financing the cases themselves because the case evaluation and investment structuring is highly specialised and labour intensive.

To determine which lawsuits are worthy of investment, one would not only need a nuanced understanding of the legal system but also of how the facts of a particular matter align with prevailing case law and whether the defendant can pay any damages awarded. This may require reviewing a myriad of case documents and pleadings to assess whether the claim is a compelling investment opportunity, he adds. 

“In addition, litigation financing investments typically involve complex deal structuring with the attorney and plaintiff, who need to sign off on any agreement before it can be executed. That is why we employ a team of former litigators who, given their experience practising law, have a strong understanding of litigation risks. Their in-depth knowledge and our employees’ 70-plus years of combined industry experience have allowed us to maintain a strong underwriting function, leading to our proven track record,” says Greenberg.

Consistently finding qualified investment opportunities is another major challenge for new entrants to the litigation financing industry. LexShares uses a proprietary Diamond Mine software to source more than 1,000 cases per day from federal and state court dockets. The software’s algorithm analyses complaints against its internal investment criteria to ensure a healthy pipeline of cases for its legal experts to review.

“We are proud to be one of the few firms that provide individual investors with access to singular litigation financing investments. We are primarily focused on the commercial litigation financing ‘middle market’, pursuing case investments with at least a funding requirement of US$200,000,” says Greenberg.

Focusing on relatively smaller deals than its market’s largest players allows LexShares to operate in a segment with limited competition, he adds. “We have invested in more than 100 cases since our inception, making us one of the most active litigation financing firms in the world.”

LexShares has a dedicated team of former litigators led by chief investment officer Max Volsky, whose primary role is ensuring that the firm invests in legal claims with a high likelihood of success. He has been investing in legal claims for more than 20 years, says Greenberg.

“The team consists of former litigators with experience representing some of the case types we invest in. They rely on a disciplined due diligence process when making their assessments. As a result of their hard work, we invest in fewer than 5% of the investment opportunities they review,” he says.

LexShares does not impose a management fee on investors of individual cases. Instead, it takes a carried interest in each successfully funded case, which is a share of the profit from an investment. However, there are fees associated with its affiliates such as an administration fee, a prepaid operating fee and fees related to bridge loan financing for pre-funded deals.

Meanwhile, AxiaFunder is the only platform in Europe offering direct access to litigation. The UK’s first for-profit litigation financing platform, which was launched in November 2018, is open to global investors.

AxiaFunder’s team has a combined financial experience of 40 years and a combined litigation experience of 30 years. Information on the company’s current and previous case investments can be found on its website. 

AxiaFunder is a trade name for Champerty Ltd, an appointed representative of Share In Ltd, which is authorised and regulated by the UK’s Financial Conduct Authority.

The only fees that the platform charges are a fixed upfront fee and a performance fee. So, investors stand to receive higher returns on AxiaFunder than other similar platforms in the region, says Leech. 

The typical minimum investment amount is £500 (RM2,690), although this may vary in certain instances.

AxiaFunder seeks to ensure that cases available for funding on the platform satisfy its predetermined criteria. First, the legal merit of the claimant’s case must be strong and have a high probability of success. These cases are typically endorsed by independent legal counsels. 

Also, the firm only funds cases that already have After The Event (ATE) insurance, which covers the legal costs and expenses involved in litigation. In the UK, the party that loses a litigation case is liable for the costs of the other party. The ATE insurance is purchased to mitigate this risk.  

“With the ATE insurance, our investors are protected from any adverse cost risk, which can make the case very unattractive. The insurance also serves to filter out cases that ATE providers do not believe to be sufficiently attractive to insure, thus improving the quality of the pool of cases being assessed,” says Leech. 

He adds that viable economics and timing are also considered. The estimated damages normally must be at least five times the estimated costs of pursuing the case to trial, with an expected time to resolution of typically less than three years.

“On top of that, there must be enforceability. There must be clear evidence that the defendant has the financial resources to pay any settlement or judgement,” says Leech. 

“Also, AxiaFunder will only fund cases for which the claimant’s legal counsel is clearly capable. We believe a weak or in­experienced coun­sel can prevent an otherwise strong case from succeeding.”

Other considerations include whether the claimant’s counsel has skin in the game and the downside risks that the claimant would face if the case is lost. AxiaFunder will monitor the progress of the case and provide updates to investors on a quarterly basis. 

There are other platforms around the world providing individual investors with access to litigation financing, although they are not focused on funding litigation. US-based YieldStreet, for example, provides investments in commercial and residential real estate as well as art financing. 

Meanwhile, Money&Co aims to help British businesses crowdfund to finance their growth. It previously raised money intended for tenants to take action against their landlords or for homeowners of new builds to take action against their insurance companies for housing disrepair. 

Currently, YieldStreet and Money&Co are only available to investors in their respective countries.

High risk, high return

Litigation financing is often touted as being able to provide investors with significant returns. Typically, the returns are a multiple of the investment, a percentage of the settlement, or a combination of both. It is common for investors of a winning case to expect to double, triple or quadruple their initial investment. 

However, this also means that it is a highly risky investment as investors could lose their money, says Leech. “Some cases do provide investors with unusually high returns, but success is never guaranteed. This asset class is not for people who cannot afford capital risk. Investors should also recognise that any returns are likely to take several years to materialise.”

Greenberg says most deals on litigation financing platforms are structured as non-recourse investments, meaning the recipient has no obligation to pay the funder if the case resolves unsuccessfully.

As at April 24, nine litigation cases had been fully funded via AxiaFunder, of which two have been successfully resolved. The cases generated a return of 43% and 94% for investors over eight and 15 months respectively. The total amount of capital raised was £985,440 while the average internal rate of return (IRR) on resolved cases stood at 69.8%.

Meanwhile, as at June 10, LexShares had invested in 103 case offerings. Of those, 43 investments have been resolved, resulting in a median IRR of 52% net of fees and expenses. Over the past year, the company’s average investment per case offering was US$1.4 million, up from US$845,250 in the previous year.

Litigation financing is inherently risky and sometimes unpredictable as newly discovered information can alter the course of a case. It is also an illiquid investment that is locked up until the case is resolved. To spread the risk, diversifying investments across multiple litigation financing assets is strongly recommended, says Greenberg.

“LexShares and many other funders do not control litigation strategy or settlement decisions. Our role is passive, which means we take care to evaluate our ability to work with the attorney and client before investment,” he adds. 

Leech says investors should avoid putting all of their capital in a single case. Instead, they should put their money in a portfolio of 10 to 20 cases to increase their probability of a successful outcome. 

AxiaFunder is currently working on a secondary market to address the problem of illiquidity. It may be made available next year. 

“We funded a case just before Christmas. Based on our analysis, we find that the case would have appreciated by 20% to 30% now, after more than six months,” says Leech.

“We think there are investors who like the idea of selling their investments before the case is settled. Similarly, there may be investors with a higher risk appetite who want to invest in shorter-term cases. We think this could potentially be very interesting.”