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2020 Co-Investment Survey Results

The following article is part of an ongoing column titled ‘Investor Insights.’ 

Brought to you by Ed Truant, founder and content manager of Slingshot Capital, ‘Investor Insights’ will provide thoughtful and engaging perspectives on all aspects of investing in litigation finance. 

EXECUTIVE SUMARY

  • Survey suggests the litigation finance industry has demand for co-investment capital
  • Speed to commitment and having a fully funded commitment ranked highest in terms of co-investor characteristics
  • Most funders expect a co-investment commitment within less than 4 weeks

INVESTOR INSIGHTS

  • While investors might be attracted to co-investment opportunities, diversification is a strong component to successful long-term investing in commercial litigation finance
  • Co-investing should only be considered in the context of creating a portfolio, or to add specific exposures to an existing portfolio, but should never be viewed as a single investment

Slingshot Capital and Litigation Finance Journal recently undertook a survey of commercial litigation finance participants to obtain a deeper understanding of the extent to which there is demand for third-party co-investment capital.

The survey was distributed globally, with the majority of responses coming from constituents in the USA (50%) and UK (18%) markets, or from funders that invested globally (18%).  Of the responses, 22% were from advisors/intermediaries and 78% were from funders (with the vast majority of funders having dedicated litigation finance funds).

Co-Investment in Litigation Finance

 Co-investment opportunities are an attractive sub-set of opportunities for many investors in a variety of asset classes, with particular appeal for private equity (buy-out, growth equity, real estate and venture capital) asset classes.  However, in the context of litigation finance, an investor needs to take a different perspective when considering co-investment opportunities.

Whereas it may be perfectly acceptable for a family office, endowment or pension plan to co-invest in a specific private equity opportunity as part of their larger portfolio, the quasi-binary nature of litigation finance should make investors think twice about how they approach investing in litigation finance.  The key difference lies in the probability weighted set of outcomes accorded to each asset class. In a private equity buy-out transaction, a high number produce positive results, and the results vary across a spectrum of potential return outcomes (from 1+ X original investment, to a 5+ X original investment).

In litigation finance, even though many cases settle before going to court, there tends to be two outcomes – a win or a loss.  The wins are allocated across a tighter spectrum than private equity, and the losses tend to be absolute (with exceptions).  Accordingly, due to the quasi-binary nature of the outcomes of litigation finance, co-investing should only be considered where the investors are committed to assembling a portfolio of such co-investment opportunities, and have the ability to assess the fundamental aspects of litigation finance.  Alternatively, to the extent an investor has existing investments in litigation finance, but is looking to round out his or her portfolio with specific case exposures to achieve a particular portfolio objective, co-investment opportunities may play a role in that investor’s portfolio construction approach.

2020 Co-Investment Survey results are summarized below:

Demand

Of the 23 respondents, 70% stated they had a need for co-investment capital, whereas 30% did not.  However, 13% indicated that the need for co-investment was occasional, and that sometimes their LPs had pre-emptive rights with respect to investing in those opportunities.

Frequency

In terms of frequency of co-investment opportunities, almost 50% of respondents indicated they have from 1 to 5 opportunities in a given year, with just over 20% in the 6-10 range, and a few managers indicating they had 20 such opportunities in a given year.  The number of opportunities directly correlated with the size of the funder and the size of the cases they typically finance.

Co-Investor Characteristics

Regarding the characteristics that are most important in a co-investment partner, speed to commitment and having a funded capital source ranked the highest, with responsiveness and understanding complex litigation also ranking highly.  However, there was not a huge disparity in terms of the importance of the six criteria listed, suggesting that all criteria were factored into their decision-making process. Keep in mind that the compilation of rankings on the chart below is an average of the six criteria, so a high number on the chart should be viewed as being more important (even though that answer drew more 1’s and 2’s), whereas a low number on the chart should be viewed as less important. For example, ‘Speed to Commitment’ and ‘Having a Funding Capital Source’ both received the most 1’s and 2’s, but their average ranking is the highest and therefore most important.  ‘Flexible Capital’ received the most 6’s, but has the lowest average score, and is therefore the least important metric.

When we dive further into the ‘speed to commitment’ characteristic, we find the vast majority of respondents expect a commitment within 3-4 weeks.  It remains to be seen if expectations and reality are in alignment, a good question to include in the next survey.

Expected Duration

With respect to the underwritten expected duration, most fall within the 12-36 month range, which is consistent with duration expectations for the industry as a whole.  However, 30% of respondents did indicate that duration was a function of the type of case being underwritten, with certain case types (patent, international arbitration, etc.) having longer durations and appeal cases having shorter durations.

Co-Investment Structuring

In terms of insight into how these co-investment transactions are typically structured, the responses varied.  In the ‘other’ category, some respondents indicated they have used a variety of the choices offered, whereas one respondent stated that they received a specified interest in the profits produced by the investment.

Current Co-Investors

As it relates to where the current co-investment opportunities are being offered, the majority were offered to other funders, suggesting there is a fair amount of cooperation in the litigation finance marketplace.  However, within the ‘other’ category, most respondents suggested it was a combination of all of the choices listed.

This brings to a close the results of our first commercial litigation finance co-investment survey.  Slingshot Capital and Litigation Finance Journal would like to thank those that participated in the survey for their time and feedback.

Our next survey will cover fundraising initiatives by fund managers in the commercial litigation finance sector. We anticipate making the fundraising survey an annual survey so we can track fundraising activities over time.

If you would like to participate in future surveys, please contact Ed Truant here to register your interest.

Edward Truant is the founder of Slingshot Capital Inc. and an investor in the consumer and commercial litigation finance industry.

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Commercial Law Firm Corner

Litigation Funding – Section 107 Needs Amending

By Ken Rosen |

The following was contributed by Ken Rosen Esq, Founder of Ken Rosen P.C. Ken is a frequent contributor to legal journals on current topics of interest to the bankruptcy and restructuring industry.

The necessity of disclosing litigation funding remains contentious. In October 2024, the federal judiciary’s rules committee decided to create a litigation finance subcommittee after 125 big companies argued that transparency of litigation funding is needed. 

Is there a problem in need of a fix?

Concerns include (a) Undisclosed funding may lead to unfair advantages in litigation. Allegedly if one party is backed by significant financial resources, it could affect the dynamics of the case. (b) Potential conflicts of interest may arise from litigation funding arrangements. Parties and the court may question whether funders could exert influence over the litigation process or settlement decisions, which could compromise the integrity of the judicial process. (c) The presence of litigation funding can alter the strategy of both parties in negotiations. Judges may be concerned that funders might push for excessive settlements or prolong litigation to maximize their returns. While litigation funding can enhance access to justice for under-resourced plaintiffs, judges may also be wary of the potential for exploitative practices where funders prioritize profit over the plaintiffs' best interests.

A litigant’s financial wherewithal is irrelevant. A litigant’s balance sheet also addresses financial resources and the strength of one’s balance sheet may affect the dynamics of the litigation but there is no rationale for a new rule that a litigant’s balance sheet be disclosed. What matters is the law and the facts. Disclosure of litigation funding is a basis on which to argue that anything offered in settlement by the funded litigant is unreasonable and to blame it on litigation funding. 

Ethics rules

The concerns about litigation funding are adequately dealt with by The American Bar Association’s Model Rules of Professional Conduct, as well as various state ethical rules and state bar associations. An attorney's obligation is to act in the best interests of their client. Among other things, attorneys must (a) adhere to the law and ethical standards, ensuring that their actions do not undermine the integrity of the legal system, (b)  avoid conflicts of interest and should not represent clients whose interests are directly adverse to those of another client without informed consent, (c) fully explain to clients potential risks and implications of various options and (d) explain matters to the extent necessary for clients to make informed decisions. 

These rules are designed to ensure that attorneys act in the best interests of their clients while maintaining the integrity of the legal profession and the justice system. Violations of these ethical obligations can result in disciplinary action, including disbarment, sanctions, or reprimand. Disclosure of litigation funding is unnecessary because the ethics rules adequately govern an attorney’s behavior and their obligations to the court. New rules to enforce existing rules are redundant and unnecessary. Plus, disclosure of litigation funding can be damaging to the value of a litigation claim.

Value maximization and preservation

Preserving and enhancing the value of the estate are critical considerations in a Chapter 11 case. Preservation and enhancement are fundamental to the successful reorganization, as they directly impact the recovery available to creditors and the feasibility of the debtor's reorganization efforts. Often, a litigation claim is a valuable estate asset. A Chapter 11 debtor may seek DIP financing in the form of litigation funding when it faces financial distress that could impede its ability to pursue valuable litigation. However, disclosure of litigation funding- like disclosure of a balance sheet in a non-bankruptcy case- can devalue the litigation asset if it impacts an adversary’s case strategy and dynamics.

The ”364” process

In bankruptcy there is an additional problem. Section 364 of the Bankruptcy Code sets forth the conditions under which litigation funding – a form of “DIP” financing- may be approved by the court. 

When a Chapter 11 debtor seeks DIP financing, several disclosures are made. Some key elements of DIP financing that customarily are disclosed include (a) Why DIP financing is necessary. (b) The specific terms of the DIP financing, including the amount, interest rate, fees, and repayment terms. (c) What assets will secure DIP financing and the priority of the DIP lender's claims. (d) How DIP financing will affect existing creditors. (e) How the proposed DIP financing complies with relevant provisions of the Bankruptcy Code. 

Litigation funding in a bankruptcy case requires full disclosure of all substantive terms and conditions of the funding- more than just whether litigation funding exists and whether the funder has control in the case. Parties being sued by the debtor seek to understand the terms of the debtor’s litigation funding to gauge the debtor’s capability to sustain litigation and to formulate their own case strategy.

Section 107 needs revision

Subsection (a) of section 107 provides that except as provided in subsections (b) and (c) and subject to section 112, a paper filed in a case and on the docket are public records. Subsection (b) (1) provides thaton request of a party in interest, the bankruptcy court shall protect an entity with respect to a trade secret or confidential research, development, or commercial information.Applications for relief that involve commercial information are candidates for sealing or redaction by the bankruptcy court. 

But the Bankruptcy Code does not explicitly define "commercial information." 

The interpretation of "commercial information" has been developed through case law. For instance, in In re Orion Pictures Corp., 21 F.3d at 27, the Second Circuit defined "commercial information" as information that would cause an unfair advantage to competitors.” This definition has been applied in various cases to include information that could harm or give competitors an unfair advantage, and it has been held to include information that, if publicly disclosed, would adversely affect the conduct of the bankruptcy case. (In re Purdue Pharma LP, SDNY 2021). In such instances allowing public disclosure also would diminish the value of the bankruptcy estate. (In re A.G. Financial Service Center, Inc.395 F.3d 410, 416 (7th Cir. 2005)). 

Additionally, courts have held that "commercial information" need not rise to the level of a trade secret to qualify for protection under section 107(b), but it must be so critical to the operations of the entity seeking the protective order that its disclosure will unfairly benefit the entity's competitors. (In re Barney’s, Inc., 201 B.R. 703, 708–09 (Bankr. S.D.N.Y. 1996) (citing In re Orion Pictures Corp., 21 F.3d at 28)). 

Knowledge of litigation funding and, especially, the terms and conditions of the funding can give an adversary a distinct advantage. In effect the adverse party is a “competitor” of the debtor. They pull at opposite ends of the same rope. Furthermore, disclosure would adversely affect the conduct of the case- which should be defined to include diminution of the value of the litigation claim. 

The Federal Rules of Bankruptcy Procedure should be amended to clarify that information in an application for litigation funding may, subject to approval by the bankruptcy court, be deemed “confidential information” subject to sealing or redaction if the court authorizes it.

Conclusion

A new rule requiring disclosure of litigation funding is unnecessary and can damage the value of a litigation claim. If the rules committee nevertheless recommend disclosure there should be a carve out for bankruptcy cases specifically enabling bankruptcy judges to authorize redaction or sealing pleadings related to litigation funding. 

Commercial Deals

Hedge Funds and Private Equity Avoiding the Legal Funding Limelight

By Harry Moran |

There are household names in the litigation funding world that are well-known throughout the industry and beyond. However, some financial institutions seek to benefit from the lucrative returns available from litigation finance whilst trying to avoid the public spotlight on these activities.

Reporting by Bloomberg Law offers fresh insights into the involvement of non-traditional litigation funders in the market, with investments from hedge funds and private equity firms in high-value cases and deals only coming to light through court documents and filings. 

The article highlights the role of Davidson Kempner in funding patent claims brought by Audio Pod IP LLC against Audible Inc., which was revealed through a countersuit by Audible in a Manhattan federal court. Notably, Bloomberg’s investigation of public filings also found that this was not an isolated example of Davidson Kempner’s ties to patent holders engaged in lawsuits against large technology firms including ByteDance, Hulu, Samsung and SAP America. 

Other examples of these non-traditional funders' engagement with the legal sector include BlackRock’s use of its credit fund to lend to law firms and plaintiffs, and Cliffwater’s $14 million involvement in the funding deal between Gramercy Funds and Pogust Goodhead.

The extent to which these companies do not want to be publicly associated with litigation finance was strikingly demonstrated in the article. Beyond the number of firms who declined to comment on the reporting, when Bloomberg Law reached out to Soros Fund Management about one of their analysts whose LinkedIn revealed a focus on litigation finance, the analyst quickly removed the reference to legal funding from their profile.

More detail on the specific cases these hedge funds and private equity firms are backing can be found in Bloomberg Law’s full article here.

Commercial Regulatory Issues

Arizona Legislature’s Two Litigation Funding Bills Divided on Disclosure Rules

By Harry Moran |

As LFJ reported at the end of February, Arizona’s legislature appears set on moving forward with some form of enhanced regulation for litigation funding in the state. However, a recent development in the House has demonstrated that there is not yet consensus on the final scope and focus of these new rules.

An article in the Arizona Capitol Times provides an update from the state legislature on the progression of two competing bills, each offering a different approach to the regulation of third-party litigation funding in Arizona. Whilst both bills successfully passed through votes in the House Judiciary Committee, it is not yet clear which bill will be the preferred candidate in an eventual floor vote, with the differences in disclosure rules between the bills being a key factor.

Senate Bill 1215, sponsored by Senator Leach, was passed by the Senate on March 13 and contained the oft-seen provisions of mandating disclosure of funding agreements, limiting funder control over legislation and some prohibitions against foreign funders. SB 1215, which Leach described as a “consumer protection bill”, retains the backing of chambers of commerce, insurance companies, and business associations.

Senate Bill 1542 was introduced in response to Leach’s proposal by Rep. Alexander Kolodin, seeking to limit the disclosure provisions to only include foreign funders or civil cases involving the state. Furthermore, disclosure of third-party funding would only be made to the attorney general rather than to the court itself. Kolodin suggested that existing court mechanisms for discovery are sufficient and questioned the potential for malign use of mandatory disclosure, arguing that “you shouldn’t be able to deprive somebody of the ability to pursue a case by threatening their source of funding.”

While Kolodin joined the rest of the committee in unanimously voting in favour of SB 1215 at the committee stage, he said that he would likely vote against it in a floor vote. Kolodin’s alternative bill passed comfortably at the committee vote, but did receive two no votes from Rep. Selina Bliss and Rep. Lupe Contreras.

The full text of SB 1215, as well as information on the passage of the bill, can be found here.

The full text of SB 1542, as well as information on the passage of the bill, can be found here.