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 Summary
- Business under-performance in the commercial litigation finance market has typically stemmed from 3 main causes
- Business partner selection is critical to success & corporate culture
- Portfolio Construction is critical to success and longevity in commercial litigation finance
- The application of debt is generally not appropriate in the commercial litigation finance asset class, with some exceptions, but may be appropriate in other areas of legal finance
Slingshot Insights:
- Spend the time to determine whether your partners are additive to what you are trying to achieve and understand their motivations
- Debt is a magnifying glass on both ends
- Portfolio concentration – even when you win, you lose
A number of years have passed since the commercial litigation finance industry was established in the UK, USA & Australia (the more mature markets of the global industry), and so I thought it appropriate to reflect on some of the lessons learned within the industry to extract insights both for investors and fund managers. Some of these lessons resulted in the wind-down of funders, some resulted in restructurings of the management company and their funds, some represent a “failure to launch,” and some resulted in changes in ownership. Some of the failures have been more public in nature, whereas others have resulted in restructurings and new ownerships (reluctantly) behind the scenes, and while they may now appear to be healthy funders, they underwent some restructuring to get there.
This article will not name the specific companies that have failed or faced significant adversity (they know who they are), but through a fair amount of rumour, press and feedback from former employees, one can start to assemble a story around the cause of fund failures related to a number of fund managers in various countries. Sometimes, the pioneers in an industry are those that make the biggest sacrifice for the good of those who follow in their footsteps (assuming they learn, which is why this article has been written). Marius Nasta of Redress Solutions PLC previously wrote an article entitled “Why do litigation funders fail?’ and this is an attempt to take a deeper look into the causes, and extract insights for fund managers and investors.
This article will not touch on the various frauds that may have occurred in the industry as those are beyond the scope of this article, but bear scrutiny nonetheless. For edification, some of the articles that cover those frauds can be found below. Interestingly, a recent case in the UK ended in a fourteen-year jail sentence for one of the founders of Axiom.
Commercial Litigation Finance
Axiom Legal Finance
Consumer Litigation Finance
Cash4Cases
As I reviewed the various fund managers’ experiences in the industry with a focus on distressed situations, some themes started to arise which I have classified into various categories, as outlined below. Sometimes, the cause is singular in nature and sometimes it is a combination of issues that result in an unexpected outcome resulting in a business setback, which can be fatal. In any event, I think the following insights are ones that all fund managers and investors should take into consideration as they operate, diligence and invest in the commercial litigation finance market.
Insight #1 – Pick Your Partners Slowly & Carefully & Don’t be Afraid to Walk Away
There is an adage in human resources, “hire slowly and fire quickly”. The same holds true for any business where partnerships are involved, although the ‘firing’ aspect is much more difficult. There is another adage that says you don’t really know your partners until you either start working together or until money is involved, and that is true of any venture where partners come together to form a business.
In the early days of any asset class, there is a fervor and an anxiousness to ‘get on with it’ in order to capitalize on the opportunity before others beat you to it. As a consequence, partnerships are formed all too quickly and with the wrong partners, and typically among people that have never worked together before. The first few months can be exhilarating and then reality sets in and eventually people’s ‘true colours’ start to show (both good and bad). It is important in the early days of assessing the merits of a business partnership to have an open dialogue about business goals and expectations, roles and responsibilities, individual strengths and weaknesses, relative motivations and incentives, distractions (i.e. is one partner independently wealthy and the other living ‘paycheck to paycheck’, as these economic differences will surely result in motivational differences and likely impact the amount of time and effort each will spend on the business), and generally what each party is looking to get out of the business. As this is a finance business, there are requirements around investor relations and fundraising to consider beyond the business of marketing, originating and deploying capital, and you need to be very clear what the expectations are of the partners in this regard, as it tends to be an ‘all hands on deck’ situation in the early days of establishing a business and some partners may not be comfortable with the fundraising role.
Fund managers should be under no illusions, it’s extremely difficult to raise a new fund in a new market with limited liquidity, unknown duration and quasi-binary outcomes …. and all with no track record to show for it. In fact, if you were to consult the investor playbook, these are often characteristics most investors absolutely avoid. This is the task at hand for any new manager looking to establish themselves in the litigation finance sector. But the allure of big multiple payouts is often hard for investors to ignore, and that is in essence what has allowed this industry to grow and prosper (hope is a powerful aphrodisiac).
Accordingly, the early days of forming a business can be very telling about how the business will perform and where tensions will arise. In the field of litigation finance, your pool of experienced talent from which to hire is very limited, as the industry has not been around for a long time. My observation is that some of the best funding teams in the world have a combination of partners with different business backgrounds and experiences. While litigation experience is clearly a desirable skill set to invest in litigation finance opportunities, finance experience is equally critical to the success of a litigation finance fund. The important thing for partners is to recognize their strengths and weaknesses, and partner up with someone that fills the voids. Of course, this all means that people need to be self-aware, and that can often be a challenge, especially with individuals who have had some success in their field and who have never been told of their ‘blind spots’ by their peers.
The strongest and most effective teams I have come across in the industry have a combination of experience in litigation and finance. The value add of those with litigation experience is self-evident, although many litigators come with their own biases based on their experience which require balancing via a different perspective. The value of those with finance experience is not only as a second set of eyes on the merits of the case (i.e. keep the biases in check), but perhaps more important are the structural benefits they can bring to the construction of the funding contract and their focus on risk mitigation. This is a subsector of specialty finance, after all.
Nevertheless, a business partnership may under-perform for any number of reasons. At that point, your options are quite limited. Generally, you have four options:
- you can attempt to restructure your internal operations and economic allocations around the reality of people’s efforts and value they bring to the partnership, so that there are appropriate incentives and procedures in place to deal with issues (good luck with that one),
- you can exit and start from scratch, with the appropriate exit agreements in place which may make it more difficult to start a new business for the exiting partner in the short term (while more difficult, this may ultimately be the most rewarding (financially and ‘spiritually’) if it can be done successfully),
- Status Quo – you can attempt to make it work, although the issue is that this may ultimately result in significant resentment, which in turn makes it extremely difficult to create an environment to attract top talent, and generally results in a sub-par business. In essence, you’re just delaying the inevitable, and potentially degrading the value of the business in the interim.
Of course, if one of those three doesn’t work, there is always the nuclear option – blow it up & start over, separately. This tends to be the ‘scorched earth’ option where the partners decide that if they all aren’t going to benefit, then no one will benefit. While this does nothing for reputations and personal brands, it can be immensely satisfying (albeit short lived) for the partner that has suffered the most. Generally, people should try to avoid this option, if at all possible.
Selecting partners (and hiring employees in general) is the single most important value driver for equity creation in the fund management business (secular trends also help, a lot!) yet it is constantly the area where business owners spend the least time and attention. I encourage those looking to form a business to over-invest their time on the people side of the equation early on to avoid missteps. Just like marriages, business partnerships can be difficult even when they are working well.
Insight #2 – Concentration is a Killer – Diversify, Diversify, Diversify
One of the easiest errors to make in commercial litigation finance is to be inadequately diversified; and diversification should be multi-faceted. I have covered the benefits of portfolio diversification in a prior article, but for this article, let’s talk about some of the challenges in creating a diversified business.
Manager Bias…or Wishful Thinking
The first challenge to creating a diversified portfolio is eliminating bias. I have often heard fund managers refer to cases as “slam dunk cases”, only to be proven otherwise by a judicial decision. I have also personally reviewed many cases where I thought the balance of probabilities outweighed the plaintiff over the defendant, only to be shown otherwise by a judicial outcome. In short, no one knows. What I do know, based on the extensive data I have reviewed, is that litigation finance is successful about 70% of the time (where “success” = profit), across geographies. With a 70% success rate, I can figure out an appropriate portfolio construction (size, concentration, number of investments, case types, etc.) but if I allow my bias to enter into my decision making, I may make the mistake of putting too much of the fund in one transaction or case type (see below), and this one mistake may be fatal, as it could determine the overall outcome of the fund’s returns, and hence impact that manager’s ability to raise another fund.
As your fund grows, you can then look to address bias through attracting different human capital to the business, each of whom will have different experiences (and biases) which will hopefully provide different perspectives that will result in superior decision making. The networks of these additional people will also add a different origination source to the business, which will further serve to diversify the portfolio through other case types, law firms, case sizes, case jurisdictions, etc. All should serve to diversify and strengthen the business, if executed well.
Deployment Risk
The second challenge is portfolio concentration relative to deployment risk. In an asset class that has double deployment risk, the first level of deployment risk is the risk associated with whether the manager will invest the commitments. The second layer of deployment risk in litigation finance is whether the commitments made by the manager will draw 100% of the commitment, and this layer of risk is almost impossible to quantify, although there are ways to mitigate it.
In commercial litigation finance it can be extremely difficult to create a diversified portfolio on a ‘dollars deployed’ basis, simply because you don’t know how much of your fund commitments will ultimately be deployed. I have seen many limited partnership agreements that have 10% concentration limits. Those concentration limits are based on funds committed, so on a funds deployed basis, those concentration limits could be well in excess of 10%. With a 10% concentration limit, as goes those investments, so goes the fund, which is an overly risky position for a fund manager and investor to take. We also can’t lose sight of the fact that for any given fund, about 15-25% (depending on your management fees & operating costs) of the fund’s commitments will be consumed by management fees and operating expenses, and so the fund manager is really investing seventy-five to eighty-five cent dollars, which makes portfolio concentration even riskier.
Accordingly, fund managers should target fund concentration limits in the 5% range (5% of dollars deployed, that is), which would result in about 20 investments in any given fund, thereby giving the manager a reasonable chance at success, statistically speaking. But, in order to achieve 5% concentration on a dollars deployed basis, they should really be looking at about fifty to seventy-five percent of that rate on a dollar committed basis. Said differently, the fund manager should be targeting about a 2.5-3.5% concentration limit on a ‘dollars committed’ basis that may ultimately result in something closer to 5% on a dollars deployed basis for some of the investments in the portfolio (the same math does not hold true for managers that focus on investing in portfolio investments, which by their nature are diversified and cross-collateralized).
In part two of this two-part series, we further delve into portfolio construction issues, and then discuss the appropriateness of utilizing debt within the context of commercial litigation finance.
Slingshot Insights
Much can be learned from the misfortune of others, and this is what I have attempted to summarize in the article. To be fair, in the early days of an asset class, establishing a business is much more difficult than in more mature asset classes. The learning curve, both for managers and investors, is steep, and those that came before were pioneers. There are a lot of unknown unknowns in commercial litigation finance, and things don’t often end up going the way people thought they would go, but we learn from the benefit of hindsight. In short, establishing a new asset class is very difficult, and everyone can learn from the missteps of others as they build their own successful organizations. Coupled with the difficulty inherent in establishing a new asset class is the fact that this asset class is unique with many risks that only come to light with the benefit of time – idiosyncratic case risk, double deployment risk, duration risk, quasi-binary risk, etc. Accordingly, the industry owes a debt of gratitude to those that came before as we are now smarter for their experiences. But beware!
Those who fail to learn from history are doomed to repeat it!
– Winston Churchill (derived from a quote from George Santayana)
As always, I welcome your comments and counter-points to those raised in this article.
Edward Truant is the founder of Slingshot Capital Inc. and an investor in the consumer and commercial litigation finance industry. Slingshot Capital inc. provides capital advisory services to fund managers and institutional investors and is involved in the origination and design of unique opportunities in legal finance markets, globally.
