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 design 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, 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
In part one of this two-part series, we explored the importance of partnerships and we started to discuss elements of portfolio construction. In part two, we further delve into portfolio construction issues and then discuss the appropriateness of utilizing debt within the context of commercial litigation finance.
Insight #2 – Concentration is a Killer – Diversify, Diversify, Diversify
Continued…
Portfolio Concentration
The third challenge is specialization, or case type concentration. Any given litigator will have a bias based on their personal experience. Litigators often migrate to become specialists in a particular area of litigation, which is where they are knowledgeable and where they likely have achieved success, and hence created biases. Those litigators are pre-disposed to be comfortable working with those case types, and they have relationships in the legal community that would bring those opportunities to their attention. Hence, there is a statistical likelihood that the portfolios of their funds will similarly become concentrated with a particular case type. The same issue holds true for fund managers who decide to specialize in an area of law (e.g., intellectual property, bi-lateral investment treaty, anti-trust, etc.), the difference being that they have made that conscious choice and their portfolios will reflect that by design.
The problem with focusing on a particular case type is that the manager really limits itself to the idiosyncrasies of the particular area of law. As an example, it is well known that within intellectual property, as a result of intellectual property reforms in prior years there was a ‘swing in the pendulum’ away from protecting innovation created by small technology companies and ‘patent trolls’ in favor of big technology companies. Now, we are witnessing the pendulum swinging (albeit slowly) in the other direction. So the problem is that as goes the regulation, legislation and legal precedent, so goes your fund returns. Because you make commitments in advance of knowing changes in legislation or precedence, you will not have the ability to pull back on your commitment, and hence your fund becomes stuck with the investments you have made up until that point in time. As a manager, you don’t want to be exposed to /dependent on a particular area of law, as your portfolio will be exposed to the specifics of that area of law or case type, which is completely beyond your control. There are enough uncontrollable factors inherent in litigation finance already, so you’d prefer to be able to control as much as possible.
Now, some may make the argument that by specializing, you are more in control, because you have the knowledge and ‘inside track’ on upcoming legislation and trials that could impact your area of specialty. In addition, specialists can make the argument, credibly, that the mere act of specialization lowers risk in the portfolio, because you are focused on a particular case type and know everything there is to know about that case type and hence you have a higher propensity to avoid the losers and focus on the winners, prior comments on the ability to pick winners, notwithstanding. I can’t argue with the merits of specialization, as I am a bigger believer in the concept and the underlying value it can create, but there is no doubt that it adds a risk that is otherwise not inherent in a highly diversified portfolio, which is possibly more than offset by the incremental value it delivers. Investors need to recognize that this case specific risk exists, and that they need to anticipate its impact on the portfolio of investments they may be making in the litigation finance space.
At least one of the companies that suffered from an overly concentrated portfolio in a specific case type is no longer actively deploying capital, and so the question then becomes, ‘was this a consequence of the case type, the inexperience of the manager as regards to that case type, or merely the result of having an overly concentrated portfolio?’ My point of view is that it was a combination of the three factors, with an overly concentrated portfolio being the single biggest factor.
The reality of concentration is that even if you are lucky and have a home run in a concentrated bet, you won’t benefit. In other words, even if you win, you lose. Why? Because any sophisticated investor is not solely interested in your results but more importantly how you achieved them. Accordingly, if you show a sophisticated investor that the main reason underlying your positive performance was a single large case, they will be savvy enough to figure out that had that case gone the other way, it would have likely wiped out their investment in the fund. After all, investors are trying to mitigate against binary risk, not accentuate it. In this asset class, the importance of portfolio construction cannot be underestimated whereas in other asset classes you will have more degrees of freedom.
Investor Diversification
Not only is diversification important to how the manager deploys capital, it is equally important as to how the manager funds his business. More so than in other asset classes with which I have had experience, the propensity for managers to accept commitments from relatively few investors seems to be more pronounced in commercial litigation finance. I believe the reason for this mainly stems from the nascent nature of the asset class and all of the inherent risks associated with financing litigation. Since it is generally a higher risk venture, in part due to a lack of transparency of the risk/return profile, many investors tend to shy away from the asset class (at least they did in the early days). In order to fill the void, more opportunistic investors (family offices, hedge funds) came in and assumed the risk, but often at the expense of controlling the investment. The idea was that they will give you all the money you need, but they will be involved in the decision-making process through their veto rights (the right not to make an investment that is being proposed by the manager). The problem with accepting money from too few investors is that when it comes time to raise the next fund (i) you’re at a disadvantage if the original investor does not make a new commitment to your next fund, and then you are left to scramble for a plausible explanation, (ii) you will likely have to expand your investor base regardless, because your current investor base might be tapped out depending on their fund and the distributions you have been able to provide them, and (iii) you now have to explain a track record that was in part determined by the prior investor’s use of their veto rights (so, who is responsible for the track record – the manager or the investor?).
In essence, diversification across all of these characteristics will not only serve to create a more sustainable business, but will increase your chances of being able to replicate your success over and over again. This should all serve to increase your assets under management, attract top talent and ultimately improve manager cashflow and manager equity value while providing your investors with an appropriate return profile for the risk they are assuming. A key focus of any commercial litigation finance manager should be to reduce risk, whether that is at the fund level (for the benefit of investors) or at the manager level (for the benefit of shareholders/employees).
Insight #3 – Apply Debt Very Cautiously, if at All – Debt is a Magnifying Glass on Both Ends
Leverage (debt) is a tricky bedfellow. On the one hand, it can enhance your returns and create significant performance fees for managers. On the other hand, you can lose your business. In essence, the decision to use leverage in commercial litigation finance is akin to making a fairly binary bet in an otherwise quasi-binary investment strategy. The more managers can do to mitigate risk, the greater the chance of developing a sustainable business and the greater the applicability of debt, which is one of the reasons it has been successfully applied in the consumer litigation finance market.
Leverage is used liberally (too liberally in my opinion) in a variety of asset classes, from hedge funds to leverage buy-outs and everything in between. Leverage has become ubiquitous in finance, for better or for worse. However, the application of leverage is only appropriate in certain circumstances where there is a high degree of certainty regarding cashflows and it must be structured appropriately to fit with the asset’s cashflow patterns.
Some of the large publicly listed managers like Litigation Capital Management and Omni Bridgeway have raised debt in the public markets either through private debt facilities or through public bond offerings. These organizations have generally taken a cautious approach to leverage, and have added it only when their balance sheets were large enough to comfortably support not only the quantum of debt, but also the ability to service the debt in a manner that comfortably allows for the repayment of the debt by the end of the facility term. This is much easier for a publicly listed entity to do, because they have more financing options available to them by virtue of being public and the inherent liquidity that provides to its investors. In addition, because of the size of these entities they also are afforded more relaxed terms (PIK interest, covenant light deals) which is derivative of the diversification inherent in their portfolios, which are otherwise not available to smaller private fund managers. However, I will say that in each and every case it appears they have put in place an appropriate amount of leverage and have structured it in a way that matches the cashflows with the inherent liabilities associated with the facility. Asset/Liability mismatch is probably the single biggest cause of default when it comes to leverage facilities and this is particularly the case with commercial litigation finance.
So, how does the application of leverage apply to private commercial litigation finance funds? Unfortunately, it generally does not, with few exceptions. For private fund managers, the application of leverage has not gone well. In the three instances of manager failure related to leverage of which I am aware, the managers of those funds lost control, and ownership of their management companies or were transitioned into run-off. The problem stems from the inability to accurately forecast the success rate and the quantum and timing of cashflows derived from the portfolio. As leverage tends to be a fixed maturity obligation with financial covenants and often ongoing cashflow servicing requirements (i.e. interest payments), it inherently requires an element of predictability of cashflows, which is missing from most commercial litigation finance portfolios. Accordingly, it is impossible to put in place a leverage facility with any level of certainty about the ability to service the debt without having a high degree of certainty over the portfolio’s ability to generate cashflows. This mismatch, along with higher than expected or poorly timed losses in the portfolio, is what has led to the loss of control of fund manager’s funds. The problem with losses is that you know they are going to happen, typically 30% of cases lose, you just don’t know when and in what sequence (will they all happen at the beginning, the end or sporadically over time?). Lenders will tend to move quickly to enforce their security opposition and salvage what they can from the existing portfolio, which results in significant reductions in headcount to the point of a skeleton staff to run off the portfolio to maximize their asset value. In other words, this is typically the beginning of the end.
So, why do private fund managers use leverage? Often, they don’t have a choice or they don’t think they have a choice. Those managers that have used leverage have either been fundraising for a number of months/years and they are at the end of their rope when they consider using a leverage facility, or they have had some initial success with their first pool of capital and decide they want to use leverage to scale their operations. They know they shouldn’t, but they have no option if they want to get their business off the ground, or have decided to aggressively grow their business using leverage. Unfortunately, using debt to finance what is typically financed by equity (sweat or otherwise) is not a good financial solution (i.e. hope is not a good strategy).
In terms of where leverage may be appropriate, there could be specific case types or segments of the market, consumer litigation finance comes to mind, where they run large portfolios of very small investments and they have the ability to forecast cashflows with a high degree of certainty of their cashflow timing and quantum, but these characteristics are few and far between in the commercial litigation finance sector. In fact, the consumer litigation finance market has such strong cashflow characteristics and predictability, that they are now able to obtain funds from the securitization market, long reserved for some of the best credits.
Where might leverage be appropriate in the commercial market? Certain strategies that focus on short-term litigation (i.e. appeals financing) or where the manager decides to put a small amount of debt with appropriate (and very flexible) repayment terms can result in a positive outcome for both leverage provider and fund manager. Just don’t add too much debt, and be very aware to structure appropriately for the predictability of the portfolio’s underlying cashflows.
If a manager is able to secure a debt obligation that is fairly flexible in terms of interest payments and repayment terms, there may be an opportunity to appropriately apply debt to the asset class. To this end, a European group has designed a flexible, insurance wrapped bond offering that may fit the bill and I will follow their progress with great interest to see if they are able to secure the necessary funding to be successful in raising capital and then ultimately deploy that capital in a way that produces the necessary returns to service the bond.
I would generally caution first time fund managers to avoid leverage altogether, and for more established fund managers, I would caution them to use it sparingly and structure it appropriately and with lots of margin for error. We should all heed the sage advice of Warren Buffet when considering using leverage:
“If you don’t have leverage, you don’t get in trouble. That’s the only way a smart person can go broke, basically.
And I’ve always said, ‘If you’re smart, you don’t need it; and if you’re dumb, you shouldn’t be using it.'”
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.
