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
- Indemnities are not costless instruments; they are akin to securities options, but without a stated option value
- Approaches to determining cost of indemnity include: Probability weighted outcome approach, Opportunity Cost Approach and Approach based on empirical evidence
- Implications for Portfolio Returns are that improper assessment of indemnity returns may materially skew return results of a portfolio
Investor Insights
| o Indemnities have a cost and their cost should be used to determine investor returns | o Depending on how indemnity performance is measured, it has the ability to skew portfolio performance |
Some litigation finance providers offer a product called indemnity protection (please don’t call it insurance), which is a product designed to protect plaintiffs against adverse costs in certain jurisdictions (Canada, Australia and the UK, for example) where the plaintiff may be found liable for defense costs should the defendant win the case. Indemnity protection is prevalent in product class action and securities class action cases.
What makes indemnity protection challenging is the process of estimating the returns inherent to providing the protection. Indemnities differ from traditional litigation finance, in that the latter requires the funder to finance hard costs (legal counsel, court costs, expert witness costs, etc.), while the former only pays out once a case is lost by the plaintiff, and subject to the court’s determination regarding the application of adverse costs. In the event the plaintiff is successful, the indemnity provider shares in the contingent proceeds and is not liable for any payout.
However, in the event the defendant is successful, the indemnity provider must pay the indemnity amount and forego any prospective proceeds. In a normal rate of return calculation, the numerator (i.e. gains or proceeds) and denominator (dollars deployed to finance costs) help determine a Return on Invested Capital (“ROIC”) or Multiple of Invested Capital (“MOIC”). However, with indemnities there is no denominator; in the event the plaintiff wins the case and hence there is no “cost”.
Or is there?
I think most people in finance would argue strongly, and rightly so, that there is indeed a cost. I liken the analysis to that of a securities option. In the context of a securities option (a put or call option, for example) one pays an upfront amount (i.e. the option price) to attain the right to benefit in either the reduction or increase in the underlying stock price. The value of the option is based on the market’s view of the weighted average probability of the event taking place (i.e. achieving the strike price in a given period of time).
In the case of an indemnity, there is no cost to providing the indemnity (other than out of-pocket contracting costs) even though the opportunity has value to the indemnity provider. The value of the indemnity for the investor is inherent in the pay-out they expect to receive on success, which is offset by the likelihood of having to pay out under the indemnity. Essentially, it is a costless option. The upside produces infinite returns, while the downside produces a total loss.
Approaches to Valuing the Indemnity Protection
As we all know, nothing is “costless”. Instead, I would suggest that an investor in an indemnity needs to determine a theoretical cost for that investment.
One approach is to look at the litigation funder’s underwriting report and economic analysis to determine the probabilities associated with various negative outcomes pertaining to the case, and probability-weight the negative outcomes to determine a theoretical cost of capital. Of course, these need to be looked at in the context of the risks of the various case types in the relevant jurisdiction, in addition to the risks of the case through the various stages of the case, as adverse costs can have multiple pay-out points throughout the case. As an example, securities class actions in Australia and Canada, when certified by a court, have an extremely high success rate (meaning that they typically settle quickly after the certification).
Another approach might be to look at the alternative to utilizing that same capital in an investment with a similar risk profile, where the potential outcome could be the same and the risk of loss is similar. As an example, if the opportunity cost of providing an indemnity was to buy a securities option with a similar risk profile, then you could use the market cost of the option as a proxy for the cost of the indemnity.
Yet another alternative would be to study the outcomes of a large sample of identical indemnities to try and determine the probability of a negative outcome and apply it to the indemnity amount to determine a notional cost. Unfortunately, much of this information remains in the private domain, as most cases which use indemnity protection tend to settle. In time, it may be that there is sufficient data to make this approach realistic, but as it stands, there is insufficient data to make this a viable alternative.
While approaches will differ by fund manager and investor, the important point is to eschew the concept that an indemnity is a costless financial instrument, as to do so would skew the results inherent in a fund manager’s track record where indemnities are an important part of their strategy. This same result can also occur in more traditional litigation finance cases where there is a settlement shortly after the funding contract has been entered into, and which did not necessitate the drawing of capital. In this case, the returns are also infinite, but perhaps there should have been a theoretical cost of capital based on the probability of the funding contract being drawn upon.
Investor Insights: When assessing the rates of return on an indemnity, my approach is to determine a weighted average probability of loss outcomes and apply them to the Indemnity amount in order to determine a notional cost for the indemnity. This analysis becomes extremely important when assessing portfolio performance because most often fund managers do not assign a notional cost to their indemnities when providing their investment track records, and hence positive indemnity outcomes make their overall portfolio performance seem more impressive than one might otherwise assess. A simplified example of the potential for an indemnity to skew portfolio performance based on approach is as follows:
Assumptions:
Case Type: Security Class Action
Indemnity Amount: $1,000,000
Damage Claim: $10,000,000
Contingent Interest: 10%
Contingent Interest Award: $1,000,000
Probability of Loss $ Loss*
Loss at Summary Judgement: 10% $100,000
Loss at Certification: 5% $50,000
Loss at Trial: 25% $250,000
Notional Cost of Indemnity: $400,000
* calculated as probability of loss multiplied by Indemnity Amount.
- Return Calculation applying a theoretical cost to the Indemnity in a win scenario:
ROIC: = $600,000 ($1,000,0000-$400,000) = 150%
$400,000
MOIC: $1,000,000 = 2.5
$400,000
- Return Calculation applying no cost to the indemnity in a win scenario:
MOIC &
ROIC: $1,000,000 = Infinite
$0
Edward Truant is the founder of Slingshot Capital Inc. and an investor in the consumer and commercial litigation finance industry. Slingshot’s blog posts can be accessed at www.slingshotcap.com.
