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Portfolio Theory in the Context of Litigation Finance (pt. 2 of 2)

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. 

In part one of this two part series, which can be found here, I explored a variety of portfolio theories and applied them to the litigation finance asset class. This second article continues the application to commercial litigation finance and discusses implications for portfolio construction.

Executive Summary

  • Modern Portfolio Theory (MPT) – a mathematical framework based on the “mean-variance” analysis – argues that it’s possible to construct an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk
  • MPT states that assets (such as stocks) face both “systematic risks” – market risks such as interest rates – as well as “unsystematic risks” – mostly uncorrelated exposures that are characteristic to each asset, including management changes or poor sales resulting from unforeseen events
  • Post-modern Portfolio Theory (PMPT) adds a layer of refinement to the definition of risk
  • Diversification of a portfolio can mitigate the impact of unsystematic risks on portfolio performance – although, it depends on its composition of assets
  • Behavioural Finance (BF) introduces a suggestion that psychological influences and biases affect the financial behaviors of investors and financial practitioners, also applicable to litigation finance

Slingshot Insights:

  • Portfolio theory is important to the commercial litigation finance asset class due to its inherently high level of unsystematic risks
  • Slingshot’s Rule of Thumb: a portfolio should contain no less than 20 investments in order to provide the benefits associated with portfolio theory
  • Diversification is critical for every fund manager
  • Specialty fund managers may play a positive role in a comprehensive litigation finance investing strategy by assisting with meeting a particular performance objective when defined in the context of acceptable “mean-variance” targets
  • Diversification provides optionality for an under-performing manager to ‘live to fight another day’ if their first fund achieved sub-par performance
  • Portfolio theory is applicable to consumer litigation finance

How Big is Big Enough?

There are many theories about how large a portfolio should be to meaningfully benefit from the application of portfolio theory, with analysts suggesting anywhere from 20 to over 100 investments (typically in relation to public equities).  While I have yet to conduct a study to determine a more finite range applicable to litigation finance, I will say that there are a few elements that are critical to consider, which are specific to litigation finance.

First, litigation finance is by its very nature uncertain in terms of the amount of commitment the fund manager will ultimately deploy in relation to its financial commitment to a single case (i.e. while a manager may commit $5 million to a case, the legal team may only deploy $2MM by the time the case settles). Capital deployment (both quantum and timing) is an uncontrollable variable that makes portfolio theory difficult to apply, because portfolio theory assumes the dollars deployed in each investment are (i) known and (ii) of equal size (although weightings can be assigned).  Accordingly, in order to ensure that the portfolio is diversified on a dollars deployed basis, the portfolio needs to be sufficiently large to ensure that on a committed basis it is not skewed by a few cases which have deployed 100% or more of their initial commitment relative to those cases that have deployed less than 100%.  It is also not uncommon for managers to deploy nil or very little against their commitment as a result of an early settlement (perhaps brought on by the existence of litigation finance itself, or by virtue of the investment being in the form of adverse costs indemnity protection), which adds another element of complexity as relates to the application of portfolio theory.

Second, diversification in the context of litigation finance is not only a mathematical exercise of ensuring no one case represents a disproportionate amount of the fund, it also covers the types and extent of case exposures in the portfolio.  If one is investing only in a single manager, one wouldn’t necessarily want a fund that invests solely in Intellectual Property cases, as an example, because a Systematic risk that effects that sector (for example, litigation reform such as Inter Partes Reviews in patent litigation, or an important case precedent with broad implications) will likely effect all cases in the portfolio and hence diversification will not aid at all in terms of addressing the Systematic risk. Case types, defendants, jurisdictions, judges, plaintiff counsel, defense counsel, case inter-dependencies (where the outcome of one case has a direct impact on the likely outcome of another case in the same portfolio) are all important variables that a manager should consider when creating their portfolio.

Third, litigation finance portfolio financings (the concept of a funder investing in a portfolio of law firm or corporate cases) are, by their very nature, benefitting from the application of portfolio theory. Therefore, in constructing one’s portfolio, one should consider whether the committed capital is being invested in single case portfolios, cross-collateralized portfolio financings or a combination thereof, each of which having different risk-reward profiles.

When we take all of the above into consideration, especially the uncertainty inherent in capital deployment, my general rule of thumb is for managers to target a minimum of 20 equally sized litigation finance case commitments within a portfolio. From there, I adjust based on a variety of factors including case types, financing sizes, jurisdictions, currencies, etc.  Other investors may have a different perspective.  Of course, the portfolio will never be comprised of 20 equally-sized cases due to deployment uncertainty, so I view this as a baseline. If the portfolio is made up of cases with a higher inherent volatility (class actions, intellectual property, international arbitration or large cases), then a larger portfolio would be more appropriate, such that the higher loss ratio in the portfolio – which is inherent in higher risk portfolios – will not disproportionately contribute to the portfolio’s overall performance.

Applicability to Consumer Litigation Finance

Portfolio theory suggests that diversification is exceptionally good at reducing Unsystematic risk; hence, it comes as no surprise that MPT should be more frequently applicable to the commercial litigation finance asset class given the high level of idiosyncratic case risk.  The consumer litigation finance market also exhibits similar idiosyncratic case risk, but I believe it has more Systematic risks related to defendants (usually, insurance companies with a common approach), regulation, and established case precedent where the damages are much more prescribed.  Accordingly, while portfolio theory may not be as critical in this segment of litigation finance, as an investor in the asset class I believe it remains an important value driver for the consumer litigation finance market, especially since the return profile of a single piece of consumer litigation finance is generally not as strong as those inherent in commercial litigation finance due to risk and regulatory differences.

Fund Managers’ Perspective

As an investor experienced with managing capital, deploying capital and portfolio construction, I offer a few observations for consideration.

First, don’t fall in love with your investments (i.e. don’t get caught with personal biases working into your portfolio construction).  It is easy for a fund manager to be attracted to certain cases thinking the particular case is a ‘no brainer’ (perhaps due to personal experience and/or comfort with the merits of the case) and allocate a disproportionate amount of the portfolio to finance that case. However, in the context of an asset class with binary and idiosyncratic risk, the portfolio manager would be taking on a disproportionate amount of risk in doing so.  Once a manager has determined that the case meets their rigid underwriting criteria, her or she must change their mindset to one of portfolio allocator and take a dispassionate view of the case to ensure the portfolio is optimized.  In fact, I would suggest splitting the functional role of underwriting and portfolio construction to ensure the underwriting doesn’t influence portfolio allocation decisions!

Second, do not insist on exceptions to concentration limits.  I have seen a number of fund documents where the manager has carved out exceptions to concentration limits (many of which are not appropriate for this asset class (10%, 15%, 20%) and have been derived from other PE asset classes with completely different risk profiles). By doing so, the manager is adding a lot of risk (and bias) to the portfolio that is both unnecessary and risky to the longevity of the fund, not to mention investor returns.  In my mind, the equation is quite simple: if one creates a diversified set of investments of relatively equal size, and one maintains a sound underwriting methodology, industry data suggests that one’s investment thesis should work. So why jeopardize a sound strategy?

Third, fund managers will live and die by their portfolio results, so why take unnecessary risk in haphazardly allocating capital?

To illustrate the second and third points, let’s consider four potential portfolio outcomes: (i) non-diversified portfolio with poor performance, (ii) non-diversified portfolio with exceptional performance, (iii) diversified portfolio with good performance and (iv) diversified portfolio with poor performance.

As an investor, I would look at situations (i) and (ii) and say “as a fund manager you are ‘dead in the water’”. Why? Situation (i) is self-explanatory: poor underwriting which impacts fund performance, and is buttressed by the fact that the fund manager isn’t astute enough to diversify the portfolio. Situation (ii) communicates the exact same thing, but in a different way. It tells an investor that the fund manager was ultimately successful, but in a way that was risky (in other words, the manager ‘got lucky’) and not likely repeatable (because fund performance was dependent on too few outcomes), which is not what attracts most investors who are looking for a measure of conservatism and persistence in their managers’ return profiles. I contend that this asset class should exhibit a return profile closer to that of growth or leveraged buy-out private equity (strong returns across the portfolio with a few losers for an overall strong return profile) and not venture capital (mostly losers with some exceptionally strong performers which contribute disproportionately to the overall portfolio return, which may be positive or negative).  Recent shifts toward portfolio financings by Burford and other private fund managers, suggest that there is a consensus as to the benefit of diversification on the volatility of portfolio returns.

On the other hand, situation (iii) is an ideal one, where the manager was prudent and the results illustrate underwriting and portfolio construction acumen, with portfolio returns not being disproportionately impacted by a few cases. Situation (iv) is interesting because it is a scenario where a manager can potentially ‘live to fight another day,’ since he or she was prudent with capital allocation, but perhaps something went awry with underwriting, or the portfolio was negatively impacted by a Systematic risk which was beyond the manager’s control. Every fund manager should ask themselves, “why take the risk” in creating a non-diversified portfolio, because it is a lose-lose scenario?  Diversification will always provide the optionality of raising a subsequent fund, even if returns are sub-par.

As we live in a dynamic world with a myriad of financial innovations being developed daily, managers should remain aware of new approaches to reducing risk in their portfolio (i.e. insurance, co-investing, risk-sharing with law firms), which may allow them to invest a smaller amount without taking on undue case concentration risk.  Of course, any instrument that reduces risk incurs a cost, and so one will need to assess the overall risk-reward equation to determine whether it is appropriate for both the manager and the investor.

Diversification is in the eye of the Investor

Managers should also keep in mind that each investor is different.  A manager may have one investor that has decided to maintain a single exposure to litigation finance through the manager, in which case the investor is likely counting on that manager to ensure application of portfolio theory.  On the other hand, an investor may be looking for specific exposures to complement his or her numerous allocations within the litigation finance sector, and so the investor is expected to apply portfolio theory to the various allocations within their portfolio and are less reliant on the fund manager for doing so in their specific fund.

What is critical for managers is that they deploy capital in a responsible manner and not acquiesce to the demands of a given investor with respect to their perspective on portfolio construction and portfolio theory. We are all here to create sustainable long-term businesses, and a given investor may have different objectives that could derail the manager’s own goals.

Slingshot Insights

Investing in a nascent asset class like litigation finance is mainly about investing in people.  Most managers simply don’t have the track record of a fully realized portfolio on which investors can base their investment decision.  Accordingly, much time and attention is spent on understanding how managers think about building their business and in particular their first portfolio.  In addition to the underwriting process, one of the most important considerations for investors to understand is how managers think about portfolio construction and diversification. Portfolio theory plays an integral role in terms of how managers should be thinking about constructing their portfolios from the perspective of the number of cases in the portfolio, but managers should also ensure their own personal bias is not entering into the portfolio and that they have thought about all of the systematic risks that can affect like cases. My general rule of thumb is that most first time managers should be targeting a portfolio of at least 20 equal sized commitments, appreciating that it is almost impossible to achieve equal sized deployments due to deployment risk. It is also not in the manager’s best long-term interest to take a short-cut on diversification for expediency sake (i.e. to raise the next larger fund) and to do so may be interpreted as poor judgment from an investor’s perspective!

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.

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Community Spotlights

Community Spotlight: Dean Gresham, Managing Director, Certum Group

Dean Gresham is a Managing Director who oversees the evaluation, underwriting, and risk management of all the company’s risk transfer solutions, including litigation finance and contingent risk insurance. With 25 years of experience in complex litigation and legal risk analysis, Dean ensures rigorous underwriting standards and strategic risk mitigation across the company’s risk transfer solutions.

Before joining Certum Group, Dean was a trial lawyer for more than 21 years handling complex commercial, catastrophic injury, qui tam, and class action litigation across the country. While practicing, Dean litigated on both sides of the docket and developed a keen ability to analyze and assess risk from both the plaintiff’s and defendant's unique perspectives.

In 2020, Dean was awarded the Elite Trial Lawyer of the Year award by the National Law Journal for his trailblazing work on a complicated wrongful adoption case. Dean is consistently chosen by his peers as a Texas Super Lawyer (2009-2024); one of the Best Lawyers in Dallas by D Magazine (2009-2024), one of the Top 100 Trial Lawyers in Texas by the National Association of Trial Lawyers (2011-2024), and in the Nation’s Top One Percent by the National Association of Distinguished Counsel (2019-2024).

Dean is the 2025 Chair of the Dallas Bar Association's prestigious Business Litigation Section and sits on the DBA’s Judiciary Committee.

Company Name and Description: Certum Group offers a next-generation litigation risk transfer platform that provides bespoke solutions for companies, law firms, and funders facing the uncertainty of litigation. Latin for “certainty,” Certum represents the core benefit the company delivers to its clients across its entire suite of risk transfer solutions.  Certum is the full-service funding and insurance partner for law firms and their business clients.

Company Website: www.certumgroup.com

Year Founded: 2014 

Headquarters:  Plano, Texas

Area of Focus: Member: Head of Underwriting and Chair of the Investment Committee.

Member Quote: “Litigation funding doesn’t just fuel cases—it fuels justice. Power should never trump merit.”

Commercial Special Features

Highlights from LFJ’s Virtual Town Hall: Investor Perspectives

By John Freund and 4 others |

On March 27th, LFJ hosted a virtual town hall featuring key industry stakeholders giving their perspectives on investment within the legal funding sector. Our esteemed panelists included Chris Capitanelli (CC), Partner at Winston and Strawn, LLP, Joel Magerman (JM), CEO of Bryant Park Capital, Joe Siprut (JSi), Founder and CEO of Kerberos Capital, and Jaime Sneider (JSn), Managing Director at Fortress Investment Group. The panel was moderated by Ed Truant (ET), Founder of Slingshot Capital.

Below are highlights from the discussion:

One thing that piqued my interest recently was the recent Georgia jury that awareded a single plaintiff $2.1 billion in one of 177 lawsuits against Monsanto. What is your perspective on the health of the mass tort litigation market in general?

JSn: Well, I think nuclear verdicts get way more attention than they probably deserve. That verdict is going to end up getting reduced significantly because the punitive damages that were awarded were unconstitutionally excessive. I think it was a 30 to 1 ratio. I suspect that will just easily be reduced, and there will probably be very little attention associated with that reduction, even though that's a check that's already in place to try to prevent outsized judgments that aren't tied as much to compensatory damages. I expect Monsanto will also likely challenge the verdict on other grounds as well, which is its right to do.

The fact is, there are a whole number of checks that are in place to ensure the integrity of our verdicts in the US legal system, and it's already extraordinarily costly and difficult for a person that files a case who has to subject himself to discovery, prevail on motions to dismiss, prevail on motions for summary judgment, win various expert rulings related to the expert evidence. And even if a plaintiff does prevail like this one has before a jury, they face all sorts of post-trial briefing remedies that could result in a reduction or setting aside the verdict, and then they face appeals. The fact is, I think corporate defendants have a lot of ways of protecting themselves if they choose to go to trial or if they choose to litigate the case.

And I think, oftentimes when people talk about the mass tort space, their disagreement really isn't with a specific case, but with the US Constitution itself, which protects the right to juries, even in civil litigation in this country. The fact is that there is a rich tradition in the United States that recognizes tort is essential to deterring wrongdoing. And ensuring people are fairly compensated for the injuries that they sustained due to unsafe products or other situations. So, broadly speaking, we don't think in any systematic a way that reform is required, although I suspect around the margins there could be modest changes that might make sense.

Omni has made a number of recent moves involving secondary sales and private credit to improve their earnings and cash flow. What is your sense of how much pressure the industry is under to produce cash flow for its investors?

JM: I think there is some pressure for sure, but more than pressure, I think it's a natural thing for self-interested managers to want to give their investors realizations so that they can raise more capital, right?

So, even if no one had ever told me, boy, it would be nice to get money back at some point in the future, that would obviously still be what I'm incentivized to do because the sooner I can get realizations and get cash back, the sooner people can have confidence that, wow, this actually really works, and then they give you 2x the investment for the next vehicle.

So the pressure is, I think, part of it. But for a relatively new asset class like litigation finance, which is still in middle innings, I think, at most, you want realizations. You want to turn things over as quickly as you can, and you want to get capital back.

In terms of what ILFA is doing, do you feel like they're doing enough for the industry to counter some of the attacks that are coming from the US Chamber of Commerce and others?

CC: I think there has been a focus from ILFA on trying to prevent some of the state court legislation from kind of acting as a test case, so to speak, for additional litigation. So there's been, you know, they've been involved in the big stuff, but also the little stuff, so it's not used against us, so to speak.

So I think in that regard, it's good. I wonder at what point is there some sort of proposal, as to if there's something that's amenable, is there something that we can all get behind, if that's what's needed in order to kind of stop these broad bills coming into both state legislatures and Congress. But I think overall, the messaging has been clear that this is not acceptable and is not addressing the issue.

Pretium, a relative newcomer to the market, just announced a $500 million raise. At the same time, it's been rumored that Harvard Endowment, which has traditionally been a significant investor in the commercial litigation finance market, is no longer allocating capital to the Litfin space. What is your sense of where this industry continues to be in favor with investors, and what are some of the challenges?

JSi: On the whole, I think the answer is yes, it continues to be in favor with investors, probably increasing favor with investors. From our own experience, we talk to LPs or new LPs quite frequently where we are told that just recently that institution has internally decided that they are now green lighting initiatives in litigation finance or doing a manager search. Whereas for the past three or four years, they've held off and it's just kind of been in the queue. So the fact that that is happening seems to me that investors are increasingly interested.

Probably part of the reason for that is that as the asset class on the whole matures, individual managers have longer track records. Maybe certain managers are on their third or fourth vintage. And there are realized results that can be put up and analyzed that give investors comfort. It's very hard to do that on day one. But when you're several years into it, or at this point longer for many people, it becomes a lot easier. And so I think we are seeing some of that.

One of the inherent challenge to raising capital in the litigation finance asset class is that even just the term litigation finance itself is sort of shrouded in mystery. I mean, it's very unclear what that even means and it turns out that it means many different things. The media on the whole, not including LFJ obviously, but the media on the whole has not done us many favors in that regard because they often use the term litigation finance to mean one specific thing, oftentimes case finance, specific equity type risk on a single case, when in fact, there are many of us who do all kinds of different things: law firm lending, the credit stuff, the portfolio finance stuff. There's all kinds of different slivers. And so the effect of that is that an LP or factions within an LP may have a preconceived notion about what litigation finance is, which is completely wrong. And they may have a preconceived notion of what a particular manager's strategy is. That's completely wrong.

I also think that litigation finance provokes an almost emotional reaction sometimes. It's often the case that investments get shot down because someone on the IC says that they hate lawyers, or they got sued once, and so they hate lawyers. And so they want nothing to do with litigation finance. And so whether that's fair or unfair is irrelevant. I think it is something that is a factor and that doesn't help. But I'd like to think that on the whole, the good strategies and the good track records will win the day in the end.

The discussion can be viewed in its entirety here.

Announcements Commercial Fundraising

Manolete Partners Announces New Revolving Credit Facility with HSBC Bank

By Harry Moran and 4 others |

Manolete Partners Plc (AIM:MANO), the leading UK-listed insolvency litigation financing company, is pleased to announce it has signed a new Revolving Credit Facility ("RCF") with its existing provider, HSBC UK Bank Plc ( "HSBC"). 

The new RCF provides Manolete with the same level of facility as the previous arrangement, at £17.5m. However, the margin charged to Manolete by HSBC on the new RCF is at a reduced rate of 4.0% (previously 4.7%) over the Sterling Overnight Index Average (SONIA) and has a reduced non-utilisation fee, from 1.88% to 1.40%. 

The new RCF is a 3.25-year facility with an initial maturity of 27 June 2028. Manolete has the option to further extend the facility on its current terms by an additional year. 

The covenants remain unchanged except for the Asset Cover covenant which has been relaxed for the next six months. 

Steven Cooklin, CEO commented: "We are delighted to have secured a new long-term commitment to the business from HSBC, which is testament to the strong partnership we have established since 2018. The improved terms of the facility demonstrate confidence in the Manolete business." 

This announcement contains inside information as defined in Article 7 of the Market Abuse Regulation No. 596/2014 ("MAR").