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Investor's Corner Slingshot Capital Special Features

Investor – Beware Outliers!

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
  • Commercial litigation finance does not have the same investor model as venture capital
  • Win rates in the commercial litigation finance industry are approximately 70%, globally
  • Investors need to assess outliers very carefully, as there is much to be learned from their contribution to portfolio returns
  • Outlier outcomes may enhance returns, but should not be counted on as the main contributor to returns
Slingshot Insights:
  • Investors should assess unrealized and realized cases in making their determination about fund manager performance
  • A good manager will understand how to avoid/minimize outlier risk and focus on creating diversified, well-balanced portfolios to deal with the various unknowns inherent in the asset class
Having reviewed over 100 different fund offerings in the commercial litigation finance space over the last five years, I have gained a certain level of insight into the spectrum of results that fund managers have been able to generate through their portfolios (some fully realized, but many more partially realized portfolios).  In the past, I have written about the importance of diversification, the applicability of portfolio theory (articles one, two & three), and the perils of fund concentration; but I also believe that investors in the asset class should understand the perils of relying on outliers to drive fund performance. In the context of a portfolio of litigation finance cases, an outlier can be defined as a case outcome that sits outside a probabilistic range of acceptable (and preferably defined) outcomes within, say, (approximately) 2 standard deviations of (mean - average) expectations.  That is to say, if you target a portfolio of cases with basic value distribution characteristics (such as minimum and maximum values), such a portfolio will produce an average (a mean) and a standard deviation (a dispersion around the mean)1.  Therefore, for a normal bell-shaped distribution (with no skewness / heavy tail), you can assume  that those results that sit beyond two standard deviations should be considered outliers in that they don’t represent what you would typically anticipate to see in such a portfolio, because the result would be outside of a 5% - 95% confidence interval (i.e., the range within which you would expect most case values to fall, on both sides of the average). However, one also needs to be cognizant that for litigation finance portfolios, it is not unusual to see a concentration of lower end cases (those with values well below the average), while outliers on the high end are quite uncommon. Expressed differently, a probability of low end outliers (both for individual cases, and in aggregate) is greater than a probability of high value outcomes.  In this context, assuming a normal bell-shaped distribution of values is an overly-simplistic assumption. In reality, it is rare that an accumulation of below-average cases is more than offset by a big win; although still a possibility.  Practically speaking, portfolio construction should not be based on the assumption of (exaggerated) high values materializing. The other way to think about litigation finance, is that the dataset can be bifurcated into two subsets – there are the losers, which are typically (but not always) complete write-offs, and there are the winners, which can have a wide spectrum of outcomes,. As described above.  In the aggregate, this bifurcated data set makes it difficult to utilize traditional statistic methodologies to apply to the asset class, because the losers skew the averages and the standard deviations, but not as much as the winners do, because the winners have a larger dispersion of results.  Accordingly, one must be careful in applying statistics to commercial litigation finance asset class. The one asset class where similar dynamics exist is the insurance industry, specifically, in the analysis of catastrophic events, and re-insurance and insurance-linked securities.  Investors with an insurance background would be used to dealing with investments that have similar outcome profiles, and to the extent they are working for a large insurer, they have the added advantage of being privy to settlement outcomes where their insurance company was involved in settling the claim.  A competitive advantage indeed! Is Commercial Litigation Finance akin to Venture Capital?  Some have described the commercial litigation finance asset class as having a “venture capital” type risk/reward profile, a contention with which I strongly disagree.  The typical venture capital portfolio model is highly skewed, the outcomes of which can be illustrated in this graph shared by Benedict Evans on Twitter. As one can see from the chart in the above hyperlink, 6% of the deals within a VC portfolio produce 60% of the returns.  In essence, this is a model that is dependent on outliers to drive returns.  So, what’s wrong with that?  Well, the problem is that if you don’t get an outlier in your VC portfolio, the manager will not likely survive to live another day, which is a difficult way for a manager to run a business on a long-term basis.  It also means that for investors, it is difficult to select managers that can replicate outliers on a regular basis, as they are essentially statistical anomalies. This also explains the relatively high failure rate of fund managers in the venture capital industry. Coincidently, those VC managers that produce high end outliers frequently claim to produce high alpha returns (sometimes calling it a “secret sauce”) - while, in reality, their success may have more to do with “luck” than a systemic outcome - but that’s perhaps a topic for another article. So, why do I think this is not an appropriate analogy for the commercial litigation finance asset class? The numbers just don’t support it.  I have been privy to over 1,000 litigation finance case outcomes in different case types, different sizes, different durations, different legal jurisdictions, and different defendants, and the reality across jurisdictions is that cases win (i.e. the manager makes a profit on its investment) approximately 70% of the time, and hence lose about 30% of the time.  This stands in stark contrast to the Venture Capital model where the VC manager is losing over 50% of the time and making less than 2X its investment 70% of the time.  So, whereas Venture Capitalists need to count on having outliers in their portfolio to create sufficient returns, a well-diversified litigation finance fund should not rely on outliers to produce returns, as there should be sufficient wins in their core portfolios (net of losses) to produce acceptable overall returns for investors, given the underlying risk profile of litigation finance portfolios (that are more akin to insurable exposures).  If a manager believes that outliers are necessary to produce returns, then I believe that manager does not understand the benefits of applying portfolio theory to the asset class, and the investor is taking unnecessary risk, because the stark reality is that no manager can tell you which case is going to be a home run case, and hence does not have the ability to include one in their portfolio. While outliers in commercial litigation finance can enhance returns (albeit infrequently due to the low probability of such being the case), investors should not count on outliers for contributing to the majority of the fund’s returns, because the particular case that gave rise to the outlier event could have very easily ‘gone the other way’, especially if the outcome resulted from a judicial/arbitral decision, which are inherently binary outcomes. The ‘Math’ The basic math of commercial litigation finance, although it rarely works out exactly this way, is that managers generally (emphasis added) underwrite to a 3X multiple of invested capital (“MOIC”), and managers win approximately 70% of their cases on average, hence the portfolio should theoretically produce a gross return of 3 X 70% = 2.1 X MOIC, which gets whittled down to say 1.75 x MOIC after management and performance fees and fund operating expenditures. Internal rates of return will then be derived based on the timing of funds deployed and the overall case duration of the portfolio. Some case types having longer duration but a higher probability of outlier returns, and other case types having shorter duration and generally lower potential for outlier returns. In other words, if a high value outlier is obtained, it’s IRR is likely “diluted” by a (much) longer than average case duration, thereby, its impact on the portfolio’s IRR is diminished. In this context, when investors are assessing investing in a commercial litigation finance managers’ portfolio, especially one that mainly consists of single case investments, they should analyze the portfolio from two different perspectives: (i) determine how the fund would have performed if that outlier was not in the portfolio; and (ii) determine how the fund would have performed if that outlier resulted in a loss.  These are “incremental impact” analyses that are designed to capture a true value of such outliers. The first analysis will provide the investor with a perspective on how the fund performed without the benefit of the outlier event.  If the fund still maintained respectable performance, this may illustrate that the outlier event was not significant to the performance of the fund, which tells the investor that the manager was very thoughtful about the construction of a balanced portfolio, which is exactly what you want in a long-term oriented manager.  The second analysis enhances the first analysis by answering the question “Did the manger get lucky?”  If the second analysis shows that the opposite outcome would have decimated the fund returns, then it buttresses the first analysis and also indicates that perhaps the fund was too concentrated in terms of its deployed capital (which can be very different from its committed capital, as I have addressed in a previous article). Corporate and Law Firm Portfolios Fund managers investing in corporate portfolios or law firm portfolios provide yet another layer of complexity.  In the case of corporate portfolios, these portfolios are groups of single cases that have a common plaintiff.   In the case of law firm portfolios, these portfolios are with law firms that have a contingent interest in a group of cases.  By their very construct, portfolio investments are inherently less risky than single cases because the portfolios are generally cross-collateralized, so the risk of having an outlier event within the sub-portfolio is that much more remote.  Nevertheless, investors should assess the component parts of the sub-portfolio’s results, because if the sub-portfolios themselves are generating returns through an outlier event, then the exact same risk exists as a manager that focuses on single cases within their portfolio.  The key difference is that a fund manager that invests in a series of sub-portfolios will have more chances to make errors than one that focuses on a portfolio of single cases. Other Considerations The other thing to consider, is that not all cases and case types are alike.  Each case has its own idiosyncrasies and each case type has its own unique risk/reward profile.  Accordingly, an investor cannot look at a portfolio of single cases and assume that each of the cases within the portfolio has similar risk / reward characteristics.  So, when an investor assesses the outcomes of cases, it is not only important to look at the outliers, but also to look at, among other attributes, (a) the types of cases, (b) the life cycle of the cases (important for determining duration), and (c) how the outcomes of the case were derived (judicial/arbitral outcomes vs. settlements) and the derivation’s effect on returns (a portfolio that derives most of its results from settlements (non-binary) is far superior to a portfolio that derives its results from 3rd party decision makers (binary), but this risk also varies by case type and venue). Portfolio Theory plays a significant role in investing in the commercial litigation finance market, and so investors need to be aware of its application and the various permutations that can arise in the construction of a portfolio, which generally starts with an investment in a ‘blind pool’ type fund.  More active investors can eliminate the risk inherent in a blind pool by selecting individual case or portfolio exposures, but they generally need to have internal resources to appropriately assess risk, or be prepared to incur the cost to outsource those underwriting activities. Equally important is the selection of a business model under which a portfolio is sourced, evaluated, and constructed. A manager philosophy that equates litigation finance investing with venture capital investments can be misguided and possibly result in unrealistic assumptions and faulty portfolio construction that can produce real results quite distinct from the manager’s intentions. 1Standard deviation is the measure of dispersion of a set of data from its mean. It measures the absolute variability of a distribution; the higher the dispersion or variability, the greater the standard deviation and the greater will be the magnitude of the deviation of the values from their mean. Slingshot Insights  For investors, I strongly advise diving deep into both realized and unrealized cases within the portfolio to get a better understanding of the manager’s appreciation for portfolio construction and their appetite for risk.  While it may be cost prohibitive to do deep diligence on every case in the portfolio, analyzing high level data about the nature of the various case exposures can bring an investor a long way to understanding the risks inherent in the portfolio and the manager’s approach to investing.  For the realized subset of the portfolio, understanding the dynamics at play within the case and its contribution to overall fund performance is critical to assessing a fund manager’s ability to replicate results (termed persistency in private equity), which is critical to long-term investing in the space. I don’t believe this is a venture capital asset class, and a manager that tries to convince an investor otherwise is either taking unnecessary risk, or does not understand how the asset class benefits from portfolio theory. 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. is involved in the origination and design of unique opportunities in legal finance markets, globally, investing with and alongside institutional investors.
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Regulatory Issues

Is Legal Funding to Blame for Rising Insurance Premiums?

There’s been a lot of talk about how well-funded collective actions are driving up the price of liability insurance, particularly for directors in corporate settings. Furthermore, one of the ways to address this issue seems to be increased regulation and more stringent disclosure requirements. But is this an accurate representation of the facts? Andrew Saker, Managing Director & CEO of Omni Bridgeway doesn’t think so. Omni Bridgeway details that oft-repeated warnings of a sudden glut of frivolous class-action suits are not grounded in reality. No funder wants to bankroll a losing case, nor is it in anyone’s best interest to clog court dockets with cases that lack merit. This holds true among most types of collective actions, including shareholder class actions. It is true that Director & Operator insurance premiums have increased in recent years. But is that due solely, or even mostly, to funded class action cases? Saker breaks down these facetious arguments one by one:
  • There has not been a steep rise in shareholder class actions. In fact, according to KWM, there’s been a decrease since 2017.
  • Opportunistic class actions, a common boogeyman argument, do not exist. When the Treasury Department and the AG’s Department were asked to show a real-world example of an opportunistic class action—they produced nothing.
  • Costs of D&O insurance are rising globally, not just in jurisdictions where funding is common. In truth, there’s more risk in the world than ever for businesses—owing largely to cybersecurity concerns, and factors relating to climate and the pandemic.
  • There may not be any causative link between shareholder class actions and D&O premiums. Arguments to the contrary are increasingly difficult to defend.
One likely explanation for rising premiums may be years of underpricing. Correcting this is causing higher prices, and insurers are looking for someone, anyone to blame. And who better than a newer industry that many people don’t yet understand?
Case Developments

London Appeals Court Agrees to Reopen BHP Mining Case

Last week, the London Court of Appeal agreed to reopen a suit against an Anglo-Australian mining company, BHP. The case centers on a 2015 dam rupture that caused the worst environmental disaster in Brazilian history. Reuters explains that the $7 billion lawsuit on behalf of 200,000 claimants was struck down as an ‘abuse of process’ in 2020. Since then, lawyers for the claim have been seeking a resurrection—even after the dismissal was upheld this past March. Three appeals court judges have now given permission for an appeal, in a decision considered highly unusual in the legal community. BHP stated their position that the case should not be heard by UK courts. The far-reaching impact of the Fundao dam spill may suggest otherwise. The collapse killed 19 people, as well as spilling over 40 million cubic meters of mining waste into villages and waters as much as 400 miles away. The case may establish if multinational companies should be liable for the conduct of their overseas subsidiaries. Six years after an unthinkable environmental disaster, citizens will finally have access to justice.
Commercial

The Benefits of Cross-Disciplinary Analysis

Anyone hoping to be a success in the world of legal finance should expect to amass knowledge from multiple industries. Banking, litigation, corporate finance, IP and patent laws, and more. This is why many of the most successful funding entities employ staffers from multiple business disciplines, and why they seek out those with cross-disciplinary skill sets. Profile Investment explains that litigation funding's three foundational pillars are Legal, Quantum, and Enforcement. These are the three knowledge bases that are utilized for each application for funding. Lawyers, financial and valuation specialists, and recovery professionals are all consulted to determine whether a case is a strong candidate for funding. This cross-disciplinary approach to litigation funding is increasingly important as funders pursue claims with varying degrees of specialization. These areas of focus could be based on jurisdiction, legal forums, specific case types, or they may set their sights on a specific industry such as construction. Ultimately, cross-disciplinary analysis is a vital part of any successful litigation funding entity.
Case Developments

Google Faces Class Action in UK Over Illegal Charges in Google Play Store

Nearly 20 million users in the UK may be eligible claimants in a lawsuit against Google, stemming from allegations of illegal charges in its Google Play store. The alleged overcharges impacted UK users of Android phones. Hausfeld reports that the estimated damages sought in the case could be as high as GBP 920 million. According to the claim, Google is alleged to have restricted users from accessing apps from its competitors. Further, it specifies a whopping 30% commission charge on all items purchased digitally. This practice, which also includes various technical and contractual elements restricting access to other platforms, allegedly violates the UK Competition Act section 18, and the Treaty on the Functioning of the European Union article 102. The case is an opt-out model, which means that all eligible claimants are included unless specifically requesting not to be. Major players in this potentially enormous collective action include Vannin Capital, which is funding the case. This funding ensures strong legal representation from Hausfeld, and affirms that claimants endure no upfront costs. Lesley Hannah, a partner at Hausfeld, is the leading litigator in the case. She stated that Google has used its dominance in the Android market to leverage high fees while shutting out competition. Thankfully, consumer protection laws are robust in ensuring fair competition. The class representative is Liz Coll, who explains that while Google has helped consumers in some ways, it’s presenting a closed system as an open one—removing options from consumers in a way that’s unfair and potentially damaging. The claim impacts several popular apps, including Tinder, Uber, Candy Crush Saga, and Roblox, among others. This is not the first time Google has experienced legal trouble over its treatment of Android customers. It was fined over EU 4 billion in 2018 over similar conduct regarding the Google Play Store.
Regulatory Issues

Motion to Dismiss Filed with Appeals Court in Sax v Fast Track Investments

As Litigation Finance regulations evolve, those involved in active cases may change their tactics. On July 19th, a motion to dismiss a pending appeal was filed by the parties in Sax v Fast Track Investments. In this case, legal finance agreements affirm that New York laws apply to the question of whether or not the funding was a loan. Lexology explains that the Ninth Circuit Court concluded that the New York Court of Appeals should make that determination. Several questions about the funding agreement were submitted, ostensibly to determine whether the terms of the agreement equated to usury. This motion to dismiss coincides with multiple decisions which are pending involving third-party legal funding, as well as the enactment of a new disclosure rule in the District of New Jersey. The new disclosure rule requires parties to disclose information about any non-parties providing financial support for a case. This includes funds provided in exchange for a financial interest that’s predicated on the results of the action, or those provided with the expectation of specific types of non-monetary results. The Northern District of California has also imposed a requirement of disclosure of all third-party funding in collective actions. West Virginia and Wisconsin courts have passed similar laws, along with usury-adjacent laws that regulate how much interest may be legally charged. The impact of these changes can be seen in several cases, including Breen v Callagy. In this case, the Third Circuit rejected a claim that the terms of a litigation funding agreement constituted a debt under the Fair Debt Collection Practice Act. The Northern District of California allowed Brice v Haynes Investments LLC to proceed. The case will now determine whether the founders and funders running a “Tribal Lending Scheme” will be held liable for usury violations. It remains to be seen whether these laws will benefit those who make use of legal funding to pursue cases they otherwise could not.
Announcements Fundraising

Leading disruptor in civil litigation finds capital solution to drive unprecedented growth

PURE Business Group (PURE), the multi-discipline legal services business, has today announced a new £multi-million funding facility with Sandfield Capital. PURE, which currently handles over 12,000 new instructions each year, hopes that this move will dramatically accelerate its ability to develop record numbers of cases over the next few years. The agreement is anticipated to deliver dominant market-share in the volume civil litigation space in PURE’s current six case verticals, plus extend then across four new areas of focus. Combined with planned increases in the coming months, PURE will target 30,000 new cases per year from 2022, whilst more than doubling turnover and profit. Group CEO, Phil Hodgkinson commented: “Now in our seventh year of trading, I’m proud to say that our business continues to go from strength to strength. Despite the challenges of the global pandemic, we have remained profitable throughout, and continue to break case settlement records month on month. Aside from fuelling a transformational growth in case volumes, the new funding agreement allows us to launch innovative new products and enter new markets, too. The future is incredibly exciting for this business and our colleagues within it.” Sandfield Capital CEO, Steven D’Ambrosio said: “We are delighted to support PURE in its future. Having run an initial pilot with them from January this year, we have already seen 25% of the total funded book come to settlement resolution. Based upon current data, we will see 100% settlement of the pilot scheme cases within a further six months. That has given us the confidence to extend the facility to a significant eight-figure sum, enabling PURE to increase new case volumes significantly and pursue those cases aggressively on behalf of clients.” About Pure Business Group PURE Business Group was created to provide a unique, innovative and collaborative solution to the civil litigation legal sector. Founded in early 2015 by Phil Hodgkinson, and bringing thirty years’ experience within the insurance and legal sector, the group employs in excess of 450 staff in four UK locations. The group comprises a number of complimentary companies, including an ABS-structured barristers chambers and law firm, a technology business, a specialist vetting business, a claims-handling business and multiple marketing brands. Its unique model centres around non-recourse CCA disbursement loans to customers, which are fully insured by a large panel of A-Rated Insurers and Re-Insurers. This model allows us to concentrate its own cash flow on business growth and taking on new cases. It can also litigate in volume, without constraint, against any defendants who refuse to come to the table and settle valid cases in a reasonable and timely manner. Sandfield Capital has been designed to support individuals pursuing legal claims and facilitate their access to justice. It was launched in 2020 by Steven D’Ambrosio, a former Finance Director at Close Brothers Premium Finance, who has conceived and built a number of highly-successful ventures in the financial and legal sectors and remains extremely passionate about creating and tailoring funding solutions. Sandfield works directly with accredited legal firms to ensure that all clients achieve the best possible outcome, complimented by straight forward, innovative products that support their legal cases.
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Commercial

An Investor’s Take on Burford Capital

Burford Capital is the largest Litigation Finance company on Earth. Returns on litigation investments are consistently high, yet investment pros can’t seem to agree whether Burford stock is a big risk or a sure thing. The truth, as always, may be somewhere in between.

Seeking Alpha reports that Andrew Walker of Rangeley Capital interviewed Artem Fokin (AF) of Caro-Kann, a small-cap focused investment firm. The pair discussed the idea that Burford shares are worth much more than current share prices indicate.

Below are some key takeaways from their interview:

Does Burford bring more than just money to the table?

AF: That’s an excellent question. The qualification, when you look at the Litigation Finance space, two types of investment professionals tend to work there—either people coming from a law background, or finance background. Obviously, both have advantages and disadvantages. A good litigator who comes from a top law firm may not necessarily view the world through an investment lens. So they’ll need to make that transition. Similarly, finance people will know all about finances, but they know nothing about law. You need to have a team that combines both.

Burford cannot tell a client to settle or not settle, appeal or not appeal. That’s not allowed because Burford is not a client. The law firm owes the duty to the plaintiff; they are the client. But funders, through the funding agreement, can encourage certain types of behavior.

Are returns to litigation funding sustainable?

AF: Burford isn’t the only funder raising very attractive returns. There are other very skilled litigation finance players who generate returns that are very comparable. We’re not talking about a phenomenon where there’s one player that’s very big and they’re generating returns like nobody else can—and then eventually people will come after them.

The entire industry is doing well, as long as they have skill. Skillful players do well in general. Sure, there is more capital coming in, but at the same time, the penetration and use of litigation finance is expanding. It’s difficult to quantify. But the capital coming in is absorbed.

Litigation funding is expanding the total addressable market. What nobody can calculate with any degree of precision, is that some cases that would have never been brought to court are being pursued now because there are litigation finance providers who are willing to finance it. Consider what would happen with innovation in all tech companies if there were no venture capitalists who were willing to invest.

How do you value Burford?

AF: Earnings from any period may or may not be meaningful. If you have a big settlement or victory, you can get a big payout. Alternatively, it can be very slow with no cases either settled or adjudicated.

If you look historically, the IRR has been around 24%. If you look at Burford's numbers, they report high IRR, around 30. But that includes a case in Argentina where they already made some money.

The future rate should grow over time to the mid-teens. After that, you get to a normalized net income. That’s how I’m getting to 70-75 cents or so, EPS.

What about Burford's Value Component #2: Asset Management?

AF: Burford manages several hedge funds, some of which have already been fully deployed. Some of those pools of capital are being invested as we speak. There’s a variety of assets.

There is this way to calculate, called ‘European Waterfall.' What it means is that until the initial capital has not been returned to limited partners, the litigation funder doesn’t recognize the incentive fee on its booking records. It means if you took $100 million and invested into ten matters, and the first matter comes out, and it’s a home run (I’m using an extreme example) you just made $100 million of profit. You as a litigation finance provider, using European Waterfall structure, will not recognize any incentive fees. You’ll only start recognizing fees when your second matter is resolved.

But that first big win, even though it’s amazing...you recognize zero. And right now, Burford has recognized very few incentive fees from most of the funds. As those funds get more and more into harvest mode, those incentives will be disproportionate.

Commercial

Offshore Asset Recovery in a Post-Pandemic World

Litigation Finance has seen big legal developments over the last year and a half. Especially impacted are insolvency practitioners and those who work in asset recovery. Burford Capital explains that these changes include the Private Funding of Legal Services Act 2020 in the Cayman Islands. This new law, enacted in May of this year, allows law firms to engage in contingency fee arrangements, and permits third-party legal funding in a much wider range of cases than before. John O’Driscoll of Walkers (London) explains that prior to the PFLSA, third-party funding was technically permitted. But court approval was needed for every case, and was granted on an extremely limited basis. Laura Hatfield, Partner at Bedell Cristin, lauds the new law as it negates the need to avoid champerty and maintenance considerations. This keeps costs lower and allows for more meritorious cases to move forward despite financial constraints. Other legal minds chimed in, calling the act “welcome” and “overdue,” while affirming that third-party funding is a necessary aspect of today’s legal landscape. The need for funding is only expected to rise. Clearly, the main impact of the PFLSA will be increasing access to legal remedies for those who have been wronged.