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- Evolution of Litigation Finance necessitates the need for a secondary market
- Investing in Litigation Finance secondaries is much more difficult than other forms of private equity due to the inherent difficulty in valuing the ‘tail’
- Experts should be utilized to assess case merits and valuation
- Life cycle of litigation finance suggests timing is right for secondaries
Slingshot Insights:- Investing in the ‘tail’ of a portfolio, where most secondary transactions will take place, can be more difficult than primary investing
- Dynamics of the ‘tail’ of a portfolio are inherently riskier than a whole portfolio, which is partially offset by enhanced information related to the underlying cases
- Secondary portfolios are best reviewed by experts in the field and each significant investment should be reviewed extensively
- Derive little comfort from portfolios that have been marked-to-market by the underlying manager
- Investing in secondaries requires a discount to market value to offset the implied volatility associated with the tail
In my discussions with litigation finance institutional investors, the topic of secondary investments has been raised a number of times by those who understand the economics of the asset class and are seeking to take advantage of some of the longer duration cases and portfolios in existence. In this article, I explore why there is interest in the secondary market, why now, and how best to approach investing in secondary investments, as well as some watch-outs. The concept of secondaries has been well established in the private equity world, specifically leveraged buy-out private equity, and, having been in existence for a couple of decades now, represents a mature strategy not only within leveraged buy-out, but also infrastructure, real estate, venture capital, growth equity, etc. So, it is not surprising to see the concept applied to litigation finance. As David Ross, Managing Director & Head of Private Credit at Northleaf Capital Partners, notes "Having been active in private equity secondaries for close to twenty years, Northleaf has extended its secondaries expertise over the past few years to include investments in litigation finance, which is an area that provides attractive and uncorrelated returns for our investors. Executing investments in litigation finance requires dedicated expertise but can provide attractive transaction dynamics for both existing investors seeking liquidity and prospective investors capable of underwriting and structuring an attractive secondary." To begin with, let’s first define what constitutes a “secondary” transaction. Essentially, a secondary is any transaction where one party is acquiring the interests from the original investor (the ‘primary’ investor) in an investment opportunity. In the case of litigation finance, this could take the form of a single case investment, portfolios or LP interests in funds, among other opportunities. In this sense, they are the ‘second’ investor to own the investment, as they have acquired their interest from the first investor through the acquisition transaction.
Types of Secondaries In order for a secondary market to make sense, at least for institutional investors, there needs to be a sufficient number of opportunities that are adequately aged to allow for one party to sell at typically, but not always, a discount to either their original cost or their current fair market value of the investment. These opportunities can arise for a number of reasons, as outlined below. For fund managers, they may be looking to raise a new, larger fund, and in order to do so they will have to demonstrate that they are good stewards of capital and that they can produce attractive returns to investors relative to the risk they assume. If these managers do not have a sufficient number of realizations in their predecessor portfolios, they will have to create a track record by selling off interests in single cases or entire portfolios. In this way, they will receive arm’s length validation that their portfolio has intrinsic value, with the idea that other potential investors should take comfort in the fact that a third party has assessed the attractiveness of opportunities and decided to invest at a value that is, hopefully, in excess of their original cost, or matches their internal assessment of fair market value. Of course, this assumes that the purchaser is a knowledgeable purchaser of litigation finance assets and an expert at valuing litigation finance investments, of which few exist in the world, as valuation is perhaps more art than science. A relatively recent public example of this is Burford’s multiple secondary sales of interests in their
Petersen case, which was sold in several tranches at increasing valuations as Burford continued to de-risk their investment through positive case developments during its hold period. According to the Petersen article hyperlinked above, Burford generated $236 million in cash from selling off interests in the claim, which significantly benefited its reported profitability and cashflow, and evidently, fueled its stock price at the time. All in all, a smart move by Burford to hedge its bets and de-risk its investment by selling down to other investors. However, it remains to be seen whether those who acquired the secondary interests in Peterson were as astute as the sellers, time will tell. For investors, they may be in a situation where they are in a liquidity squeeze, and could be frustrated with the duration of the litigation finance portfolio and therefore wish to exit the remainder of their investment to redeploy capital into a new fund or a new strategy. They could also have had a change in management which created a shift in strategy, or any number of other causes. For investors in individual cases or funds, they currently face a difficult task in finding a secondary investor to acquire their interests, which can be made more difficult by the fact that the manager may not be motivated to find them a purchaser, as there is no economic incentive to do so. The fate of these investors remains in the hands of the manager. However, if there are enough investors clamoring for liquidity, then the manager may be forced to hire an investment bank or another intermediary expert to solicit the markets’ appetite and obtain bids for the portfolio; but this will come at a cost which is typically assumed by the selling investor.
But is a secondary a “realization”? The short answer is NO! While a secondary can be an indication of perceived value in the market, it is simply a point-in-time estimate of value by the new, prospective owner that makes a series of assumptions to underlie their valuation. As such, it has no bearing on whether the case is more or less likely to settle or win, whether the defendant has the resources to pay, and whether it could take two years or ten years to collect. Litigation is well known to have a binary outcome. In the context of large cases where there are significant dollars at risk, it may be in the best interests of the defendant to take the trial risk and deal with the consequences by ultimately settling for a fraction of the damages after the court decision is handed down. In the Petersen case referenced above, it has been felt by some in the market that an award could still be years away (in the absence of collection frustration tactics that the Argentinian government may pursue); and even then, there is some concern that the decision may allow for damages denominated in Argentine pesos, which have been significantly devalued since the case began. In addition, the Argentine government has defaulted on its sovereign debt a few times over the last numbers of years and is currently in default on its International Monetary Fund loans, so it is difficult to assess the risk of collectability. Just because you win a case, doesn’t mean you get to collect the spoils. Collection is a whole other issue and perhaps a topic for another article. Suffice it to say, that a case is not completely de-risked until the ‘cash is in the bank’ (your bank account, not the lawyer’s trust account). So, I personally would take very little comfort in the fact that another party has looked at a case and made a decision that it has value – you would have to have a deep understanding of that buyer’s motivations (are they merely incentivized to get money invested? Are they motivated by Litigation Finance FOMO?) and that buyer’s ability to value litigation, which is difficult to do with accuracy because of the number of variables & uncertainties involved.
Why are litigation finance secondaries interesting? Perhaps the better question is, “Are litigation finance secondaries interesting?” And the answer is, “It depends”. When you look at a portfolio of litigation finance single cases, there are a number of individual investments that typically resolve early in the fund’s life, and this usually gives rise to attractive internal rates of return (“IRR”), but low multiples of invested capital (“MOIC”); then, there are those that resolve in and around the 30 month mark, which is a fairly typical duration, which should result in stronger MOICs and perhaps somewhat lower IRRs; and then, there is the ‘tail’ of the portfolio (see chart below). The ‘tail’ of a portfolio refers to those cases that are outside of the normalized expectation for case realizations in terms of duration that reside in the portfolio near the end of, or perhaps even outside of, the investment vehicle’s life. These cases could be outside the normal time distribution because the cases are highly complex, the defendant has tried to procedurally frustrate & delay the litigation, the case is going through a long drawn out trial or arbitral process, or the nature of the case simply takes longer (intellectual property, international arbitration, etc.) among other explanations. Often, when an investor is provided with a secondary opportunity, they are quite likely looking at investing in the ‘tail’ of the portfolio because the early part of the portfolio has already been resolved, and the proceeds have either been paid out or used to fund the cases remaining in the tail. Investing in the tail has many implications for expected outcomes. The potential tail outcomes, as depicted with red arrows in the chart below, indicate the uncertainty in both quantum and duration of the tail.
In part 2 of this article, I will explore some of the intricacies of ‘investing in the tail’ and explore considerations for investing in secondary transactions in litigation finance investments.
Slingshot Insights For those investors interested in the litigation finance secondary market, I think it is important to approach the investment with caution and a high level of expert diligence to offset the implied volatility that the ‘tail’ of the portfolio offers. It is also important to understand the motivations of the seller – a manager looking to create a track record will have different motivations than an investor who needs liquidity. The seller’s motivations may also offer insight into the extent price can be negotiated. It is important not to lose sight of the typical loss rate of the industry and the fact that the tail should exhibit enhanced volatility (more losses) as compared to a whole portfolio, and so an investor should model their returns, and hence their entry price, accordingly. Should you choose to make a secondary investment, consider a variety of options to de-risk the investment by sharing risks and rewards with others (i.e. insurance providers or the vendor of the asset). Above all else, make sure your secondaries are diversified or part of a larger diversified pool of assets. 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
