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

• Article draws comparisons between commercial litigation finance and private equity (leverage buy-out) asset classes
• Similarities and differences exist between private equity and litigation finance operating costs, but there are some significant jurisdictional differences to consider
• Value creation is front-end loaded in litigation finance vs. back-end loaded in private equity
• Litigation finance can be a difficult investment to scale while ensuring the benefits of portfolio theory

INVESTOR INSIGHTS

• The ‘2 and 20’ model is an appropriate baseline to apply to litigation finance, but investors need to understand the potential for misalignment of interests
• As with most asset classes, scale plays an important role in fund operating costs
• Deployment risk and tail risk are not insignificant in this asset class
• Investor should be aware of potential differences in the reconciliation of gross case returns to net fund returns
• Up-front management fees may have implications for long-term manager solvency

In Part 1 of this two-part series, I compared litigation finance to private equity (i.e. leveraged buy-out) and the deployment problem endemic to litigation finance and the impact it has on the effective cost of management fees. In Part 2, I drill deeper into the operating costs inherent in running a litigation finance strategy. Fees The “2 and 20” model in the private equity asset class was established early on in its development, and for the most part it has not materially changed since inception (after decades).  Sure, there are some managers that charge less of a management fee and more of a performance fee, but the industry generally operates from a compensation perspective, as it has since its inception.  There have been many reasonable arguments suggesting that as a fund scales and the manager’s Assets Under Management (“AUM”) increases, the management fee as a percentage of AUM should decrease because of (i) economies of scale, and (ii) the amortization of management costs over multiple funds being managed simultaneously.  Despite these well-reasoned arguments, limited partners (LPs) have not been overly successful in moving managers off of the compensation model other than those LPs who have been able to use their scale to their advantage by making large commitments in exchange for lower management fees.  In addition, some large PE fund managers recognize the scale inherent in investing billions of dollars, and have accepted lower levels of management fees accordingly, but this dynamic is not currently relevant given the scale of most fund managers in the litigation finance market. Why has fee compression been absent in private equity? Because the performance of private equity has justified the fee structure, although Ludovic Phalippou’s recent research entitled “An Inconvenient Fact: Private Equity Returns and the Billionaire Factory” may contribute to changing that sentiment.  Then again, private equity can always turn the page on institutional investors and ‘pivot’ to the trillions available in the 401(k) market, which has recently become more accessible. At present, I don’t see a compelling reason for the existing compensation models changing, as private equity is a much more management-intensive asset class than public equities, and does require some unique skill sets given the breadth and depth of issues inherent in managing a private business, even if only at the board level. And while the “2 and 20” model is also prevalent in litigation finance, there have been some marked exceptions.  First, let’s take a look at the publicly-listed fund managers who also run private partnerships. Publicly Listed Managers In the private equity world, there are a number of managers that are currently publicly-listed.  These managers typically became publicly-listed not out of business necessity, but more so out of a necessity to monetize their shareholders’ investments in their private equity firms for the benefit of departing partners who contributed to the success of their organizations over decades, and also as part of their succession strategy.  Alternatively, they may have floated once they created a certain level of scale in the private equity business, to justify attracting investor capital in the public markets in order to scale their already sizable organizations in a variety of different asset classes (credit, distressed, real estate, etc.).  However, one thing never changed – their fee structures.  I would argue that the reason their fee structures never changed is due to the fact that such structures were at the heart of their business models since inception – 2% management fee ‘keeps the lights on’, and the 20% performance fee creates wealth (if the manager performs).  Arguably, for those that have achieved scale, both the 2% and the 20% have contributed significantly to their wealth and continue to do so.  We are even at a point in time of the lifecycle of the PE asset class that fund managers have been able to monetize their excess management fees and performance fees by selling minority interests in their PE firms to the very same institutions that pay their excess management fees & performance fees to begin with – talk about double dipping! Conversely, the publicly-listed litigation finance managers did not always start off with a strong private partnership model, but were forced to look to the public markets for capital (see my recent article entitled “Investor Evolution in the Context of Litigation Finance” which explains why).  Instead, they ran a business off of their own balance sheets and they didn’t have to live within the confines of a 2% management fee model to finance their operations, as they could rely on funding from their balance sheets, although they ultimately had to deliver profits to their investors which forces a different type of discipline.  This had the benefit of allowing managers to expand more quickly than they could in a private partnership context, but perhaps did not have the same level of financial discipline, as the case outcome results were co-mingled with the expenses, and the investor could not necessarily bifurcate the results. More recently, certain publicly-listed litigation finance managers have decided to forego management fees in exchange for a bigger percentage of the contingent profit of the portfolio, which appears to be unique to this asset class.  When I originally contemplated publicly-listed managers raising money through private partnerships, my thought was that they would do so to ‘smooth out earnings’ by generating consistent and recurring management fees to offset their operating expenses, and thereby contribute to producing more consistent operating profits on which their equity would be valued with less inherent volatility.  In essence, their share price would appreciate solely due to the mitigation of earnings volatility.  However, given their openness to foregoing management fees, perhaps their philosophy is that having covered off the operating costs through the public balance sheet, they should ‘leverage’ their balance sheets by maximizing their performance fee and thereby enhance their return on equity for the benefit of public investors (i.e. forget the management fees, we prefer higher performance fees).  Both approaches are equally supportable, although I would tend to favour a strategy that promotes earnings stability in an asset class than can otherwise be relatively volatile, although I also recognizine that it would take a significant amount of AUM in order to generate sufficient fees to make a meaningful difference. As a private partnership investor, I would view the low/no management fee approach as quite attractive, because it’s almost as if the operations are being ‘subsidized’ by the public balance sheet, from which I would benefit. I am more than happy to give up some extra fees on the ‘back-end,’ as those fees are paid out of contingent profits as opposed to up-front principal, plus it selfishly helps my own cash-on-cash returns.  More recently, I have heard rumours that a private fund manager that runs multiple funds has taken the same approach – presumably the prior funds’ management fees are paying to ‘keep the lights on,’ and so they are more apt to forego current fees for a larger share of the back-end.  Of course, this might make prior fund investors wonder whether their management fees were too high if they can carry the subsequent fund’s operating expenses, in addition to covering the operations of the fund in which they invested. The issue that foregoing management fees for additional performance fees may present, is whether this affords the publicly-listed fund managers a competitive advantage from a fundraising perspective, since most of the private fund managers don’t have the luxury of being able to forego management fees, as they rely on them to ‘pay the bills’ while they invest. One could argue that the publicly-listed managers’ compensation systems distort the marketplace, but then again, they are obtaining a higher share of profits than a private fund manager would with a ‘2 and 20’ model, and so one could say that the difference is simply a trade-off between ongoing cashflow from management fees and deferred performance payments with incremental risk.  I think given the relatively early stage of industry development, there is enough room for multiple manager compensation models, and one will not necessarily compete with the other.  After all, the only basis on which performance should be measured is net returns.  However, we are at a stage of the industry’s development where many newer managers can’t show empirical results to prove out net fund returns to investors, which may ultimately result in term modifications to established compensation norms, in order to address the inherent risk of uncertainty associated with younger managers. Management Fee Logistics Not all management fees are created equal, and not all management fees are as transparent as a 2% annual fee, paid quarterly.  Some fund managers have decided to charge the plaintiffs an origination fee, which may ultimately get capitalized as part of the investment in the case, but is funded by the fund investors through a larger draw, as contrasted with the draw required without an origination fee. This origination fee construct comes with the benefit of providing the investor with a return on their origination fee, but arguably this is inherent in all management fees, as there is typically a hurdle return to investors for all capital called as part of the proceeds waterfall. The negative aspect of an origination fee is that the fee is charged and funded upfront, and so it represents an incremental ‘drag’ on Internal Rates of Return (“IRRs”).  Conversely, it may not show as an operating cost of the fund if the fee is capitalized as part of the investment, and thus may help with the J-curve effect in the early years of the fund’s performance.  However, the difference is rooted in ‘playing with numbers’. My one caution to investors on the topic of upfront origination fees is that the manager is effectively front-loading management fees that would otherwise be charged and earned over time by the fund manager.  The implication is that an investor needs to take a closer look at the long-term solvency of the fund manager when considering an investment in their fund offering, because if the manager’s returns fail to persist, they may not be able to generate sufficient fee income to run-off the remainder of the portfolio, which potentially leaves the investor in a precarious position.  Ideally, upfront fee income would be put into escrow and released to the manager over time to prevent future liquidity issues, although I have never seen this proposed (and this concept may cause “dry income” to the manager, which is taxable income for which there is no corresponding cashflow). Other Operating Costs: Different than some other asset classes, an investor in the litigation finance asset class has more than management fees to consider when assessing the returns inherent in the asset class, but these costs can be jurisdiction-specific. Adverse Costs Perhaps the most extensive cost is that of investing in jurisdictions that levy adverse costs (also known as “loser pays” rules) against plaintiffs who lose their case, which effectively makes the plaintiff responsible for the costs of the defendant’s litigation costs.  Adverse costs can be found in Australia, Canada and the UK among other jurisdictions, but they are not generally found in the US market.  These adverse costs can either be covered through an indemnity by the plaintiff, an indemnity from the litigation funder, or through the use of an After-The-Event (“ATE”) insurance policy.  It should also be noted that some judges have found the litigation funder to be ultimately responsible for adverse costs even if an indemnity for such costs was specifically excluded from the funding agreement (this is the ‘ability to bear’ principle at work, rightly or wrongly), so this should factor into your manager diligence. Some litigation funders will put in place individual insurance policies on a case-by-case basis, and others will put in place a blanket policy at the fund level to cover all adverse costs throughout the fund.  Depending on how these costs are accounted, they could represent an upfront cost (insurance premiums are generally paid upfront) at the fund level or on a case-by-case basis, or they could be capitalized to the individual investments which would be appropriate as they are in fact a benefit to the investment.  Regardless of the manager’s approach to ATE, they represent incremental costs, and since they are funded upfront, they represent a drag on IRRs and may contribute to a more substantial J-Curve effect for the fund in its initial years (assuming they are expensed currently).  While there are many financial differences between legal jurisdictions, this is certainly one significant cost that investors who invest globally should be aware of when assessing manager performance in different jurisdictions. I would also encourage fund managers who put in place blanket policies, to ensure the costs of such policies are being incorporated into the economics of the funding agreements and passed along to the plaintiff, as there is a significant cost and benefit attached to the existence of the policy which should be recognized as a pass-through benefit.  ATE policy protection is really a plaintiff benefit, as the funder typically considers it a defensive measure, knowing that the courts have sought adverse costs protections from the funder in cases where the plaintiff does not have the financial resources to indemnify. External Diligence Costs The other cost which does not vary jurisdictionally that investors should be cognizant of, is the extent to which a fund manager uses external parties to diligence their cases vs. internal resources and how these costs are accounted for – expensed or capitalized as part of their investment (the more typical treatment).  It would be unreasonable to expect a fund manager to be able to perform 100% of their diligence internally, as much of litigation is nuanced and requires the input of professionals (lawyers, experts, etc.) to obtain a realistic and informed opinion of the risk associated with a particular legal or technical issue.  Some managers employ an outsourced model, while others conduct most of their diligence in-house, and the costs associated with each can influence the operating costs of the fund. The larger litigation finance fund managers have economies of scale to their advantage, and are more likely to employ litigators and executives with specific expertise in a variety of areas, and so they are less likely to employ third parties to provide these services. With these managers, the diligence expertise is contained within their operations team, which is funded by their management fees (and may be funded by balance sheets for the publicly-listed funders). Smaller fund managers, lacking economies of scale, would be more apt to use external parties for diligence.  The question then is how are they accounting for these costs?   Are they being run through the operating expenses of the fund, are they being capitalized to the cost of the investment or are they applying a hybrid approach? The other issue is how are “broken deal costs” accounted for, and who is responsible for picking up the external costs of undertaking diligence, only to walk away from the investment (the General Partner or the limited partners or a combination of both), perhaps as a result of the insight gained from the external party.  These costs are typically included as part of operating expenses of the fund, but not exclusively. From this perspective, litigation finance is superior to private equity as an asset class, because PE firms tend to spend hundreds of thousands to millions of dollars in external deal costs, whereas litigation finance tends to limit these to the tens of thousands of dollars (although in either case they are directly influenced by the size of the investment), as much of their diligence expertise remains in-house. This dynamic could justify a relatively higher compensation model for litigation financiers, because those costs are effectively funded through the management fees, whereas the comparable costs in private equity are funded by the limited partners through fund operating expenses, or capitalized to the cost of the investment. Net-Net? When I assess a litigation finance manager for potential investment, my baseline is to look at their compensation system relative to a “2 and 20” model, with the devil being in the details in terms of how those items are defined.  For small managers, of which the majority of litigation finance managers would be classified, it is difficult to make anything other than “2 and 20” work from a cashflow perspective.  For most managers, I don’t believe there is a lot of excess profit inherent in the management fees found in a “2 and 20” model, but it should be sufficient enough to hire strong people and execute on the business plan, generate solid returns if done correctly, and if management pays proper attention to portfolio construction.  Compensation should also be predicated on the fund manager deploying a high percentage of its committed capital (85-100%). Where the manager does not meet its deployment targets, perhaps there should be a ‘claw back’ of management fees. The issue of excess compensation starts to become significant as any manager scales its operations into the hundreds of millions and billions of AUM.  This phenomenon is no different for litigation finance, but it is much more acute given the deployment issue highlighted previously. Also, relative to other asset classes, the litigation finance asset class suffers a bit from a lack of available data that would provide comfort to investors in the absence of having data to confirm that completed portfolios of litigation finance investments produce a level of return commensurate with the risk. I have been investing in the industry for the better part of five years, and I have yet to see more than a handful of examples of fully realized net fund returns globally, which forces investors to be cautious on fees to minimize the downside risk.  There is a sufficient amount of ‘tail risk’ inherent in any portfolio, and even more in litigation finance, and so the quicker the industry can produce and disseminate data on completed portfolios, the quicker this risk can be mitigated and the industry can be viewed as a true private equity asset class with perhaps less pressure on compensation models.  Conversely, this data will also provide fund managers with additional confidence to consider different compensation models so that they can put more of their own money at risk and benefit from enhanced performance fees, which is the approach that has been taken by some of the larger publicly-listed managers who have the benefit of realization data to justify putting their fees at risk. Investors should focus not only on management fees, but on the entire operational model, of which manager compensation may be one significant cost factor.  Certain jurisdictions and legal systems come with other costs that also need to be factored into the equation. Certain case types and strategies may also be more resource-intensive and need to be factored into the overall risk/reward characteristics of the investment (i.e. if you had to pay more people to generate a more diversified portfolio in order to reduce portfolio risk, perhaps the investor will be satisfied with a lower overall return which is reflective of the de-risked nature of the investment).  No different than litigation finance itself, investing is a form of risk-sharing.  Managers and investors who recognize the symbiotic relationship between investor and manager will soon come to appreciate the benefits of transparency and fairness that will serve as the foundation for a long-term business relationship. Investor Insights Any fund operating model needs to be designed taking into consideration all of the operating costs inherent in the manager’s operational model in the context of expected returns and timing thereof.  Investors care about being treated fairly, sharing risk and sharing the upside performance in order to foster long-term relationships that reflect positively on their organizations’ ability to perpetuate returns.  Professional investors rely on data to make decisions, and in the absence of data which might get them comfortable with a manager’s performance, they will default to mitigating risk. Tail risk in this asset class is not insignificant, which makes investing that much more difficult.  A performing manager that does a good job of sharing risk and reward with investors will have created a sustainable fund management business that will ultimately create equity value for its shareholders beyond the gains inherent in its performance fees.  Edward Truant is the founder of Slingshot Capital Inc., and an investor in the litigation finance industry (consumer and commercial).  Ed is currently designing a new fund focused on institutional investors who are seeking to make allocations to the commercial litigation finance asset class.

International law firm Brown Rudnick announced today the launch of the Litigation Funding Working Group (LFWG), which brings together leading litigation funders, insurers, institutional claimants, legal advisors and other participants across the litigation funding market in the UK and Europe to develop model documentation to help support the continued growth and development of the litigation funding market. Led by Elena S. Rey, a partner at Brown Rudnick’s Special Situations team, this initiative comes at a time of rising demand for litigation funding products in an evolving regulatory environment. The model documentation will be freely available and will provide the following benefits across the litigation funding market:

• Promote efficient markets: Improve speed of execution and streamline the negotiation process.
• Develop secondary market: Provide a platform for the development of secondary market transactions by way of novation, participation, assignment or other risk transfer arrangement.
• Market integrity: Improve protections for market participants and provide a bench mark for the judiciary by incorporating best market practice, regulatory standards (including data protection) and judicial practice and adopting a balanced approach between stakeholders.
• Simplicity and Flexibility: Follow the model of other major financial markets by standardising structure and key clauses in a model document while leaving market participants free to incorporate their own commercial and other terms.
• Reduce Risk: Promote the adoption of high standards across the industry and reduce exposure to reputational risk and disputes from poorly constructed contracts.

The initiative will build on the firm’s experience of working with major litigation funders on preparing their model funding documentation for the US market as well as working with the Loan Market Association (LMA) over the last 10 years in preparing model documentation for the real estate finance market and secondary trading documentation. The model documentation will be produced after extensive consultation with the members of the Working Group and the wider market and will represent an agreed common wording and structure, so that users and providers of litigation funding can rely on standardised boiler plate provisions and focus their negotiations on the commercial elements and other specific considerations. The documentation will be subject to regular review by the LFWG to ensure that it reflects current regulations in relevant jurisdictions and continues to accommodate the requirements of the respective parties. Elena S. Rey, Partner at Brown Rudnick said: “I would like to thank all of the members for their commitment and enthusiasm towards this important initiative, which will support the development of the litigation funding market and the institutionalisation of the industry by introducing best-in-class documentation. I look forward to collaborating with our members and to making these model documents available to all, which will help ensure that the market continues to operate efficiently and with the highest standards in place.” The LFWG consists of major funders and institutional claimants - including Affiniti Finance Limited, Arrowhead Capital, Augusta Ventures, BDO Global, Bench Walk Advisors, Deminor Recovery Services, Galion Capital, Grant Thornton UK LLP, King Street, LionFish Litigation Finance, Litigation Capital Management Limited, North Wall Capital, Omni Bridgeway, Therium Capital Management - insurers and brokers - including AmTrust Financial, Litica Ltd., Marsh Ltd., QLCC, and others as well as leading legal & expert advisers and barrister chambers. About Brown Rudnick LLP Brown Rudnick combines ingenuity with experience to achieve great outcomes for our clients. It delivers partner-driven services and excellence across its practice areas, which include special situations, finance & litigation funding, distressed debt, corporate restructuring, M&A, tech & life science investments, white collar defence, IP & international disputes. It has offices in key financial centers in the US and Europe and serves its clients in the Middle East, North Africa, Eastern Europe, the Caribbean and Latin America. Elena S. Rey  Elena represents funders, private equity funds, major corporations and family offices on complex litigation funding as well as leverage finance matters. As a member of the Special Situations team, Elena provides a range of services from helping clients to raise finance for litigation, corporate or tech projects to introducing investors and connecting sources of capital to off-market investment opportunities. Elena holds a law degree from Harvard University, and is fluent in Russian and French. She is admitted to practice in England & Wales, and is also a member of the New York bar.

Tribeca Capital Group, LLC, a leading pre-settlement litigation funding company, announced today that it is accepting applications for litigation advances from patients who have filed claims or lawsuits against any of the manufacturers of the heartburn medication ranitidine (eg. Zantac, a brand name of the pharmaceutical company Sanofi). As of April 1, 2020, Zantac and other ranitidine products are the subject of an FDA recall. They have been found to contain N-Nitrosodimethylamine (NDMA), a probable human carcinogen, and are suspected of causing cancers of the digestive tract and blood. The recall applies to both over-the-counter and prescription forms of the drug, which was marketed under the brand names Zantac, Deprizine, and the generic Ranitidine. "Already numerous lawsuits have been filed against the companies that manufactured Zantac, many of which have been brought together as a class action in federal court," explains Rory Donadio, founder of Tribeca. "Because Zantac was such a popular and widely distributed drug, many people in the know believe that claims against these companies could number in the tens of thousands and be worth billions," says Donadio. In addition to Sanofi, ranitidine was manufactured and marketed by several dozen companies, including Apotex Corp. (labeled by Walgreens, Walmart, and Rite-Aid), Reddy's Laboratories (labeled by Walgreens, Walmart, CVS, Target, and Kroger), GlaxoSmithKline (GSK), Novitium Pharma, Perrigo Company and Sandoz. For ten years Tribeca has provided litigation funding to plaintiffs in personal injury suits, including those for dangerous drugs and defective medical equipment. Litigation funding, or lawsuit loans, allow someone who suffered injury to obtain an advance on the proceeds they expect to receive on a claim or lawsuit. Says Tribeca's Donadio, "Litigation funding can help a plaintiff cover everyday expenses or pay for medical treatment they would otherwise not get until the case settled or went to trial. Then, if for some reason the claim is denied or the client loses the lawsuit, they're not required to pay back the advance. It's a win all around." To be eligible for an advance on a Zantac claim, it is not necessary to have filed a lawsuit. But it is necessary to file a claim in the Zantac litigation and be able to provide copies of medical records, including a pathology report. To learn more or to file an application, contact Tribeca Lawsuit Loans toll-free at (866) 388-2288 or visit TribecaLawsuitLoans.com.

Lupaka Gold Corp. ("Lupaka" or the “Company") (TSX-V: LPK, FRA: LQP) reports that it has completed the next step in its international arbitration claim against the Republic of Peru. The Company has now submitted a Request for Arbitration in accordance with Article 36 of the Convention on the Settlement of Investment Disputes between States and Nationals of Other States (“ICSID Convention”) and Article 824 of the Free Trade Agreement between Canada and the Republic of Peru. This announcement is a follow up to Lupaka’s earlier news releases on 16 December 2019 regarding the filing of a Notice of Intent to Submit a Claim to Arbitration and on 4 August 2020 regarding Lupaka entering into a Finance Agreement for its Arbitration Claim Under the Canada-Peru Free Trade Agreement (“FTA”). The Request has been filed with ICSID in Washington D.C., USA. The dispute arises out of Peru’s breaches of the FTA in relation to Lupaka’s investments in Peru. More specifically, the dispute stems from the Republic of Peru’s actions, namely the illegal acts of its subdivision, the Community of Parán, which illegally invaded Lupaka’s project held through Invicta Mining Corp. (“IMC”) and set up a permanent blockade to the site, as well as from the lack of support from the Peruvian police force, prosecutors and central government officials to remove the illegal blockade and restore Lupaka’s rights to its investment. By September 2018, IMC had developed approximately 3,000 meters of underground workings, secured community agreements from communities that own the superficial lands within the project area, completed a 29-kilometer access road sufficient to handle 40-tonne ore trucks and completed numerous metallurgical tests ranging in size from a few hundred to a few thousand tonnes. In September 2018, IMC requested that the final inspection of the completed works take place in order to allow exploitation to begin. In mid-October 2018, just before the final inspection was to take place, the neighboring Community of Parán’s gunmen forced IMC’s personnel from the project’s area including from its offices located at the camp and erected a blockade thereby preventing access to the mine and camp. The blockade was erected on the road built by the mining company and on the Community of Lacsanga’s recorded property. IMC has existing agreements with the Community of Lacsanga. The Community of Parán’s blockade party were often violent and did not hesitate to fire rifles and threaten Lacsanga’s community members and IMC’s employees. Both Lacsanga and IMC requested that authorities assist to remove the blockade and restore access to the mine. This assistance was not provided. Funding for IMC’s development of the mine was provided through a gold loan. During the blockade period, Lupaka was scheduled to have been processing material, creating cashflow and paying down the loan. It was unable to do so because of the illegal blockade. Ultimately, ten months later in August of 2019, with no apparent progress being made in the conflict, the lender foreclosed on the loan and Lupaka lost its entire investment. Lupaka’s loss of IMC and the mine was a consequence of Peru’s acts and omissions. Lupaka has therefore commenced arbitration proceedings against the Republic of Peru seeking compensation in an amount in excess of USD 100 million, to be further quantified during the course of the arbitration. With respect to the arbitration proceedings, Lupaka is represented by the international law firm, LALIVE, and has the financial backing of Bench Walk Advisors. About Lupaka Gold  Lupaka is an active Canadian-based company focused on creating shareholder value through identification and development of mining assets. About Bench Walk Advisors Bench Walk Advisors is a global litigation funder with over USD 250m of capital deployed across in excess of 100 commercial cases. Bench Walk and its principals have consistently been ranked as leading lawyers and litigation funders in various global directories. About LALIVE LALIVE is an international law firm with offices in Geneva, Zurich and London, that specializes in international dispute resolution. The firm has extensive experience in international investment arbitration in the mining sector, amongst others, and is currently representing investors and States as counsel worldwide.

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

• Article draws comparisons between commercial litigation finance and private equity (leverage buy-out) asset classes
• Similarities and differences exist between private equity and litigation finance operating costs, but there are some significant jurisdictional differences to consider
• Value creation is front-end loaded in litigation finance vs. back-end loaded in private equity
• Litigation finance can be a difficult investment to scale while ensuring the benefits of portfolio theory

INVESTOR INSIGHTS

• The ‘2 and 20’ model is an appropriate baseline to apply to litigation finance, but investors need to understand the potential for misalignment of interests
• As with most asset classes, scale plays an important role in fund operating costs
• Deployment risk and tail risk are not insignificant in this asset class
• Investor should be aware of potential differences in the reconciliation of gross case returns to net fund returns
• Up-front management fees may have implications for long-term manager solvency

My overarching objective for Slingshot is to educate potential investors about the litigation finance asset class and to improve industry transparency, as I believe increased transparency will ultimately lead to increased investor interest and increased access to capital for fund managers.  In this light, I was asked to write an article a few months back about management fees in the commercial litigation finance sector, and my immediate reaction was that it would be a controversial topic that may not even be in my own best interests—and so I parked the idea.  However, the seed was germinating and I began to think about an interesting discussion of the various operating costs, including management fees, inherent in and specific to the asset class, including geographic differences therein. While I always attempt to provide a balanced point of view in my articles, I should first point out my conflict of interest as it relates to this article.  As a general partner of a commercial litigation finance fund-of-funds, and being in the design stages of my next fund offering, my compensation model is based on a combination of management fees and performance fees no different than litigation finance fund managers.  Accordingly, my personal bias is to ensure that I structure my own compensation to strike a balance between investor and manager so that each feels they are deriving value from the relationship.  If I overstep my bounds by charging excessive fees, I believe that a competitive market will recognize the issue and prevent me from raising sufficient capital to make my fund proposition viable.  I am also kept in check by a variety of other managers in the same and similar asset classes who are also out raising money which help to establish the “market” for compensation. I further believe a smart allocator, of which there are many, will know what fee levels are acceptable and appropriate based on the strategy being employed and the resources required to deploy capital into acceptable investments (they see hundreds, if not thousands, of proposals every year, and are focused on the compensation issue).  On the other hand, the litigation finance market is a nascent and evolving market with many different economic models, specific requirements and unique participants, and so a ‘market standard’ does not exist, therefore it is common to look at similar asset classes (leveraged buy-out, private credit, etc.) to triangulate an appropriate operating cost model. At the end of the day, the most compelling philosophy of compensation is rooted in fairness.  If a manager charges excessive fees and their returns suffer as a result, that manager will likely not live to see another fund. However, if  a manager takes a fair approach that is more “LP favourable” in the short-term (as long as the compensation doesn’t impair its ability to invest appropriately), it can move its fees upward over time in lock-step with its performance as there will always be adequate demand to get into a strong-performing fund.  There are many examples in the private equity industry of managers who have been able to demand higher performance fees based on their prior performance.  So, if you have a long-term view of the asset class and your fund management business, there really is no upside in charging excessive fees relative to performance, but there is clear downside. With my conflict disclosed, let’s move on to the issues at hand which are more encompassing than just fees. Litigation Finance as a Private Equity Asset Class For fund managers operating in the commercial litigation finance asset class, many view themselves as a form of private equity manager, and for the most part, the analogy is accurate.  Litigation finance managers are compensated for finding attractive opportunities (known as “origination”), undertaking due diligence on the opportunities (or “underwriting”, to use credit terminology) and then stewarding their investments to a successful resolution over a period of time while ensuring collection of proceeds. Similarly, Private Equity (“PE”) investors (for purposes of this article I refer to “Private Equity” as being synonymous with “leveraged buy-outs”, although use of the term has been broadened over the years to encompass many private asset classes) spend most of their time on origination and diligence on the front-end of a transaction, and increasingly, on value creation and the exit plan during the hold period and back-end of the transaction, respectively. In the early days of the PE industry, the value creation plan was more front-end loaded and centered around buying at X and selling at a multiple of X (known as “multiple arbitrage”), usually by taking advantage of market inefficiency, and accentuated through the use of financial leverage and organic growth in the business.  Over time, the multiple arbitrage strategy disappeared as competitors entered the market and squeezed out the ‘easy money’ by bidding up prices of private businesses.  Today, PE firms are more focused on operational excellence and business strategy than ever before (during the hold period of the transaction).  Having been a private equity investor for two decades I have seen a significant change in the PE value creation strategy.  While organic and acquisition growth still feature prominently in PE portfolio company growth strategies, the extent to which PE managers will go to uncover value opportunities is unprecedented. This highlights a key difference between private equity and litigation finance.  In PE, the majority of the value creation happens after the acquisition starts, and ends when a realization event takes place.  In litigation finance, the fund manager, in most jurisdictions, is limited from “intermeddling” in the case once an investment has been made, so as to ensure the plaintiff remains in control of the outcome of the case and that the funder does not place undue influence on the outcome of the case.  Nonetheless, some litigation funders add value during their hold period by providing ongoing perspectives based on decades of experience, participating in mock trials, reviewing and commenting on proceedings to provide valuable insight, reviewing precedent transactions during the hold period to determine their impact on the value of their case, case management cost/budget reviews, etc. Accordingly, it is easy to see that relative to private equity, the litigation finance manager’s ability to add value during the hold period is somewhat limited, legally and otherwise.  One could use this differential in “value add” to justify a difference in management fees, but a counter-argument would be that in contrast to private equity, litigation finance adds value at the front-end of the investment process by weeding out the less desirable prospects and focusing their time and attention on the ‘diamonds in the rough’.  Of course, private equity would make the same argument, the key difference being that in private equity there is much more transparency in pricing through market back-channeling (many of the same lenders, management consultants and industry experts know the status and proposed valuations of a given private equity deal) than what is found in the litigation finance industry. An argument can be made that inherent in litigation finance is a market inefficiency that is predicated on confidentiality, although I don’t believe that has been tested yet. The other issue that differentiates litigation finance from PE is the scale of investing.  PE scales quite nicely in that you can have a team of 10 professionals investing in a $500 million niche fund and the same-sized firm investing $2B in larger transactions, while your operating cost base does not change much, which is what allows PE operations to achieve “economies of scale”.  In litigation finance, the number of very large investments is limited, and those investments typically have a different set of return characteristics (duration, return volatility, multiples of invested capital, IRR, etc.), so even if you could fund a large number of large cases, you may not want to construct such a portfolio, as large case financings will likely have a more volatile set of outcomes, so the fund would have to be large enough to allow diversification in the large end of the financing market during the fund’s investment period.  Accordingly, litigation finance firms typically have to invest in a larger number of transactions in order to scale their business, and doing so requires technology, people or both.  At this stage of the evolution of the litigation finance market, scale has been achieved mainly by adding people.  Accordingly, as the PE industry has been able to achieve economies of scale through growth, it is reasonable for investors to benefit from those economies of scale by expecting to be charged less in management fees per dollar invested.  The same may not hold true for litigation finance due to its scaling challenges, although there are niches within litigation finance that can achieve scale (i.e. portfolio financings & mass tort cases, as two examples) for which the investor should benefit. The Deployment Problem A third significant issue that litigation finance and investors therein have to contend with is deployment risk.  In private equity, managers typically deploy most of their capital in the investment on ‘day one’ when they make the investment.  They may increase or decrease their investment over time depending on the strategy and the needs of the business and the shareholders, but they generally deploy a large percentage of their investment the day they close on their portfolio acquisition.  Further, it is not uncommon for a PE fund manager to deploy between 85% and 100% of their overall fund commitments through the course of the fund. Litigation Finance on the other hand rarely deploys 100% of its case commitment at the beginning of the investment, as it would not be prudent or value maximizing to do so.  Accordingly, it is not uncommon for litigation finance managers to ‘drip’ their investment in over time (funding agreements typically provide the manager with the ability to cease funding in certain circumstances in order to react to the litigation process and ‘cut their losses’).  The problem with this approach is that investors are being charged management fees based on committed capital, while the underlying investment is being funded on a deployed capital basis, which has the effect of multiplying the effective management fee, as I will describe in the following example.  This, of course, is in addition to the common issue of committing to a draw down type fund that has an investment period of between 2-3 (for litigation finance) and 5 (for private equity) years, for which an investor is paying management fees on committed capital even though capital isn’t expected to be deployed immediately.  Litigation finance adds a strategy-specific layer of deployment risk. For purposes of this simplistic example, let’s contrast the situation of a private equity firm that invests $10 million on the basis of a 2% management fee model with that of a litigation finance manager that also invests $10 million, but does so in equal increments over a 3-year period.   Private Equity (PE) Model (based on a $10 million investment)

	Year 1	Year 2	Year 3
Capital Deployed1	$10,000,000	$10,000,000	$10,000,000
2% Management Fee	$200,000	$200,000	$200,000
Expressed as % of deployed capital (B)	2%	2%	2%

  Litigation Finance Model (based on a $10 million investment evenly over 3 years)

	Year 1	Year 2	Year 3
Capital Deployed1	$3,333,333	$6,666,666	$10,000,000
2% Management Fee	$200,000	$200,000	$200,000
Expressed as %1 of deployed capital (A)	6%	3%	2%

  Differences in Fees in relation to Capital Deployed

Absolute Difference(A-B)	4%	1%	0%
Difference as a multiple of fees in PE ((A-B)/2%)	2X	0.5X	0X

¹ Calculated assuming the capital is deployed at the beginning of the year. The difference highlighted above can be taken to extremes when you have a relatively quick litigation finance resolution shortly after making a commitment.  In this situation, you have deployed a relatively small amount of capital that hasn’t been invested for long, but has produced a strong return – this typically results in large gross IRRs, but a relatively low multiple of capital (although the outcome very much depends on the terms of the funding agreement).  While this phenomenon produces very strong gross IRRs, when the investor factors in the total operating costs of the fund, the negative impact of those costs can significantly affect net IRRs.  Accordingly, investors should be aware that this asset class may have significant ‘gross to net’ IRR differentials (as well as multiples of invested capital), and one could conclude erroneously that strong gross IRRs will contribute directly to strong Net IRRs, but the ultimate net returns will vary with capital deployment, case duration. extent of operating costs and timing thereof. I wouldn’t want this observation to discourage anyone from investing in litigation finance, but awareness of this phenomenon is important and very much dependent on the strategy of the manager, the sizes and types of cases in which they invest, and of course, is in part a consequence of the uncertain nature of litigation.  As an investor, I do think it is appropriate and fair where a fund manager obtains a quick resolution, that the commitment underlying the resolution be recycled to allow the Investor a chance to re-deploy the capital into another opportunity and achieve its original portfolio construction objectives  - recycling is beneficial to all involved. However, I would argue that it is not necessarily fair to charge the investor twice for the same capital, as that capital has already attracted and earned a management fee. Stage of Lifecycle of Litigation Finance Perhaps litigation finance is at the same stage of development as private equity experienced 20 years ago in terms of finding the “multiple arbitrage” opportunities, but a key difference is that the success rates in litigation finance are lower and the downside is typically a complete write-off of the investment, whereas private equity has many potential outcomes between zero and a multiple of their initial investment.  Of course, the home runs in litigation finance can be quite spectacular.  The quasi-binary nature of the asset class does present a dilemma in terms of compensation for managers and the costs inherent in running the strategy. The scale and deployment issues raised above are other issues that need to be addressed by fund managers and their compensation systems. Notwithstanding the aforementioned, it takes highly competent and well-compensated people to execute on this particular strategy which sets a floor on management fee levels. A well-run and diversified litigation finance fund should win about 70% of their cases, and if they underwrite to a 3X multiple for pre-settlement single cases, then they should produce gross MOICs of about 2X (i.e. ~70% of 3X) and net about 1.75X (after performance fees and costs).  This would be the type of performance that is deserving of a ‘2 and 20’ model as long as those returns are delivered in a reasonable time period.  Conversely, if the majority of a manager’s portfolio is focused on portfolio finance investing, there may have to be a different compensation scheme to reflect the different risk/reward characteristics inherent in the diversification, scale and cross-collateralized nature of this segment of the market. One size does not fit all. Let’s also not forget that litigation finance is delivering non-correlated returns, and one could easily assess a significant premium to non-correlation, especially in today’s market. In Part 2 of this two-part series, I will explore the application of the ‘2 and 20’ model to litigation finance in comparison to private equity, the implication of the private partnership terms of some of the publicly-listed fund managers, and other operating costs specific to litigation finance. Investor Insights Any fund operating model needs to be designed taking into consideration all of the operating costs inherent in the manager’s operational model in the context of expected returns and timing thereof.  Investors care about being treated fairly, sharing risk and sharing the upside performance in order to foster long-term relationships that reflect positively on their organizations’ ability to perpetuate returns.  Professional investors rely on data to make decisions, and in the absence of data which might get them comfortable with a manager’s performance, they will default to mitigating risk. Tail risk in this asset class is not insignificant, which makes investing that much more difficult.  A performing manager that does a good job of sharing risk and reward with investors will have created a sustainable fund management business that will ultimately create equity value for its shareholders beyond the gains inherent in its performance fees.  Edward Truant is the founder of Slingshot Capital Inc., and an investor in the litigation finance industry (consumer and commercial).  Ed is currently designing a new fund focused on institutional investors who are seeking to make allocations to the commercial litigation finance asset class.

Lawyers from Mbuyisa Moleele and Leigh Day today announced that a class action lawsuit has been filed against Anglo American South Africa Limited (“AASA”), a subsidiary of London-headquartered multinational mining company Anglo American Plc (LSE: AAL, JSE: AGL), in the Gauteng Division of the High Court of South Africa. The action has been filed on behalf of a class estimated to comprise more than100,000 individuals in the Kabwe District of Zambia who are believed to have been poisoned by lead. The application is brought by 13 representative plaintiffs on behalf of children under 18, and girlsand women who have been or may become pregnant in the future. The claimants – principally young children – are suffering from alarming levels of lead poisoning which, depending on various factors including the blood lead level (“BLL”), causes a range of significant conditions, from psychological, intellectual and behavioural damage to serious and permanent physical damage to their bodily organs, neurological systems and fertility. In extreme cases, serious brain damage and deaths occur. In pregnant women, lead they ingested as children is absorbed into their bones and released during pregnancy. Women are also exposed to lead during pregnancy from the surrounding environment. Lead is known to cross the placenta, resulting in the unborn child being subjected to the same concentration of lead as the mother. Notonly can the baby’s health be damaged, lead causes pregnant women to have a higher risk of pre-eclampsia; gestational hypertension and miscarriage. Generations of children have been poisoned by the operations of the Kabwe mine, originally known as Broken Hill, which caused widespread contamination of the soil, dust, water, and vegetation. The main sources of this poisonous lead were from the smelter, ore processing and tailings dumps. The BLLs of the vast majority of children in Kabwe exceed the BLL limit of 5 micrograms per decilitre set by the U.S. Center forDisease Control. A substantial proportion of the children have BLLs in excess of 45 ug/dl, the limit at which medical treatment is required. There are numerous cases of young children (including among the representative plaintiffs) with BLLs in excess of 100 ug/dl, at which serious brain damage and death may occur. The Kabwe mine was part of AASA group from 1925 until 1974 and was one of the world’s most productive lead mines during this time. It is alleged in the class action that AASA is liable, including for the following, because of AASA’s role in controlling, managing, supervising and advising on the technical, medical and safety aspects of the mine’s operations:

1. a) Substantial emissions of lead into the local environment were due to deficiencies in the design and systems of operation and control of lead, which AASA failed to ensure were rectified;
2. b) AASA failed to ensure the clean-up of the communities’ contaminated land; and
3. c) Accordingtoexperts1, aroundtwothirds of the leadcurrently inthe local environment is likely to have been deposited there between 1925 and 1974 when the mining operation was transferred to ZCCM, a Zambian state-owned company, in 1974.

The class action seeks to pursue remedies in the form of compensation for these children, as well as girls and women with lead poisoning who have or may become pregnant in the future. Also sought is (a) blood lead screening for children and pregnant women in Kabwe, and (b) clean up and remediation of the area to ensure the health of future generations of children and pregnant women is not jeopardised. Richard Meeran, Partner & Head of the International Department at Leigh Day, said: “From the 1950s, Anglo American publicly committed to making a lasting contribution to communities in which it operated. Its current human rights policy is to contribute to remediation when its business has contributed to adverse human rights impacts. This ongoing public health disaster is the result of a flagrant disregard for the health of the local community, which is totally at odds with those grand public pronouncements.” Zanele Mbuyisa, Partner at Mbuyisa Moleele, added: “AASA is considered amining giant that has been instrumental inbuilding theeconomies ofvarious countries, but it also has to be acknowledged that their operations have caused the decimation of communities and long-lasting damage to the health of those communities.” Mbuyisa Moleele is a Johannesburg-based law firm led by Zanele Mbuyisa, and Leigh Day is a leading international law firm specialising in human rights and mass environmental tort claims. Both firms have a proven track record of litigating complex international class actions on behalf of victims from disadvantaged backgrounds. The case is being funded by Augusta Ventures, the UK’s largest litigation fund by volume of claims. More information about this matter can be found at www.childrenofkabwe.com.