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 SUMARY
- Survey suggests the litigation finance industry has experienced an increase in demand due to the Covid-related financial crisis
- Law firm portfolio financings are a particular active sector of the market
- Defendant collectability risk is top of mind for most respondents
- Covid-19 related cases are predominant in the contract and insurance case types
INVESTOR INSIGHTS
- 2020 should be a good vintage for new litigation finance opportunities
- Generally, there is a feeling that the current economic crisis will put some pressure on IRRs or MOICs of existing portfolios
- Additional diligence on unrealized portions of litigation finance portfolios is warranted in the current environment when assessing fund manager performance
Slingshot Capital and Litigation Finance Journal recently undertook a survey of commercial litigation finance participants to obtain a deeper understanding of the extent to which demand for financing had changed as a result of the current Covid-related financial crisis.
Editor’s note– the following contribution appears with illustrative graphs and charts here.
Demand for Litigation Finance during Economic Crises
It has been thought that crises breed litigation, and while that appears to be the case in the current crisis, that may not have been the case in the Great Financial Crisis of 2008/9, as pointed out by Eric Blinderman in an article he contributed to Law360 in 2019, also referenced in a recent article in Litigation Finance Journal. The reason for the ultimate lack of litigation, Eric argued, was fear.
In the current environment it appears as though people are less fearful (of litigation, that is) as the number of Covid-specific cases is clearly on the rise, and I suspect that will continue for the foreseeable future as the crisis increases its impact on businesses and forces business owners to react in ways previously thought unthinkable, but in the current context are deemed necessary. When the data is analyzed with respect to case type, it is evident that the volume of cases is focused on contract and insurance claims, which should come as no surprise.
Issues of Force Majeure and breaches of contract are likely the majority of the volume of contract claims. Business owners have been placed in an unprecedented position in that they are likely being forced to breach contracts to save their businesses. While business owners and executives may regret their actions and would not have acted in a similar way under normal circumstances, they are no doubt acting in the best interests of the business to avoid insolvency and will deal with the repercussions (litigation) once they have ‘righted the ship’. The insurance sector has also been particularly negatively impacted, and much of this likely stems from denial of payouts under policies, with business interruption insurance being particularly active. In fact, the UK insurer, Hiscox, is being sued in a class action-style litigation in the UK with Harbour Litigation Funding providing the litigation finance to pursue the case. Accordingly, litigation finance has and will continue to be a beneficiary of this activity.
Covid Survey Results
Let’s now take a look at the Covid Survey results to see how the broader commercial litigation finance industry has been impacted by the Covid-induced financial crisis.
The survey was distributed globally. Of the respondents, the vast majority were funders with dedicated litigation finance funds.
Overall, the industry has been positively impacted by the financial effects of Covid-19 with 64% of respondents experiencing an increase in origination activity.
In some cases, the increase in origination activity has been dramatic, with originations in excess of 25% being experienced by approximately half of respondents.
The largest impact in terms of the type of activity is equally split between law firm portfolio financings and single case financings. However, since portfolio financings are inherently larger, it stands to reason that a much larger dollar volume of financing will be required for these financing types.
In terms of the source of originations, it appears to be a combination of existing relationships, mainly from law firms, and new relationships, mainly from law firms and directly from plaintiffs. It is encouraging to see new relationships continuing to be formed at this stage of the evolution of the industry.
A natural consequence of demand for litigation finance is a demand for capital commitments by the litigation funders. Accordingly, it appears that the demand impact of Covid will have the effect of accelerating plans for new fundraisings, with about half of respondents indicating their fundraising plans have been accelerated. Accordingly, investors in search of good risk-adjusted and non-correlated returns should expect to see more opportunities in the marketplace. As always, diversification is critical to successful and prudent investing in the litigation finance marketplace.
As it relates to the impact that the current financial crisis will have on the expected return profile, almost 50% of respondents suggested it is too early to tell. However, for those who did have some visibility or were confident in making an estimate, it appears that the expectation is that their existing portfolios may be negatively impacted, which is consistent with what I would have expected given the extent of this economic crisis.
I was personally forecasting that durations would be longer, simply due to the effect that court closures would have on existing cases, where the timing of settlement discussions are ultimately impacted by the timing of the court process. In this light, I would expect to see portfolios maintain longer durations which may equate to lower internal rates of return, but this depends on the escalator clauses within their funding agreements, which may see funders obtain larger multiples of invested capital if the delay breaks through timing thresholds. I would also expect that the threat of collectability risk might put pressure on plaintiffs to accept lower settlement amounts, and defendants will use liquidity concerns to their advantage by low-balling settlement offers. However, this phenomenon could be situation-specific, and more prevalent in certain industries.
As previously stated, one of the reasons I would have expected return expectations to be increasingly negative is due to defendant collectability risk. In this vein, it seems that most managers are focused on the impact this risk will have on their portfolios, with most managers indicating that collection risk has increased, which is expected given the impact the crisis has had on certain industries, and the impact it has had on corporate liquidity.
Looking forward, managers are focusing on credit risk more than they have in the past, and this is mirrored in their focus on the industries in which their defendants operate. Interestingly, despite the significant impact the crisis has had on the demand for legal services, few managers are concerned about the impact on the solvency of the plaintiff law firm. This may be explained by the fact that the law firm can be substituted by the plaintiff should it run into solvency issues, and so managers may view this as an acceptable risk.
The Bonus Question
And now the moment you’ve all been waiting for….
When asked whether Covid-induced isolation has caused respondents to think about the benefits of boarding school, the majority confirmed that their children are angels and that they would like to spend as much time with them as possible. Although, there were a few who noted an interest in boarding schools, and one did attempt to sell his child to the highest bidder.
This brings to a close the results of our second commercial litigation finance survey. Slingshot Capital and Litigation Finance Journal would like to thank those that participated in the survey for their time and feedback.
Our next survey will cover fundraising initiatives by fund managers in the commercial litigation finance sector. We anticipate making the fundraising survey an annual survey, so we can track fundraising activities over time.
If you would like to participate in future surveys, please contact Ed Truant here to register your interest.
