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Valuing Indemnity Protection Investment Returns in Litigation Finance

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

  • Indemnities are not costless instruments; they are akin to securities options, but without a stated option value
  • Approaches to determining cost of indemnity include: Probability weighted outcome approach, Opportunity Cost Approach and Approach based on empirical evidence
  • Implications for Portfolio Returns are that improper assessment of indemnity returns may materially skew return results of a portfolio

Investor Insights

o   Indemnities have a cost and their cost should be used to determine investor returnso   Depending on how indemnity performance is measured, it has the ability to skew portfolio performance

Some litigation finance providers offer a product called indemnity protection (please don’t call it insurance), which is a product designed to protect plaintiffs against adverse costs in certain jurisdictions (Canada, Australia and the UK, for example) where the plaintiff may be found liable for defense costs should the defendant win the case.  Indemnity protection is prevalent in product class action and securities class action cases.

What makes indemnity protection challenging is the process of estimating the returns inherent to providing the protection.  Indemnities differ from traditional litigation finance, in that the latter requires the funder to finance hard costs (legal counsel, court costs, expert witness costs, etc.), while the former only pays out once a case is lost by the plaintiff, and subject to the court’s determination regarding the application of adverse costs.  In the event the plaintiff is successful, the indemnity provider shares in the contingent proceeds and is not liable for any payout.

However, in the event the defendant is successful, the indemnity provider must pay the indemnity amount and forego any prospective proceeds.  In a normal rate of return calculation, the numerator (i.e. gains or proceeds) and denominator (dollars deployed to finance costs) help determine a Return on Invested Capital (“ROIC”) or Multiple of Invested Capital (“MOIC”). However, with indemnities there is no denominator; in the event the plaintiff wins the case and hence there is no “cost”.

Or is there?

I think most people in finance would argue strongly, and rightly so, that there is indeed a cost.  I liken the analysis to that of a securities option.  In the context of a securities option (a put or call option, for example) one pays an upfront amount (i.e. the option price) to attain the right to benefit in either the reduction or increase in the underlying stock price.  The value of the option is based on the market’s view of the weighted average probability of the event taking place (i.e. achieving the strike price in a given period of time).

In the case of an indemnity, there is no cost to providing the indemnity (other than out of-pocket contracting costs) even though the opportunity has value to the indemnity provider.  The value of the indemnity for the investor is inherent in the pay-out they expect to receive on success, which is offset by the likelihood of having to pay out under the indemnity.  Essentially, it is a costless option.  The upside produces infinite returns, while the downside produces a total loss.

Approaches to Valuing the Indemnity Protection

As we all know, nothing is “costless”. Instead, I would suggest that an investor in an indemnity needs to determine a theoretical cost for that investment.

One approach is to look at the litigation funder’s underwriting report and economic analysis to determine the probabilities associated with various negative outcomes pertaining to the case, and probability-weight the negative outcomes to determine a theoretical cost of capital. Of course, these need to be looked at in the context of the risks of the various case types in the relevant jurisdiction, in addition to the risks of the case through the various stages of the case, as adverse costs can have multiple pay-out points throughout the case.  As an example, securities class actions in Australia and Canada, when certified by a court, have an extremely high success rate (meaning that they typically settle quickly after the certification).

Another approach might be to look at the alternative to utilizing that same capital in an investment with a similar risk profile, where the potential outcome could be the same and the risk of loss is similar.  As an example, if the opportunity cost of providing an indemnity was to buy a securities option with a similar risk profile, then you could use the market cost of the option as a proxy for the cost of the indemnity.

Yet another alternative would be to study the outcomes of a large sample of identical indemnities to try and determine the probability of a negative outcome and apply it to the indemnity amount to determine a notional cost.  Unfortunately, much of this information remains in the private domain, as most cases which use indemnity protection tend to settle.  In time, it may be that there is sufficient data to make this approach realistic, but as it stands, there is insufficient data to make this a viable alternative.

While approaches will differ by fund manager and investor, the important point is to eschew the concept that an indemnity is a costless financial instrument, as to do so would skew the results inherent in a fund manager’s track record where indemnities are an important part of their strategy.  This same result can also occur in more traditional litigation finance cases where there is a settlement shortly after the funding contract has been entered into, and which did not necessitate the drawing of capital.  In this case, the returns are also infinite, but perhaps there should have been a theoretical cost of capital based on the probability of the funding contract being drawn upon.

Investor Insights: When assessing the rates of return on an indemnity, my approach is to determine a weighted average probability of loss outcomes and apply them to the Indemnity amount in order to determine a notional cost for the indemnity.  This analysis becomes extremely important when assessing portfolio performance because most often fund managers do not assign a notional cost to their indemnities when providing their investment track records, and hence positive indemnity outcomes make their overall portfolio performance seem more impressive than one might otherwise assess.  A simplified example of the potential for an indemnity to skew portfolio performance based on approach is as follows:

Assumptions:

Case Type:                             Security Class Action

Indemnity Amount:             $1,000,000

Damage Claim:                      $10,000,000

Contingent Interest:              10%

Contingent Interest Award:  $1,000,000

Probability of Loss                $ Loss*

Loss at Summary Judgement:                  10%                     $100,000

Loss at Certification:                                   5%                       $50,000

Loss at Trial:                                                 25%                     $250,000

Notional Cost of Indemnity:                                                  $400,000

* calculated as probability of loss multiplied by Indemnity Amount.

  1. Return Calculation applying a theoretical cost to the Indemnity in a win scenario:

ROIC: =       $600,000 ($1,000,0000-$400,000) = 150%
$400,000

MOIC:                  $1,000,000 = 2.5
$400,000

  1. Return Calculation applying no cost to the indemnity in a win scenario:

MOIC &
ROIC:          $1,000,000 = Infinite
$0

Edward Truant is the founder of Slingshot Capital Inc. and an investor in the consumer and commercial litigation finance industry. Slingshot’s blog posts can be accessed at www.slingshotcap.com.

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Who Could Regulate the Litigation Funding Industry after the CJC Review?

By Harry Moran |

As funders and law firms await the outcome of the Civil Justice Council’s (CJC) review of litigation funding later this summer, industry experts are opining not only on the potential direction any future regulation could take, but what body would be in charge of this new oversight function.

In an insights post from Shepherd and Wedderburn, Ben Pilbrow looks ahead to the CJC review of litigation funding and poses the question that if some form of regulation is inevitable, who will act as the regulator for these new rules? Drawing upon two previous reports that reviewed the funding of litigation, Pilbrow points out that historically there have been two main bodies identified as the likely venues for regulation of third-party funding: the courts or the Financial Conduct Authority (FCA).

Analysing the comparative pros and cons of these institutions as prospective regulators, Pilbrow highlights that each one has two core contrasting qualities. The courts have the requisite expertise and connection to litigation funding yet lacks ‘material inquisitive powers’. On the other hand, the FCA does not have the aforementioned ‘inherent connection to the disputes ecosystem’, but benefits from being an established regulator ‘with considerable enforcement powers’.

Exploring options outside of these two more obvious candidates, Pilbrow suggests that utilising one of the existing legal regulators may be viable due to the fact they are all ‘largely staffed by lawyers but have regulatory powers.’ However, Pilbrow notes that these legal regulators may have common flaw that would stop them taking on this new role. That flaw being the comparatively small size of these organisations, with the Solicitors Regulation Authority (SRA) still only boasting 750 employees despite being the largest of these legal regulators.

Concluding his analysis, Pilbrow suggests unless the government opts for an expanded system of self-regulation under an industry body such as the Association of Litigation Funders, the most likely outcome is for the FCA’s remit to be expanded to include the regulation of litigation funding.

The full article from Ben Pilbrow can be read on Shepherd and Wedderbun’s website.

Omni Bridgeway Announces Final Payment for Acquisition of its Europe Business

By Harry Moran |

In an announcement posted on the ASX, Omni Bridgeway announced that it had completed the final payment for the acquisition of the Omni Bridgeway Europe (OBE) business that took place in 2019. The litigation funder confirmed that 5,213,450 fully paid ordinary shares had been ‘issued in satisfaction of the fifth and final tranche of variable deferred consideration’ to complete the acquisition.

Highlighting the progress of the business over the past six years, Omni Bridgeway said that the European business ‘has been successfully integrated into the global operations of the group, creating the most diversified legal asset management platform globally, covering all relevant civil and common law jurisdictions and all relevant areas of law.’ 

The announcement also revealed that OBE has ‘achieved the defined five-year KPIs in full’, whilst the management team ‘has been fully retained.’

Burford Capital CEO Says Litigation Finance Market is ‘Booming’

By Harry Moran |

With the global economy and financial markets in a current state of uncertainty, the stability of litigation funding as an uncorrelated asset class for investors is attracting wider attention than ever.

In an interview with Bloomberg TV, Christopher Bogart, CEO of Burford Capital discussed the current state of the litigation finance market, explained why third-party funding is attractive to clients and investors alike, and addressed the common critiques that are levelled at the industry.

On the enduring appeal of litigation funding to corporate clients, Bogart said that for many CEOs and CFOs the truth is that their companies are “spending too much money today on legal fees”. He went on to say that money spent by companies on legal fees is “not doing anything that advances their core undertaking”, and as a result, “the ability to offload that to somebody like us [Burford] is very valuable.”

When asked about why the litigation finance market is thriving during the global economic uncertainty, Bogart highlighted that all of Burford’s “cash flows come entirely out of the outcome of litigation results and those are independent of what’s happening in the market, independent of what’s happening in the broader economy.” In terms of the future of litigation funding and the potential for the market to continue to grow, Bogart pointed out that between legal fees and litigation judgments there is a “multi-trillion dollar a year global market” and that whilst the industry is already “booming”,  there is still “a lot of room to run here” for litigation funders.

In response to a question on the criticisms of litigation funding and the suggestion that funders may look to prolong the duration of cases, Bogart pointed out that Burford is just like any other investment firm that is “looking for high quality assets that are going to produce a reasonable return in a short period of time.” Bogart emphatically rejected what he described as “false concerns” by opponents of third-party funding, and stated plainly: “we’re absolutely not in the business of being interested in prolonging duration or in bringing forward things that are not ultimately going to yield a good result for our shareholders”.

The full interview can be found on Burford Capital’s website.