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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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Community Spotlights

Community Spotlight: Dean Gresham, Managing Director, Certum Group

Dean Gresham is a Managing Director who oversees the evaluation, underwriting, and risk management of all the company’s risk transfer solutions, including litigation finance and contingent risk insurance. With 25 years of experience in complex litigation and legal risk analysis, Dean ensures rigorous underwriting standards and strategic risk mitigation across the company’s risk transfer solutions.

Before joining Certum Group, Dean was a trial lawyer for more than 21 years handling complex commercial, catastrophic injury, qui tam, and class action litigation across the country. While practicing, Dean litigated on both sides of the docket and developed a keen ability to analyze and assess risk from both the plaintiff’s and defendant's unique perspectives.

In 2020, Dean was awarded the Elite Trial Lawyer of the Year award by the National Law Journal for his trailblazing work on a complicated wrongful adoption case. Dean is consistently chosen by his peers as a Texas Super Lawyer (2009-2024); one of the Best Lawyers in Dallas by D Magazine (2009-2024), one of the Top 100 Trial Lawyers in Texas by the National Association of Trial Lawyers (2011-2024), and in the Nation’s Top One Percent by the National Association of Distinguished Counsel (2019-2024).

Dean is the 2025 Chair of the Dallas Bar Association's prestigious Business Litigation Section and sits on the DBA’s Judiciary Committee.

Company Name and Description: Certum Group offers a next-generation litigation risk transfer platform that provides bespoke solutions for companies, law firms, and funders facing the uncertainty of litigation. Latin for “certainty,” Certum represents the core benefit the company delivers to its clients across its entire suite of risk transfer solutions.  Certum is the full-service funding and insurance partner for law firms and their business clients.

Company Website: www.certumgroup.com

Year Founded: 2014 

Headquarters:  Plano, Texas

Area of Focus: Member: Head of Underwriting and Chair of the Investment Committee.

Member Quote: “Litigation funding doesn’t just fuel cases—it fuels justice. Power should never trump merit.”

Highlights from LFJ’s Virtual Town Hall: Investor Perspectives

By John Freund and 4 others |

On March 27th, LFJ hosted a virtual town hall featuring key industry stakeholders giving their perspectives on investment within the legal funding sector. Our esteemed panelists included Chris Capitanelli (CC), Partner at Winston and Strawn, LLP, Joel Magerman (JM), CEO of Bryant Park Capital, Joe Siprut (JSi), Founder and CEO of Kerberos Capital, and Jaime Sneider (JSn), Managing Director at Fortress Investment Group. The panel was moderated by Ed Truant (ET), Founder of Slingshot Capital.

Below are highlights from the discussion:

One thing that piqued my interest recently was the recent Georgia jury that awareded a single plaintiff $2.1 billion in one of 177 lawsuits against Monsanto. What is your perspective on the health of the mass tort litigation market in general?

JSn: Well, I think nuclear verdicts get way more attention than they probably deserve. That verdict is going to end up getting reduced significantly because the punitive damages that were awarded were unconstitutionally excessive. I think it was a 30 to 1 ratio. I suspect that will just easily be reduced, and there will probably be very little attention associated with that reduction, even though that's a check that's already in place to try to prevent outsized judgments that aren't tied as much to compensatory damages. I expect Monsanto will also likely challenge the verdict on other grounds as well, which is its right to do.

The fact is, there are a whole number of checks that are in place to ensure the integrity of our verdicts in the US legal system, and it's already extraordinarily costly and difficult for a person that files a case who has to subject himself to discovery, prevail on motions to dismiss, prevail on motions for summary judgment, win various expert rulings related to the expert evidence. And even if a plaintiff does prevail like this one has before a jury, they face all sorts of post-trial briefing remedies that could result in a reduction or setting aside the verdict, and then they face appeals. The fact is, I think corporate defendants have a lot of ways of protecting themselves if they choose to go to trial or if they choose to litigate the case.

And I think, oftentimes when people talk about the mass tort space, their disagreement really isn't with a specific case, but with the US Constitution itself, which protects the right to juries, even in civil litigation in this country. The fact is that there is a rich tradition in the United States that recognizes tort is essential to deterring wrongdoing. And ensuring people are fairly compensated for the injuries that they sustained due to unsafe products or other situations. So, broadly speaking, we don't think in any systematic a way that reform is required, although I suspect around the margins there could be modest changes that might make sense.

Omni has made a number of recent moves involving secondary sales and private credit to improve their earnings and cash flow. What is your sense of how much pressure the industry is under to produce cash flow for its investors?

JM: I think there is some pressure for sure, but more than pressure, I think it's a natural thing for self-interested managers to want to give their investors realizations so that they can raise more capital, right?

So, even if no one had ever told me, boy, it would be nice to get money back at some point in the future, that would obviously still be what I'm incentivized to do because the sooner I can get realizations and get cash back, the sooner people can have confidence that, wow, this actually really works, and then they give you 2x the investment for the next vehicle.

So the pressure is, I think, part of it. But for a relatively new asset class like litigation finance, which is still in middle innings, I think, at most, you want realizations. You want to turn things over as quickly as you can, and you want to get capital back.

In terms of what ILFA is doing, do you feel like they're doing enough for the industry to counter some of the attacks that are coming from the US Chamber of Commerce and others?

CC: I think there has been a focus from ILFA on trying to prevent some of the state court legislation from kind of acting as a test case, so to speak, for additional litigation. So there's been, you know, they've been involved in the big stuff, but also the little stuff, so it's not used against us, so to speak.

So I think in that regard, it's good. I wonder at what point is there some sort of proposal, as to if there's something that's amenable, is there something that we can all get behind, if that's what's needed in order to kind of stop these broad bills coming into both state legislatures and Congress. But I think overall, the messaging has been clear that this is not acceptable and is not addressing the issue.

Pretium, a relative newcomer to the market, just announced a $500 million raise. At the same time, it's been rumored that Harvard Endowment, which has traditionally been a significant investor in the commercial litigation finance market, is no longer allocating capital to the Litfin space. What is your sense of where this industry continues to be in favor with investors, and what are some of the challenges?

JSi: On the whole, I think the answer is yes, it continues to be in favor with investors, probably increasing favor with investors. From our own experience, we talk to LPs or new LPs quite frequently where we are told that just recently that institution has internally decided that they are now green lighting initiatives in litigation finance or doing a manager search. Whereas for the past three or four years, they've held off and it's just kind of been in the queue. So the fact that that is happening seems to me that investors are increasingly interested.

Probably part of the reason for that is that as the asset class on the whole matures, individual managers have longer track records. Maybe certain managers are on their third or fourth vintage. And there are realized results that can be put up and analyzed that give investors comfort. It's very hard to do that on day one. But when you're several years into it, or at this point longer for many people, it becomes a lot easier. And so I think we are seeing some of that.

One of the inherent challenge to raising capital in the litigation finance asset class is that even just the term litigation finance itself is sort of shrouded in mystery. I mean, it's very unclear what that even means and it turns out that it means many different things. The media on the whole, not including LFJ obviously, but the media on the whole has not done us many favors in that regard because they often use the term litigation finance to mean one specific thing, oftentimes case finance, specific equity type risk on a single case, when in fact, there are many of us who do all kinds of different things: law firm lending, the credit stuff, the portfolio finance stuff. There's all kinds of different slivers. And so the effect of that is that an LP or factions within an LP may have a preconceived notion about what litigation finance is, which is completely wrong. And they may have a preconceived notion of what a particular manager's strategy is. That's completely wrong.

I also think that litigation finance provokes an almost emotional reaction sometimes. It's often the case that investments get shot down because someone on the IC says that they hate lawyers, or they got sued once, and so they hate lawyers. And so they want nothing to do with litigation finance. And so whether that's fair or unfair is irrelevant. I think it is something that is a factor and that doesn't help. But I'd like to think that on the whole, the good strategies and the good track records will win the day in the end.

The discussion can be viewed in its entirety here.

Manolete Partners Announces New Revolving Credit Facility with HSBC Bank

By Harry Moran and 4 others |

Manolete Partners Plc (AIM:MANO), the leading UK-listed insolvency litigation financing company, is pleased to announce it has signed a new Revolving Credit Facility ("RCF") with its existing provider, HSBC UK Bank Plc ( "HSBC"). 

The new RCF provides Manolete with the same level of facility as the previous arrangement, at £17.5m. However, the margin charged to Manolete by HSBC on the new RCF is at a reduced rate of 4.0% (previously 4.7%) over the Sterling Overnight Index Average (SONIA) and has a reduced non-utilisation fee, from 1.88% to 1.40%. 

The new RCF is a 3.25-year facility with an initial maturity of 27 June 2028. Manolete has the option to further extend the facility on its current terms by an additional year. 

The covenants remain unchanged except for the Asset Cover covenant which has been relaxed for the next six months. 

Steven Cooklin, CEO commented: "We are delighted to have secured a new long-term commitment to the business from HSBC, which is testament to the strong partnership we have established since 2018. The improved terms of the facility demonstrate confidence in the Manolete business." 

This announcement contains inside information as defined in Article 7 of the Market Abuse Regulation No. 596/2014 ("MAR").