The Difference Between Legal Lending and Litigation Finance
Far too often, a lack of resources is the biggest hurdle for those seeking justice. While everyone is equal in the eyes of the law, the sheer cost of litigation can limit access to representation to only a minority of plaintiffs.
Closing this funding gap has created an attractive asset class for sophisticated investors. Hedge funds, family offices and high net worth individuals can now directly lend to law firms or finance specific cases to help plaintiffs pursue justice. In return, these investors may enjoy a return that is both more lucrative and more insulated from the global economy. Litigation Finance is a truly alternative asset that is uncorrelated to the general investment market.
Below is an overview of this growing niche alternative, as well as a comparison between two strategies that we are deploying in the space.
THE FUNDING GAP
There are over 435,846 law firms in the United States alone. Ranging from sole practitioners to full-service legal firms, these service providers are part of a market that is estimated to be worth $313 billion this year. That makes the legal services industry comparable in size to the utilities or mining sector in the United States.
However, law firms and litigation are rarely on the radar of investors who target utility stocks or mining rights for fixed income, despite litigation often being as capital-intensive as purchasing mining equipment or constructing a power plant. The average Fortune 200 company spent over $115 million annually on litigation. In 2016, the U.S. spent 2.3% of its total GDP on litigation, far higher than any other nation.
The fact that the market is huge, expanding, and overlooked creates an opportunity for savvy investors. The legal system is uncorrelated with the rest of the economy. Pending suits and cases go on regardless of recessions. In fact, court cases spike when the economy dips. The number of cases in New York skyrocketed shortly after the 2008 financial crisis.
This can make litigation funding an appealing asset class for investors looking to boost their returns while diversifying their portfolio away from traditional assets. There is some correlation in a major recession in the event that the defendants are unable to pay awards won against them, but this is a very low correlation if proper defendant credit analysis is done prior to funding.
LEGAL LENDING VS. LITIGATION FINANCING
The Litigation Funding industry has matured in recent years to provide investors two paths for funding justice. Investors can choose to fund individual lawsuits directly or finance the law firm itself. The former is known as “Litigation Finance,” while the latter is what we call “Legal Lending.” The differences in structure determine the payout and level of risk.
Litigation Financing is based on the merits of a specific lawsuit. The financier agrees to bankroll the litigation process and help the case move through the court system until a verdict is declared or the case is settled. If the case is won or settled for a fee, the financier receives a portion of the settlement payout.
Of course, this strategy can be risky. The case may languish in court for several years or the plaintiff may lose. A detailed analysis of the underlying case merits, as well as the psychology of the counterparties (to determine the likelihood of a settlement) and the creditworthiness of the defendant must be undertaken. It is generally advisable to build portfolios of cases, spread across jurisdiction, counterparties, litigating law firms, core point of law, and other factors to minimize correlation and risk.
These investments are generally structured as loans, with returns that are based on the greater of an interest rate or a percentage of the proceeds received by the plaintiff, often subject to a cap on the total proceeds to ensure that the plaintiff still receives a substantial portion of any successful outcome.
Gross returns across a portfolio are typically in the 30-40% annualized IRR range. This seems very attractive at first, but the downsides of Litigation Finance are evident in that the average net return falls to the high-teens for most litigation finance funds.
The reason for this decline in return is driven by an issue with cash utilization. Sufficient funding must be made available to take the case through the entire court process, but the majority of such costs are incurred during the actual court hearing. Most commercial cases settle rather than being decided in court, which means that only a small portion (on average 40-50%) of capital committed is ever drawn. In addition, the capital drawn is skewed towards the later stages of the case cycle, meaning that the average duration of capital draw on a 5-7 year commitment may only be 1.5-2.5 years.
The end result is an attractive, uncorrelated net return, but the ability to craft a diversified portfolio and manage the cash utilization efficiently can be more challenging.
By comparison, Legal Lending is a form of private credit offered to a law firm to allow them to run their business or take on particular cases. The loans are generally secured by the assets of the law firm, most of which are in the form of billing receivables.
This form of litigation funding is most prevalent in the United States, where law firms are much more likely than their peers in other countries (both due to regulatory and cultural reasons) to take cases on contingency where they must bear the costs of building the cases.
In effect, the law firms are undertaking the litigation finance of the cases themselves, and are financing part of this by borrowing from a legal lender.
The benefits of this from an investor’s standpoint are multiple. The loans are typically done at Loan to Values of 20-30% as compared to 100% in litigation finance. This means that there is far lower risk as the loss of any one case (in a properly diversified security pool) is unlikely to impact the investor’s return negatively.
In addition, these types of investments do not have the cash utilization problem described above. The loans are typically drawn fully upfront, though they can also be done in stages.
The evaluation of the cases is also easier in this format, as the borrower law firms act effectively as the first layer of evaluation. They are taking the equity risk of the cases, and they are best placed to determine the true value as they are working on them every day. The lender must still evaluate the underlying collateral, but with such a large loan-to-value cushion, plus the knowledge that the litigating law firm is fully aligned with the lender, makes the quality of the collateral greater and more easily evaluated.
Though private credit has attracted an immense amount of assets over the past decade, the increase in capital supply in this niche has been strongly outpaced by demand.
The ability to maintain strong covenants and reasonable LTVs has allowed default rates to be only ~2% since 2010, while the average interest charged results in net investor returns of 14-16%.
BENEFITS OF LEGAL LENDING
Legal Lending is akin to receivables factoring, albeit requiring more diligence on the quality of the underlying receivables. It offers far higher return potential than receivables factoring or other asset backed lending. Its return competes favourably with unsecured and, mezzanine loans, but with far lower risk due to the strong asset backing and low LTVs.
Since most law firms handle several cases simultaneously, their streams of income tend to be diversified well across cases, and reasonably across case type or key point of law.
Interest rates are typically in the 17%- 23% range, exceeding most other forms of secured private credit. In addition, many legal loans begin repayment in 1 year, and are fully repaid within 3 years, making them more liquid and shorter duration than most private credit that offers double digit returns.
Furthermore, the investment is uncorrelated to the general market, providing diversification for investment portfolios and an attractive opportunity in this volatile part of the investment market cycle.
THE HEIRLOOM LEGAL LENDING FUND
In this unprecedented time, investors are encouraged to de-risk their portfolios with investments that are uncorrelated to traditional asset classes and have additional security in the form of hard asset backing or otherwise.
Heirloom provides loans to US law firms, secured by a diverse portfolio of client receivables and backed by the assets of the law firm, and often by personal guarantees from the equity partners.
The Heirloom Legal Lending Fund is managed by Heirloom, co-investing alongside it into this strategy, and providing family offices, individual investors and their advisors with access to this attractive, but hard-to-access strategy.
Heirloom’s Legal Lending focus is on mid-sized ($5 –$50mm) loans where little lending competition exists. We have identified a pipeline of ~$200mm of attractive loan opportunities to compose a diversified portfolio of the best opportunities based on underlying case type and counterparties. Deploying against these opportunities is arguably the most experienced legal lending team, including Heirloom principals, advisors, collateral evaluators, loan servicers and legal counsel.
(If you would like to speak with someone at Heirloom to discuss the ideas presented here, or to learn more about the Heirloom Legal Lending Fund, please contact Beth at firstname.lastname@example.org.)
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[i] McKinsey & Company. “From Big to Great”.