Courting success: litigation funding a fresh alternative to stock market
Returns are uncorrelated to share moves and prevailing economic conditions
Fears of a stock market bubble and severe correction are troubling investors, not least because of the retail investors piling into the market. But if not equities and the stock market, where can investors expect to find a credible return?
One asset class gaining traction in SA is litigation funding, because the returns are uncorrelated to the stock market and prevailing economic conditions. While already fairly well established in European and US markets, litigation funding is still quite new to our shores.
Litigation funding occurs when a third party, with no direct interest in a legal case, finances the legal costs in return for a share of the claim proceeds if successful. This form of finance allows proceedings to be pursued that otherwise would be hindered by a claimant’s lack of funds.
Viewed from the perspective of a funder, litigation provides a uniquely attractive investment proposition. The litigation funding asset class offers a high-alpha/low-beta risk-return profile, which is invaluable in enhancing a portfolio’s asset allocation composition.
The litigation funding asset class is well established globally, with the UK, US and Australia accounting for more than half of all international investments. There is no central database but estimates value the global market at $50bn-$100bn, with an annual growth rate of about 40% over the last decade.
In SA, the litigation finance market is still in its infancy. However, with a large commercial sector and well-established justice system, the room for growth is significant. Taurus Capital is the pioneer of this asset class locally, having raised the country’s first dedicated litigation fund of R80m to pursue litigation investments on a pooled basis. This vehicle allows investors the opportunity to gain exposure to a diversified portfolio of cases, mitigating the risk of losses on any single matter.
A key feature of the litigation funding asset class is the asymmetrical return profile — the gain potential in a win scenario is far greater than the possible loss. Assume a lawsuit requires R10m in legal costs and in return would pay the funder R30m if the case is successful, or a R10m capital loss in the event of failure. If the odds of winning or losing are 50-50, the probability-weighted outcomes are as follows: probability-weighted loss: R5m (50% of R10m); probability-weighted win R15m (50% of R30m); expected return R10m (R15m minus R5m).
While the above example assumes a 50% win ratio, a professional litigation funder will perform significant legal due diligence on a case before investing to ensure they back cases with strong legal merits and thus higher prospects of success. It is thus not uncommon for investors to double, triple or quadruple their initial investment. This is clearly an attractive return for sophisticated investors such as family offices, high net-worth individuals or hedge funds, which are paid to take risks methodically and calculatedly.
While some cases can provide investors with unusually high returns, success is not guaranteed. Funding is typically structured on a non-recourse basis — the recipient has no obligation to pay the funder if a case resolves unsuccessfully. The litigation asset class is thus inappropriate for investors who cannot afford capital losses. Many litigation funds also have significant minimum investment sizes, making them inaccessible to small retail investors.
Most traditional asset classes — including bonds, equities and cash — generate returns based on underlying economic factors such as interest rates, inflation, employment and GDP. Even the so-called “alternative asset classes” are still heavily influenced by market vagaries and sentiment. It is thus difficult to find truly uncorrelated assets that can deliver genuine diversification to an asset portfolio.
Litigation finance is unique. Returns are generated by legal intricacies and idiosyncratic factors influencing the underlying merits of a case. A court’s adjudication of a plaintiff’s claim is based on the specific facts in the matter, judicial precedent and common law jurisprudence. There is thus no inherent correlation between investment returns and, say, the JSE, rand-dollar exchange rate or gold price.
The litigation funding asset class is defined as having a medium-term time horizon, as commercial disputes can take three to five years to reach final judgment. While there is often the prospect of an early settlement, investors need to be prepared for procedural delays and appeals through the court process, which can serve to extend the investment period.
What sets litigation financing apart from other alternative asset classes is that every lawsuit will eventually resolve through settlement or adjudication. This inevitable realisation event is different to private equity, for example, which requires an initial public offering or sale to exit the investment.
The fee structure of litigation funds is often similar to that of private equity, with a smaller management fee to cover the highly specialised and labour-intensive upfront case evaluation and investment structuring process. Most management compensation comes from a so-called “carry”, which ensures incentives are aligned and investors only pay for demonstrable outperformance.
What remains is for the astute and prolific investor to assess whether they can afford not to invest in this burgeoning niche, which remains highly active in terms of demand from funding recipients.
• Smadja is CEO of litigation financier Taurus Capital.
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