What is litigation financing?
Litigation financing, also known as third-party funding, is a mechanism by which a third party (the funder) provides funds to a party, usually the plaintiff in the context of a dispute, in exchange for a portion of the amount eventually recovered in the proceeding. Generally, this type of financing is non-recourse, meaning that the plaintiff only has to pay the funder if their claim succeeds.
Although this mechanism has existed for decades, it has only recently transitioned from being a relatively unknown investment product to becoming an asset class that has sparked significant interest among venture capital investors who see it as a new investment opportunity, as well as the possibility of financing the litigation of companies in their investment portfolios.
In its early days, investments in individual cases were relatively small and were mainly funded by high-net-worth individuals or asset managers using capital from family and friends. While these agreements still exist, the sector has matured and is increasingly attractive to a much broader market. Many litigation financing funds are now structured as venture capital funds or hedge funds, with two main functions: raising capital and investing that capital in litigation.
With the help of private fund investment vehicles, funders have managed to secure substantial amounts of capital. This level of capital has transformed the sector from occasional litigation funding to investments in larger portfolios. Although there is no precise information on the current size of the global litigation financing market available, according to a study published by Deminor in 2022, the investment potential was estimated to be $11.2 billion. Deminor also predicts that this potential will continue to grow, especially in Europe and Asia.
The benefits of litigation financing
Litigation financing is not just a mechanism for parties facing economic difficulties; it is also a very interesting alternative for parties with sufficient resources who wish to allocate capital that would otherwise be spent on legal fees to other areas of their business. Additionally, the use of this type of financing helps companies mitigate their risks, as in the event of an unfavourable judgment in litigation, they incur no costs, and any adverse cost award may be covered by an insurance policy that is usually part of the financing package. Therefore, the benefits of this mechanism can be summarised as follows:
- Maintenance and acquisition of liquidity: Clients obtaining this type of financing avoid having to use their own funds for the pursuit of litigation, on which there is uncertainty about the outcome and the time it will take to collect a potentially favourable judgment. Thus, it is an interesting mechanism for maintaining the company's liquidity. Additionally, clients also have the option to monetise their proceedings before obtaining a favourable judgment, allowing them to obtain liquidity in advance.
- Risk mitigation: Litigation costs are considered expenses on companies' balance sheets. Litigation financing allows companies to mitigate a legal risk on the balance sheet and transform litigation into a financial asset that could generate income without using their own resources to achieve it. Furthermore, the risk of obtaining an adverse cost award can also be mitigated.
Differences and similarities between venture capital investment and litigation financing
In general, the returns sought by litigation funders range from around 10% to 35% of the amount recovered in litigation (depending on the amount of the claim) or, if the remuneration is calculated based on multiples of the investment, between two to four times the investment made by the funder (once the investment is recovered). Remuneration (percentage or multiple) can also be adapted to the duration of the legal process.
On the other hand, there is less volatility associated with this asset class because the viability and performance of litigation depend on each specific case and are not subject to the whims of the financial market. The success or failure of a lawsuit and the monetisation of an asset essentially depend on the legal and economic aspects of the case and the execution of the judgment or award (if necessary).
These factors eliminate exposure to broader financial concerns linked to the economy or market performance. Therefore, it is not surprising that institutional investors have invested in this asset class in recent years.
However, there are also similarities between venture capital and litigation investments. Specifically, both the due diligence process carried out to assess these types of investments and the economic parameters used in both cases are similar.
Types of cases: post- M&A disputes
In general, issues typically viable for funding include arbitration (national, international, investment, and commercial) and litigation, including consumer class actions, disputes related to environmental issues, economic competition issues, commercial litigation, and other business disputes.
It is also very common for disputes to arise post-M&A, particularly contractual disputes and those related to price and valuation calculations. In particular, the most frequent disputes that typically arise are related to, among other things:
- Post-closing adjustments based on calculations of working capital and net equity.
- Calculation of price adjustments conditional on future performance.
- Quantification and valuation of assets, liabilities, or balance reserves.
- Pre-closing adjustments and indicators.
- Claims for damages for loss of profits.
- Evaluation of the possibility of a "material adverse change" occurring.
- Valuation given to shareholders.
- Breaches of representations and warranties.
These types of disputes often fit into litigation financing or purchase mechanisms. Many times, clients find themselves facing litigation arising from M&A transactions, leading them to make additional fund disbursements once the deals have been closed. In these circumstances, litigation financing or litigation purchasing presents itself as a very interesting option to avoid incurring higher costs or to receive in advance the amounts that could eventually be recovered in the event of a favourable outcome in a judicial or arbitral proceeding.
Financing or purchase of portfolios
Clients with a high volume of litigation can benefit from financing a portfolio of cases. Portfolios usually consist of three or more cases; however, there is no maximum limit on the number of cases that can be grouped and financed within a portfolio. Financing portfolios offer the same benefits as financing a single case, with additional advantages of economies of scale, risk diversification, and access to a larger pool of capital.
Moreover, funders can also finance law firms' portfolios in a specific practice area. Instead of covering legal fees for a specific case, large sums of money can be deployed to cover multiple existing and even future matters.
In many cases, the portfolio of funded cases will have cross-collateralization to protect investors from the risk of one or more cases not being profitable. These types of agreements are often beneficial for all parties involved: plaintiffs receive funding for their cases, law firms can work on the cases while receiving total or partial compensation for their services, regardless of the outcome, and investors are more likely to achieve higher returns while minimising the risk of losses.
Some funders even offer credit solutions to these law firms, providing credits based on a group of secured cases instead of making a capital investment. The result for investors is a high-yield credit operation with minimal risk of default or loss, given the value of the secured assets in relation to the granted credit. Institutional investors (such as pension funds and university endowments) are the latest to join the litigation financing model and often contribute significant capital to litigation financing funds. This type of investment fulfils many of the requirements that investors seek when allocating capital to alternative asset classes.
Founded in 1990, Deminor is a leading international litigation financing company with offices in Brussels, London, Hamburg, Stockholm, New York, Hong Kong, Madrid, Milan, and Luxembourg.
Deminor's international profile (19 different nationalities and the ability to work in 22 languages) has allowed us to finance cases in 21 jurisdictions so far. Specifically, Deminor has achieved positive recoveries for clients in over 80% of the cases it has funded, compared to an industry average of 70%.
In addition to financing individual commercial litigations, Deminor originates and finances group actions. In 2018, Deminor played a crucial role in achieving the largest settlement in European history (1.3 billion euros in the Fortis case). Likewise, we were the first funder to support class actions in Italy, and in 2017, we reached a historic settlement in the Olympus case in Japan, representing the highest recovery so far achieved by non-Japanese investors.
Deminor is immensely proud of its diverse client base, which includes some of the most innovative and entrepreneurial companies in the world, as well as leading public and private pension funds, asset managers, and sovereign wealth funds. Of the top ten investors in the world, four are recurring clients of Deminor.
Written on January 15, 2024 by
Senior Legal Counsel & Head of Madrid Office
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