4 September 2011
Third-party funders of corporate litigation may be waiting longer for their investments to pay off, but they are finding the returns are a whole lot healthier. Paul Sullivan reports
Corporate claims financing took off in the UK in late 2007. At the time commentators hailed the creation of a new asset class enabling investors to profit from the expensive, complex and high-risk world of commercial legal disputes.
But the real change that quoted corporate claims financiers brought to legal markets was a disciplined focus on litigation as an investment, only committing capital to those cases from which high-quality returns could be realised.
The concept of third-party finance for corporate litigants has long been a part of the legal system. Before corporate claims finance arrived businesses were able to fund litigation through traditional mechanisms such as bank debt and collateralised loans; lawyers acting under alternative fee arrangements that provided a form of third-party funding; and liability insurers that offered policies enabling companies to hedge litigation risks.
Sophisticated businesses understand that lawsuits are valuable corporate assets - or liabilities - that require substantial financing and that many third-party funding options exist. The growth of the corporate claims finance market in complex business-to-business litigation since 2007 demonstrates the value these companies place on the third-party option.
But the growth of the corporate claims finance market is part of a broader set of trends shaping the business of law, including rising demand for alternative fee arrangements in the US, alternative business structures in the UK, the increased availability of after-the-event insurance in both, the rocketing expense of commercial litigation and the slow progress of complex commercial cases through the courts.
The growth of corporate claims finance was also affected by the 2008-09 downturn, which created more demand for third-party finance from businesses and law firms of
all sizes. As credit conditions tightened companies sought to hedge risk and cut their expenses, including litigation costs.
Some of this demand was absorbed by law firms, but they too faced capital constraints. In this environment corporate claims finance provided a more attractive solution, allowing companies to obtain financing secured only by the proceeds of a lawsuit rather than their assets generally, freeing up valuable cashflow for core business activities.
But while the demand for financing increased, the credit crunch tended to slow the pace of litigation settlements. This was driven by a number of factors, including reduced funding for the court system, resulting in congested civil court dockets; a bottleneck in the appointment of judges in the US after the Senate’s failure to fill 114 vacancies in the federal judiciary; and greater reluctance by defendants to settle in a period of increased risk and uncertainty.
Carefully does it
In the past 18 months several potential new entrants have tried and failed to raise funds to invest in litigation. Capital markets continue to face significant constraints as the focus on sovereign debt pushes up yields, making both debt and equity investors cautious. This situation presents corporate claims financiers with two big challenges.
The first involves their existing portfolios, largely invested in US claims, where the sclerotic pace of the US judicial system has extended the time horizon for investments, delaying potential returns and reducing the quantity of investment capital available to invest in new situations.
As the same time financiers have been inundated with investment opportunities as demand for capital has increased. Many of these opportunities exhibit heightened levels of risk, particularly in terms of time to return on capital.
To address this, corporate claims financiers have employed more demanding underwriting and valuation standards when selecting new investments and stepped up their monitoring of existing investments. As a result, while the overall number of corporate claims investments has increased, an even greater proportion of cases have failed to make the cut.
The next 18 months are set to be an exciting time as portfolios mature and investors evaluate the sector’s investment thesis. The prospect of significant settlement and litigation activity in investment portfolios is increasing despite the lingering effects of the credit crunch and the continuing sovereign debt crisis.
Demand for capital remains high as sophisticated companies seek solutions to the rising expense and risk of large and complex commercial litigation. Finance providers will increasingly evaluate opportunities using underwriting and valuation guidelines that take into account the effect of external factors, especially macroeconomic trends, on the likely progress and eventual resolution of the litigation itself.
The good news for investors is that, if the underlying cases on which investments are based are successful, the longer holding period is expected to deliver greater returns to shareholders as settlement values increase and risk turns in plaintiffs’ favour as cases mature.
Paul Sullivan is senior vice-president at Juridica Capital Management