Hulk Hogan needed more than 24 inch biceps to beat the deep pockets of modern media.
As the celebrity professional wrestler’s invasion of privacy suit against gossip site Gawker progressed, Hogan’s financial limitations nearly put an end to the trial. When the plaintiff appeared close to settling, Peter Thiel, successful entrepreneur and co-founder of Paypal, emerged as a white knight, bankrolling Hogan with $10 million to pursue the litigation. With deep pockets, Hogan was able to ride out the case, ultimately winning $140 million and forcing Gawker into bankruptcy.
As this case showed, even presumably high net worth individuals can benefit from tapping outside sources of capital to fund their legal cases. Litigation financing levels the legal playing fields so that David can battle Goliath. And Thiel isn’t the only high profile investor to finance lawsuits: pop sensation Taylor Swift recently provided financial assistance to fellow performer Kesha
thorough a protracted contract dispute. These examples of litigation financing may have been driven by social justice and not ROI, but there’s a whole field of financing that views litigations as ripe opportunities for investment.
The old-school litigation finance market
Around 6 years ago, I was living in Los Angeles and investing in small businesses. A broker pitched me on investing in personal injury lawsuits. He explained that his company fronted plaintiffs cash to be used for living expenses while their lawsuit progressed. Through the investment, his company purchased a portion of the settlement, with terms negotiated on a case-by-case basis.
I chose not to invest in the company for a variety of reasons, but my eyes were opened to this alternative form of investment. The industry’s growth since my meeting is impressive: the litigation financing market was estimated to be $1 billion in 2011, and since then, 4 times as many law firms have participated in litigation finance, according to a report from Burford Capital, an active investor in the space.
Third party litigation funders are divided into two groups. The small players are individuals like my buddy who pitched me -- they're small business owners or individual investors who fund cases on a deal by deal basis. Most of their cases are personal injury lawsuits — you may catch their commercials while watching high-quality early afternoon TV shows like Maury Povich and Jerry Springer.
Funders invest between 10%-15% of the litigation’s expected future value, and plaintiffs use funds as bridge loans to pay for bills and expenses they incur during the lifetime of the trial. Successful litigations of these sorts are typically worth less that $100k, and plaintiffs are charged interest by their financiers, to be paid out of the winnings. Return profiles differ on a case-by-case basis and of course are affected by the size and scope of the trial, but it's not uncommon for investors in litigation financings of these sorts to see returns between 30%-40% annualized, according to Josh Schwadron, CEO of Mighty, a software firm that services litigation financiers.
On top of the litigation finance food chain are investment houses that back corporations in need of liquidity for legal expenses. Funders deal with the plaintiff directly or through lawyers working on contingency, and usually invest a minimum of $2 million, according to Burford Capital. Unlike personal injury cases, funds invested go directly to legal fees.
The largest fish in the litigation finance pond, Burford Capital, has raised over $500 million for these types of investments. To manage its risk and identify investment opportunities that on average receive $10 million per case, Burford employs a 5 stage vetting process, including legal and economic assessments of the litigation, multiple presentations to investment committees, and evaluations of outcomes and settlement prospects. The UK-based firm rejects the majority of the cases it reviews. This process must be working: recent financial filings show that the company claims an impressive 60% net ROI on its litigation finance portfolio.
Investors in litigation finance like the lack of correlation to other markets, according to Jay Greenberg, CEO of litigation finance platform, LexShares. Litigations exist in an economic vacuum, and changes in interest rates, currency values, and housing prices don’t seem to have an effect on court proceedings. Also, investors like the natural exit and liquidity - the average case lasts around 28 months, giving the investment a short-term life cycle. Finally, individuals with legal expertise, like attorneys, are able to convert their experiences into profits, passively observing court cases from the back of a courtroom.
"Attorneys have expertise that can help them become good lawyers, but outside of their primary business, they can’t leverage their expertise," said Mighty's Schwadron. "Now for the first time through litigation finance, they have the ability to make money off an expertise they have.
Until now, all sizes of litigation financing investments have been reserved for those close to the legal system. Just like most secondary market investments, litigation funders need to know a guy, who knows a guy…who knows a guy. But with new startups emerging, the market for investing in litigation finance is opening to everyone.
Fintech brings technology to litigation finance
Litigation finance remains more focused on sourcing quality cases than technological advances. But there are fintech startups trying to bring this industry into the 21st century. Founded in 2015, Mighty originally acted as a 3rd party funding platform for personal injury cases, but eventually pivoted to service professionals and organizations in the litigation finance industry, helping small individual funders organize and optimize investments with its software.
Lexshares is a crowdfunding platform for litigation funding, focusing on litigations between $100K and $1M in value. Founded in 2014 and with offices in New York and Boston, Lexshares attempts to strike balance between advice and guidance when investors use their platform.
Investors using the Lexshares platform don't always have a legal background. In order to properly educate users, Lexshares provides its case-analysis to investors. Using a vetting process similar to Burford Capital’s 5 point checklist, Lexshares analyzes prospective cases applying for funding and approves only 4% of litigations for investment. When a potential investor accesses investments on the startup’s platform, he can review the findings of the underwriting team, including a case's background and details, relevant court documents, and actual pleadings. An investor with a legal perspective can choose to read all the nitty-gritty documentation, and if not, he can use the findings of the Lexshares' vetting committee to help make an investment decision.
The magnitude of the Hogan/Gawker case brought litigation financing into the general public’s eye, and Lexshares CEO Jay Greenberg has seen an uptick in investors since Peter Thiel got involved. “Funds have been taking advantage of litigation financing behind opacity,” Mr. Greenberg remarked. "This is the first time investors are able to participate in the asset class."
So far, investors on Lexshares have funded 13 cases, 11 of which are awaiting resolution. Two cases were settled in under a year, netting 93% and 88% IRR on a tiny sample size -- great for returns but not for capital gains taxes (which should be any investors worst problem). Lexshares monetizes in a similar fashion as a hedge fund, taking 20% of profits from investors (after principal is paid back), and between 5-10% from plaintiffs for raising funds.
An investment with hair on it
Litigation financing claims big yields and IRRs, but the investment isn’t all sunshine and moonbeams. For anyone with a basic understanding of economics, high yields come with high risks - it’s the same reason why mortgage rates are so low and student loan rates are so high. The risks that come with yields as high as a 60% return on capital and 93% IRR are not negligible.
Investors should consider the actual litigation -- settlements can give a high yield in a short amount of time, but they aren’t gimmies anymore. “Insurance companies are much less interested in quick settlements than they used to be and will often run the clock at the expense of claimants and those funding them,” said Ethan Benovitz, partner at NY based investment firm Genesis Capital Advisors, A longer litigation also puts pressure on the plaintiff to settle for less money, affecting investor yields. Mr. Benovitz agrees: “Many risks associated with delays and extensions of timelines for settlement or resolution can impact rates of return measurably,” he wrote in an email exchange with Tradestreaming.
Investors also have to contend with the binary nature of litigation finance. Just like being a little pregnant, you can’t win a little of a court case -- you either win or lose. Unlike a real estate or business investment, there aren't assets to sell off if the deal goes south. Money fronted to plaintiffs is non-recourse, eliminating any chance for a claw-back in the event of a loss.
Some investors feel uncomfortable profiting off of someone’s (or something)’s loss. The social aspects of investing in litigation finance may turn some investors away.
Proponents of litigation financing embrace the social aspect of helping the little guy seek justice, while simultaneously pulling in a nice yield. Others would say investors are taking advantage of the legal system, and that investments are too binary and risky. Either way you look at it, fintech companies have brought litigation financing out of the shadows, and investors can chose if they want to participate or not. The fact that investors have more access and choices helps keep it real in the investment marketplace.
It will be interesting to see if litigation financing becomes more mainstream or if it continues as a peripheral alternative investment. The jury’s still out, and only time and dollars will give the marketplace a true verdict.