Finance And Law: Returns To Litigation Finance Investments

Returns to litigation finance appear to be extraordinarily high, but options for investing are limited.

gavel money litigation financeThe law is very lucrative. Most people think of the business of law as being about having a career as an attorney. And that can be a lucrative and rewarding field in some cases, but like any career, it varies greatly from person to person. Yet the law is lucrative in an entirely different way – as an investment opportunity set. Based on quantitative research I have done, quantitatively screened investments in litigation financing can return between 29.4% and 43.2% annually, with an average annual return of about 36%. The key to higher returns is selecting lawsuit investments with key characteristics that mark them as effective investments. And thanks to a variety of modern innovations in finance and the law, investors can access litigation markets in ways that were not possible even a decade ago.

Like any investment, lawsuits require an upfront investment in exchange for an uncertain payoff down the road. Lawsuits, in other words, offer the same basic type of structure as stocks, bonds, or options. The distinction, of course, is that lawsuits are generally binary outcomes – the suit either ends favorably or it doesn’t. If the investor’s side of the lawsuit loses, then the money is generally gone completely. In contrast, stocks that decline in value or even bonds from companies that default usually have some sort of payout at the end. Lawsuits in that respect share significant similarities to equity options.

On the positive side, in exchange for this skewness, litigation funding investments have several significant benefits for investors. First, litigation returns are mostly uncorrelated to U.S. stocks returns. There are arguments to be made about the correlations of lawsuit returns to U.S. stock returns – perhaps most persuasively, litigation in economic recessions becomes comparatively more expensive as corporate cash becomes tight. As a result, it is possible that only the most meritorious claims survive the litigation process in a recession. On the other hand, one might argue that juries are less inclined to award large cash settlements in recessions or that companies are less inclined to settle and face short-term settlement payout costs in a recession. Regardless, there is limited quantitative evidence to support the view of these correlations in either direction. The quantitative evidence does suggest that any correlation with traditional equity returns is weak at best, though.

Second, and perhaps more importantly to investors, the returns to litigation finance appear to be extraordinarily high based on the quantitative research I have done. My best estimate using proprietary data gathered from across the country is that returns on lawsuits feature roughly a 36% rate of return. That figure is broadly consistent with the limited publicly available data found in reports, filings, and investor call transcripts from the few publicly traded litigation finance firms. Litigation finance – like venture capital, real asset investment, select reinsurance investments, and a few other specialties – is insulated from much of the rest of the investment world. This opacity and the associated lack of liquidity leads to significantly higher investment returns than comparable widely available liquid alts.

Investors looking for litigation investment options have unfortunately few options. Lexshares and Mighty are both online litigation funding platforms that aim to revolutionize the space, but they face some significant hurdles in that quest, based on my empirical research. Larger firms like Burford are publicly traded in some cases – but not in the U.S. Based on conversations with various litigation finance firms, there are specific reasons for that investment structure, and it’s unlikely U.S. investors will see publicly traded litigation finance companies anytime soon. Wealthy investors can access litigation finance through select hedge funds, but those aren’t available in 40 Act compliant structures to my knowledge. The only other option is direct investment in one of the various small firms that are looking to target new areas of the litigation finance space but aren’t large enough to seek institutional capital yet.

Regardless of which vehicle is right for various investors from Burford to Lexshares, this is clearly a space that any investor with an interest in the law and a desire for superior returns should be examining closely. The law has rarely looked so lucrative.

Future columns will explore the issues of debt versus equity participation in litigation funding, portfolio investments versus individual investments, and the role of litigation finance brokers. Stay tuned.

Sponsored

(Given the popularity of my last column on this topic and the number of questions I received, again please feel free to email me with questions or comments, good or bad. I can be reached at M.McDonald@MorningInvestmentsCT.com)

Earlier: Finance And Law: How Does Litigation Finance Influence Attorneys?


Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at M.McDonald@MorningInvestmentsCT.com.

Sponsored