Litigation Finance: Interview With A Funder
How does a litigation financier value a legal claim? And other mysteries revealed.
I’m taking a break from my normal column this week and doing something a bit different. A few readers asked me questions recently about the status quo for various aspects of the litigation finance industry. Rather than give my own take on these issues, I decided to interview someone who actually works in the industry — Lee Drucker, co-founder of Lake Whillans — and get his take. (The following is edited for brevity and clarity in places.)
Michael McDonald: Your firm has a heavy focus on valuation and using a systematic approach to valuing investments. That’s something that I feel is a bit abnormal in the industry today. Many industry participants have even said that legal claims cannot be systematically valued effectively. So how do you value litigation finance investments that come your way?
Lee Drucker: When valuing a legal claim, we are interested in assessing four key aspects of the asset:
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Likely Duration of the Litigation Process
The shorter the likely duration, the more valuable the litigation asset. We invest in claims at all stages of the litigation process, from pre-filing to the eve of trial to post-judgment. Factors that affect the likely duration include (i) the stage of the litigation at the time financing is sought; (ii) the case schedule; (iii) the practices of the presiding judge and/or jurisdiction; (iv) the likely outcome and duration of any appeals; and (v) the complexity of the subject matter.
Damages to Investment Ratio
Generally, the greater the likely damages, the more valuable the claim and the smaller the percentage of proceeds that will be needed in consideration of the investment. Many litigations are embedded with multiple claims, each with a different model of damages and likelihood of success. In such scenarios, we will work to structure an investment that balances our returns with the various potential outcomes.
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Probability of Success on the Merits
Litigation is inherently uncertain. Each side has its own story, which may or may not be fully revealed until trial. Discovery may provide new information unavailable at the outset of a case. Witnesses may perform well or poorly. Judges or juries may act in unanticipated manners. We therefore believe that the probability of success for any individual claim ranges from 20% to 80%. While handicapping the precise probability of success can be difficult, we invest only in claims to which we assign a probability of success of 60% or greater, meaning that our analysis at the time of investment shows that the party that we are financing has the better of the arguments at issue. The more information available to establish liability and damages, the more valuable the claim and the better pricing a claimholder can expect to receive. Factors that increase the likelihood of success include (i) documentary evidence supporting the case narrative and damages; (ii) strong witnesses; and (iii) favorable discovery.
Other Variables
Some litigations present additional risk factors such as collection risk (if the defendant is domiciled in an unfavorable jurisdiction) or economic risk (if the defendant’s financial position is questionable), which may affect the pricing of the litigation asset.
MM: That’s very interesting. Now of course the challenge in applying that methodology even more broadly is getting the right data to create a systematic valuation approach. There are ways around that, of course – surveys, web scraping with Python or something similar, etc. – but let’s leave that for another day.
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Let’s talk about opportunities in the industry. What do you think the biggest opportunities in the space are right now?
Lee Drucker (Lake Whillans)
LD: The litigation finance industry in the U.S. is a green field. At Lake Whillans, we are focused on measured growth. Building a business that is a valued and integrated member of the legal community remains the biggest opportunity in litigation finance.
McDonald: So the industry is still very wide open. Let’s talk about risk then. How do you measure risk in your litigation portfolio? What type of statistics are you reporting to your investors? Do you think the risk/return statistics that are used in other branches of finance are equally apropos in litigation funding, or are new metrics needed here analogous to the evolution in hedge fund statistics that we have seen over time?
LD: Many risk/return statistics that are used in other branches of finance do not translate well when applied to legal claims. The Sharpe Ratio (the industry standard for calculating risk-adjusted return), for example, loses meaning when there is virtually no correlation among the assets in a portfolio (as the number of assets in the portfolio increases, the standard deviation of the portfolio approaches zero).
I am not sure what new statistics should or will emerge to better evaluate the performance of litigation funders. If you believe, as I do, that legal claims are a largely uncorrelated asset, then perhaps the performance of a portfolio of legal claims should be directly compared to the risk-free rate?
MM: I certainly agree with you that traditional financial statistics cannot be directly applied and that new metrics are needed. That is an opportunity in the space, and I believe standardization will help bring in new investment, which in turn will lower cost of capital. Speaking of risks, though, what type of deal covenants do you put in place to avoid adverse selection problems?
LD: None. We thoroughly underwrite each opportunity, and rely on that analysis to make an investment. While there is a movement in the industry to require a unilateral right to prematurely exit an investment based on any reevaluation of the merits of a claim, that is something that Lake Whillans will not be engaged in.
MM: OK, fair enough – the industry is certainly still evolving, and it will be interesting to see what covenants if any become standard in the future. Now how about benchmarks — how should investors think about benchmarks for litigation funding firms? What benchmarks do you use, and what makes those benchmarks appropriate?
LD: We do not use benchmarks. As I noted before, I think there is an argument for benchmarking against the risk-free rate. If you zero out beta in the CAPM model, the risk-free rate is what is left.
MM: Wow, I’m surprised to hear that you don’t use benchmarks. Your point regarding the risk free rate vis-a-via the CAPM is notable, though. Again, it will be interesting to see how this aspect of the industry changes over time.
Anyway, thanks for your time, and I really appreciate your willingness to talk about your firm. I look forward to hearing about Lake Whillans’s continued success.
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.
