Picking Litigation Finance Fund Managers
The mutual fund industry has something to teach investors in the litigation finance space.
There is a long history in finance of investors trying different methods to select the best mutual fund managers. The theory is that if an investment manager has skill, then he can provide value to investors through his investment selections. The same premise applies to litigation funds and the selection of meritorious cases. And the broader mutual fund industry has something to teach investors in the litigation finance space.
In the mutual fund world, investors have been trying to pick the right managers for decades. Bill Miller, Peter Lynch, Bill Gross, and a host of other Wall Street names all built their reputations around successful stock picking, and fund firms like Legg Mason and Pimco prospered as a result of their purported prowess.
The first lesson for litigation finance funds, then, is that having an all-star fund manager can be very good for the overall business. It certainly creates key-man risk, as Pimco discovered when Bill Gross left, but the fact remains that when attracting investors, reputation matters. Companies also went out of their way to appeal as prospective investments to managers like Gross and Miller because the firms realized that if Bill Miller was seen to invest in Company XYZ, many other investors would surely follow.
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Litigation fund managers that want to grow their businesses should bear that parallel in mind. Establishing your fund manager as a superstar can help bring in investors and potential investments. Investors and prospective investments herd to a select few funds.
Establishing a fund’s manager as a superstar requires two things – performance and a good story. All of the legendary investors from Lynch to Warren Buffet have demonstrated their prowess for investors via clear performance metrics, and consistent outperformance of a benchmark. Bill Gross’s returns are quite low compared with the S&P 500, for instance – but Gross invests in bonds, and so the S&P 500 is not his benchmark.
At present, litigation finance has no benchmarks and no established system of return metrics, and many funds have limited ability to present or demonstrate financial acumen to investors or potential investments. None of that inspires confidence in the finance world. The litigation funding arena needs help filling that talent void.
There is another lesson in the mutual fund space for litigation finance managers as well, though.
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In 1997, a PhD student at University of Chicago named Mark Carhart wrote a wildly popular research study that demonstrated skill in mutual fund managers was almost non-existent. Carhart showed that successful mutual fund managers were successful because they invested in stocks with certain quantitative characteristics. That investment decision was likely unconscious – but the managers who were successful were all investing in stocks that scored highly on four different characteristics: beta, book to price, market capitalization size, and past twelve months momentum.
Once these characteristics were taken into account, virtually all skill disappeared from the mutual fund world. The only skill that remained and was significant was persistent underperformance by the worst managers. Everything else was due to quantifiable characteristics or luck. In other words, bad managers remain bad at their jobs. Everything else can be replicated by a systematic investment process.
Carhart’s findings helped pave the way for what is today the biggest trend in the broader investment world, the shift from actively managed funds to passively managed funds. If you can replicate skill with a quantifiable mathematical model, why pay for the manager?
The silver lining in the story is that once firms did not need to worry about selling their manager any more, they could focus on selling their story, and their investment process. The biggest fund companies today, from Blackrock and Vanguard to AQR and Bridgewater, are all built around their process and story, rather than a single manager.
This is a lesson that litigation funds should take to heart as well. At present, many litigation fund managers are interested in quantitative models of their business, but almost no one has a robust model. Many funds databases consist of just a few dozen investments – hardly enough to build a robust model around.
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Moving forward, the industry as a whole should look closely at the mutual fund world. Smart funds are the ones that will try and get ahead of the competition by positioning themselves around a manager and a process that demonstrate clear and provable value for investors. It’s time to embrace the finance in litigation finance.
Author’s note: As part of an industry whitepaper, I am working with the Litigation Finance Journal on the first survey of institutional investors and their expectations around litigation finance. I also intend to do a similar survey on best practices in litigation finance by fund managers in the next few weeks. Feel free to reach out if you are interested in being part of the survey process – my email address is [email protected].
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 [email protected].
