Litigation Funding – Making a market out of the courtroom

Litigation funding, also known as litigation financing or third-party litigation funding refers to the financing of lawsuits from a third-party. A third-party funder can pay some or all the expenses related to the dispute in return for a certain share in proceeds of the disputes. In case the litigation is not successful, the funder has to bear the costs. A third-party funder can also buy litigation claims of an involved party.

Litigation funding can be broadly classified into two sections – consumer financing and commercial litigation funding. Consumer financing refers to pre-settlement funding or plaintiff advances. Wall Street mainly focuses on commercial (corporate) litigation funding. These are non-recourse cash advances hence they’re investments and not loans. Litigation funding has been around since the 1960s in England and Wales but the modern-day commercial litigation only gained popularity in around 1990s in Australia. Two of the biggest names in this space are – IMF Bentham (ASX: IMF), an Australian firm is the world’s first publicly listed commercial litigation funding company and Burford Capital (LON: BUR), a London based capital market company providing specialized finance to the legal market.

Source – Financial Times

Over the course, litigation funding has garnered a lot of traction from various funding institutions. Endowment funds, savvy investors, family offices et. al., has been allocating their funds to lawsuits. As the returns are not correlated to equity and bond market, this acts as an attractive alternative investment class that manages to offer investors with double-digit returns when the other asset classes are underperforming. Making litigation funding a rapidly growing alternative asset class and a multi-billion-dollar industry. The litigants’ interest in alternatives ways to fund their hourly-legal fees and large-scale unrealized commercial litigation claims has been a driving force for this sector.

One of the biggest and popular investors in litigation financing deals have been Hedge Funds. A typical structure of a deal is as follows –

Let’s say, a litigation financer will invest around $200,000 and the case happens to settle for 10 times of that amount. The financer will get back the first $200,000. Plus 100% of the initial investment. Along with that, they will get a percentage of the settlement amount. Generally, the percentage varies from case to case but a general range is between 10 to 20 per cent. Let’s say in this case the cut is 15%. So, first, the financer will get the initial investment along with that 100% of the initial making it $400,000. And then 15% on the balance amount giving $240,000. Hence the total amount received by the financer is $640,000 on an initial investment of $200,000, giving a 220% return. What if the case settles for $500,000? The same structure will be applied. The financier will get the initial investment of $200,000 plus another $200,000 and then 15% on the balance i.e. $15,000. So, the total amount received by the financer is $415,000, giving a return of 107.5 per cent. In case there is no win, the finance wins nothing. Just like in stocks, the loss is limited to the investment and that being said, the firms protect their risks pretty aggressively. The funds conduct extreme due diligence before investing in the case, therefore, they wouldn’t invest unless they have a good shot. Hence, legal financing being completely independent of the stock market makes it an attractive alternative investment option.

Source –Bloomberg

Recently, Blackrock along with a few other investors purchased claims worth INR 1,750 cr of Hindustan Construction Company (HCC) in March 2019. This move will help HCC to prepay a debt of INR 1250 cr, including an entire term loan of INR 942cr. And the balance INR 500cr will be utilized to fund the working capital and business growth. HCC will transfer the beneficial rights of the claims to a special purpose vehicle (SPV) which is controlled by the consortium of investors. The agreement also specifies that in case of recovery of claims and awards being more than the threshold, the excess amount will be transferred to HCC. This abovementioned move will help HCC to get rid of the mismatches in the cash flows caused by prolonged litigation cycles.

Another example from earlier this year, also captures the essence of investments in litigation space. Baupost Group, a US-based hedge fund, purchased legal claims worth $1 billion against a utility company PG&E. The fund purchased the claims against PG&E as a hedge on its investment in the company’s stocks.

Basically, after California’s wildfires, PG&E’s stock plummeted by 80%, leaving the company in $30 billion in debt and almost facing bankruptcy. However, the fund in a process of subrogation purchased the claims against PG&E which was originally held by the utility company’s insurer. The fund paid around 35 cents on the dollar for those claims, now has the rights to sue the company in which it has the investments. This is not the first litigation claim which the hedge fund has purchased.

The above two examples showcase how far the institutions, hedge funds and various other investors are willing to go when it comes to capitalizing on legal claims. Connection Capital LLP, a private equity firm based in London invests on behalf of its wealthy clients in litigation funding and legal claims.

Having a right fund manager can help to generate outsized returns but it’s difficult to figure out if there is too much capital chasing this asset class and also how do litigation fund managers find a quality of case inventory in the packed global market?

Isha Khuteta
Team Member– Alternative Investment Funds
(M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

Connect with Isha on LinkedIn

Rise of Alternative Investment Funds in India

The name Alternative Investment suggests investments which aren’t traditional by nature and it differs not only in types of asset classes but also the structure of the investment vehicle. On comparing Alternative Investments with Traditional Investments, we can notice that –

  • Alternative Investments have less liquidity of assets.
  • It requires specialized investment managers.
  • They are more concerning since there is no historical data on return and volatility data.
  • They have different legal issues and tax treatments.

But in spite of the above stated issues, Alternative Investments Funds (AIF), a part of Alternative Investments is on the rise in India. Alternative Investment Funds refers to privately pooled investment funds, either from Indian or foreign sources. AIFs were allowed by SEBI in 2012, and by end of 2013, there were 84 registered AIFs in India.

When we look at the year 2013, India was ranked 9th by the Global Limited Partner Survey of ‘Emerging Markets Private Equity Association’ for the ‘most preferred destination’ by global investors. Fast forward to 2017, India has been ranked numero uno in the same category. This upward climb on the ladder can be attributed to the rise of AIFs in India from 84 registered AIFs in 2013 to 517 in 2019, more than a six-fold increase.

Relation between AIFs and Indian Economy

According to SEBI, AIFs are classified in 3 broad categories –

  • Category I– These AIFs invest in startups, early stage ventures, infrastructure, SMEs or any area which the government and regulators think are socially and economically beneficial. Category 1 AIFs include Venture Capital Funds, SME funds, Infrastructure funds etc.
  • Category II- The AIFs which don’t fall in category 1 and 3 are the part of this category. These mainly include Private Equity funds, Real Estate funds et al. These funds don’t take leverage or borrowing for their operational requirements.
  • Category III- The AIFs which use complex trading strategies and employ debt including through listed or unlisted derivatives fall under this category. Hedge funds, PIPE funds et al are to name a few.

AIFs offer High Net worth Investors (HNIs) and Institutional Investors diversified portfolios which are not offered by the traditional investment options. Over the period of last 7 years the funds raised and invested by AIFs have been increasing year on year. This in turn shows the growth of the Indian economy landscape. India being a developing country the scope of investment in vast and the government is trying to make India not only business friendly but also investor friendly which further increases the scope for AIFs. AIFs invest in startups, SMEs, infrastructure, real estate etc. using mutual funds strategies and by not taking long or a short position which helps in direct capital infusion.

Over the years the Indian government has taken various steps in favor of AIFs such as –

  • RBI issued a notification in 2015 wherein it stated that AIFs having majority foreign capital will be considered as local fund and FDI regulations won’t be applicable. This was under Automatic Route.
  • Category III funds are allowed to invest in commodity derivatives.
  • Proper structure was put in place to avoid double taxation for the Category I and II funds investors.
  • Government of India has set up National Infrastructure Fund of INR 20,000 crores.
  • AIFs being illiquid by nature, but allowing them to be listed on stock exchange help them to be traded easily. All AIFs expect the open-ended AIF can be listed on the stock exchange.
  • Funds of Funds are the funds which invest in multiple Category III funds. Although in India it’s still at a nascent stage.

From the above graph we can see the gradual but a steady rise not only in the funds raised but also in the investments made by AIFs. India being a young nation with a lot of untapped capital and has tremendous growth prospects in the future and with such funds on a rise will not only help to reduce the investment deficit of the country but also harness her growth potential.

AIFs being diverse are able to meet the financial needs to HNIs wherein they can choose between short term i.e. liquid funds and long term i.e. physical assets or longer duration funds.  AIFs has low returns correlation with the traditional investment products in longer period and aren’t as volatile as stock and bond markets which helps to reduce the portfolio risk.

Although AIFs market is rapidly growing in India it is still paltry in comparison to the global AIF market. The regulators and Government have taken various steps in favor of AIFs there is still a long way to go from here. But the future does look bright.

Isha Khuteta
Team Member– Alternative Investment Funds
(M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

Connect with Isha on LinkedIn