Litigation funding: Pioneering an alternative asset class in South Africa
18 Mar 2021
Litigation funding occurs when a third party, with no direct interest in a legal case, finances the legal costs in return for a share of the claim proceeds if successful. “This form of finance allows proceedings to be pursued which otherwise would be hindered by a claimant’s lack of funds,” explains Elad Smadja, CEO of litigation financier Taurus Capital.
Viewed from the perspective of a funder, litigation provides a uniquely attractive investment proposition. “The litigation funding asset class offers a high-alpha / low-beta risk-return profile, which is invaluable in enhancing a portfolio’s asset allocation composition,” says Smadja.
The litigation funding asset class is well established globally, with the UK, US and Australia accounting for over half of all international investments. There is no central database but estimates value the global market between $50 and $100 billion, with an annual growth rate of around 40% over the last decade.
In South Africa, the litigation finance market is still in its infancy. However, with a large commercial sector and a well-established justice system, the room for growth is significant. Taurus Capital is the pioneer of this asset-class locally, having raised the country’s first dedicated litigation fund of R80 million to pursue litigation investments on a pooled basis. This vehicle allows investors the opportunity to gain exposure to a diversified portfolio of cases, mitigating the risk of losses on any single matter.
Asset return profile
A key feature of the litigation funding asset class is the asymmetrical return profile, meaning the gain potential in a win scenario is far greater than the possible loss. Let us illustrate this with an example:
Assume a lawsuit requires R10 million in legal costs and in return, would pay the funder R30 million if the case is successful, or a R10 million capital loss in the event of failure. If the odds of winning or losing are 50:50, then the probability-weighted outcomes are as follows:
|Probability-weighted loss||(R5,000,000)||50% * R10,000,000|
|Probability-weighted win||R15,000,000||50% * R30,000,000|
|Expected Return||R10,000,000||(R5,000,000) + R15,000,000|
While the above example assumes a 50% win-ratio, a professional litigation funder will perform significant legal due-diligence on a case before investing to ensure they back cases with strong legal-merits and thus higher prospects of success. As a result, it is not uncommon for investors to double, triple or quadruple their initial investment. This is clearly an attractive return for sophisticated investors such as family offices, high-net-worth individuals or hedge funds who get paid to take risks in a methodical and calculated fashion.
However, Smadja warns that “while some cases can provide investors with unusually high returns, success is never guaranteed. Funding is typically structured on a non-recourse basis, meaning the recipient has no obligation to pay the funder if a case resolves unsuccessfully. For this reason, the litigation asset class is not appropriate for investors who cannot afford capital losses.” Furthermore, many litigation funds have significant minimum-investment sizes, making them inaccessible to small retail investors.
Most traditional asset classes – including bonds, equities and cash generate returns based on underlying economic factors such as interest-rates, inflation, employment and GDP. Even the so-called “alternative asset-classes” are still heavily influenced by market vagaries and sentiment. As a result, it is difficult to find truly uncorrelated assets that can deliver genuine diversification to an asset portfolio.
Litigation finance, on the other hand, is uniquely different. Returns are generated by legal intricacies and idiosyncratic factors influencing the underlying merits of a case. For example, a court’s adjudication of a plaintiff’s claim is based on the specific facts in the matter, judicial precedent and common law jurisprudence. Consequently, there is no inherent correlation between investment returns and, say, the JSE Index, Rand Dollar exchange or gold-price.
Other investment characteristics
The litigation funding asset class is defined as having a medium-term time-horizon, as commercial disputes can take between three and five years to reach a final judgment. While there is often the prospect of an early settlement, investors need to be prepared for procedural delays and appeals through the court process, which can serve to extend the investment period.
What sets litigation financing apart from other alternative asset classes is that every lawsuit will eventually resolve through settlement or adjudication. This inevitable realisation event is different to private equity, for example, which requires an initial public offering or sale to exit the investment.
The fee structure of litigation funds is often similar to that of private equity, with a smaller management fee to cover the highly specialised and labour-intensive upfront case evaluation and investment structuring process. The majority of management compensation comes from a so-called “carry”, which ensures that incentives are aligned and that investors only pay for demonstrable outperformance.
What remains is for the astute and prolific investor to assess whether they can afford not to invest in this burgeoning niche that remains highly active in terms of demand from funding recipients. Valuable, innovative – this asset class is a prize for the sophisticated South African investor, who is keen on earning above-inflation, uncorrelated, risk-adjusted returns that many peers in the country have not yet cottoned on to.
See also:(This article is provided for informational purposes only and not for the purpose of providing legal advice. For more information on the topic, please contact the author/s or the relevant provider.)