For much of its relatively short history, litigation finance has remained out of reach for the broader alternative investment community. Regulatory uncertainty, combined with the traditional dominance of large institutional players in the space, fueled a lack of awareness and access among individual accredited investors that contrasted with the market’s rapid growth in the United States.
Even among those with finance backgrounds, like LexShares President and Co-Founder Jay Greenberg, litigation finance was not a widely-recognized asset class 10 years ago. But since then, important attributes that distinguish litigation finance from better-known alternative asset classes have helped to close the industry’s investor education gap.
“When I started looking at this space in 2013, I saw a cottage industry that was not well-known,” Greenberg said during an appearance on the Money Tree Investing podcast. “What immediately attracted me was litigation finance’s lack of correlation to broader economic activity. It does not matter what the stock market, interest rates, or commodity prices do. To a large extent, a commercial legal claim investment operates inside of the courtroom vacuum.”
The low beta, historical returns, and moderate investment durations claimed by commercial litigation funders quickly drew Greenberg to the asset class. In 2014, LexShares was co-founded by Greenberg and Max Volsky, an experienced trailblazer in the U.S litigation funding market, to expand investor access to these traditionally closed-off investment opportunities. The firm has since pioneered an innovative fundraising method that allows accredited investors to gain exposure to these opportunities through its online marketplace.
In his conversation with Money Tree Investing host Kirk Chisholm, Greenberg outlines several key aspects of litigation finance for prospective investors, including how the asset class operates, how its pricing models typically function, and how firms like LexShares attempt to diversify their offerings.
You can read an edited excerpt from that discussion or listen to an audio recording of the full interview below. To learn more about the LexShares platform, click here.
Note: Questions and responses have been edited for length and clarity.
Kirk Chisholm: What did you originally like about this asset class?
Jay Greenberg: When I started looking at this space in 2013, I still saw a cottage industry that was not well-known. What immediately attracted me was litigation finance’s lack of correlation to broader economic activity. It does not matter what the stock market, interest rates, or commodity prices do. To a large extent, a commercial legal claim investment operates inside of the courtroom vacuum. Given my experience [in corporate finance], I realized how difficult it is for institutional investors, as well as individual investors, to get their hands on these [largely] uncorrelated assets.
To a large extent, a commercial legal claim investment operates inside of the courtroom vacuum.
Another is what I would call moderate duration compared to other alternative asset classes. The average civil case in the U.S. takes about 27 months from filing to adjudication. Another would be a natural realization event. You don't need an IPO or a sale process to get liquidity. Lawsuits are eventually won or lost. I looked at those unique attributes in the context of the return profile associated with these assets. In 2013, there were a few publicly-traded funds in London and Australia that purported somewhere in the 60% annualized return range. The combination of all those factors certainly piqued my interest when I started researching the space.
Chisholm: How does the process of litigation finance work?
Greenberg: When I say litigation finance, I'm talking about commercial litigation finance, which in this case means providing non-recourse capital to a business litigant who is involved in a commercial dispute. For instance, say Kirk Company has a lawsuit against Acme Corporation. Kirk Company, you’re a capital-constrained startup. You need to cover payroll and buy large machinery. You don’t have a large litigation budget. To push this meritorious case against Acme Corporation forward, you might look for outside financing to do that.
As a commercial litigation funder, we would provide Kirk Company with non-recourse capital. The only collateral we receive for our investment in the lawsuit is the potential future outcome of that case. If the lawsuit is unsuccessful and does not result in a monetary recovery, Kirk Company would owe us, the litigation funder, nothing back. That’s a risk we took for investing in the case. If Kirk Company wins against Acme, we would receive a portion of what Kirk Company recovers in that lawsuit. That’s a simple example of a transaction we might enter into.
Chisholm: If you win, you get ‘X.’ If you lose, you get zero. What do you look for when trying to decide whether a lawsuit makes sense to fund?
Greenberg: That's the purview of our underwriting team. All of our underwriters are former litigators. When they're doing their analysis as to what may be a worthy investment opportunity, it's a three-pillar process for them.
The first pillar is looking at the legal merits of that case. How well does the fact pattern of what allegedly transpired in that lawsuit align with prevailing law? For example, with a breach of contract case, was there a contract? Was that contract breached? Does prevailing law say that you can breach contracts? With our underwriting team, a former litigator is going to be reading all of the pleadings of this case, speaking with the plaintiff, speaking with the attorney, and making an assessment on the strength of the fact pattern of this particular matter.
We want to ensure we're funding cases where defendants are liquid or there is some type of bond or insurance policy backing up that particular claim.
Pillar number two is examining the strength of the involved counsel. We want to ensure the attorney representing this matter is extremely experienced, has been successful in litigating similar types of claims previously, and is comfortable in the jurisdiction in which they're litigating. We’re looking at the track record.
Pillar number three for the case vetting process is looking at defendant creditworthiness. It's great if we have an extremely strong fact pattern being litigated by well-resourced, high-caliber counsel. But if we win via settlement out of court or when the case is adjudicated, and the defendant is unable to pay on a recovery, that doesn't work for that particular investment. We want to ensure we're funding cases where defendants are liquid or there is some type of bond or insurance policy backing up that particular claim.
Creditworthiness is a big reason we do not fund a lot of case investment opportunities. We might be able to get comfortable on the merits and with the plaintiff's counsel. We cannot see a clear path to recovery unless we can see the financial resources of the defendant. If that path to recovery is opaque, that is likely not a case we are going to invest in. The top of our funnel for looking at these case investment opportunities is very large. The bottom of the funnel of what gets funded is relatively small. A large reason why those opportunities fall out is due to defendant creditworthiness.
Chisholm: Juries are not always perfect. How much of litigation finance investing comes down to chance? How do you assess that?
Greenberg: The outcome of any lawsuit is certainly unknown at the outset. At the end of the day, what it comes down to is pricing that risk appropriately. This is a risky asset class. There could always be the chance that you get a jury verdict that doesn’t go the right way, or you get a judge that doesn’t understand the particular facts of the case. To really mitigate that risk, these investments need to be priced appropriately. And given that most of these investments are non-recourse in nature, where the outcomes are binary, it’s also important to get diversification across a large number of these assets.
Chisholm: Let’s say you have 10 cases. Some are zeros, some are wins. How are you able to structure that with diversification so you can see a positive outcome?
Greenberg: We offer investors the ability to build portfolios of these legal claims by investing in single cases on our platform. We also offer them the ability to invest in a fund vehicle which in turn diversifies them across all of the case investment opportunities on our platform—because we do believe that diversification is extremely important. When we started investing in the space in 2013, there weren’t many players doing it at the time. You had a dearth of capital chasing a large number of high-quality investment opportunities. To me, the market looked similar to private equity in the early 1980s.
We have seen Harvard’s endowment fund, University of Michigan’s endowment, sovereign wealth funds, and hedge funds make investments in private litigation finance vehicles.
Since then, in an effort for a lot of firms and investors to get diversification, the pendulum has swung. We have seen a lot of institutional investor interest in our space over the past five years. We have seen Harvard’s endowment fund, University of Michigan’s endowment, sovereign wealth funds, and hedge funds make investments in private litigation finance vehicles. Now, you have a large quantum of capital that’s chasing a number of opportunities. Diversification is important. That’s why at this point, sourcing high-quality, recurring, sustainable deal flow is the lifeblood of any successful commercial litigation finance firm.
Chisholm: What is attractive about litigation finance right now?
Greenberg: We have seen a lot of volatility in public equity markets, especially with the pandemic. We sit at an apex between investors in the space and recipients of funding. This recent dislocation in the market has caused both sides of the two-sided marketplace to increase in lockstep. You have investors who are maybe looking to rotate capital out of public equities. The fixed income interest rates being so low, they are looking for an alternative for yield. Because of that, this asset class could be attractive.
On the other side of the marketplace, plaintiffs and attorneys might want to shore up their balance sheets and ensure they are well-resourced to continue to pursue their claims. We have certainly seen increased demand on both sides of the marketplace in the last six months.
Ultimately, I think litigation finance is here to stay. I think we are going to see increased transparency and standardization in the arena, which was previously opaque. We have seen a number of large institutional players enter our space. I think that is only going to continue.
Litigation Finance: One of Many Alternative Investment Options for Accredited Investors
For those interested in broadening their exposure to litigation finance, LexShares Marketplace Fund II (LMFII) is accepting commitments from accredited investors. By participating in our second dedicated fund, LMFII investors can expect:
- Participation in all of LexShares’ marketplace offerings
- Increased portfolio diversification through a wide variety of legal claims investments
- Enhanced access to an asset class historically reserved for institutional investors