The following article was originally published by LawFuel, and was co-authored by LexShares' David Shack (Vice President, Marketing & Product Strategy) and Gerson Lehrman Group's David Solomon (Global Head of GLG Law).
The legal services industry in the United States alone represents more than a $430 billion market. While the substantial growth in client demand has led to rising costs for the highest quality legal services, it has also sparked an evolution of product offerings that accommodate a wider range of client and law firm needs.
Enter litigation finance, the practice by which a third party invests in a legal claim in exchange for a portion of the monetary recovery upon a successful settlement or judgment. Litigation finance encompasses a range of products, including investments in single cases, diversified portfolio deals, and law firm financing. The use of proceeds can cover legal expenses, expert witness fees, court costs, working capital for corporate plaintiffs, and more.
Why is it that this industry, which took shape in the United Kingdom and Australia more than 20 years ago, has recently begun to explode in awareness and usage in the United States? Why are more and more corporate plaintiffs taking advantage of litigation finance solutions, and why are more top tier firms exploring this innovative practice as well?
Clients are increasingly disenchanted with the traditional law firm billable hour model
With rapidly increasing competition among law firms but a stagnant business model reliant on revenue from billable hours, clients demanding change is a reasonable and sensible outcome. The numbers help paint a clearer picture: as of 2018, average law firm billable rates had risen to $450 per hour on average in the U.S., up nearly 30% from just ten years prior.
Not surprisingly, clients looking to engage with top-tier legal talent have ultimately found themselves seeking creative new arrangements to offset these steep and often inefficient fees, especially for long-term engagements.
Technological advances have widened access to global law firms, creating more competition for law firms and transparency for their clients. At the same time, digital products and self-help platforms have helped reduce the cost of routine legal work for individuals and companies.
For example, it is now possible to quickly and inexpensively form a business, create wills and trusts, register most intellectual property rights, and file lawsuits in small claims court, all without using a lawyer. The productivity gains resulting from automation have empowered consumers in most sectors of the economy, including the legal industry.
As a result, clients demand more control over their relationships with law firms and increasingly require legal arrangements that are flexible, efficient, and more affordable.
This industry dynamic has created a seismic shift in power to the client, helping fuel the rise of litigation finance.
Third-party funding bridges the gap between a client’s capacity to pay hourly legal fees and the firm’s appetite for contingency arrangements. It has quickly become a logical solution for many plaintiffs seeking to engage with top firms because it enables clients to pay reduced or no fees while allowing law firms to continue to receive current hourly pay.
It’s not just individuals—corporations are averse to hourly billings, too
In 2017, the legal industry witnessed a bombshell that further challenged its traditional business models. Microsoft, a $1 trillion-dollar company, announced it would no longer enter hourly arrangements with legal service partners.
Its Deputy General Counsel explained that their desire to foster closer relationships with outside counsel would be facilitated by shifting away from the billable hour model to alternative fee arrangements.
When corporations pay for litigation expenses from their balance sheets, it reduces EBITDA and other profit metrics, which risks eroding shareholder value. In other cases where treasure chests are smaller, many companies choose to abandon meritorious claims for fear of the impact to their bottom line.
Using outside capital, therefore, can help mitigate these associated upfront costs from the balance sheet, potentially increasing shareholder value.
For this reason, in-house legal departments are increasingly taking advantage of litigation finance as a tool to convert them from cost centers to profit generators.
Introducing a litigation funding partner and its associated resources can help align the interests and objectives of the company while redistributing risk to a third-party that is a repeat player within the legal system. This helps create flexibility for long-term relationships and enables the monetization of meritorious legal claims.
Law firms also increasingly rely on litigation funding to shore up their balance sheets
Law firms do not traditionally retain excess balance sheet capital and do not have the same broad access to capital as other types of businesses.
Therefore, the demand for outside capital has naturally emerged—which has birthed a new wave of dedicated litigation finance firms that specialize in providing capital directly to law firms. In the U.S., for example, law firms cannot access public capital markets. Furthermore, most banks will not lend to certain types of law firms that have large contingency portfolios, as they will not accept legal claims as collateral.
Outside funding from a dedicated litigation finance firm enables law firms to gain greater flexibility for their business models. For some firms, litigation can allow them to provide a more client-friendly alternative fee arrangement or navigate riskier contingency matters.
For others, litigation finance can be a meaningful driver of new business. Third-party funding can supplement hybrid contingency engagements, cover the costs of top experts, and help support a corporate plaintiff’s business expenses—all attractive opportunities for law firms to support their clients’ needs.
Investor interest in litigation finance assets is making capital more widely accessible
The uncorrelated nature of litigation finance investments has made them increasingly attractive. An uncorrelated asset is one that is largely insulated from the volatility of other markets and broader macroeconomic factors.
Litigation finance falls wholly into this category, where the outcome of litigation is determined by judges, juries, and arbitrators, and where investment performance is mostly dictated by the merits of the case and the skill of the legal team.
Litigation is also typically characterized by a moderate investment cycle relative to other alternative asset classes like commercial real estate or venture capital. So, one can understand how an uncorrelated asset with shorter investment durations might attract significant interest from institutional and individual investors.
These factors have driven a substantial increase in investor demand, creating a dramatic surge of capital accessible to attorneys and plaintiffs who might benefit from outside funding. These days, there is no shortage of new entrants into the litigation finance market who seek to deploy capital into high-caliber investment opportunities.
What does the future hold for litigation finance?
As the litigation finance industry continues its ascent, new products are likely to get introduced that will address an even wider range of needs for the modern law firm and client. In addition, litigation funding is becoming more global in its reach.
For example, we have seen substantial growth in Hong Kong, Singapore, and continental Europe over the past several years. This trend is expected to continue as the industry explores new markets.
Additionally, the rapid growth and continued globalization of litigation finance are expected to catalyze more transparency from funding participants and regulatory standardization across different jurisdictions.
While most of today’s litigation finance investments are consummated with plaintiff’s firms, we can reasonably expect to see more meaningful implementations of defense-side funding products in the future.
Defendants, like plaintiffs, will inevitably seek unique ways to mitigate their litigation risks. In these types of transactions, instead of making investments in exchange for a share of the settlement or judgment, capital would likely be committed in exchange for a portion of the costs or damages saved.
While litigation funding is still nascent compared to more established financial industries, it undeniably has considerable momentum, which should carry it into a permanent and powerful feature of the modern global legal system.