Funders keepers: is litigation funding too expensive? (Part 2)

There are many ways to price litigation funding transactions, and different funders and their investors may employ different methods even for the same investment. In this piece and a preceding part 1, I explain one method of pricing single case investments using a simplified fundamental analysis where “risk” is reduced to a straight percentage chance of winning or losing (which is obviously a simplified view of the world of litigation funding). I then look at pricing from the other end of the equation to determine what a funder’s pricing may imply about the risk of a case. Finally. I turn to some real-world applications of implied risk to explain why it is often irrational for funders to abandon cases, and whether funders are too expensive.

+ But losers run long and winners settle early…

If a case settles early rather than running the full course to trial, a funder will usually be paid a lower absolute return because a smaller proportion of the funder’s total funding commitment will have been drawn at the time of settlement. On the other hand, if the analysis in Part 1 of good versus bad money is correct then, because it will often be rational for a funder to keep investing into a case as its prospects gradually worsen, losing cases are more likely to see a full deployment of capital than winning cases. This assumes that all cases start out with the same prospects of success. Therefore, it may be objected that, across a portfolio, the breakeven analysis will not work, since funders are more likely to suffer their maximum loss on losers but will make less than their maximum profit share on winners. To demonstrate why this isn’t correct, imagine a single case with a USD $1 million commitment that is initially priced at the breakeven price:

• Commitment amount: USD $1 million
• Prospects of winning: 60%
• Breakeven multiple of capital based on risk: 1.67x
• Payout in funding agreement as multiple of capital: 1.67x

Imagine that the case is funded in four tranches of 250,000 each and some bad event occurs after funding each of the first three tranches, such that the prospects of a win become progressively worse over time:

• Revised prospects of winning after bad event: 50% | 40% | 30%
• Remaining undrawn capital at time of bad event: 750,000 | 500,000 | 250,000
• Payout if Funded to Conclusion and Won: 1.67 million | 1.67 million | 1.67 million
• Breakeven multiple of capital based on remaining funding commitment to conclusion: 2x | 2.5x | 3.33x
• Actual multiple of remaining capital if fund to conclusion and win 2.23x | 3.34x | 6.68x

If we analyse each individual stage of the case as a single, discrete investment rather than as part of a single case, and assuming the assessment of the revised prospects is correct, then each of these investments is also a rational one on its own terms. In fact, each discrete investment is better in relative terms than the original investment since the original deal was struck at breakeven, whereas, for each subsequent investment, the actual multiple to conclusion is substantially better than the breakeven price at that time.

Crucially, this holds good only if the funder has constructed a sufficiently diverse and broad portfolio such that the law of large numbers can be relied upon. If a funder has only a handful of comparable investments, it is buying lottery tickets and its investors will not be grateful…

+ Are funders too expensive?

Let’s apply the implied probability of loss analysis to a fairly typical pricing structure where a funder is entitled to receive, on a win, a return of drawn capital plus a further doubling for a total payout of 3x drawn capital. The implied probability of loss from this pricing is: P(Loss) = 1-1/3 = 66.67%.

The funder’s pricing implies that the case has, on a breakeven basis, a 33.33% chance of winning. Let’s assume the funder has run its due diligence and determined that the prospects of winning the case are not really 33.33%, but 60%. The funder’s pricing therefore includes a profit element equal to the difference between the breakeven price for the true probability of winning the case, 60%, and the 3x capital outlay that is actually being charged, which implies only a 33.33% chance of winning:

• Probability of loss: 66.67% (implied) | 40.00% (actual) = Difference 16.67%
• Breakeven multiple: 3.00x | 1.67x | 1.33x = Difference 1.33x
• Profit multiple (Breakeven multiple less return of capital): 2.00x | 0.67x = Difference 1.33x

Therefore, on successful cases, the funder is making a profit of 1.33x its deployed capital in excess of the risk being run on that individual case. That may sound high to the claimant/plaintiff borrower on that case, but to get a fair picture we need to net out the losing cases across the funder’s wider business. Imagine that a funder has a large enough book of cases to have statistical significance and that every case has identical prospects, size, pricing and drawn amounts. In that case, the funder would expect the following outcome across the book:

• Actual number of winning cases = 60%
• Total expected profits from winners = 60% x 2.00x = 1.20x
• Total losses from losers = 40% x 1.00x = 0.40x
• Net profits to investors across all cases = 1.20x – 0.40x = 0.80x = 80%

The funder’s money will actually be invested for several years before a return is earned, say 2.5 years on average. Therefore, the funder has made 80% / 2.5 = 32% per annum on a simple interest basis. When we factor in compounding, the funder has actually made a return for its investors of 26.5% per annum before fees and operating costs, to say nothing of the impact of under commitments, undrawn commitments and lazy money… And I have calculated here only the average returns across a well-constructed book and I haven’t, therefore, accounted for the fact that, unless a funder has a large number of substantially uncorrelated cases in its portfolio, there will be some variation around this average number in the real world. And the fewer cases and less diverse a funder’s portfolio, the greater the variability of its performance relative to that average. (In a nutshell, a funder with ten cases will, all else being equal, have a far greater chance of seeing final portfolio performance that is well below or well above average than the funder with 50 cases who, in turn, will be less certain of achieving the average performance than the funder with 100 cases and so on. Professional investors value that certainty. There’s another blog in this…) Funders will often, therefore, need to charge higher profits to offset the higher potential for losses, due to the uncertainty arising from having relatively few cases. But even leaving aside all these complexities, while 26.5% is a respectable return it’s far from extraordinary in the world of hedge funds and private equity. So, while the price for single case funding may sometimes look expensive to the plaintiff/borrower on that case, across an entire book of business the pricing is actually pretty balanced.