Litigation finance: Deal types and structures

Welcome to the second installment of our four-part Alts Academy series on Litigation Finance.

As I mentioned last week, we’re getting ready to launch our first litigation finance deal through ​Altea​.

To prepare for launch, we’ve partnered with our friends at ​Homefront Group​, who are helping educate us on this tricky area of alternative investing through a four-part series:

• We kicked off Part 1 by understanding the ​foundations​.
• Today, in Part 2, we’ll explore different deal structures.
• In Part 3, we’ll look at the risks.
• Finally, we’ll end with a deal memo on the actual deal we’re putting together — which you can invest in.

Legal documents can be long, detailed, and boring. As always, we’ll explain things simply and make it fun.

Let’s go 👇

Market segments

Commercial litigation

Litigation finance traditionally targets commercial litigation.

The complexity and large sums at stake make it attractive to investors, due to high potential returns and predictable outcomes (compared to consumer cases)

Examples:

• Breach of contract disputes, like ​PartnerRe v. RPM Mortgage​. PartnerRe was awarded $10.8 million for a breach of contract due to RPM Mortgage’s failure to complete a merger.
• Intellectual property cases, like the upcoming Supreme Court case ​Vidal v. Elster (2024)​. This case could further define the limits of free speech in trademark law, particularly in cases where trademarks are used to express opinions about public figures.

IP cases get a lot of media attention, but experienced investors privately say they love ​earn-out disputes​ with Delaware corporations. (Psst: there’s a niche opportunity here to originate earn-out dispute cases…)

Consumer litigation

While traditionally less common, demand is growing in consumer litigation, where individuals or small groups seek redress against larger entities.

Unlike commercial cases which operate on a billable hours basis, consumer cases often operate on a contingency fee basis. This better aligns client and lawyer interests but strains law firms’ finances, especially in lengthy cases.

And that’s where litigation finance comes in. It offers these firms the capital needed to cover expenses, enabling effective representation and broader access to justice for consumers.

Types of deals

Non-recourse loans against existing dockets

In this deal, investors lend money to law firms based on the firm’s docket (the list of cases that a law firm is currently handling or have scheduled to handle in the future).

Handling multiple cases simultaneously gets expensive. So investors offer non-recourse loans (i.e., loans that are collateral-dependent) to cover the firm’s legal fees and expenses.

This loan helps law firms meet their cash flow needs, and allows them to take on even more cases.

Repayment terms are tied to the expected future revenue from the firm’s cases.

Revenue share for potential settlements (or court awards)

In this structure, investors give plaintiffs or law firms funds to cover litigation costs, and receive a portion of the eventual settlement or award in return.

This provides plaintiffs with the resources to pursue their claims, and offers investors significant upside if the case resolves favorably.

Portfolio funding

Portfolio funding involves backing multiple cases for a single client or law firm. This approach allows for risk diversification and potentially more favorable terms for the funded party.

• Spreads investor risk across multiple cases
• Can mean lower costs for clients
• Allows for more flexible use of investor funds

Judgment enforcement funding

This type of funding assists with the often complex and costly process of enforcing a judgement after a successful litigation.

This can create some very complicated cross-border enforcement challenges. It often involves a separate set of legal expertise

A real-life example of judgment enforcement funding can be found in the case of ​Yukos Oil Company v. The Russian Federation​.

Background:

• Yukos Oil, once a major Russian oil company, was dismantled by the Russian government, and its assets were auctioned off.
• In 2014, the Permanent Court of Arbitration in The Hague ruled that the Russian Federation had unlawfully expropriated Yukos’s assets, ordering Russia to pay $50 billion to former Yukos shareholders.

Enforcement challenge:

• Despite winning the case, enforcing the judgment against Russia proved extremely difficult.
• Russia resisted the ruling and refused to pay the amount owed. The shareholders faced significant challenges in seizing Russian state assets around the world to satisfy the judgment.

Role of funding:

• Judgment enforcement funding came into play as the Yukos shareholders needed significant financial backing for legal fees, asset tracing, and other costs associated with locating and seizing Russian assets in various countries.

Enforcement efforts are still ongoing! Investors have had varying degrees of success in different jurisdictions.

Other enforcement cases aren’t quite as difficult. Fighting Russia is playing this game on hard mode.

Deal structures

Single-case funding

This is the most straightforward structure, where funding is provided for a single, specific case.

It can be arranged directly with the plaintiff or through their law firm.

Law firm funding

Some funders provide capital directly to law firms, either for general operating expenses or for specific case costs. This structure can help firms manage their cash flow and take on more contingency fee cases.

Former Y Combinator startup, ​Legalist​, allocates the majority of its nearly $1 billion of AUM to law firm funding. Founder ​Eva Shang​ wisely saw a gap in the lower end of the litigation funding market and quickly became the leader in small law firm funding.

Key components of litigation finance deals

When structuring a litigation finance deal, there’s a lot you need to be aware of.

Funding amount and tranches

The total amount of funding and how it will be disbursed is a crucial aspect of any deal.

Funders often structure the investment in tranches, releasing funds as the case progresses and certain milestones are met. This approach helps manage risk and ensures that funds are available throughout the litigation process.

Return calculation methods

The way returns are calculated can significantly impact the profitability of the investment. Common methods include:

• Multiple of Invested Capital (MOIC): A straightforward approach where the funder receives a predetermined multiple of their investment.
• Percentage of Recoveries: The funder receives a fixed percentage of the total recovery
• Internal Rate of Return (IRR): This standard method takes into account the time value of money, providing a more nuanced view of the investment’s performance.

Priority of payments

The waterfall structure determines how proceeds are distributed among the parties involved.

Typically, the waterfall looks like this:

1. Legal fees and expenses are paid first
2. Followed by the investor’s return
3. Remaining amount goes to the plaintiff

However, this can absolutely vary depending on the specific deal structure and negotiated terms.

Control and decision-making rights

While funders generally don’t have direct control over case strategy, they may negotiate certain rights, such as:

• Information rights: Regular updates on case progress
• Consultation rights: The ability to provide input on major decisions
• Approval rights: Veto power over settlement offers or choice of counsel

Confidentiality and privilege

Maintaining attorney-client privilege is crucial. Deals often include provisions to protect privileged information while allowing funders access to necessary case details.

This may involve using common interest agreements or carefully structuring information-sharing protocols.

Duration and exit strategies

The expected timeline of the litigation and potential exit strategies for the funder should be clearly defined. This may include provisions for early termination or the ability to sell the investment on a secondary market.

What should investors look for when reviewing a deal?

Find your niche

The legal landscape is vast and varied. The complexities and nuances in a Fortune 500 patent infringement case are way different than a civil rights case in Portland, OR.

Savvy investors pick a niche where they may have a knowledge advantage.

Pick a niche that intrigues you and research the heck out of it. Talk to your own lawyer — one you know and trust.

(Or, just join an ​SPV or litigation fund​. Stay tuned!)

Case merit and probability of success

In previous litigation finance articles, we’ve likened litigation funding to highly educated gambling. If you’re going to place a bet, you first want to know if it’s worth placing a bet at all.

Compare the ​Tylenol Autism Mass Tort​ to the ​Camp Lejeune Water Contamination Mass Tort​. Many law firms and funders built sizable dockets in the Tylenol Autism case with the belief that Tylenol caused autism.

The federal court ​cases were dismissed​ in December 2023. A new expert witness is now focusing on ADHD in this case, which has created new optimism for potential success.

Conversely, the US Government passed The Sergeant First Class Heath Robinson Promise to Address Comprehensive Toxics ​(PACT) Act of 2022​ which set aside billions of dollars to compensate veterans harmed by contaminated drinking water at Camp Lejeune in North Carolina.

Case merit and probability of success isn’t often as clear as the scenario above. Lawyers, funders and subject matter experts need to assess:

• Strength of legal arguments: Are the claims well-founded in law?
• Quality of evidence: Is there strong, admissible evidence supporting the claims?
• Jurisdiction and applicable laws: How favorable is the legal environment?
• Precedents: Have similar cases been successful in the past?

Potential damages and recovery amount

Once you’ve determined that a case has merit and a high probability of success, you need to figure out if it makes financial sense.

Valuing a lawsuit is a lot like handicapping odds in sports betting. In both scenarios, you’re analyzing a mix of known factors and uncertainties to estimate the probability of a particular outcome.

Think of it like realtors using past home sales as comps.

Lawyers and funders use other similar cases to create a range of economic outcomes.

In the Camp Lejuene mass tort, the US government published this ​settlement matrix​ for qualifying conditions, which made it easy for funders to value cases at an average of $150,000 per case.

Getting a good estimate of a potential compensation is critical for law firms and funders to generate a profit. You don’t want to end up with cases that cost more to originate and work than they pay out.

This, unfortunately, is the case for many people involved in the 3M Earplug mass tort. Many people were projected $50,000+ payouts, but they turned out to be ​$5,000 – $24,000​.

Timeline to resolution

Talk to any experienced funder and you’re bound to hear them moan about duration risk.

Some jokingly say “take whatever time you think it will take and double it.” This isn’t always the case, but was exacerbated due to the pandemic.

Some case types are hard to gauge for timeline. The jurisdiction plays a part. Sometimes a judge just wants it off his or her plate and will push to move things along.

But there are more rinse and repeat type cases that follow a predictable timeline which makes funding more predictable, like car accidents and disability claim appeals.

Creditworthiness of the defendant

There’s a strong argument to start all funding opportunity evaluations with one question. Can they pay?

While car accident cases typically are highly fundable, you don’t want to fund cases against insurance companies that could be forced into bankruptcy.

Most investors look for deep pockets.

Fortune 500 companies are usually considered safe bets. One outlier is Johnson and Johnson trying to use ​bankruptcy​ to mitigate its financial burden related to the talcum powder mass tort.

Homefront Group prefers cases with the deepest pockets of them all: the US Government. In theory, the United States could go bankrupt, but for as long as the US Dollar is the primary currency of the global economy, the US Treasury is effectively an unlimited source of settlements and awards.

That is a big reason Homefront started with the Camp Lejeune mass tort and will continue on with VA Disability Claim Appeals.

Experience and track record of the legal team

The quality of legal representation can significantly impact the case’s outcome. There’s a reason why ​Morgan and Morgan​ makes over $1 billion a year doing personal injury cases.

It’s like startup investing. Would you rather back a first time founder? Or one that has built and sold a business already, and is back for more?

The same goes for litigation funding. It’s wise to back a team that has a track record of success in the niche you’ve chosen. Past success arguably plays a bigger role in litigation. The opposing team knows who will fight and who will roll over.

In mid 2023, experienced angel investor ​Nick Kelermeyer​ decided that ​Attorney Chris Czaplak​ and Homefront Group was the right funding opportunity for Camp Lejuene admin claims.

As a former Navy JAG, Attorney Czaplak has first hand experience on how the Navy tort unit operates. Heck, he worked in the same building where these cases are being processed. This deep operational experience allowed Homefront to anticipate the many changes the Navy made throughout the filing period.

Whether it’s Homefront Group or another law firm, you should look for law firms with a successful track record that can be leveraged for future dockets.

Exit strategies/liquidity options

Much like valuing a case, predicting when a case will resolve involves a lot of speculation.

Historical data tells us that VA Disability Appeals resolve in 12-24 months, and Mass Torts in 5-7 years.

Within mass tort cases, there is an advantage to being the first mover. You can often originate cases for lower costs. The tradeoff is that you carry a longer timeline to settlement.

There is a late mover advantage too! At Homefront we often wait until a mass tort case has matured before entering it. This lowers duration and settlement risks. This late mover strategy can be good for funders with duration concerns.

There are options available to investors in select classes of cases than have yet to exit. Secondary markets exist, whether the funding agreement is structured as credit or revenue share, but selling an interest in a settlement is also available.

Monetizing a lawsuit award before the case is resolved can be done by selling minority interests in the case to investors.

This strategy, as exemplified by Burford Capital in the ​Argentina case​, allows the plaintiff (or investor) to generate liquidity while the case is still ongoing, reducing the binary risk of a win or loss.

By periodically selling stakes in the potential award, the case’s value is partially realized, providing financial returns even before the final judgement is rendered! es, where the plaintiff has a direct relationship with the funders.

(Side note: ​Burford​ tripled its revenue to $1.1 billion in its last fiscal year…and they haven’t yet collected their ​$6.2 billion​ of a $16.1 billion verdict against the Argentine government!)

Regulatory and ethical considerations

The litigation finance industry has traditionally been opaque and unregulated. Calls for transparency have gotten louder in the halls of Congress, but little action has been taken.

Nevertheless, transparency with clients and funders are an attorney’s obligation. In every jurisdiction that licenses attorneys to practice law, there is a professional obligation above what is often contractually required to disclose material information in a transaction.

Homefront is dedicated to maintaining the ethical high water mark. Our clients expect it. We have a duty to maintain our objectivity and not let our legal decisions be influenced by financial pressures.

And the fact is, litigation funding alleviates these pressures.

As long as the lawyers and the clients are making the legal decisions, and the funding arrangements do not incentivize the attorneys to try to drive up settlements when it’s clearly not in the client’s best interest, litigation funding is increasing access to courts and justice.

That’s it for part 2 of this series. A big thanks to our friends at Homefront Group.

Next week, in part 3 we’ll get into the risks & pitfalls — what can go wrong in this world, and how to mitigate the risk.

As ever, if you have any questions, just smash the reply button.

See you next time, Wyatt

Disclosures

• Altea does not have any holdings in any litigation finance deals, or in any companies mentioned in this issue.
• This issue was co-authored by our friends at Homefront Group
• This issue was not sponsored by Homefront Group. No money exchanged hands.
• This issue contains no affiliate links.