Litigation financing: profitable and decorrelated - Funds August 2023
Litigation financing: profitable and decorrelated
Litigation finance funds finance legal proceedings in return for a share of the winnings in the event of victory. Still rare in France, they are set to expand with the growth of the sector. Investors can expect to earn a substantial return and add decorrelation to their portfolios.
The association Collectif Porteurs H2O, which brings together over 4,000 investors who feel they have been wronged by the well-known fund manager H2O AM, anticipates that the procedure to recover its members' money will be long... and costly. That's why, since September 2022, it has enlisted the services of Deminor, a company specializing in the financing of legal proceedings. This is a little-known activity in France, in which the third party provides the funds needed to finance the legal action and, in the event of success, earns a return on the sums recovered. In this case, if the Collectif Porteurs H2O wins its case, it will transfer 30% to Deminor and other parties financed by Deminor (including the association's lawyer). Litigation finance originated in Australia and took off in the Anglo-Saxon countries of Australia, the United States and England in the early 2000s. Litigation procedures are very expensive, but the damages awarded in the event of victory can also be very high. According to a McKinsey study published in September 2021, the market accounted for almost $11 billion in financing worldwide in 2018. The consulting firm anticipates growth of around 8.3% per year, reaching an estimated $22.4 billion in total financing in 2027.
A gain on damages received
The business is highly lucrative for players in the sector, generally backed by law firms, since they recover either a multiple of the sum advanced for litigation costs, or a percentage of the damages (in the order of 20 to 40%). Amounts can increase with the length of the procedure. "We define with the plaintiffs either a senior multiple on the winnings, thus served first, or a percentage on the final value. This practice is now commonplace in the world of legal finance," points out Sidney Oury, co-founder of IVO Capital Partners, one of the few players to manage a strategy of this type in France. On the other hand, if the court decision is unfavorable, the financing is said to be non-recourse and the legal finance funds lose the sums committed to the losing cases." As a result, case selection is crucial in limiting the risk of loss. "When we solicit funds, they look first and foremost at whether the opposing party is solvent, what the case's chances of success are, and the potential for damages, bearing in mind that on average they aim for compensation corresponding to 10 times the sums committed," relates Samantha Nataf, lawyer and partner at De Gaulle Fleurance. For the parties financed, whether individuals or companies, these funds make it possible to obtain capital they do not have, or to avoid tying up cash for a procedure with no direct link to the company's day-to-day business. Especially since banks do not lend to finance this type of expense. Litigation financing has several attractive features for investors, not least of which is its high return potential. But above all, this strategy stands out for the decorrelation it brings to a portfolio. "This is what attracted us in the first place, because during crises, everything goes to the cellar at the same time," says Pierre-Marie de Forville, co-founder of family office iVesta. We've seen this happen on several occasions,
including last year. Litigation finance is the exception that proves the rule, because a court decision is totally uncorrelated with the economic environment."
Few investment vehicles for retail investors
However, investment opportunities for private individuals are still rare, as the market is mainly driven by large institutional investors. IVO Capital Partners has launched three litigation finance funds, the latest of which, IVO Legal Strategies Fund III, is a société de libre partenariat (SLP), accessible from 100,000 euros and eligible for Luxembourg life insurance. The management company intends to raise €100 million through this fund, which is still being marketed until mid-August (unless extended). "In 2013, a year after the creation of the management company, we wanted to develop an unlisted business, and several lawyers in our network talked to us about litigation finance," relates Sidney Oury. As a result, we financed our first transaction in 2014, and since 2018 we've been doing our own sourcing thanks to a six-strong team of legal experts and lawyers." The latter work with around ten law firms
EUROPE WANTS TO REGULATE THIS ACTIVITY
Faced with a booming phenomenon in Europe, the number of players is multiplying. We're in great demand," says lawyer Samantha Nataf. We're witnessing a proliferation of funds, with many new entrants to the market." Nataf, who specializes in international arbitration, is cautious in her choice of partner funds. In particular, they must be strong enough to support the plaintiff through to the end of the proceedings, which can take several years. However, the European Union is alerted to the issue, and is seeking to regulate the private financing of litigation by investment funds. In a Resolution dated September 13, 2022, the European Parliament called on the Commission to present a proposal for a directive on the subject by June 25, 2023. The text notes: "Although in most Member States the practice of third-party commercial litigation funding has been limited in scope to date, it is expected to play an increasing role in the years to come, but largely escapes regulation in the Union, even though it could present not only benefits but also significant risks to the administration of justice which need to be addressed". Among the institution's fears: a lack of transparency of funds, a monopolization of gains by the latter to the detriment of claimants, or the development of a two-speed justice system, with financeable lawsuits on the one hand, and those that are not, on the other. "At this stage, there are no binding regulations, so the Parliament is calling on the European Commission to present common minimum standards", explains Samantha Nataf. Among the solutions envisaged, the Parliament recommends the introduction of an approval system for third-party funders, as well as capping the amount granted to funds in the event of a win at 40%, apart from exceptional cases. According to Samantha Nataf, "It's a good thing to provide a framework, particularly in terms of transparency, ethics and the origin of third-party funding. But the texts must not be too strict, as certain elements could act as a deterrent to major players in the sector."
business providers. Unlike the first two, this third vintage is focused on Europe, where litigation financing has developed more recently. "Since the 2018 Damages Directive, American funds are starting to take an interest in the region," notes Sidney Oury. And Paris is an internationally recognized place for arbitration." Arbitration is the private settlement of disputes through an arbitrator, rather than through legal proceedings. IVO's specificity: their fund operates with an insurance mechanism, making it possible to limit the risk of loss as well as the hazard of the duration of each procedure. We work with a pool of 4 major European insurers who validate each case," explains Sidney Oury. These insurers address the two main risks of the asset class, namely: the duration of proceedings (maximum duration of 5 years) and the risk of adverse scenario (loss)." These solid guarantees come at a cost, since in addition to the insurance premium, the insurers deduct half of the sums due to the fund when the case wins. Nevertheless, the fund's target return on investment is 1.5 times the stake after 4 years. What's more, the guarantee is a way of reassuring investors. Family office iVesta, which has been banking on this strategy since 2016, is convinced of its relevance today. But before taking the plunge into this so-called exotic investment, it conducted a thorough investigation. "We carried out a benchmark of existing funds, notably in the UK and Switzerland, and performed fairly extensive legal due diligence to assess the risks, particularly counterparty risks with insurers," relates Pierre-Marie de Forville. IVO Capital Partners' third fund this time includes an uninsured portion. Without insurance, it's much more sporting," says Pierre-Marie de Forville. At present, we classify this investment as a brick of private debt, which is subscribed to by two-thirds of our clients. Without insurance, we'd be more at the risk level of venture capital."
Diversification within a mandate
Auris Gestion also provides access to a litigation finance strategy through its management mandates, without directly piloting such a strategy. The company has created a Luxembourg-domiciled SIF Sicav in which it has grouped some fifteen decorrelated strategies (including hedge funds, tangible assets and intangible strategies). One of these gives access to the fund of a British management company with expertise in litigation finance, associated with an American law firm (via a feeder fund, regulated by the AIFM directive). "These are exclusively Anglo-Saxon litigation finance operations, as the culture of compensation is stronger in the United States and England than in continental Europe, and damages can be very high there," describes Sébastien Grasset, head of Auris Gestion's asset management division. The selected fund's portfolio includes some forty lawsuits, including a number of high-profile cases. One example is the Bayer-Monsanto Roundup case, in which the fund won a settlement in the first US jurisdiction, giving it a return of 80% in 2020. A result that cannot be repeated every year (the fund has achieved annual growth of close to 8% in 2021 and 2022). At Auris Gestion, the fund receives an annual return on the money it lends. This coupon is increased from time to time by success fees on successful trials, the aim being to achieve a multiple of 3 on the capital invested after 4 years. As a result of the Sicav-SIF's diversification, the litigation finance strategy accounts for only 5-6% of the total. "Some of our customers may invest directly in the litigation finance fund, but only through a management mandate, for compliance reasons", explains Sébastien Grasset.
Aurélie Fardeau
