At Lake Whillans, I spend most of my time valuing litigation related assets. There are many considerations in this exercise, some of which I wrote about here.

Today, I am going to write about cost of capital, which is a key component in valuation. Aswath Damodaran recently wrote:

“If there were a contest for the most measured number in finance, the winner would be the cost of capital. Corporate finance departments around the world compute it as an integral part of investment analysis. Appraisers estimate it as a step towards estimating intrinsic or discounted cash flow value. Analysts spend disproportionate amounts of their time working on it, though not always for the right reasons or with the right inputs.”

[You can read his full article here]

The cost of capital is particularly interesting in the context of litigation finance because it can be argued that a portfolio of claims should have a cost of capital equal to the risk free rate. To understand this argument, and why it’s not currently the case, let’s first explore some key concepts.

* What is cost of capital?*

The cost of capital is simply the return that an investor or CFO will demand for the financing of a business or line of business, and it represents a hurdle rate that the company must overcome to create a surplus of value (also known as Alpha).

Why is the cost of capital important?

When an investor values a company, there are two key inputs: estimated cash flows and the cost of capital. The lower the cost of capital, the more valuable the cash flows. To illustrate, let us assume that Company A and Company B will each produce profits of $100,000 a year in perpetuity. Let us further assume that investors will only finance Company A if they can achieve a 10% return on their investment, while they will finance company B for only a 5% return. The value of Company A would be $1,000,000 (an investor can buy Company A for $1,000,000 and receive $100,000 a year in perpetuity – a 10% annual return), while the value of Company B would be $2,000,000 (an investor can buy Company B for $2,000,000 and receive $100,000 a year in perpetuity – a 5% annual return).

Determining the cost of capital

The cost of capital is the weighted average of a company’s cost of debt and equity. Today I am going to focus on cost of equity because this where there is an interesting interplay with litigation funding. One of the most widely used methods for calculating a company’s cost of equity is the Capital Asset Pricing Model (also known as CAPM). This model relies on three variables to quantify the return one should expect from investing in a company: the risk free rate, beta, and the risk equity premium.

The risk free rate is the theoretical rate of return of an investment with no risk of loss. In practice, investors use, as a proxy, the yield of a government issued bond where the risk of default is so low as to be negligible (such as a US treasury bill).

Beta is the tendency for an asset to move in accordance with the general market (as opposed to idiosyncratic factors). To illustrate, the market portfolio of all investable assets has a beta of exactly 1. An asset that has a tendency to perform better than the market when the market rises and worse than the market than the market falls will have a beta that is greater than 1 – a good example of this type of asset would be a luxury brand. An asset that has a tendency to perform worse than the market when the market rises and better than the market when it falls will have a beta that is less than 1 – a good example of this type of asset would be a utility company (an asset’s beta is calculated using regression analysis).

The risk equity premium is the return in excess of the risk free rate that an equity investor requires as compensation for taking on the relatively higher risk of the equity market. For a vibrant discussion on the methodologies for calculating a risk equity premium I will direct you again to Mr. Damodaran.

Investors use these inputs to determine the required rate of return for a particular investment. The CAPM formula is as follows:

Expected Return = Risk Free Rate + Beta * Risk Equity Premium

Translating this from formula to concept, an investor should expect a return that captures the time value of money (represented by the risk free rate) and any additional market risk borne by holding the asset. This additional risk is measured by taking the average risk of holding equity (represented by the risk equity premium) and adjusting this risk by the particular asset’s tendency to move in sync with the general market (represented by beta).

* How does this relate to litigation finance?*

As I mentioned in this post, a portfolio of litigation related assets should have almost no tendency to move in sync with the general market. As opposed to, say, a luxury brand that sells more shoes as the general economy does well, and less shoes when the economy does poorly, litigation related assets produce revenues as they methodically work their way through the legal system – a system which is highly uncorrelated with the general market.

In practice, this means that the beta of a portfolio of litigation related assets should be 0 or extremely close to zero. If this is the case, then cost of capital to finance a portfolio of litigation related assets should be the risk free rate! (Risk Free Rate + 0 * Equity Risk Premium = Risk free Rate).

Currently, the risk free rate is about 2% and the equity risk premium is about 6%. This means that the average cost of capital for the market is 8%, while a portfolio of litigation related assets should in theory be 2%. So, for the same set of cash flows, litigation finance portfolios should be four times more valuable than the average market portfolio.

As I write this, this is of course not the case. Here are some thoughts on why (I am sure there are many more):

• A sufficient portfolio of litigation assets has yet to be accumulated

• Nascent industries such as litigation finance tend to demand a higher cost of capital

• Illiquid assets demand a higher cost of capital

However, this is a powerful concept, and as litigation finance continues to grow, it will be interesting to see how the cost of capital changes.