For the past couple of months, we have been mostly discussing the benefits of using litigation funding, how it can help companies grow, and how it provides new paths for entrepreneurial litigators.
For those of you who have been following these posts, I thought it might be interesting to share a little about our vision of litigation finance and how we are building our company. In this series, I will talk about finding investment opportunities, the ins-and-outs of working with businesses, and any other topics that you might be curious about (just email me at drucker@lakewhillans.com).
Today, I want to start with what I think is the most critical aspect of building a successful litigation finance company: case selection.
It might seem pretty obvious that picking smart investments is critical for developing a successful litigation funding company, but what might not be obvious are all of the reasons why.
If Lake Whillans makes two $5 million investments, each expected to return $12.5 million in three years, then, if each investment meets its target, the expected internal rate of return (a rate of return metric used for long term projects) on the combined $10 million portfolio is ~36%. [1]
If, however, one of the investments is successful and the other investment fails, and returns nothing, then the effective IRR on the portfolio drops dramatically to ~8%. [2] While only 50% of the portfolio failed to meet its target, the IRR of the portfolio dropped by more than 75% (from a 36% IRR to an 8% IRR).
Why is any of this important (other than the fact that it is more profitable to have a higher rate of return)? Because in order to remain as a viable business, Lake Whillans, or any litigation funder, must generate a rate of return (after deducting expenses) that equals or exceeds its cost of capital.
Therefore, for every loss incurred by a litigation funder, that funder must charge a higher corresponding price to finance any new litigation in order to meet or exceed that cost of capital. It might be helpful to think of procuring litigation finance as buying car insurance. In order to achieve the best rate for your car insurance one should find a provider that only insures safe drivers; safe drivers get in less accidents; insuring drivers that get in less accidents costs the insurance company less money, and therefore the insurance company can offer a lower rate for a given amount of coverage. The same holds true in litigation finance. If a litigation funder is better able to select successful investments, then that company will be able to achieve the same rate of return as a competing funder that charges higher rates but less often selects successful investments.
To illustrate, imagine two litigation funding companies. Funder A invests $5 million in five litigations, which take three years to complete and, if successful, will achieve a gross return of $25 million each. Funder B invests $5 million in three litigations, which take three years to complete and, if successful, will achieve a gross return of $25 million each. Litigation Funder A achieves success in only three of its five investments, while Litigation Funder B achieves success in all three of its investments. In order to achieve an IRR of ~20% on its portfolio of investments, Litigation Funder A would have to achieve an IRR of ~44% on each of its successful investments [3], while Litigation Funder B would only have to achieve an IRR of ~20% on its investments [4].
What does this mean for the claimholder? Litigation Funder A would have to charge a claimholder return of capital plus 50% of net proceeds on all of its investments to achieve a ~44% IRR in this scenario [5], while Litigation Funder B would only have to charge return of capital plus 20% on all of its investments to achieve its necessary ~20% IRR [6].
These are substantially different offerings for a business seeking litigation finance. If a business accessed capital from Litigation Funder B, rather than Litigation Funder A, it would be able to retain approximately 30% more of its asset.
When thinking about building a litigation finance company, it is important to attract the highest quality claims available. The best way to do this is to offer the most competitive financing terms, and the best way to offer the most competitive financing terms is to select the best claims right from the start, and that is what we have set out to do.
[1] See google spreadsheet Scenario One
[2] See google spreadsheet Scenario Two
[3] See google spreadsheet Litigation Funder A
[4] See google spreadsheet Litigation Funder B
[5] Total Proceeds=$25M; Return of Capital=$5M; Net Proceeds=$20M [$25M – $5M]; 50% of Net Proceeds=$10M [.5 * $20M]; Total Return to Funder=$15M [$5M + $10M]; IRR = ~44% [See google spreadsheet Litigation Funder A]
[6] Total Proceeds=$25M; Return of Capital=$5M; Net Proceeds=$20M [$25M – $5M]; 20% of Net Proceeds=$4M [.2 * $20M]; Total Return to Funder=$9M [$5M + $10M]; IRR = ~20% [See google spreadsheet Litigation Funder B]