By now you’ve likely heard about litigation finance and some of the advantages it can offer to claimholders (in a nutshell, the flexibility to pursue a claim without having to pay attorneys’ fees or other costs from the company’s balance sheet, as well as the ability to monetize all or a portion of a claim). “Sounds great,” you might be thinking, “but how much is this going to cost me?”
This article will review the basic pricing structures that litigation funders typically employ and the reasons why a claimholder may prefer one approach over another. At Lake Whillans, we have transacted using each of these pricing structures, and approach each transaction flexibly with the mindset of utilizing whatever structure works best for the claimholder. Further, we provide pricing early in the process; you can generally expect to have terms from us within 5-10 days of reaching out to discuss your matter.
Factors driving litigation finance pricing
Litigation funders consider two primary factors when setting pricing for an investment: risk level and timeline of the case. For a funder, investments in a single litigation or arbitration claim investment involves significant risk. Funders provide capital on a non-recourse basis, meaning that if the claim fails, the funder loses its entire investment. The greater the risk that a case will fail to achieve a return, the greater the cost of funding will be. Key drivers of the risk level of a case are the strength of the claim (and any defenses), the certainty and amount of damages, and likelihood of collection. When claims are bundled in a portfolio, the risk of loss is generally mitigated to a degree (as long as the claims do not all turn on the same risk), and therefore portfolios will generally receive lower pricing than a single claim.
As for timeline, the longer the funder anticipates its capital will be tied up, the greater the return the funder needs to reflect the time value of money. Key drivers of the timeline of a case include the stage of the case at the time of investment, the type of case, and the particular decision maker (i.e., the court/judge/tribunal). Litigation funders can make an investment at any stage, ranging from before the case has been filed through to after a judgment has been secured (but before it has been collected). Early-stage cases tend to be riskier and to have a longer timeline than later-stage cases, and the pricing will reflect those differences.
Given the high degree of uncertainty inherent to a litigation investment, funders naturally must require a larger return than, for example, a bank would earn on a fully secured recourse commercial loan. At the same time, responsible funders agree that the claimholder should keep the majority of any litigation proceeds. An experienced funder like Lake Whillans will work with the claimholder to structure a funding agreement that makes sense for all parties. Responsible funders will model various outcomes in terms of timeline, range of awards, and settlement projections, and may decline to fund a case if, in the likely scenarios, too little is left for the claimholder, in particular when the funding would prevent the claimholder from accepting a reasonable settlement.
Fixed multiple vs. percentage of litigation proceeds
There are two basic models for structuring a litigation funder’s return on capital: fixed multiple and percentage of proceeds, and a combination of both is often utilized. In the fixed multiple model, the funder recoups its capital along with a multiple of the amount it invested. The multiple can vary over the duration of the case: for example, the funder may be entitled to a multiple of 0.5 on capital invested if the capital is returned within a year and then to a larger multiple as time increases. As an example of this type of arrangement, suppose the funding agreement entitles the funder to (i) return of the capital it invested plus (ii) a 2x multiple on the capital invested. Let’s suppose the capital invested is $1 million; when the matter concludes successfully, the funder would receive $1 million as return of capital, plus a 2x multiple or $2 million for a total of $3 million. (This might be referred to as 3x pricing since the funder receives 3x what it put in).
In a percentage of proceeds model, the funder recoups (i) return of its invested capital plus (ii) a percentage of the proceeds from the litigation, 20% for example. So using our $1 million investment hypothetical, if the claim recovers $10 million, the funder receives $1 million plus 20% of $10 million (i.e., $2.0 million) for a total of $3.0 million. In the percentage model, the funder’s share of proceeds may be subject to a maximum dollar amount, or the percentage may decrease as the award size increases.
These two basic models can also be combined. The funder may be entitled to a certain multiple, plus an additional percentage return. In this hybrid structure, both the multiple and the percentage return are smaller than in a pure fixed multiple or percentage structure, but the combination of the two provides a risk-balanced approach to account for the possibility of achieving either the low end or high end of possible award size outcomes, which we will demonstrate below.
Reasons to prefer a given model
A claimholder’s preference for a given pricing model will depend largely on its risk tolerance and its assessment of the expected recovery relative to the funder’s investment. In our above example, assuming a $1 million investment and a $10 million return, the 3x pricing and the 20% of proceeds model yield the same result for funder and claimholder ($3 million to funder/ $7 million to claimholder). But the ratio changes depending on the size of the award.
In our example, if the award comes in at the high end of the expected range at $20 million, the 3x multiple pricing yields the funder the same $3 million, and the claimholder receives $17 million (or 85%). But if it was priced using the return of capital plus 20%, the funder recovers $5 million, and the claimholder receives $15 million (or 75%). Thus, if the claimholder expects a large recovery (as compared to the capital provided by the funder), it might prefer a fixed multiple model because the claimholder retains more of the upside in a high-recovery scenario.
The converse is also true: in a low-recovery scenario, the fixed multiple is relatively more favorable to the funder. Using the same example, if the award is $5 million, the 3x multiple pricing again yields $3 million for the funder, and the claimholder receives $2 million (or 40%). This result would likely be undesirable to the claimholder, so it may prefer the return of capital plus percentage model. Applying the return of capital plus 20% pricing would yield $2 million to the funder and the claimholder would receive $3 million (or 60%). Thus, if the claimholder wants to protect against the downside risk of a lower recovery, it may prefer a percentage of proceeds model, in which it has to share more of the upside in the high-recovery scenario but is relatively more protected in the low-recovery scenario.
Of course, the funder’s view of the case and its risk tolerance will also inform the pricing it prefers, and a hybrid model provides a compromise option that often appeals to both funder and claimholder. For example, hybrid pricing may include (i) return of capital, plus (ii) a 1x multiple plus (iii) 10% of proceeds. If the award yields $10 million, the split is the same ($3 million to funder, $7 million to claimholder) as it was in our two pricing examples above, but allots the risk/reward more equitably between funder and claimholder in the low recovery scenario ($2.5 million to funder, $2.5 million to claimholder) or the high recovery scenario ($4 million to funder and $16 million to claimholder).
The reserved facility vs. disbursed funds
To further understand pricing, especially in the context of a fixed multiple return structure, it is important to be aware of the distinction between the reserved facility and amount disbursed. Funders typically do not pay out their full investment in one lump sum; instead the funder makes a series of payments over the course of the case. The reserved facility is the amount that the funder sets aside to cover its full (projected) investment. Disbursed funds are what the funder has paid out at any given point. For a case litigated through trial, the reserved facility may equal the amount disbursed. Conversely, if a settlement offer is accepted at an early stage, only a small proportion of the reserved facility is likely to have been disbursed.
From a claimholder’s perspective, it may seem most appropriate to pay the multiple on the amount disbursed: why should the claimholder have to pay for funds it never actually receives? From the funder’s perspective, however, the reserved facility is capital that cannot be used for other investments and is at risk from the moment it is reserved or committed, so if the case settles before a large portion of the earmarked funds have been disbursed, payment of the multiple only on the disbursed funds will result in a low return to the funder that may not adequately compensate it for the risk that it took. These conflicting aims are frequently addressed by pricing that is based on a multiple of amounts actually disbursed, coupled with a minimum return for the funder.
The last key term of a pricing agreement is the waterfall. The waterfall is the order of priority in which shares of any recovery are paid to entitled parties, including the funder, the claimholder and, in some cases, counsel (if counsel has a contingent stake in the litigation).
A standard waterfall provides for the funder to recoup its invested capital before any other party is paid. The order of allocation of the remaining proceeds will be a product of negotiation, but it typically involves pro rata payments to the funder and counsel, based on their relative entitlements. The claimholder typically takes the remainder, after the funder and counsel have been paid.
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For an experienced provider of litigation finance like Lake Whillans, each funding agreement is the product of careful assessment and discussion with the relevant stakeholders. There is no one-size-fits-all pricing structure. The best way to determine which structure best fits the needs of your situation is to contact us.