About a month ago, I discussed the venture capital landscape, and why litigation funders are attractive partners for VCs and VC-backed companies in need of resources to adequately defend their businesses. A similar, but distinct, phenomenon exists in private equity.
Private equity firms (which invest in a broader class of companies and employ a wider array of value generating techniques than venture capital) share some common characteristics that make litigation finance a useful product within the industry.
- Disciplined Budget: Private equity firms (or “PE firms”) typically implement disciplined budget allocations to meet operational targets and service debt payments. For example, a PE firm might invest in a middle-market company selling a specialized product within a specific region, and attempt to grow the value of the company by using excess cash flows to grow sales in broader market channels. Or a private equity firm might invest in various companies within a fragmented industry with the aim of consolidating the companies into a single entity and thereby reduce redundant costs.
- Debt Financing: PE firms often utilize debt in order increase return on equity. Debt reinforces a portfolio company’s need to maintain a disciplined budget. Some have theorized that the discipline of debt itself is a benefit:
“This “discipline of debt” can force management to focus on certain initiatives such as divesting non-core businesses, downsizing, cost cutting or investing in technological upgrades that might otherwise be postponed or rejected outright. In this manner, the use of debt serves not just as a financing technique, but also as a tool to force changes in managerial behavior.”[1]
- Exit Strategy: PE firms most typically monetize their investments through some form of divestiture, such as a sale to a strategic acquirer or an IPO. In either case, the sale price of the company is usually based on applying a multiple to the relevant metric (EBITA or NOPAT are popular metrics in private equity) or valuing the company by a discounted cash flow analysis. In both methodologies, the vast majority of a company’s value is derived from its core earnings. Revenues from a litigation are considered non-operating revenues, which are reported on an income statement separate from operating revenues, and therefore are likely to be discounted by investors as a one-time gain.
These common characteristics among private equity firms make it difficult for them and their portfolio companies to invest in monetizing a legal claim. The strategies outlined above put a premium on maintaining a disciplined budget in order to effectuate the goals of the PE firm; this makes it difficult for a company to divert resources to unanticipated investment opportunities such as the monetization of a legal claim.
Further, the debt burden on these companies makes it imperative that short term cash flows do not falter. Many portfolio companies are forced to make tough decisions about divesting non-core business and downsizing in order to facilitate debt payments. In this environment, it can be particularly difficult for a company to divert cash flows that could be used to ease the debt burden to a litigation which might not realize its value for a number of years.
Ultimately, private equity firms are focused on creating profitable exits, and this is achieved by driving metrics that will be used to value the company at sale. For example, if a private equity firm both acquires and sells a company at an EV/EBITA ratio of 10, any increase in the EBITA of that company will result in a 10X increase in value for the PE firm (before taking account of debt account, which further compounds the effect). Any award in a legal claim, however, is not likely to increase the value of the company by more than the amount received, and therefore will derive far less value for the private equity investor.
Litigation finance companies, such as Lake Whillans, can help PE portfolio companies unlock the value of legal claims, which would otherwise be dormant assets. Further, litigation financiers can provide capital to help sustain the company’s operations using only the legal claim as security.
[1] http://pages.stern.nyu.edu/~igiddy/LBO_Note.pdf