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.
“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]
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
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