Litigation funding versus other investment opportunities

Harry Markowitz - the Nobel prize-winning economist and godfather of modern portfolio theory - famously remarked that diversification is “the only free lunch in finance” and, as a result, it is a term that gets tossed around fairly indiscriminately in the investment community – often by financial advisors and private wealth managers or in product marketing pitches. The usual intention being to reassure investors their exposure is not concentrated in one single risky investment but instead spread across a number of different investment opportunities that are supposedly uncorrelated with one another.

The idea being that this should significantly increase the likelihood of a positive return given that there should, at least in theory, be only a remote chance that all these smaller investment opportunities yield negative outcomes simultaneously.  

However, the danger is when investors are sold what they are told is a diversified, low-risk investment opportunity but the individual sub-investments are either correlated to each other or to one or more common factors. This was witnessed during the global financial crisis of 2008, when portfolios of bonds were packaged together to “reduce risk” through diversification without acknowledgment that, in many cases, no matter which way they were presented, they were, in fact, all still exposed to similar risks – namely rising interest rates and slowing property price growth. 

It is also true with many of the more traditional markets open to smaller investors – for example, real estate, where prices are generally sensitive to fluctuations in the broader economy. Similarly, a major geopolitical shock can cause the entire stock markets to react such that it makes little difference whether you chose to buy shares in a tech start-up or the most stable utility - particularly with increases in globalization and interconnectivity between markets and sectors and where computers are able to exploit even the smallest arbitrage in prices within fractions of a second. 

One investment opportunity that should live up to its claim of offering real diversification is litigation funding. In contrast to other investment opportunities (e.g., equities or real estate), litigation funding has zero correlation with the fluctuations in the broader economy and other assets. It is likely that litigation funding might even be inversely correlated with the state of the financial markets if litigation increases during an economic recession — namely due to a sharp increase in insolvencies. The demand for litigation funding is expected to increase as more companies file lawsuits related to contract disputes and business insurance claims arising from the COVID-19 pandemic. Many of these litigants may require capital to pursue their claims, in which case the non-recourse nature of litigation finance investments should stay particularly appealing.

However, this might not always be the case. Macroeconomic events could adversely affect litigation funding indirectly, for example, via a reduction in investor confidence or issues related to enforceability/recoverability in case of a sudden decline in the defendants’ net worth. Nevertheless, litigation funding as an asset class still exhibits many benefits. Notably, each legal case is almost entirely uncorrelated with each other, so when investors decide to include new cases in their portfolio, the volatility of their portfolio would be reduced significantly. Thus, portfolio litigation funding offers further diversification. Investors can significantly increase the likelihood of a positive return of their overall investment by dividing their total investable sum amongst a number of claims.

Also, in contrast to other investment opportunities, litigation funding investment is also attractive because of its relatively short investment cycle and natural exit – namely, a court settlement creates a natural exit after typically two to three years. In addition, apart from providing investors with clear economic value, litigation funding offers more certainty than other investment opportunities as each case will lead to a binary outcome. Litigation funding also helps to level the playing field to offer access to justice for those who need it the most. For example, Small and Medium-sized Enterprises (SMEs) and individuals who enter contractual agreements with large companies often find themselves exposed to additional commercial risk due to the prohibitive cost of protecting their legal interests. Litigation financing is often characterised by generating significant returns to investors. Normally, the returns are a multiple of the investment, a percentage of the settlement, or a combination of both. It is common for investors of a winning case to expect to double, triple or quadruple their initial investment. 

However, this also means that it is a highly risky investment as investors could lose their entire investment. In some remote scenarios, investors could lose more than they invested. We view this scenario as unlikely as it would require that the insurance company refuses to pay or becomes insolvent (and for the claimant themselves to lack the means to pay their opponent's costs). AxiaFunder only funds cases that have ATE insurance cover from an insurer that is investment grade or that has a Solvency Capital Ratio of at least 110% to cover the adverse costs risk. This asset class is not for people who cannot afford capital risk. Investors should also recognise that any returns are likely to take several years to materialise.