Anyone reading an equity or fixed income fund document today should be impressed. Whether we are talking about fact sheets, annual reports, or prospectuses, funds today generally offer clear and understandable analyses of portfolio composition, portfolio value, and returns, as well as the performance of fund managers over both short and long-term. Hedge funds, and even private equity and venture capital funds, generally offer similar documents.
Legal funding, however, is not yet at this level.
Moreover, there is a fundamental disagreement within the industry as to whether analytics and reporting really matter. Funders routinely send me emails saying my views are unrealistic, while investors send messages encouraging me to continue advocating for these official reports.
As discussed in past articles--for starters, Finance for Legal Funders 101: Speaking Finance--I strongly believe the industry should emulate the more developed areas of finance.
This post will consider where the legal funding industry is today in terms of reporting, as well as look at some best practices funders can use to get started on the right foot.
A unifying feature of those investment funds mentioned above is that each niche is served by industry-specific software that helps make reporting easier. Similarly, there are legal funding specific software providers that can help create better analytics and processes in litigation funding, but that software is not yet widespread.
One restrictive factor is the different halves of the litigation funding market: personal injury versus commercial funders.
Personal injury funders are in many respects more developed in their reporting and analysis than their commercial counterparts simply due to the volume of investments. They analyze and fund hundreds, and often thousands, of cases during a given year and make greater use of pricing algorithms than commercial funds.
On the flip-side, as of March 2016, Burford's portfolio was comprised of just 54 investments and as of February 14, 2017, Bentham's U.S. arm had made just 45 investments over a 6 year period. This characteristic makes a personal injury fund more like a traditional bank or equity investment fund, compared to a commercial fund.
The large number of pre-settlement plaintiff investments enables economies of scale for personal injury funders that are not possible for or available to commercial funding today. Funding decisions can be made in just a matter of days, or sometimes even hours if a fund has a well-designed algorithm for pricing claim values.
Still, whether a fund is a personal injury funder, a commercial funder, or one of the other smaller niches in the space, reporting can be done most effectively with software.
Whether you're using Mighty's software for funders, ACT, Salesforce, homegrown software, or are just getting started and using spreadsheets, ensuring you're capturing the correct information will set you up to keep your current investors informed, as well as attract new ones when you raise your next fund.
In general, reporting has two sides: internal reporting and external reporting.
Investor-facing external reports for litigation finance tend to be almost non-existent at this stage of the legal funding industry's maturity. Investors generally have no realistic idea what portfolio valuation, exposure, or value at risk are on even a quarterly basis.
Litigation finance does, however, have a few unique features that internal reports can capture and communicate, and legal funders should consider.
One example of this is lead source. Identifying and recording sources for inbound cases is critically important in litigation finance, just as it is in mortgage origination. The costs associated with the "Big Four" sources for origination - law firm referrals, brokers, search engine optimization and search engine marketing - vary widely, and that data can be extremely relevant to pricing, as well as help funders decide which channels they should double down on, and which they should cut ties with.
Realistically, software offers one of the best tools for tracking this reporting. Litigation finance firms should maintain records of both the lead source category, as well as the specific name.
Image Courtesy of Mighty
Litigation finance firms also need to be able to track specific characteristics of their cases for the purposes of both attribution analysis and effective pricing models.
This is something that is widely done in finance. Four-factor pricing models are the basis of stock selection and returns analysis for most sophisticated institutional investors. This type of analysis has started to go mainstream with some of the "Smart Beta" products offered by iShares and AQR's mutual fund group.
Factor analysis does not exist in mainstream litigation finance yet, and, as a result, the vast majority of funds have no way to price claims effectively or predict returns based on case characteristics. I have done some work in building custom factor models for litigation finance funds, but such analysis is decidedly atypical at most funds.
Yet factor analysis and pricing for litigation finance is feasible with the right tools in place. Funds simply need to follow and note the course or progress of case characteristics and outcomes for matters they fund, as well as characteristics of cases they reject. Examples of data that should be captured, organized, and further analyzed could include:
The screenshot provides a snapshot of this in practice
Image Courtesy of Mighty
In the above example, expected settlement dates and case value might be based on internal models or estimates by external parties. Soon, automated models should be able to improve these point estimates.
Tracking returns on a case-by-case basis as well as for a portfolio is not only critical but also much more difficult than many people think. One dilemma that arises in traditional finance all the time concerns whether returns should be calculated based on equally weighted investments or value-weighted investments.
Equally-weighted return calculations give us a better sense of a fund's ability to "pick" investments, while value-weighted returns tell us more about overall value creation for investors. The reality is that both metrics are important, and well-run litigation funds have the ability to produce both sets of figures as the graphic below illustrates.
Image Courtesy of Mighty
The point to be made here is that, while different funds are looking at distinct types of cases in separate areas of the market, the type of metrics reported to investors are similar.
The key for litigation fund managers is to realize that simply giving investors a single IRR or MOIC number is no longer sufficient and to stay updated on the state-of-the-art reporting methods and software.
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