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Finance for Legal Funders

[Updated] Finance for Legal Funders 401: Portfolio Construction

March 10, 2017
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Updated 3/17/17 with Andrew Sakar's of IMF Bentham comment  on this post, and Michael's response at the bottom of this post. They provide two different but very well-informed and measured perspectives that are useful for all legal funders to take into consideration. Scroll to the bottom of this post to read more.   In this series on finance for legal funders, so far we've covered:

  1. Why it's crucial for legal funders to use proper financial language when raising capital
  2. How duration and convexity can be used to answer common investor questions
  3. Why accurately reporting risk is at least as important as returns

This week we'll take a look at a highly visible example of how investors may perceive funds if only limited portfolio metrics are provided.  

Key Takeaways For Legal Funders

#1 Legal funders need to present a variety of metrics (for example, Duration, Convexity, Monte Carlos, Regression analysis, in addition to IRR and MOIC) to really show how their portfolio is constructed and performing.

#2 Savvy investors are not going to be swayed by one or two eyebrow-raising metrics.

#3 Providing investors the "full story" will reduce uncertainty in the asset class, which is one of the key factors limiting investment.  

IMF Bentham as a Case Study

  By now, you may be well aware of the recent news that IMF Bentham is adding a $200M fund to its roster focused on the U.S. (see related article and commentary here). IMF Bentham's press release offers some return numbers for the fund in the U.S. and globally, and these numbers highlight the challenges of effective portfolio construction in litigation finance.

The press release also takes on added importance since Bentham is currently one of the best-known firms in the commercial litigation finance space. It is possible that investors could see the numbers provided in Bentham's press release as typical of the wider industry.

Before proceeding, one important caveat is that this is just a press release and likely isn't intended to provide the full picture. It is still worth considering, however, because it points to a broader fact that all funders should understand if they are planning on raising institutional capital: you must accurately communicate your portfolio's construction and performance through a mix of standard financial metrics.

According to IMF Bentham:

Bentham has, since its establishment approximately six years ago, concluded 14 of the 45 investments it has made in the U.S., and achieved an average internal rate of return (IRR) of 83%, a multiple on invested capital (MOIC) of 1.18x, a success rate of 64% and an investment period of 1.4 years.

IMF has commenced and completed 187 matters since inception in 2001, which includes the above US matters, that has produced a MOIC of 1.55x, a success rate of 90% and an average investment period of 2.4 years.

Over the past 5 years to 31 December 2016, IMF has achieved an average IRR of 59%, MOIC of 1.5x, and an average investment period of 3.2 years. 

The most important items to notice are that the IRRs associated with the investments are staggering, yet the MOICs are comparatively modest. This discrepancy isn't lost on savvy investors.

In a recent survey for its forthcoming 2017 Litigation Finance League Tables, Morning Investments asked investors about the factors they consider important in alternative investments and their reaction to statements made by publicly traded litigation finance companies, including the press release by IMF. This survey covered more than 20,000 investment managers and institutional investors and received more than 2,000 responses from individuals who indicated they were familiar with litigation finance to some degree.

The survey results were remarkable on several levels. The graph below offers insight into the expectations that investors have for alternatives (based on data from 2,168 survey respondents).  

  The IRR presented in the press release is even more staggering when you consider the rate of return investors expect from alternative investments. (Note: While the rate of return and IRR are different concepts, they are closely related, and both offer insight into investment performance.)

The graph shows that more than two-thirds of respondents expected to earn more than 10% on their investments, with more than one-quarter of respondents expecting to earna return greater than 20% on an annualized basis. For context, the average rate of return on stocks over the last fifty years is roughly 11.45%. Thus in general, investors expect alternatives, including litigation finance funds to provide a return at least as high as stocks, if not higher.

For those not familiar with the conversion between IRR and MOIC, the figure below lays it out. The Bentham press release describes IRRs significantly higher than 10%, yet it also details MOICs that are low in comparison.     

 

Investor Response to Bentham's Press Release

In an effort to avoid bias, all of these comments come from investors who said they were not familiar with Bentham, and they were given the exact press release issued by the firm.

So how did survey respondents react to this information? Comments included:

  1. "Unimpressive managers."
  2. "This is a low cash on cash return. You can't take IRR to the bank."
  3. "IRR is good for marketing, meaningless for investors. 1.18X MOIC does not come close to compensate (sic) for the risk associated with this strategy. A 64% success rate is uninspiring."
  4. "Recycling and hence recurring deal flow is key ... (you can't eat IRR)".

The skeptical responses are not a critique of Bentham, but they do point to a fundamental challenge that afflicts the nascent industry as a whole, portfolio construction and communication is not given enough attention.

Moving forward, for the litigation finance industry to continue growing, it certainly needs to find more deals –  there is no doubt about that. But the lack of deal flow is a problem with its roots in high cost of capital. And high cost of capital is because many investors continue to look at the existing return statistics and risk from the industry and perceive it to be excessively risky and undisciplined.

That perception is driven by funds failing to build a portfolio of investments that work together and complement one another, and legal funders communicating, either via press release or in private conversations, portfolio metrics that don't provide a full or accurate picture of the risk and return.  

  In bonds, stocks, private equity, venture capital, and every other major asset class, investments are never reviewed in isolation. Instead, investors look at the needs of their portfolio as a whole and take steps like laddering and hedging based on scenario analysis. (e.g. What happens to my portfolio if Fed rates rise 2% next year?)

In my experience consulting with funds and investors in the space, none of this is done effectively in litigation finance. The lack of effective portfolio construction techniques is holding back the space and creating a vicious circle that undermines new investment.

The funds that succeed in the future will be the ones that listen to investor concerns and build portfolios which are quantitatively valued, diversified by niche and duration, and account for reinvestment risk.  

Update 3/17/2017

Andrew Sakar, CEO IMF Bentham

Dear Michael

I have followed your blogs with interest.

You have made several comments that are sensible, and I would suggest undisputable. For example:

1. There is clearly an information gap between a number of investors and litigation funders. In my view, the key issues leading to this information gap are (a) relatively few funders provide audited reports for investors, and (b) for those funders that do report, the different reporting regimes employed by litigation funders, such as those that mark-to-market and include unrealised gains in their reporting, and those of us who report on a cost basis. This can produce results that appear significantly different.

2. The provision of information that is readily understood by the investor community would also assist in narrowing the gap. This will be a challenge whilst funders' portfolios are relatively small, and arguably undiversified. However, as portfolios expand, and reflect that of the other industries to which you have compared litigation funding (such as the reinsurance industry), opportunities to present additional information will arise, which will need to be grasped by the industry. However, until that point, it is a like comparing a corner shop to a supermarket in terms of scale.

There are other comments that you have made that are curious. Whilst I won't dispute your rigorous and impartial analysis, I note the following:

1. IMF Bentham's WACC is estimated to be less than 7%. Debt is currently provided at an average rate of 7%, and equity is estimated to be provided at 6.8% with a beta of 0.77.

2. IMF Bentham reports on a net MOIC basis. That is, net of losses and net of the principal investment. For example, and so it is clear, for $1 invested, IMF Bentham has received on completed cases to date in the US (which are as disclosed, reasonably few), after all losses, $2.18 including the $1 invested. From our discussions with US investors, we understand that this may be considered differently in the US compared to Australia, where the US tends to look at MOIC as a gross return, before losses.

3. IMF Bentham reports on average duration of completed cases, but does not provide forward guidance (given the obvious restrictions for providing guidance by our stock exchange). MOIC alone is meaningless, but coupled with duration, provides greater clarity, and as a happy coincidence, produces as a by-product an IRR calculation. With a duration of 1.4 years, and a MOIC of 1.18x, the IRR is a pure mathematical calculation, which for completed cases is 83%, after the losses reflected in the 64% success rate.

4. I understand that the concepts of duration and convexity are useful to analyse the behaviour and pricing of bonds with highly certain terms. For litigation funding, the performance of any given matter and indeed the portfolio is far too variable to apply these concepts.

5. I am also unconvinced on the relevance of convexity, or even a modified form of convexity, as neither future success rates nor duration can be measured with such precision to be meaningful. In litigation funding, the majority of outcomes are determined by way of settlement, not Court outcome. Decisions to settle are usually entirely in the control of a Defendant, not the Plaintiff client of a litigation funder. As such, measuring duration is more of a well-educated art, not a science.

6. Commercial litigation funders follow procedures and policies on investing, which in the fullness of time will be shown to be appropriate or inappropriate, usually reflected in a success rate on completed cases. For IMF Bentham, we regard our 90% success record, determined over a 16-year period on over 157 completed matters as informative of risk.

7. I understand that you have found that Burford use Monte Carlo analysis. I have not been able to locate that information, and I am not aware of any other funder that uses Monte Carlo analysis as a tool for modelling risk.

8. Investor responses we received to the information in our press release were, perhaps not unsurprising given amongst other things the differences in defining MOIC, the polar opposite to the feedback you received.

9. Your focus on portfolio construction does not take into consideration that litigation funders do not have the opportunity to invest in all litigation opportunities, unlike traditional investors in say the stock market, who can invest in any and all listed securities. Litigation funders are, by and large, deal takers. That is, from a limited pool of litigation opportunities, a litigation funder will select an investment opportunity that satisfies its own investment criteria and take that deal. There may be some portfolio constraints, for example to limit exposure to say patent claims, but beyond that, the opportunities are not so diverse as to be able to construct a truly broad portfolio in the sense as you suggest. In the fullness of time this is likely to change, as litigation funding becomes more well known, and accepted as mainstream.

Regards

Andrew Saker

CEO and MD IMF Bentham

Limited 13 March 2017  

Michael B. McDonald, PhD in Response

Hi Andrew,

Thank you for reading and for commenting. I'm delighted and flattered that you took time from your schedule to provide clarification on the post. While I believe that I have a broad perspective on the industry as a result of my work with investors and litigation finance funds, I have no doubt that you know many things I do not in this arena.

With that said, I would respectfully offer just a few thoughts on your commentary above.

1.) IMF Bentham's debt cost of capital at 7% may seem low on a relative basis, but part of that may be due to the current level of interest rates. For comparison, the average US BBB bond is currently yielding roughly 3.88%. That yield of course if for firm's on the cusp of junk status. The yield on 1 to 5 year Australian debt is roughly 3.25% - that maturity is particularly relevant in the litigation finance space given the obvious attractiveness of asset/liability matching.

While I defer to your knowledge of IMF Bentham's WACC, I am greatly surprised that your estimated cost of equity is lower than your cost of debt. That is extremely unusual not only in litigation finance but in any area of finance since debt is generally viewed by investors as safer than equity and hence equity requires a higher cost of capital.

2.) I have no doubt that many people in the litigation finance world would agree with you that duration, convexity, Monte Carlo simulation, and other quantitative metrics are not useful in the LF arena. I humbly believe that view might be incorrect. In fact, that is often the view that early participants in new asset classes have. A friend of mine is the founder of the premier pricing analytics service for senior bank loans, Loan Pricing Corp. As he tells it, when he first started the firm in the 1980's, many bank presidents laughed at the idea of putting a price on bank loans believing that they were too unique and too different from bonds to be effectively priced. That view proved erroneous and today bank loans are traded and priced like any other asset despite the fact that their is considerable variation in their terms, structure, usage, and risk. Bank loans have been embraced by many institutional investors as a result. Perhaps the same will hold true for litigation finance in the future. Only time will tell.

3.) I would certainly agree that portfolio diversification is more difficult in commercial litigation finance than in traditional equity investing for example. Nonetheless, I would argue that the industry can diversify more than it currently does. For example, at my own consulting firm, we have multiple plaintiffs bring us matters every week looking for funding. These cases are often overlooked by the traditional litigation funding industry because (1.) the plaintiffs are not sophisticated enough to be able to present the case in a compelling fashion on their own, (2.) the case falls outside the traditional spheres of the law that litigation funds are interested in, (3.) the case has a degree of complexity to it that limits investor interest (e.g. it is not US based). The reason that these cases are not funded is rarely due to financial constraints - for example, this morning I received a case with approximate estimated damages of $10M where the plaintiff is looking for $600K in funding - clearly the magnitude of potential damages is sufficient to be of interest given the needed investment.

Again, to reiterate, I certainly thank you for your time and energy in responding to my article. My goal here is not to tell you or any other funder that you are running your business "wrong". Rather, I hope to convey ideas that MIGHT help your firm and the rest of the industry to better attract interest from institutional investors and accredited investors of all stripes. In addition, based on my regular consulting work for the US Securities and Exchange Commission, my sense is that quantitative methods such as those I propose here and in past columns will help alleviate growing regulatory concern about the litigation finance space and other alternative investments.

Best Regards,

Michael B. McDonald,

PhD Partner Morning Investments

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Michael McDonald

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