With legal fees up 6% last year, the rise of litigation finance has improved access to justice for claimants who may not otherwise have the means to pursue costly litigation
Litigation finance also benefits law firms as a revenue enhancement and risk mitigation tool, enabling many firms to provide clients with alternative fee arrangements (AFAs) and realize a portion of their fees incurred litigating a case, while also sharing in the upside of a successful outcome.
While litigation funding can be essential to unlocking good claims, obtaining funding for this option presents a multitude of challenges. Indeed, the process of securing funding is complex and too often inefficient and riddled with avoidable pitfalls. These difficulties arise because of several factors, including the complexities of litigation funding itself, the opacity of the market, and the unfamiliarity that both lawyers and clients often have in dealing with the process.
Despite this, demand for litigation finance continues to grow with a significant increase in utilization by Am Law 200 firms. Indeed, $2.7 billion was committed to 353 deals in 2023, which were financed through 39 active funders that represented a total of $15.2 billion in assets under management, according to the “Westfleet Insider: 2023 Litigation Finance Market Report”. Large law firms represented 35% of the new deals, representing $960 million in new commitments, the report showed.
Going forward, we expect an increase in litigation cases this year, and litigation financing will continue to grow along with it.
Navigating the market
Clients often may engage their trial counsel to pursue litigation funding for their case. However, for counsel, this typically is new territory that is not only transactional in nature but also transpires in a niche, unfamiliar market. Even for trial counsel experienced with litigation funding, their knowledge of the market is usually limited and often out of date.
Of the 39 active litigation funders in the US, there are generally three types: dedicated funders that specialize in litigation finance, multi-strategy funders – usually hedge funds with dedicated litigation finance desks – and ad hoc funders that occasionally participate in the litigation finance space. Some funders are publicly traded companies while others are privately funded, leading to differing investment criteria and capital deployment pressures. In addition, each funder may have its own unique approach and areas of specialization.
There’s been a 6% increase in legal fees due to the rise of litigation finance
The relatively limited but diverse universe of funders results in a market that tends to be both fluid and opaque at the same time. It’s very difficult to get information on who the funders are, what size and types of cases they fund, and at what point they might be in their funding cycle (which dictates their risk tolerance and appetite). This makes it challenging to vet them to determine the best fit for a given case, often placing clients and their counsel at a disadvantage in dealing with funders to negotiate a deal. Funders can carefully evaluate a case that’s brought to them, but on the other side of the table, there’s very limited information about funders themselves, their preferences, previous deals, their standing relative to competitors, and their current market standards for deals.
The financial aspects
Litigation funding, by its nature, often involves high-stakes cases with large litigation budgets. And due to the non-recourse nature of the funding, underwriting can be laborious and time-consuming. As such, these are complex deals that differ in many ways from standard commercial financing.
When approached thoughtfully with a case ripe for funding, funders will issue a proposed term sheet that sets out the terms of their potential investment. We routinely see dramatic spreads between these proposals, specifically, their return and waterfall structures, or the order in which litigation proceeds will be allocated to the funder, counsel, and client. Unlike other capital markets in which the cost of capital is measured in basis points, litigation funders often seek returns as multiples on invested capital (MOIC) ranging from 1.5x on the lower end to as much as 5x for some matters. At these rates, even relatively small differentials in these multiples can mean variations of millions or even tens of millions of dollars in the cost of capital.
In addition, there are many ways to structure financing deals. The return structure may be an MOIC, percentage returns from the proceeds of the case, or a combination of the two, as well as the inclusion of differing stages and triggers. There may be different waterfall structures or funding schedules, such as tranches based on milestones in the legal process. Some funders require repayment of transaction fees.
All told, the process of vetting these offers can be overwhelming to an inexperienced user, and negotiations with funders can easily end up leaving millions of dollars on the table or saddling clients with high expenses or unnecessary risk. It is essential that clients have a complete understanding of transaction costs, return structures, and payouts, and how the latter will impact what the client will ultimately see from the case proceeds, depending of course, on the outcome of the matter.
Financial modeling can help lawyers and their clients interpret these intricacies to determine the best deal for them. When done right, modeling can provide a comparative analysis of competing term-sheet offers, taking into account the likely outcomes of the case to determine how various proposals will impact the funder, law firm, and most importantly, the client. It can also enable a client to determine the optimal balance of internal and external capital and undergo a cost-benefit analysis relative to the client’s specific objectives. This can streamline the decision-making process and bolster confidence that the client obtained the best financing deal possible and that all options were thoroughly evaluated.
Navigating the process
In seeking the best terms, a major obstacle is that the market tends to be very opaque – even among funders themselves – in terms of pricing and other deal terms, making it difficult to know the current market norms or trends. Because litigation financing investments are non-recourse, they are considered high risk and funders seek a high return often set up under complex structures that can be difficult to understand. All of this complicates knowing how to initially present a case to a funder, what terms to ask for, and what areas on which to potentially push back during negotiations.
Even beyond pricing, there are significant differences among funders on access to capital, preferences for deal structures, as well as critical deal terms such as control. Funders have varying diligence processes for evaluating whether to invest in a case, including methods for reviewing cases, the approval processes, and investment tolerances. Funders can invest in litigation in several different ways, including funding fees and expenses; providing advances for pending claims, judgments, or awards; accelerating payment for law firm receivables; and combining funding with contingent risk litigation insurance. Additionally, financing can be for a single case or for a portfolio of multiple cases.
Because of the cumbersome details involved with diligence, lengthy delays are not uncommon. Any surprises encountered by either side during diligence can only add to the time involved to sort through and address matters as needed. While all of this is going on, most funders require exclusivity when issuing a term sheet, which prevents the client from approaching other funders. If it turns out that the funder is not the right fit, or the terms are not favorable and a deal is not agreed upon, then the process must start all over again. Moreover, approaching the wrong funder can taint a case, raising questions about why other funders previously turned it down. We have seen this impair or even ruin the ability to fund matters that were otherwise worthy on their merits.
Beyond the deal terms
There are other things to consider in addition to securing the most favorable terms. The closing of the financing agreement is in many ways only the beginning of the relationship. Compliance and monitoring are essential for all parties involved to ensure the deal is executed properly and with clear understanding. And the relationship between funder and client is long term – often lasting for years. As such, it is imperative that clients work with funders that they can trust and are good long-term partners.
Trial counsel frequently assist clients in pursuing funding, but this is generally done as non-billable time. As such, that diverts time and resources that could otherwise be devoted to case preparation. In addition, trial counsel negotiating funding open a potential conflict of interest for the firm: They are negotiating financing that may affect to what degree the firm stands to financially benefit depending on circumstances and case outcomes.
Litigation funding can be an important tool in enabling a case to proceed to trial. However, unless approached correctly, pursuing funding can be a time-consuming, difficult experience. Counsel and their clients should proceed with caution and develop a firm understanding of the market or consider the use of an experienced advisor to help them navigate the process and achieve a successful outcome.
This article was written for Forum magazine by Wendie Childress, Counsel and Managing Director of Westfleet Advisors
