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The following is a contributed piece by Ed Truant, founder of Slingshot Capital,
Executive Summary
- EDLC Investing is a relatively new, niche market requiring highly specialized skills
- EDLC has many advantages over CLF investing, although it is not a directly comparable investment strategy due to its application to publicly traded markets
- EDLC investing requires investors to have more of a buy/hold mentality than a ‘trader’ mentality due to the ‘fundamental’ risk being assumed
- Despite EDLC ‘events’ being non-correlated, the publicly listed security aspects of their portfolios add some level of correlation which will impact fund performance, both positively and negatively
Slingshot Insights:
- There are many benefits and few drawbacks to EDLC investing as compared to CLF
- The scalability of EDLC investing is only limited to the number of dispute events
- The ability to control and take advantage of risks, including the ability to influence litigation, in EDLC investing makes this an overall superior asset class in my opinion
- The tools open to EDLC managers to mitigate risk or enhance returns (hedging, changing position sizes, trading during the investment period, liquidity) provide a number of benefits to securing better risk adjusted outcomes and allows them to avoid complete losses, although they come with a cost
- EDLC investors may also have the ability to undertake CLF investing within their mandates
As I interface with investors and fund managers in the legal finance market, I am constantly on the lookout for new investing strategies that can either provide a better risk-reward outcome than traditional legal finance investments, or add an element of ‘edge’. Edge is a word used in asset management circles to describe a unique point of differentiation that results in a better risk-reward outcome, which could either result in lower risk or higher returns or a balance of both, as compared to another manager executing the same strategy.
In the commercial litigation finance market, many of the fund offerings are generally homogenous with ‘edge’ being provided by an area of specialization where the team has a data or insight advantage in comparison to their peer group, which in turn, allows them to outperform their competitors. Sometimes the manager has decided to focus on a particular case type (consumer, mass tort, bulk claims, etc.) and their portfolio consists entirely of that single case type, where they have created a point of differentiation around their ability to identify good cases and perhaps some efficiency associated with originating and administering claims to settlement. Sometimes, the manager will have a particular expertise in a particular claim type, Intellectual Property (“IP”) for example, and their portfolio consists entirely of IP claims.
Another way to differentiate yourself is to apply an existing model to a different market. In commercial litigation finance, many of the funding contracts are private, illiquid and are generally providing financial support to small private companies with limited financial resources. However, there is another model that applies many of the same litigation finance attributes, but to the much larger public markets, and this may be referred to as the “Event Driven Litigation Centric” (“EDLC”) Investing market. Perhaps a more appropriate moniker is Event Driven Dispute Centric investing, as the strategy stretches beyond litigation and could involve any dispute (i.e. regulatory, customer, employee, etc.) that gives rise to a pricing dislocation.
“Event Driven” investing is nothing new. It has been practiced by hedge funds and professional investors for decades. Investopedia does a great job of describing event driven investing, which follows:
An event-driven strategy is a type of investment strategy that attempts to take advantage of temporary stock mis-pricing, which can occur before or after a corporate event takes place. It is most often used by private equity or hedge funds because it requires necessary expertise to analyze corporate events for successful execution. Examples of corporate events include restructurings, mergers/acquisitions, bankruptcy, spinoffs, takeovers, and others. An event-driven strategy exploits the tendency of a company’s stock price to suffer during a period of change.
However, if you do a search for Event Driven Litigation Centric investing, your browser may come back with few results, if any. If it does, it may reference situations involving securities litigation, which is but one application of this strategy.
EDLC is not for the faint of heart, but there are many attributes that merit discussion and contemplation, because in comparison to commercial litigation finance, I believe it has many advantages and few disadvantages.
First, let’s define what it is.
Event Driven Litigation Centric Investing Defined
EDLC is a form of investing where the event involves litigation either for or against a publicly listed entity, where the investment is typically in the form of debt, equity, or both. EDLC investors look for investment opportunities where a piece of litigation (or similar event like a regulatory breach or other issue) arose for or against a corporation, and the market has either misinterpreted the risk or the reward such that the debt or equity of the corporation in question is either lower or higher than its intrinsic value when you adjust for the potential effect of the litigation (or other similar) event. It is often the case that the public markets are not rational (despite efficient financial market theories), and they consistently under or over react to an event, especially a litigation event where the potential outcomes and timing are inherently uncertain and almost impossible to accurately value. To be fair to the public investor, including institutional investors, they simply have neither the information nor the skill to properly and accurately value the financial impact of such an event. Accordingly, in the absence of that information and insight, they indiscriminately ‘dump’ the stock and repatriate the proceeds elsewhere, or they mistakenly believe the event is less impactful than it is in actuality, and hold on to a stock that is overvalued (which indicates that perhaps a short position is warranted). This is the exact point in time when EDLC investors start to roll up their sleeves and do a deep dive into the event to determine whether the impact on the company’s debt/equity is justified, over-estimated or under-estimated and react accordingly.
In addition to the legal event causing the stock to drop or get mis-priced, there are also situations where the company has a claim that the market under-appreciates or is unaware of. A strong example is the Hertz equity story (see Case Studies section in part 2 of this series) where no investor believed equity was entitled to a recovery in the bankruptcy. The EDLC investors’ efforts to form an ad hoc committee, convince the court to give equity its ‘day in court’, bring in other funds believing in the equity story, and partnering with one of the private equity firms bidding for Hertz were activities an EDLC manager employed to reach a positive result In Hertz. It was the involvement of an EDLC investor that prevented Hertz equity investors from getting ‘wiped out’, which was the only plan under consideration just two months before its emergence from bankruptcy.
Once the EDLC investor validates their thesis regarding the potential impact on the subject company by combing over publicly available information, including data obtained through Freedom of Information Act (“FOIA”) requests or attending court hearings concerning the litigation and gaining a deep understanding of how these events may resolve, they then create a thesis to support an investment approach. Once an investment approach is approved by the investment committee, the team starts to acquire an appropriately sized position in the stock or debt (or derivatives thereof) of the company with the idea that once the litigation that has given rise to the market reaction is either settled or there is sufficient information in the market for the market to value the impact, the debt or equity will then become appropriately priced by the market and the investment manager may choose to sell the securities at that time to lock in their gain and move on to the next opportunity, all else being equal.
With EDLC now defined, let’s now look at how it differs from Commercial Litigation Finance (“CLF”).
Comparison of EDLC to CLF
Public Markets vs. Private Markets
As mentioned, EDLC is essentially the application of legal finance to the public markets. However, in order to appreciate what that means we must look at the differences inherent in the two markets.
The size of the public and private markets in the US are relatively comparable with the private markets larger than the public markets based on capital raised ($2.9 trillion for private and $1.5 trillion for public based on a 2019 study), depending on how you approach the valuation of each. However, the liquidity of public markets at $33 trillion dwarf the private markets at $0.10 trillion in annual trades. These factors make the public markets much more attractive as there are many more options available to fund managers to mitigate risk and enhance returns.
The public markets are also closely regulated (although some would argue not enough) and in the US financial markets this is the purview of the Securities and Exchange Commission (“SEC”). The private markets are also regulated by the SEC, but much less so than the public markets due to the sophisticated nature of the investors in the private markets. The public markets need to be more highly regulated as they are accessible by retail investors and therefore more susceptible to unscrupulous actors.
In theory, the public markets are efficient and the prices therein reflect all information about the public company. Private markets, on the other hand, are not transparent and therefore are considered to be inefficient in terms of information available to the markets (although any leveraged buy-out private equity fund may beg to differ), which many believe make them better investments.
Given that the private markets lack transparency, investors are dependent on specialists to understand the value of these assets, whether those are private equity firms or litigation assets. The quantification of value of litigation assets is that much more difficult due to the lack of information on the defendant’s position and due to the inherent idiosyncratic risk accorded every litigation in addition to the unknown position the defendant will take in terms of resolving the litigation.
While the public markets are considered to reflect perfect information, it is rarely the case. Further, in the case of an event like a dispute, the public market investors are generally ill equipped to understand the nuances of the dispute and the potential outcomes. All this to say, both markets rely on experts to guide decision making and in this respect the two markets are similar although the skill sets of the managers are very different.
Asymmetric Returns
Hedge fund managers love opportunities where their downside is limited, but their upside is not similarly constrained. In these types of opportunities, the downside risk pales in comparison to the upside potential, hence the outcomes are referred to as “asymmetric”.
To a certain degree, this applies to CLF investing. For a given $1 investment, the CLF investor may lose the $1, but can stand to earn $3, $4, $5 or more if the investment is successful. However, in many funding contracts, for competitive reasons, the upside is limited and the limits are tied to duration. For example, a funder may be limited to a three times multiple on their investment if the investment pays out within three years, and that may increase to five times if it pays out in five years, but beyond that any additional duration is the risk of the investor as few are prepared to guarantee or compensate for duration risk. Sometimes funding contract proceeds are contracted as a percentage of the case proceeds, and in such cases, the proceeds are only limited to the quantum of proceeds collected, thereby providing less constraints on the upside of the investment (but those claims generally have higher risks of downside loss).
In contrast, EDLC investors can make their investments in equities and the very nature of equities is that their upside is unlimited. And the consequence of this is not only can they benefit from the mispricing of the security in the market related to the litigation or regulatory event, they can also benefit (or potentially suffer) from the successful (or unsuccessful) operations of the company in which they are investing. Accordingly, this puts the onus on the manager to not only analyze the event in the context of the value of the business, but they must also analyze the operations of the business in the context of the market(s) in which it competes. If an EDLC manager were to invest in the equity of a business on the basis of solely the litigation event that is impairing their value of the equity, then if that same business is performing poorly any gains that may result from the resolution of the event may be completely offset by the company’s operational performance, which is where hedging may come in to play. Another tool EDLC investors have at their disposal is to vary the size of the investment to take Into account the risk of movements in fundamental value. For example, while an EDLC investor may be positively inclined to Sonos’ intellectual property claim against Google, they may decide to size their Sonos position to a small percent of their portfolio and then wait until closer to the trial to increase the size to their more typical hold size. This is unlike CLF investors who typically cannot modulate their Investment to take account of market conditions.
Hedging
When a CLF investor enters into an investment, they are typically limited in terms of their ability to hedge themselves, as their options to limit risk are constrained since many of the plaintiffs are private enterprises. Sometimes, the borrower might be a publicly-listed company that has other financial options to offer in terms of derivatives that could serve to limit downside risk to accentuate upside returns, but this more the exception than the norm. More recently, insurance products have been developed for the CLF market to effectively share the risk that CLF investors assume and while these have been generally helpful to offset loss, they can come at a steep price which significantly affects the economics of the CLF investing (although the same can be said for the cost of hedging in EDLC investing). It also remains to be seen whether these insurance products will ultimately pay off in the event of a loss as there hasn’t been a lot of empirical evidence of this given the nascency of the CLF insurance market (the same counter-party risk does not generally apply to derivatives).
Conversely, in the world of EDLC investing the investor can typically use derivatives to structure their investment from the outset, which could potentially serve as a hedge (e.g. put options) to limit their downside risk if they are investing long the equity or an equity sweetener (e.g. call options) to potentially enhance the benefits inherent in a positive outcome. Credit default swaps may be helpful to limit downside risk if the EDLC investor is investing in publicly-listed debt. Of course, as with any financial instrument the use of options comes with a cost. The other challenge associated with derivatives is that they are generally time sensitive products, and since litigation is inherently difficult to judge in terms of timing, the use of derivatives comes with duration risk in addition to the binary risk associated with the litigation inherent in the EDLC investment. In this sense, options would be considered an imperfect hedge.
EDLC Investors may also seek to Isolate the litigation claim. Some empirical examples Include: (i) long Buenos Aires bonds (the only Argentinian province that has not restructured) and short Argentina sovereign bonds (which has high correlation to Buenos Aires debt), (ii) long Hertz equity and short Avis equity, and (iii) long Mallinckrodt first liens that have a make-whole claim (claim for call-protection) and short pari passu first lien debt that has no make-whole claim, thereby taking out company and market risk. These are all tools that CLF investors typically don’t have in their funding contracts, mainly because many of their clients are privately held.
Active vs. Passive Investing
In the context of CLF investing, once the funding contract has been negotiated, the funder is prohibited by law, in most jurisdictions, from interfering in the case or influencing the lawyer or the plaintiff in their decision-making process. Some funders will actively try to assist the plaintiff and counsel by organizing and participating in mock trials or they may bring data analysis to the attention of their partners to make for better decision making but by and large they are passive investors.
EDLC investors on the other hand are typically active investors. They may sit on credit committee boards if they are owners of the debt and are actively trying to represent the best interests of the debt holders to maximize their return. They may also interact with management teams and provide their insight on the litigation event as it would not be uncommon for them to be in attendance at court events in an effort to ascertain whether the outcome of the event is likely to result in a manner consistent with their thesis, or perhaps inform them as to whether they should reduce their exposure or exit altogether. Other examples of activism include recommending supplemental strategic counsel to companies to enhance litigation strategies, sharing legal due diligence material with the company to improve litigation knowledge (i.e. sharing FOIA materials to improve knowledge about its competitors), and joining ad hoc bondholder groups. In addition, the EDLC investor can also provide the company financing to monetize litigation trust units other unsecured investors have no interest in.
Lender vs. Owner
They say “ownership has its privileges” and it is no less applicable to EDLC investing. Litigation Funders are non-recourse investors that ultimately obtain their rights through their funding contracts and as such their rights are limited to the terms and conditions of those very funding contracts and they cannot influence the outcome of the case. Once they make their investment, there is not much they can do other than provide their opinions, provide value added services and watch the investment play out, which also makes them dependent on legal counsel and subject to the plaintiff’s wishes. On the odd occasion and on the assumption the litigation has been de-risked and is of a decent size, the manager may be able to engage in a secondary market transaction to monetize part of their investment, similar to what Burford did with its “Peterson” investment.
EDLC investors on the other hand are either unsecured or secured creditors in the case of debt investments and shareholders in the case of equity investments. As a creditor, EDLC investors have a number of protections afforded them either through their contractual documents or through rights established in common law or bankruptcy law to protect their investments. Indeed, EDLC Investors in restructuring investments have an array of bankruptcy code provisions at their disposal to further their litigation interests. In Hertz, the ad hoc equity holders challenged the proposed terms of the bankruptcy plan pursuant to sections 105 and 363 amongst other provisions of the US Bankruptcy Act to require an auction for the sale of Hertz.
As an equity investor, they also have rights as shareholders in the company and protections afforded through state and federal law. A relevant example is RenRen, a Chinese company with U.S. American Depositary Receipts, where the company colluded with Softbank to transfer valuable assets at significantly below market value. Shareholders in RenRen challenged these transactions In NY state court arguing shareholder protection laws precluded the company’s actions. Shareholders succeeded with RenRen resulting in a positive resolution in December 2022. In other words, they have a seat at the table and are potentially highly influential to decision making (either through the company or through the courts if they are chairing a creditor committee) and perhaps more so than even the company’s own management, in part because they are so highly specialized in their field and in part because of the protections the law provides.
Many tools, many options
For the most part CLF investors have one tool at their disposal and that is in the form of a funding contract. As there are no limits to the imagination, there are occasions when CLF investors can get creative and design funding contracts to work like derivative agreements or add elements of optionality, but those opportunities are few and far between in the CLF market in part due to competitive pressures at the time when these funding contracts are being sought and in part due to the private ownership structure of many of the litigation funding clients. In this sense, the CLF market is a bit limited in terms of the ‘tools’ it can bring to the table and the solutions it can provide. Although, there are new insurance products being developed daily and managers like Soryn IP Capital are bringing true innovation into the legal finance market which I expect we will continue to see as the market evolves.
One of the benefits of EDLC is that the capital markets provide many potential ways to approach investing which can be utilized in concert or separately, many ‘tools’ if you will. While EDLC investors are mainly involved in public debt and equity investments, they also have many more ways to access investing in derivative markets (puts, calls, credit default swaps, etc.) that can serve to reduce risk or enhance the asymmetric returns for which this form of investing allows. EDLC investors can also undertake private transactions with these entities to provide similar outcomes to CLF, but typically they will enhance their positions by combining that with some sort of equity position to ‘juice’ their returns thereby enhancing the upside of the asymmetric return profile. In short, the EDLC investor has many more options at its disposal to create the right product for each situation to (i) enhance the risk/return profile of the investment, (ii) control duration, and (iii) avoid a complete loss scenario.
In addition to having many different options to structure their exposure, depending on the nature of their investment they may have the added benefit of being able to apply margin/leverage to enhance returns, which is something not typically available to CLF funders given the inherent binary nature of their investments and a general aversion by LP investors in these funds to allow for the use of leverage.
Of course, the ability to risk share is also something that publicly-listed companies have at their disposal. So, the EDLC manager has to be fully aware of the existence and extent of insurance coverage their investee company has in place for the given litigation exposure as this will serve to mitigate risk for the company and potentially negate the affect the outcome the litigation event will have on the price of its debt and/or equity.
Deployment Risk? What deployment risk?
I have written in the past about a risk that is unique to litigation finance relative to other alternative asset classes which is its double deployment risk. The first deployment risk stems from the fact that most funders are investing out of a ‘blind pool’ fund which requires investors to commit before investments have been identified, a very normal practice in private equity. The second deployment risk stems from the fact that commitments are deployed into cases over time as part of a risk mitigating strategy and a reflection of the fact that resolutions can happen at any given point in time in the litigation cycle. As such, monies are not drawn and put to work immediately in most claims, whereas management fees are charged on these monies regardless of whether the commitment to the investments are drawn. With less ‘money at work’ the returns on committed capital (as distinct from drawn capital) are diluted, whereas the impact of management fees on returns are accentuated, which places pressure on the portfolio to generate strong net returns.
With EDLC investing, while the first deployment risk is equally applicable, when the EDLC investor makes the decision to invest, their investment monies go to work immediately if the manager chooses to commit to a full position out of the gate. So, EDLC investing does not have the second deployment risk inherent in CLF investing, and they can scale their investments accordingly. They then have the further flexibility to either sell down their position or increase their position depending on how things are progressing, how the markets are reacting and how the investment fits into their portfolio. It is not uncommon for EDLC investors to “trade” their positions during their hold periods based on new knowledge and market reactions thereto.
The lack of the second deployment risk also has a direct impact on the extent to which the management fees can represent a ‘drag’ on returns, which are exacerbated in CLF investing.
Multiple “kicks at the can”
In the discussion of asymmetric returns, I touched on the concept of benefiting from both the event and the performance of the business excluding the impact of the event. This is an important distinction vis-a-vis CLF investing as the outcome of the event in CLF investing is the only path to generating returns. Absent a positive outcome, the investment will have to be written off to its net realizable value (often zero in the event of a loss at court).
One of the fundamental differences between EDLC and CLF is that EDLC invests in securities whereas CLF finances expenses that are used to pursue litigation which can be viewed as sunk costs. Once the investment is made, there is no option for recovery other than the outcome of the litigation. Whereas with EDLC investing there could be multiple paths to returns and the investment is never likely to be zero the way it can be with CLF, unless the subject firm is pushed into bankruptcy as a result of the outcome of the case. And even then, an EDLC investor may be able to extract some value for its investors through the bankruptcy process, as outlined in the Hertz case study. So, even if the litigation ultimately goes against the company and validates the market price of the debt or equity in the marketplace, the EDLC investor can then look to the underlying earnings of the company to potentially provide a return. For this reason, EDLC investors are less likely to invest in businesses where the fundamentals of the business are in question (Hertz was an exception given the prospects for the car rental business during Covid). Further, because the EDLC investor is involved deeply in the investment by virtue of their specialized due diligence and knowledge, they may have an informational advantage that allows them to sell their position to less informed parties and thereby minimize their losses.
In the second part of this two part series we will examine some case studies, discuss additional attributes of the two investment strategies that investors should factor in to their decision-making process and answer an important question – “is this too good to be true”?
Slingshot Insights
As you will see from my disclosure below, I like the strategy so much I became an investor and this strategy now represents my largest investment in legal finance related strategies. In my opinion it provides all of the same exposures as those of litigation finance, but does so in a way that mitigates downside risk and maximizes upside potential. It adds an element of flexibility for the manager that can’t be found in CLF investing, in my experience. The clear taxation treatment removes an area of lingering concern for me as it relates to the CLF marketplace. As long as you have an appropriate investing horizon and are prepared to deal with some mark correlation while the investment thesis plays out, this appears to me to be a significantly better approach to obtaining exposure to idiosyncratic risks to create a portfolio of uncorrelated outcomes.
As always, I welcome your comments and counterpoints to those raised in this article.
Edward Truant is the founder of Slingshot Capital Inc. and an investor in the consumer and commercial litigation finance industry. Slingshot Capital inc. is involved in the origination and design of unique opportunities in legal finance markets, globally, advising and investing with and alongside institutional investors.
Disclosure: An entity controlled by the author is an investor in investing vehicles managed by the EDLC Manager referred to herein.
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