Litigation financing tempts with high returns. Tips before buying in

For some investors, getting a piece of a legal settlement can happen without ever being part of a lawsuit.

It comes from investing in so-called litigation finance — a strategy that generally involves providing cash to litigants or attorneys to fund their cases in exchange for a portion of any awarded damages if the case is won.

If experts are right, it’s a market poised for growth: As investors search for returns uncorrelated to the markets, this small and largely unknown slice of the investment world may beckon. Additionally, demand from plaintiffs or law firms in search of funding also could rise as coronavirus-related economic fallout leads to more lawsuits — something that’s common in downturns — and more need for private funding.

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However, not everyone can access litigation-finance funds or similar options — you generally must be an “accredited investor.” That is, you must have at least $200,000 in annual income, a net worth above $1 million (excluding your home’s value) or joint annual income with a spouse of more than $300,000. 

And, there is a lot of risk. Among them: potential eye-popping returns that end up being a mirage. 

Here’s what to know.

Generally speaking, firms that provide litigation financing have a team composed of attorneys — who can assess the merits of a case and its chance of success — along with investment professionals who handle the finance side of things (i.e., structuring each deal).

“Most are set up like a private equity fund — they raise capital and have a certain deployment period to put it to work,” said Charles Agee III, CEO of Westfleet Advisors, which serves as an advisor to law firms and plaintiffs in need of litigation funding.

Commercial cases currently grab most of the action. That could include providing cash to a company suing another business for, say, patent infringement or breach of contract. In those cases, the litigation financing goes to the plaintiff that’s dealing with the cost of litigation for things like expert witnesses and their attorneys.

Or, the money could go to law firms directly, which often spread the funding among several cases. Sometimes those firms are working on a partial contingency basis; they charge the client a reduced rate and then take a percentage of any awarded financial damages.

There are roughly 40 entities involved in U.S. commercial litigation financing, with assets under management of $9.5 billion, Westfleet research shows. While there are a couple of public companies that do these types of transactions — including Burford Capital and Omni Bridgeway, both headquartered overseas — most are privately held.

Before the financial crisis of 2008-2009, there were just six dedicated litigation finance firms, according to LexShares, which entered the market six years ago.

Since its 2014 inception, LexShares has invested in 103 cases, according to the firm. Of those, 43 have been resolved with a 70% win rate and 60 remain outstanding. The return before fees and expenses is a median 52%, said Jay Greenberg, cofounder and CEO of LexShares. By comparison, if you had been invested in the S&P 500 index from January 2014 through this month, your gain would be about 71.5% (93.6% with dividends reinvested).

In contrast to the large number of funds that largely target institutional investors and come with minimums of $1 million or more, LexShares has an online marketplace for investors — both accredited and institutional — to pick and choose which cases to invest in. The minimum investment can be relatively low: $5,000 or $10,000. And while there is no management fee, you’d pay 30% of profits in so-called carried interest to LexShares.

And, of course, if the case or cases you invested in don’t pan out how you hoped, you lose your entire investment.

“If the case doesn’t settle in your favor, it can be a complete loss,” said certified financial planner Jeffery Nauta, principal and chief compliance officer of Henrickson Nauta Wealth Advisors in Belmont, Michigan.

“You either hit a home run or you lose all your money,” Nauta said.

You also may be able to invest in a fund that holds many cases in its portfolio, although the minimums can be steep. For instance, it’s $250,000 for a fund launched by LexShares earlier this month. It’s also more expensive: a 2.5% annual management fee, as well as carried interest of 25% (again, of profits). The fund has attracted $35 million of its targeted $100 million, said Greenberg of LexShares.

“This enables investors to make one investment in a [fund] and then be diversified among all the individual cases that we post to our site,” Greenberg said.

In addition to being high-risk, investing in litigation financing ties up your money, often for at least several years, simply due to the time it can take for a case to wend its way through the legal system. Often, the deals are structured so that the longer the case takes, the higher your payout.

And, because these investments are risky, it’s worth minimizing how much of your portfolio is committed to them — probably no more than 10%, Nauta said.

Additionally, as with all investment decisions, experts recommend making sure it’s done in the context of your entire portfolio and your goals for that money.

Nauta said it’s quite possible that more retail investors will end up putting money into this strategy given the volatility in the market. If the equity markets started trending south again, “there could be a re-evaluation of uncorrelated assets … and litigation financing typically has fit that bill.”

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