In many private equity asset classes, managers typically deploy most of their capital in a particular investment on day one. While they may increase or decrease the investment over time depending on the strategy and the needs of the business and the shareholders, they generally deploy a large percentage of their investment in the early stages of the fund. Further, it is common for a PE fund manager to deploy between 85 per cent and 100 per cent of its overall fund commitments through the course of the fund.
Litigation Finance on the other hand rarely deploys 100 per cent of its case commitment at the beginning of the investment because it would not be prudent or value maximizing to do so. Accordingly, it is common for litigation finance managers to drip their investment in over time. In fact, funding agreements typically provide for milestone investing and also allow the manager with the ability to cease funding in certain circumstances in order to react to the litigation process and cut their losses.
The upside of this approach is clear – it is simply a prudent way in which to manage risk. The downside of this approach is that investors are often charged management fees based on committed capital (although this is changing), while the underlying investment is being funded on a deployed capital basis, which has the effect of multiplying the effective management fee.
This, of course, is in addition to the common issue of committing to a draw down type of fund that has an investment period of between two to three years for commercial litigation finance and five years for many private equity classes, during which an investor is paying management fees on committed capital even though capital isn’t expected to be deployed immediately. Commercial litigation finance adds a strategy-specific layer of deployment risk.
For purposes of this simplistic example, let’s contrast the situation of a private equity firm that invests $10 million on the basis of a two per cent management fee model with that of a litigation finance manager that also invests $10 million in the same management fee model, but does so in equal increments over a three-year period.
Private equity model (based on a $10 million investment)
Year 1 | Year 2 | Year 3 | |
Drawn Capital | $10,000,000 | $0 | $0 |
Cumulative Capital Invested1 | $10,000,000 | $10,000,000 | $10,000,000 |
2% Management Fee | $200,000 | $200,000 | $200,000 |
Expressed as % of deployed capital (B) | 2% | 2% | 2% |
Litigation finance model (based on a $10 million investment deployed evenly over three years)
Year 1 | Year 2 | Year 3 | |
Drawn Capital | $3,333,333 | $3,333,333 | $3,333,334 |
Cumulative Capital Invested1 | $3,333,333 | $6,666,666 | $10,000,000 |
2% Management Fee | $200,000 | $200,000 | $200,000 |
Expressed as %1 of deployed capital (A) | 6% | 3% | 2% |
Differences in fees in relation to capital deployed
| Absolute Difference(A-B) | 4% | 1% | 0% |
| Difference as a multiple of fees in PE ((A-B)/2%) | 2x | 0.5x | 0x |
1 Calculated assuming the capital is deployed at the beginning of the year.
The difference highlighted above can be taken to extremes when an investor has a relatively quick litigation finance resolution shortly after making a commitment. In this situation, they have deployed a relatively small amount of capital that hasn’t been invested for long, which typically results in large gross internal rates of return and relatively low multiples of capital, although the outcome very much depends on the terms of the funding agreement.
While this phenomenon produces very strong gross IRRs, when the investor factors in the total operating costs of the fund, the negative impact of those costs can significantly affect net IRRs. Accordingly, investors should be aware that this asset class may have significant gross to net IRR differentials, as well as multiples of invested capital. Further, one could conclude erroneously that strong gross IRRs will contribute directly to strong net IRRs. Accordingly, net fund returns will vary with capital deployment, case duration, the extent of other operating costs and timing thereof.
For investors, I wouldn’t want to suggest that deployment risk should discourage anyone from investing in litigation finance as the industry is capable of achieving exceptional non-correlated returns. Rather, awareness of this phenomenon is important and very much endemic to the nature of litigation and further influenced by the strategy of the manager and the sizes and types of cases in which they invest. Therefore, it should be considered in the context of track record diligence and manager selection.
Of course, deployment risk has a positive side because depending on how the litigation finance agreement is structured, an investor may be able to earn a return on committed capital regardless of how much capital is deployed (i.e. option-like characteristics). So, if very little capital is deployed the return as measured on a capital deployed basis can be significant. However, there is an opportunity cost related to having capital set aside but unused which needs to be factored into the overall return equation.
For fund managers, I think it is appropriate and fair where a fund manager obtains a quick resolution in a case investment that the commitment underlying the resolution be recycled to allow the investor a chance to re-deploy the capital into another opportunity and achieve its original portfolio construction objectives. Recycling is beneficial to all involved.
However, I would argue that it is not necessarily fair to charge the investor twice for the same capital, as that capital has already attracted and earned management and performance fees and one of the economic reasons underlying recycling is to minimize the difference between gross and net returns.
Edward Truant is a founder of Slingshot Capital Inc. These views are those of the author and not necessarily those of the Canadian Investment Review.