High-net-worth investors who are on a quest for absolute, uncorrelated returns may want to consider an investment vehicle that can truly be called an "alternative": commercial lawsuits.

The idea is fairly simple.  A fund provides capital-either a lump sum or periodic payments-to one side in a business dispute, or its lawyers.  In exchange, the financier receives a percentage of the settlement or judgment, or a multiple of the capital employed or drawn.  Much commercial-litigation financing is non-recourse-it's an investment in the litigation, not a loan to be paid back-so the profit depends on whether the party the investor backed wins the suit or receives a settlement.

Some of the more frequently funded types of legal disputes are intellectual property, contract, antitrust, bankruptcy and insurance matters.  Plaintiffs receive most of the financing, but defense funding is becoming increasingly common.

While defendants typically don't win an award if they prevail, there are circumstances where they could.  For example, if a plaintiff brought a claim that was unsuccessful and the defendant prevailed on a counter-claim against the plaintiff, the plaintiff could end up owing the defendant money.  After evaluating all the likely claims and counter-claims in a particular lawsuit, a litigation financier might well choose to back the defendant if the financier thought the defendant would prevail overall and "net" more in damages.

Finding cases to invest in isn't difficult. The longer litigation drags on, the more costly it can become to pursue legitimate claims. Litigation financing also frees up capital, allowing companies to focus their financial resources on core business activities that generate revenue.  So many companies and their attorneys are seeking to shift the risk of litigation from themselves to investors. The top commercial litigation funders say they don't have to advertise. Many funds employ former practicing attorneys with extensive contacts.  The industry has also received a fair amount of media attention, which has boosted its profile with companies and their attorneys.

There's not much competition from banks, which are generally risk averse and lack the ability to properly assess lawsuits as investments, let alone price them. 

"Because the industry is so nascent, we can price our capital very strongly and get really good returns. There are not a lot of funds competing for these investments," notes David Desser, managing director of Chicago-based Juris Capital, a private fund that invests exclusively in business-to-business lawsuits and reports returns exceeding 25% annually on a portfolio basis.

Bye-Bye Beta
As investments, lawsuits are assets that are virtually uncorrelated with the broad economy, according to Morningstar research analyst Benjamin N. Alpert. There's effectively zero beta because the value of the investments rises or falls based on the outcome of the underlying legal claims, not what happens in the stock, bond or property markets. The cases are not even correlated with each other since they involve different parties, different attorneys and different legal issues and thus will have different outcomes.

The returns are "absolute" in the sense that litigation is not cyclical. Ken Bradt, the  CEO of private New York-based litigation-financing provider JD Capital Advisors, characterizes his fund's returns as "stable and consistent." 

Cash-on-cash returns have been 15% to 18% for the last five years.

"The volume of litigation claims is pretty static. It increases by overall growth in economic activity, but it doesn't have big peaks and valleys," says Chris Bogart, founder and CEO of Burford Capital, a closed-end commercial litigation financing fund.  The company had its IPO in October 2009 and raised additional capital in November 2010 to become the world's largest dispute financier, with about $300 million in assets under management at the end of March.

The first position taken by Juridica Investments, a closed-end commercial-litigation financing fund that launched in December 2007 and trades on the London Stock Exchange's Alternative Investment Market (AIM), was in a case where it provided a $2.5 million line of credit to the plaintiff.  "We disbursed $9,000.  Our return was $3.5 million in less than six months," CEO and co-founder Richard Fields says.

Next was a case that had already settled.  "The lawyers wanted to borrow money against their future contingency fee. We loaned them $12.5 million at 25% interest.  We had a guaranteed minimum return of $1.75 million and were in and out in less than three months," he says.  

Clients can invest in Juridica, which currently has $210 million in AUM, two other public funds, or in private funds where investment minimums are generally $100,000 to $1 million or more. Capital is typically tied up for five years or longer, and investors must be SEC-accredited.  

Bradt, who's been in the industry since 2003, says there are about 20 private funds in the U.S. and about 40 globally.  Most of the major foreign private funds are based in London, including Harbour Litigation Funding, IM Litigation Funding and Therium Capital Management.  They focus primarily on investing in litigation in the U.K., not the U.S.  

Entering The Asset Class
There are two ways to get into litigation investing: direct investments or a public or private fund.

Direct participation in specific cases provides the greatest possible returns but also carries the greatest risks.  "As stand-alone investments, these are very speculative, very high-risk," Alpert says.

As Bogart explains, "There's no liquidity and you don't have the benefit of portfolio diversification or experienced underwriting." Direct investors who aren't extremely careful can inadvertently create potential ethical problems for practitioners, like compromising the attorney-client privilege, or running afoul of numerous state laws.

Moreover, these are "medium-duration investment assets," Bogart says, because the average time to settlement or judgment is three years. That's one reason interest in investing in this asset class is strong among institutional investors and private equity firms.  Illiquidity makes these investments inappropriate for hedge funds concerned about meeting redemption requests.

Juris Capital has served as a broker for "one-off" opportunities, but the firm advises against it for all but the most sophisticated investors. Instead, they typically build pools of lawsuit assets for clients that include high-net-worth individuals and family offices with $350 million or more.  

Old Game, New Players
Investing in litigation is not a novel phenomenon. "What's new is the existence of pure-play, professionally managed investment funds," Bogart says.

There are currently three pure plays that trade.  IMF Australia, which operates primarily in the Australian legal market and invests in both commercial and non-commercial lawsuits, was the first to go public in 2000, followed by Juridica Investments in 2007 and Burford Capital in 2009, both of which invest exclusively in business-to-business lawsuits.  
Although Juridica and Burford are both domiciled in Guernsey and trade on the London AIM, they invest primarily in U.S. corporate litigation and in international arbitration involving Fortune 1000 companies and the law firms that represent them.  Their investors are mostly large, high-profile U.K. institutions.

Both funds aim to provide investors with capital appreciation and dividend returns. "Burford's dividend policy is to pay out 90% of realized gains until we get to a 5% yield.  If we're going to be above a 5% yield, we switch to a 50%-of-realized-gain payout.  The purpose of that is to craft a security that's appealing both to income-oriented investors and to people looking for capital appreciation," Bogart says.

Managing Risk
"The most significant risk lies in the valuation of the individual claims by the management team," Alpert notes.  Simply put, litigation fund managers need specialized expertise in choosing the right lawsuits, just like equity managers must have stock-picking skills.

Because they're assuming a client's litigation risk, well-run commercial lawsuit funders conduct extensive due diligence before agreeing to finance a matter. Managers seek potentially high-value/low-risk cases that vary by type of underlying legal matter, to provide portfolio diversification, and by expected completion date, to provide a steady flow of funds.  

Limiting risk starts with accepting only cases where the legal merits are strong.  Liability must also be relatively clear.  Most of the high-profile funders have in-house underwriting departments staffed by experienced attorneys and accountants who try to determine probable case outcomes and estimate financial risk.  Many funds also employ outside legal and non-legal experts to assess particularly complicated or risky matters.

The probable payoff should be large enough to compensate the fund adequately for the risk as well as for the time spent on initial and ongoing due diligence. Collection or counter party risk must also be low. That is, if the party backed by the fund wins, the loser or its insurance carrier must be able to satisfy any settlement or judgment.

Many funders avoid cases that will likely end up before a jury, which adds to the uncertainty of the outcome.  They also bypass cases that could take a long time to resolve because that could diminish IRR, if it's not properly priced into the investment.  Other factors managers consider include the quality of the attorneys and expert witnesses, as well as the jurisdiction.  Well-managed funds also conduct legal and ethics compliance reviews before accepting cases.

To screen for the dizzying array of variables that could affect the outcome of a case, funds develop complex proprietary models. "We use decision tree modeling, scenario modeling and Monte Carlo simulations to value assets for our accounts," Fields says.

After all this scrutiny, few cases pass muster.  Juris Capital's Desser says the firm probably takes a "hard look" at one of every ten cases presented to the fund.  "Of the cases we review, we probably invest in less than 5%," he says.

Once the cases are chosen, most funds enter into a formal written agreement with the party being capitalized and become passive investors, which is why due diligence is so critical.  To avoid conflicts of interest, the majority of funders choose to have no control over how the funded companies or their lawyers handle the underlying matters, although most financiers require periodic reports from the attorneys about significant changes in the status of cases.

Not every manager in this evolving space is successful at choosing investments. In the last 12 to 18 months, several litigation funds, along with some of the world's best-known hedge funds, have approached Juris Capital hoping to sell their portfolios at a steep discount. Desser says Juris declined to buy them because they were "higher-risk, lower-likely-return portfolios than the ones we build here.  It shocked us."