The Hedge Fund World’s Promising New Investment Vehicle: Lawsuits

The alternative asset space is growing exponentially in search of higher returns and greater diversification. Now, hedge funds and other deep-pocketed investors see a promising new investment vehicle: high-stakes, lucrative lawsuits. Funding such lawsuits, a practice known as "litigation finance,” currently remains niche among specialized funds, but has the potential to become a widely accepted asset class given its rapid growth in recent years. That being said, it must first overcome certain ethical and transparency challenges. 

The strategy involves providing capital to law firms or plaintiffs lacking resources to fight costly, but winnable, battles. It acts like an equity investment in the lawsuit since the funder receives a portion of the proceeds, typically as a return multiple or percentage of winnings, upon case victory. This gives the plaintiff access to the legal system without the risks of defaulting on loans or suffering other financial issues in the case of a loss. Meanwhile, the hedge fund can create annual returns as high as 50% with minimal market correlation if it successfully manages the uncertainties of lawsuits and the risk of losing its entire investment.

 The practice largely emerged from the 2008 financial crisis, where funders took advantage of the unprecedented liquidity and financial issues that heightened the need for third-party funding. This created a burgeoning industry with around 40 funds today managing nearly ten billion dollars. Small funds investing in one-to-five-million-dollar payout cases make up most of this market, but some early movers have grown into elite funds investing hundreds of millions into claims with total returns reaching into the billions. 

Now, as companies re-think risk management and emphasize flexibility in the wake of the pandemic, demand for litigation finance has soared. In 2020, a Bloomberg survey found that 48% of elite law firms indicated a higher interest in the practice and 83% of litigation funders reported increased revenues due to the downturn. Even financially healthy companies find great value in litigation finance as it provides a tool to free up valuable cash and mitigate risk by transferring it to funders.

Along with established players, new participants and deal structures are emerging by taking advantage of these growth opportunities. Multi-strategy hedge funds have dedicated more litigation capital to compete with law-specialized funds, and many new cases are being bundled into portfolios to diversify risk and increase the scope of investment interest. Harvard University’s sizable investment in a litigation fund portfolio shows the growing appeal among a wider range of institutions. 

Traditionally, funds have targeted commercial litigation, international arbitration, patent, and restructuring cases, but there is increasing interest in environmental and pro-bono lawsuits since plaintiffs in these fields lack the resources to seek justice and have been historically underfunded. In 2019, a high-profile climate investigation into ExxonMobil launched by the D.C. attorney general engaged in litigation financing, giving the prosecutor adequate resources to hire top lawyers and front millions in initial legal fees. Since the plaintiffs behind these types of cases pursue societal value and justice over profits, they are more willing to trade the end payout for initial capital that can increase the likelihood of success. 

The future prospects of litigation finance appear bright, but ethical, legal, and transparency issues need to be resolved before the practice can scale up and gain popularity among traditional finance firms, such as asset managers and fund-of-funds. Key legal concerns, which include keeping control of litigation, disclosure, and maintaining attorney-client privilege, cause a high level of opaqueness that deters investors who already lack an understanding of the industry. Lawyers value autonomy and privacy during the case process whereas investors benefit from information and the ability to exert control, causing a disconnect between parties.

 Accordingly, allowing a third party to “bet” on the outcome of a legal case could lead to negative consequences and conflicts of interest. The practice gives hedge funds and powerful financial institutions a direct incentive to try to tip the case outcome in their favor. Historically, hedge funds have been known for questionable practices like using private investigators to find information that can intimidate opponents. It may be dangerous for the legal system to include participants like activist Paul Singer, who has been accused of blackmailing board members and forcing them to submit to his will during numerous campaigns. 

Though potential adverse consequences still remain unknown, the platform of litigation finance provides enormous value as a risk management tool for corporations, a pathway to the legal system for underserved plaintiffs, and a market-uncorrelated investment approach for funds. As lawsuits continue to become more like assets on a balance sheet, it is crucial to foster transparency and align investor, plaintiff, and law firm interests to ensure all parties benefit going forward.