Investors in litigation finance are attracted to an emerging private asset that offers compelling returns that are potentially less correlated to the public and private equity and debt markets.

However, litigation finance investments often involve bespoke and complex deal structures and can present challenges for determining the fair value of the asset¹ for financial and investor reporting purposes.

In this article, we provide an overview of the asset class and discuss techniques and best practices for measuring fair value for financial reporting.

What is Litigation Finance?

The general term “litigation finance” can have different meanings and encompasses a myriad of deal types with a wide range of risk profiles. A common feature is that capital is provided by investment vehicles to law firms or plaintiffs to support legal (lawsuit) expenses or general working capital needs.

Some investments will have a fixed or capped rate of return, while others can be very sensitive (even binary), determined by the outcome of litigation either through the courts or settlement agreements.

In this article, we focus on litigation finance from the perspective of the investor. In this case, the investor is the party that outlays funds to a third party with a stake in one or more litigation matters. The repayment or return of the investors’ funds are based on the outcome of the underlying legal case(s).

In the remainder of the article, we provide an overview of investment types and then describe a framework for estimating the fair value of litigation finance positions.

Product Types

Law Firm Funding

Law firms are businesses that, like most operating companies, have working capital needs. The timing of expenses (including payroll and rent) doesn’t always align with the receipt of income (client fees). The cash flow profile will vary among firms depending on the nature of the practice. Working capital facilities provided to firms can be unsecured or asset based and secured by success-based fees receivable. For smaller law firms, funding can require personal guarantees of the principals.

Though similar to traditional accounts receivable financing, some would consider this type of working capital funding to be litigation finance.

Contingent / Plaintiff Side

As a law firm’s revenue becomes concentrated in larger contingent fees, the lumpiness and uncertainty of cash flows can increase. This provides greater financing challenges for the firm and the need for more sophisticated financing options. Credit might be secured by contingent fees, which by their nature are inherently risky. The cost of capital therefore increases but can still be financed in a secured debt structure.

Moving further out on the risk spectrum, a concentrated portfolio of contingent fees may be more unpredictable than a traditional lender would be comfortable with. In these cases, the capital provider might want to share in the law firm’s success by taking a stake in the fees.

This can be done in a structure where the fee sharing is akin to an “equity kicker” that acts to enhance return on a loan. In some instances, capital providers may forego principal and interest entirely for an equity-type deal where capital is returned only through a share in the fees.

Class Action Funding

Litigation finance is commonly used to support large class action cases, including mass tort. Take, for example, a law firm that incurs expenses over what could be several years supporting a class action, advertising, and recruiting plaintiffs to be part of the class while also paying staff. Settlements of a billion dollars or more can provide a windfall to the firm, which can often receive up to 30% as a contingent fee.

Early settlements can result in a great outcome for the plaintiff law firm if the case is settled in the client’s favor, but it is not without risk, as a settlement is only one outcome of the dispute, and the amount and timings of a settlement are highly uncertain.

In this instance, a litigation finance capital provider can finance firm operations in exchange for a share of the profits.

Patent Defense and Monetization

While providing capital to law firms is a large part of the litigation finance market, operating companies or other entities acting as plaintiffs often use these funding options for liquidity.

Take, for example, a company whose key technology is the subject of a patent dispute that, if successful, would provide a meaningful cash infusion to the business. As the legal process works its way through its various stages, the company needs capital to fund its operations and the expenses of the litigation.

While attorneys in many cases are paid on a contingent fee basis, that is not always the case, and hourly charges can run into the millions of dollars.

To protect key technologies, litigation finance is available to defend against infringers and monetize technology assets through judgments in the courts or settlement agreements.

Investment Structure

Investing in litigation finance can take different forms. In many instances, a secured interest is gained through a credit agreement which would dictate terms for payment of principal, interest, and other contingencies. For equity-like deals, if an entity’s principal asset is the anticipated cash flow from litigation, the funder may invest directly in the entity holding the rights to proceeds.

In some instances, the investment is made through a Litigation Funding Agreement. In these deals, the funder would not own debt or equity but the right to receive proceeds contingent upon the litigation, often with variable return scenarios.

Fair Value Guidance

For financial reporting, the fair value of litigation finance investments will usually need to be determined under FASB ASC 820, where “Fair Value” is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.²

In particular, ASC 820 prescribes that the measurement of the Fair Value of an asset or liability should be based on assumptions that market participants would use in pricing the asset or liability.

Accordingly, the Fair Value measurements should be based on the price that would be received to sell an asset or transfer a liability, assuming a hypothetical transaction at the measurement date (i.e., an exit price).

For litigation finance investments, the valuation challenge is to determine this exit price for measurement dates that fall between the funding date (day one) and the resolution date or repayment date (date at which the economics or cash flows of the subject dispute are known with certainty).

Valuation Approaches

Three common approaches for determining Fair Value are the Cost Approach, Market Approach, and Income Approach, and we’ll discuss each below in the context of a litigation finance investment.

Unless the measurement date is close to the investment date, the Cost Approach may not be a reliable indication of Fair Value. Even if Cost (representing the initial funded amount or outlay) is equal to the concluded Fair Value, it must still be supported by the facts and circumstances that would lead a market participant to the same conclusion.

Until recently, however, a cost-based approach was common in valuing litigation finance investments, as investors argued that the value should not change unless there were significant updates in the status of the case. Valuations therefore often did not consider accretion over time, or the time value of money.

For more traditional equity investments, Fair Value can be estimated by using a Market Approach where multiples are applied to value drivers like revenue or measures of investment earnings, yield, or cash flows to investors.

For litigation finance investments, however, there are usually not appropriate value drivers or market multiples to apply those drivers to. While certain litigation claims may occasionally trade hands, multiples are rarely available or relevant to estimating the value of a litigation finance investment.

Since the Cost Approach and the Market Approach are generally not appropriate, this leaves the Income Approach as the primary approach used to determine Fair Value for litigation finance investments. The discounted cash flow analysis (DCF) is the most common application of the Income Approach, where the investment’s expected cash flows are present valued using a discount rate that appropriately accounts for the risk.

Since most litigation finance investments are bespoke structures, determining the discount rate for each position at each measurement date can be difficult. Understanding and quantifying investor expectations at the time of underwriting can assist in this task. Like other alternative asset classes including private equity, venture capital, and private credit, calibration of model inputs to the investor’s initial funding or underwriting assumptions provides a strong foundation to the litigation finance asset valuation approach.

In the AICPA private equity valuation guide,³ “calibration” refers to the process of adjusting valuation model inputs to ensure that the calculated Fair Value of a portfolio company investment at the initial investment date matches the actual transaction price, effectively anchoring the valuation to the observed market data at the time of the investment and ensuring consistency in subsequent valuation periods. It involves using the initial transaction details as a reference point to calibrate unobservable inputs like growth rates or discount rates used in the valuation model.

Probability Weighted Models

The risk profile for some litigation finance investments can be like venture capital investments. That is, they have a wide range of potential outcomes which are difficult to predict. The investment price therefore reflects risk associated with the wide range of outcomes where a lower price correlates to higher risk.

The best way to assess value in these situations is through the use of a Probability Weighted Expected Return Model, or PWERM. In underwriting the investment, the investor would lay out a range of possible outcomes. For each outcome, or scenario, the forecasted cash flows would include an expected payout (or payouts) at a point (or points) in time. Each scenario would have a likelihood of occurrence, or probability, where the sum of the probabilities would equal 100%.

Below is a simple example for a litigation finance investment with a range of outcomes. In the example, the funder is investing in a share of proceeds in a litigation matter related to a proprietary technology and certain patents that are being infringed upon. The holder of the patents is suing the infringer for damages, and there are a range of possible outcomes.

For this example, we assume the potential scenarios or outcomes are:

• The defendant agrees to settle the case out of court with a lump sum payment to be received in the not-too-distant future
• The defendant decides to fight the case in court, but the plaintiff ultimately wins, with a lump sum payment (likely larger than that of the settlement scenario) received a couple years out
• The defendant and plaintiff agree to settle the litigation through a licensing agreement in which the plaintiff will receive an agreed-upon cash flow stream over time
• The case goes to trial, where the defendant wins, and no judgment is awarded to the plaintiff

These are just a few examples of how a case might play out, as there are endless possibilities, especially for the amount and timing of any awards. Each of these scenarios can have a different distribution profile depending on how the investment is structured. The waterfall dictating how proceeds are allocated to various parties can vary based on amounts, timing, and return hurdles.

The following exhibit expresses the scenarios outlined above in the form of a PWERM. The table shows the investor’s best estimates for the probability of each scenario and the corresponding the cash flows for each scenario.

In this example, if the funder pays $75.0 million for the probability weighted expected cash flow at entry, the expected implied return (IRR) would be 42.7%. There remains a wide range of outcomes, however, from a total loss to an IRR of 63% and 2.7x multiple on invested capital (MOIC).

When valuing fixed income securities (private credit, for example), the yield at origination is often used to anchor the discount rate for future valuations. With more predictable cash flows and generally lower rates of return, the purchase price can accrete over time at the origination yield.

In the case of litigation finance investments, however, the IRR at origination when used on its own usually does not produce reliable results for subsequent Fair Value estimates. Consider the case above, where the initial IRR was determined to be 42.7%.

Using the above example, and moving forward six months, if none of the expected cash flow assumptions had changed, using the original IRR as the discount rate in the DCF would suggest that the Fair Value of the investment had accreted to nearly $90.0 million, or a 20% increase over cost in only six months.

A 20% increase in investment value at six months since inception may seem like an unwarranted increase in the mark if nothing fundamental about the deal has changed since the underwriting. For this reason, litigation funders would often report the value of the investment at cost if nothing had changed rather than accrete a phantom value. The valuation would only be increased if a meaningful event occurred that would impact the expected cashflow. Holding the investment at cost, however, does not incorporate the impact of the money’s time value, which would likely be considered by a market participant.

While using the implied underwriting discount on its own can produce an inflated estimate of Fair Value, the underwriting model can still be effectively calibrated.

Best Practices

The world’s largest provider of litigation finance is Burford Capital, a publicly traded company with a significant portfolio and experience in financing a wide range of disputes, including international arbitrations. Burford’s Principal Finance segment provides capital against the underlying value of high-value single or multiple litigation and arbitration matters at any stage of the process from before filing to after a final judgment has been entered. Burford will also provide capital to a law firm that has agreed to take a case on a contingent fee or alternative fee basis, as well as directly to the client.

In May of 2023, Burford published its revised approach to determining Fair Value. According to Burford, its revised valuation approach was the result of constructive dialogue between Burford, the SEC staff, and the company’s external auditors.⁴ As such, it has become accepted by certain audit firms as a preferred approach to determining Fair Value for financial reporting.

Under Burford’s revised approach, expected future cash flows are discounted for time and risk, although objective case milestones remain the principal determinant of Fair Value changes. To determine the initial net present value (NPV), the anticipated realization is reduced by a “litigation risk premium” and discounted so that NPV at t=0 equals initial deployed cost.

Following this approach, let’s take another look at our earlier example. Assuming an estimated 8.0% cost of capital for a discount rate, the NPV or the originally projected probability adjusted cash flows would be $122.1 million. The cost of capital reflects the funding cost associated with carrying the investment. In Burford’s revised methodology, the discount rate accounts for the time value of money, which was not properly factored into Burford’s valuations prior to the change in methodology.

Since the cost of the investment at underwriting was $75.0 million, there is a built-in litigation discount of 38.6%, equal to one minus the result of Cost divided by NPV. This discount can then be used in a calibrated model at future measurement dates to determine Fair Value. The litigation discount, which some investors might refer to as a “haircut,” accounts for additional uncertainty which is also reflected in the cost of the investment which was lower than the NPV at origination.

At a future valuation date six months from the origination, using an 8.0% discount rate produces a NPV of $126.9 million. This value, however, is prior to the litigation discount of 38.6%, which would be applied to properly calibrate to the underwriting model. The net result would be an estimated Fair Value of $77.9 million, which reflects a slight increase over cost of $75.0 million six months earlier, and properly considers the time value of money.

The modest increase considers that, while there has been no change in the underlying assumptions, there is still some accretion for the time value of money. Even with the same risk considerations in play, logic suggests that an investment that is six months closer to being realized should be worth more to an investor than the identical investment with a longer duration.

The preceding examples are shown under the assumption that there have been no changes to expected cash flows between the underwriting or origination date and the Valuation Date. In implementing this valuation approach, each scenario needs to be carefully reviewed. As the exit approaches, probabilities can and should be adjusted to factor in the status of the investment and likelihood of success of each of the paths.

The litigation discount can also be adjusted to reflect the achievement of milestones along the way. These could be settlement offers or important rulings in favor of the plaintiff, and therefore the funder of the investment. These inputs can be the most difficult to assess, especially for independent valuation professionals.

Model assumptions should be discussed and carefully vetted through those closest to the litigation, including investment professionals and legal counsel responsible for the case or cases. In addition to changes in probabilities or the amount of expected proceeds, changes in timing can have a meaningful impact on the Valuation.

Conclusion

The valuation of litigation finance investments requires specialized knowledge, and while some core principles of valuation apply to these investments, the variation in the structures make the valuation exercise more difficult.

1. In particular, the fair value of the position in the period between the investment initiation or underwriting date and the ultimate legal resolution and payoff.
2. (FASB ASC 820-10-20)
3. Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies, August 2019.
4. Burford Capital Full-Year 2022 Results, May 16, 2023