By Marc Syz, CEO, and Hugo Lestiboudois, Principal, Syz Capital
It is a rare and exciting opportunity for a financial market participant to witness and contribute to the creation of a new asset class. It is even more so when this asset class presents characteristics typically attributed to billion-dollar businesses: a simple solution to a real problem and a large, underpenetrated market with high barriers to entry. We are not referring to cryptocurrencies or NFTs but to an asset class that serves a $750-billion-a-year industry1, the legal services market.
Legal assets are financial assets that derive their cashflows from legal outcomes—such as a court judgment, jury award, or settlement. The best-known strategy within legal assets is litigation finance. The fundamental mechanism of litigation finance is simple: most businesses are at some point involved in litigation that is costly and uncertain, and some investors can offer financing solutions to alleviate the costs and risks of litigation in exchange for a share of the potential proceeds. In 2020, it was estimated that investors poured $17 billion into litigation finance transactions globally2. Most of this capital was invested in the United States, the United Kingdom, and Australia, but deals in continental Europe, Asia, the Middle East, and Latin America are increasingly common. From family offices and specialist boutiques to some of the largest asset managers, hedge funds, insurers, and banks, the list of market participants keeps growing year after year as litigation finance becomes more institutional and offers opportunities to scale and build diversified portfolios.
Litigation finance has evolved from being a niche strategy to becoming a building block of an asset class that provides capital to unlock the value of assets in situations dependent on specific legal outcomes. The growing popularity of these financial assets, now commonly referred to as legal assets, has been attributed to the hunt for yield in a low interest-rate environment. We argue that legal assets present some fundamental attributes that make them an attractive complement to traditional investments in any market environment.
The first investment attribute that comes to mind when talking about legal assets is the uncorrelated nature of cash flows. The main trigger of returns in legal assets is a legal decision, such as a court judgment. The drivers and timing of legal determinations are unrelated to stock returns, interest rates, inflation, market sentiment, or other financial indicators driving returns across traditional asset classes, and correlation amongst portfolio constituents. The determinants of legal asset returns are mostly case-specific and related to a precise set of facts: applicable law, admissibility, liability, causality, and so on. Coincidentally, the uncorrelated nature of legal assets has recently been successfully stress-tested when most markets reacted in unison to COVID-19 lockdowns in early 2020 and the Russian invasion of Ukraine in early 2022. Many legal asset transactions were still able to generate cashflows during these drawdowns, delivering precious liquidity that could be reinvested during these market troughs or set aside to preserve treasury in uncertain times. While some transactions were affected by COVID-19 court closures that may have delayed case resolutions, this did not adversely affect case values. To some extent, the legal assets industry stands to benefit from the consequences of such crises in the economy: providers of legal capital have reported increased demand for legal financing as corporations seek to protect their working capital, and the increase in insolvencies is expected to create legal financing needs for the next five years at least.
A few alternative asset classes may come to mind when thinking about uncorrelated strategies, such as music royalties, catastrophe bonds, or life settlements, but very few exhibit the asymmetry potential of legal assets. There is a fundamental reason why legal asset strategies such as litigation finance can offer an outsized return to investors: the expected return on a litigation finance transaction is unrelated to the invested amount. This is truly unique. In other words, the amount of capital needed to develop a legal asset is not ultimately related to the asset’s future value. The amount of legal spending necessary to get to a judgment or settlement is not necessarily proportional to the value of a dispute but mainly to the complexity of the legal work. Whether a simple breach of contract relates to a 1-billion-dollar or a 10-million-dollar project, demonstrating the breach should require the same number of billable hours, but funding the former dispute can generate an outsized return for an investor even under a discounted recovery scenario. In practice, accessing these investment opportunities and evaluating them requires specific networks and skills. When sourced and executed correctly, certain transactions within legal assets offer a unique asymmetry potential for investors.
Of course, while legal assets offer the potential for decorrelation and asymmetry, investing in the asset class is no free lunch. Deploying capital in legal assets requires the ability to bear illiquidity risk, take a long-term investment approach, have robust servicing capabilities throughout the life of the investment, and, more importantly, be willing to be exposed to the volatile outcomes of legal procedures. The law and jurisprudence are evolving and constantly being tested, and the result of any legal process is inherently based on human decision-making. Any settlement or judgment results from the presentation and interpretation of facts and evidence in the context of the applicable rules, laws, and precedents by individuals who cannot rely on a formula, market pricing, or a scientific process to fully determine the outcome of a dispute. The behavioral and circumstantial elements that affect legal asset transactions are notoriously complex to translate into reliable forecasts. Consequently, legal assets are often qualified as high-risk investments, although there is a broad range of tools and approaches that an investor can use to mitigate or transfer part of that risk, some of which are unique to this asset class. The topic of risk mitigation alone could be the subject of a dedicated article.
The high-risk, high-asymmetry profile usually attributed to legal asset investments has caused many investors to draw a parallel with early-stage venture capital investing. While the expected return distributions of both asset classes do bear a resemblance, one significant difference is that, unlike venture capital investments, legal asset investments do not depend on capital markets or the appetite of other market participants (i.e., IPO or the private equity market) to be exited. Most legal asset transactions are self-liquidating since monetization is ultimately guaranteed by a final decision reached by a court. While the duration of legal asset investment may be uncertain because of the caseload at the court level, potential for appeals, or delay tactics, the monetization of legal assets is usually independent of the availability of refinancing capacity or secondary buyers.
As is the case with any financial asset class, one cannot reduce legal assets to a single investment strategy. Drawing a parallel with real estate, one can invest through equity or mezzanine instruments in early-stage residential developments, which offer high returns with limited downside protection. One can also get exposure to portfolios of senior loans on prime property anchored by quality tenants, which would have significantly more conservative risk-return profiles. The same breadth exists in legal assets, whereby on the higher end of the risk spectrum, an investor can get exposure to single high-value patent litigation or investor-state arbitration in a pure equity format; or on the lower end of the spectrum, an investor can invest in a diversified portfolio of senior secured loans to established law firms or acquire post-judgment receivables. The former investments may offer expected returns of more than five times invested capital with a 30-percent chance of loss and uncertainty on recovery timing. The latter may offer 5 to 7 percent per annum returns over a four-year maturity with a 1-percent expected loss rate.
Legal assets make sense in an alternative investment pocket for an asset allocator since they can provide genuinely decorrelated and differentiated returns. Because of the various risk-return profiles that can be carved out while preserving decorrelation, specific legal asset strategies can also help complement or rotate out of more traditional asset classes (e.g., high yield credit) or crowded alternative asset classes (e.g., mid-market direct lending).
Looking ahead to the coming years, legal assets are geared to grow and thrive with current trends. The legal world has yet to be disrupted by technology, although certain companies have ventured into technology-enabled legal asset strategies, such as using tokens to finance cases, using data scrapping to optimize sourcing, or using artificial intelligence to predict the outcomes of legal procedures. As technology further penetrates the legal industry and augments the availability and accessibility of data, legal assets will be positioned to benefit directly from such evolutions. More generally, the central role of technology in all aspects of our lives is a significant source of growth for legal assets since matters such as intellectual property, data privacy, or market dominance of technology conglomerates are sources of high-value legal disputes. Corporations and individuals are already being supported by legal financing in these technology-related matters to protect their properties and rights.
Legal assets are firmly here to stay because they present real benefits for investors and because legal finance will have a vital role in the evolution of our economy. In fact, working groups of legal professionals and providers of legal finance have recently been formed to anticipate the role of law in resolving disputes in commercial space activities or the metaverse, for example. Legal asset investors are already playing a role in protecting consumer rights in relation to the massive amounts of personal data being collected and processed by corporates, and non-profit organizations are taking corporate giants to court supported by legal finance. Multiple arbitration institutions have also reported an increase in the number of cases linked to climate change, energy transition, or policy changes related to global warming3; legal capital providers will be able to provide solutions to parties involved in these disputes, which will increasingly affect companies and individuals globally and across sectors.
Although legal assets are still being described as niche investments, one could argue that, on the contrary, because legal finance is relevant across sectors and geographies, it is a deep and global asset class. A potentially valuable legal asset will likely require capital to unlock its value anywhere a legal claim or dispute arises. And because legal assets offer significant diversification benefits, provide the potential for outsized returns, and are increasingly managed by institutional market participants, they should become a staple asset class in investors’ allocations in the years to come.
1 Statista: Size of the Global Legal Services Market 2020: “Estimated size of the legal services market worldwide from 2015 to 2021 with forecast for 2022.”
2 Swiss Re Institute: “US Litigation Funding and Social Inflation,” December 2021.
3 Pinsent Masons: “Third party funding of climate change arbitration,” Pamela McDonald, April 5, 2022.