“What trends are you seeing in the market?” is probably the most common question lawyers ask us after discussion of their individual case. Many who approach funders are curious about the funding market more generally: Who is growing? Who is doing well? And, naturally: when is pricing going to become more competitive?! I have now answered the question enough times that I feel prepared (if not qualified) to give a stock answer.
Funding is, of course, a new market. It has not been around for all that long: most of the major players are less than ten years old; and, unlike in other industries (the bar, for example), where the years of experience which leading practitioners have are measured in decades, many leading individuals in funding did not commence their careers as funders. Like most new markets, therefore, funding has massive potential to change as the market develops.
In the light of this, what is likely to happen in the next five years?
My five predictions are as follows:
- Law firms will become more like funders.
- In turn, funders will become more like financiers.
- Pricing will continue to become more competitive.
- Therefore, in order to maintain returns, funders will create new products.
- Courts will become more sophisticated at dealing with issues created by funding.
In this piece, I address the first two predictions. In Part 2, I look at the final three.
One: Law firms will become more like funders
First, many law firms are likely to find themselves operating increasingly like funders. This change is likely to be driven by, first, a “push” factor: the problems associated with single case funding; and, secondly, the recognition by law firms that borrowing money against their books of contingent fees is a way for them to be more efficient with capital.
“Push” factor: the problems of single case funding
Relative to other structures, such as a portfolio, single case funding has at least three disadvantages:
- First, it is a risky business. Pricing, therefore, is high.
- Second, several agreements need to be negotiated between client, lawyer, insurer and funder for each case. This means that the process is time-consuming.
- Third, pricing is calculated on a case-by-case basis. This means that it is difficult for clients to obtain indicative pricing from a range of funders without the need to spend time and money engaging with those funders.
Entrepreneurial lawyers are likely to recognise these problems.
In particular, the interests of individual partners at some firms could be piqued by the potential for high returns from funding. Then, as funding deepens its encroachment into the psyche of the legal market, those lawyers may be able to convince their more conservative colleagues that, really, their firm could do a better job than some funders are doing; or, at least, that their firm could do the job just as well and, in either case, make the profit which the funder is making.
“Pull” factor: efficiency with capital
Further, law firms in the US, although also increasingly in other jurisdictions, have for some years been seeking to benefit from the upside of winning cases by acting on contingency and then raising capital against that actual or potential fee income.
By raising money against this fee income, law firms will evolve to act like other businesses in the sense that they will seek to raise money, on a non-recourse basis, against their asset base.
This is likely to lead to two possibilities.
Go-getters may go it alone. Some firms may truly go it alone, creating an internal fund, most likely backed by capital from an external investor and overseen by an internal investment committee from within the firm (firms are more likely to raise capital from an external investor rather than to go to their partners with a capital call for various reasons, including the following: law firms tend to be thinly capitalised, partners are risk averse, and a significant investment by partners into a fund may tend to limit partners’ prospects for lateral mobility). By way of example, Rosenblatt recently announced the creation of an internal fund. These internal funds will bring with them the potential to make large profits for their firms. Further, they will be propelled towards that potential by an important advantage: the firm already fully owns the client relationship.
But one key problem which internal funds may face is that funding and lawyering require different skillsets and mindsets. Put another way, the best lawyers may not make the best funders. Therefore, I predict that those who choose to go it alone in this way may face substantial difficulties, unless they recognise the different skills in play. One way in which this preparation could take place is that, contrary to the current trend of lawyers joining funders, law firms may recruit individuals from funders who have relevant expertise to assist in the creation of internal funds.
Others may arrange portfolio facilities. Firms which do not choose to go it alone this way are most likely to partner with funders to create facilities.
The best facilities are likely to be those where the client only needs to negotiate with the law firm; in other words, those in which the client does not need to deal directly with either a funder or an insurer. Bench Walk’s suggestion is to achieve this by structuring facilities in broadly the following way:
Example portfolio funding structure diagram
- The firm faces the client and acts on a conditional fee agreement (CFA) or a damages-based agreement (DBA), agreed between the client and the firm.
- The funder, in the background, takes risk away from the firm by funding fees on an ongoing basis, through a special purpose vehicle (SPV) which is separate from the firm.
- In return, when the firm receives its uplift from the CFA or payment under the DBA, the funder receives a share of that profit.
- The funder takes the adverse costs risk from the client but, in the background, buys after the event (ATE) insurance from an insurer in order to hedge that risk (but, crucially, the client does not need to deal directly with the insurer).
- Use of the facility is governed by an investment committee, most likely comprised of representatives from the firm and one representative from the funder.
- Crucially, the approval of the funder’s own internal investment committee is not required to approve funding for individual cases (or at all). It is the investment committee of the funding SPV that makes investment decisions.
This structure incorporates one of the key advantages of the in-house facility, which is that the law firm can fully own the relationship with the client, whilst at the same time reducing risk for the firm, thereby allowing the expertise of the law firm in lawyering to be complemented by the expertise of the funder in funding.
As these facilities develop, whether as a result of law firms going it alone or by partnering with funders, law firms are likely to become more like funders.
Two: In turn, funders will become more like financiers
When law firms become more like funders, funders may need candidly to self-evaluate their range of value adds. That evaluation is likely to commence by assessing the various tasks at a funder. Those are, crudely, origination (finding cases), due diligence (assessing and pricing cases), execution (structuring and closing investments in cases), and monitoring (checking how cases are going).
When law firms become more like funders, the existence of in-house facilities within law firms may mean that clients with cases run by partners at that firm will naturally tend to consider the use of the in-house facility for funding in the first instance. This will have the concomitant effect that work which previously existed for funders originating those individual cases from that firm is no longer needed. Similarly, the existence of investment committees comprised of members of the firm is likely to reduce the work of the funder, in terms of gathering information and assessing cases.
But funders are very likely to always be uniquely well-placed to evaluate financial risk, for at least two reasons.
First, funders see new cases every week or, sometimes, every day; that is, far more cases than a lot of lawyers. We see more scenarios, more clients, more lawyers, more wins, and more losses; funders therefore have a certain institutional knowledge of how certain types of cases have tended to play out in the past, and a sense of what the existence of certain factors may mean for the percentage chance that various outcomes will occur again in the future. That combination of instinct and experience will, I predict, always be difficult for a law firm to parallel.
Second, funders more readily have access to individuals with financial backgrounds, such as individuals with career backgrounds in the banking sector.
As law firms become more like funders, therefore, funders are likely in turn to reinvent themselves to become more like financiers who have a particular expertise in assessing the value of litigation.
With thanks to Adrian Chopin, Bench Walk Advisors, James Glaysher, Akin Gump Strauss Hauer & Feld, and Carlos Abadi, Decision Boundaries.