Other People’s Money. It is the secret to successful commercial legal strategy that not enough General Counsels and CFOs have adopted. Whether you are an SME or Novartis, you should be leveraging OPM.
Dispute finance is the concept of funding the legal expenses of a claimant or plaintiff on a non-recourse basis in return for a share of the damages awarded in the event of success. Dispute finance is essentially off-balance sheet preferred equity funding for legal matters, and can be provided for single cases, portfolios of affirmative and defensive matters or for the enforcement of judgements and awards.
When discussing dispute finance with boards and management teams I am often confronted with the argument that dispute finance is expensive. This argument assesses the cost of dispute finance in a vacuum and often with the benefit of hindsight. In the context of the risks at hand and relative to a company’s own cost of capital, it is veritably cheap.
How can that be? A third-party litigation funder could earn a 3x multiple on the legal costs funded, while your company’s bonds trade at 3% yields. But measuring the cost of dispute finance against your levered/unlevered/re-levered beta adjusted cost of capital is just that – WACC!
Your company’s bonds trade at 3% yields and your stock at a 20x forward P/E. Your bankers tell you that you have the lowest weighted average cost of capital (“WACC”) in the industry. This may be relevant for your next M&A deal but it is inadequate when considering whether or not to fund a litigation.
Litigation and arbitration is a risky, binary endeavour and is not the core business of 99% of companies. Legal matters should therefore be assessed with significantly higher project-specific costs of capital (“PCC”). This PCC must reflect not only the probability of loss for the case (hopefully less than 50%…) but also the opportunity cost of capital that could be reinvested elsewhere in the business at significantly lower risk.
Viewed this way, a company’s PCC is dramatically higher than its WACC when assessing whether to pursue litigation. Third-party capital will inevitably be cheaper than a company’s litigation-specific cost of capital. This is because litigation funders manage diverse portfolios of uncorrelated cases with a blended return target. And because this is their business, their opportunity cost of capital is also much lower than yours.
While private companies have no immediate feedback on their allocation of capital, public companies benefit from the “sounding board” that is the capital market. Equity markets in particular are loath to attribute value to unpredictable binary events. Take a look at biopharma and pre-revenue biotech stocks, for example.
So your company trades at 20x forward P/E. You are considering a portfolio of offensive patent litigation that has an external legal budget of €20mn for next year. Assuming a 25% tax rate, the after-tax hit to earnings equates to €300mn in lost equity value!
And don’t expect the equity market to attribute any value to the potential damages you may recover. Don’t believe me? Just look at publicly traded litigation funder Burford Capital (Ticker: BUR).
Burford has been engaged in a tireless battle with Argentina to recover its Petersen Claim, a claim that stems from the nationalisation of the public shares of YPF by the Argentine government. As of this writing, Burford has a $1.3bn market cap, and pre-tax proceeds from recovering the Petersen Claim could (optimistically) amount to $1bn to $3bn. Is the market really implying that Burford’s core business is worth zero? I don’t believe so.
Litigation funders are professional investors who risk equity capital to earn a minority share of your damages. If the professional investor with a lower cost of capital than you won’t fund your litigation, your shareholders most probably shouldn’t either. Leave it to the experts.