Over the past 15 years, litigation finance has grown from a cottage industry into an essential source of capital for corporate and individual claimants and law firms looking to pursue claims. As the industry has grown, so too have the potential uses of litigation funding, including the use of third-party funding by private equity firms and direct lenders to finance the legal claims held on their portfolio companies’ balance sheets. In the current environment, unlocking trapped assets like legal claims, as well as conserving cash flow, is crucial, and litigation funding firms like Delta Capital Partners can help.
In addition to evaluating the use of litigation finance for current portfolio companies, private equity firms should make litigation underwriting an essential step in their due diligence and investment process. Indeed, litigation finance should be in the toolbox of every private equity firm and lender.
Litigation finance has numerous uses in this context, including those set forth below.
- Freeing Up Cash Flow. Rather than spending cashflow on costly litigation and arbitration, companies can fully finance meritorious claims with third-party funding, allowing them to free up cashflow once earmarked for legal claims while typically retaining the rights to a majority of the proceeds of such claims. Companies are then able to reinvest retained cash flow back to their businesses, rather than toward litigation expenses.
- Strengthening Balance Sheets. Litigation finance can strengthen balance sheets in several ways, including a cash infusion to a companies’ balance sheet or by moving costs off-balance sheet. A cash infusion is possible where a litigation funder purchases claims outright, while a commitment from a funder to finance the costs and expenses of a claim may allow the claim to be moved off the balance sheet. A stronger balance sheet can help companies that may have debt covenants tied to coverage ratios or which are looking towards a possible sale.
- Pursuing Claims. Many claimants and companies ignore, or refuse to pursue, litigation based solely on cost. Presented with a cost/benefit analysis, firms often choose not to pursue claims that have a high probability of reaching a successful outcome due to the short-term costs of pursuing such claims. Additionally, firms also may factor in time constraints, principal-agent issues, resource constraints, or “non-core business activity” labels. Litigation finance allows companies to circumvent each of these concerns, as all costs are shifted to the third-party funder, as well as the risk of loss.
Litigation finance is a powerful tool for private equity firms and their portfolio companies. Generally, a private equity portfolio company’s primary focus is on its core business, potentially to the detriment of other valuable sources of revenue such as legal claims. Reinvesting capital back into a company’s primary lines of business seems like a surefire way to increase revenues and ultimately return on equity, while siphoning cash to pursue litigation could appear to be a fool’s errand to many founders and CEOs, as well as to their private equity sponsors. However, by utilizing litigation finance, portfolio companies can pursue litigation with little or no cost to the current business and still participate in the upside of a settlement or judgment. Moreover, litigation finance allows firms to gain access to working capital today and preserve LP capital for meaningful investments tomorrow. Litigation finance also enables companies to reinvest capital back into their primary lines of business, continue to grow, bring down litigation expenses, and ultimately be more profitable, while at the same time pursuing valuable claims. In successful cases, litigation finance may even unlock more capital for a company’s balance sheet.
From a lender’s perspective, ensuring portfolio companies have both ample cash flow to make loan/interest payments while not tripping covenants is crucial. Before the advent of litigation finance, the pursuit of new litigation may have been too expensive for a borrower, absorbing too much cashflow and thus making it uneconomical to pursue. Litigation finance resolves this problem as portfolio companies can share or eliminate the cost of litigation by working with a litigation funder. Moreover, a company may be able to monetize current ligation by selling a portion of a claim, judgment, or award to a funder in exchange for cash. Litigation finance allows borrowers to shift risk from their balance sheet onto the funder’s and still capitalize on the successful resolution of their claims.
Private equity and private credit funds’ earlier vintages are often managed with orphaned assets or companies remaining in their portfolios. Such “zombie funds” create not only a headache for limited partners but also a reminder of an unsuccessful investment. Utilizing litigation finance to fund claims held by such companies (including claims relating to the circumstances that led to a failed venture) can return capital to the LPs without further spending, and thereby unlock value in a line item already marked as a zero, and enable the final wind-down of a fund. In addition, litigation finance can help both general partners and limited partners by unlocking the value of litigation on previously written-off portfolio company investments.
Delta Capital Partners Management LLC is a US-based global private equity firm specializing in litigation and legal finance, judgment enforcement, asset recovery, and related strategies serving claimants, businesses, private investment funds, law firm and other professional service firms across the world. The firm provides capital and expertise that enables such parties to de-risk, significantly enhance the probability of a successful and timely resolution of claims, and/or maximize the effectiveness of their businesses.