Finance for Legal Funders 301: Risk Metrics


 

Risk is one of the most important aspects of finance, and it is probably the central metric that institutional investors care about. While the average person often thinks that institutions, such as pension funds and endowments, are looking for returns, in reality, the opposite is true. Institutional investors generally focus more on risk than they do on return.

In my professional career as a consultant in the space, I have dealt with dozens of major investors. Most of them focus on achieving a targeted return and minimizing risk. Those that do target returns instead are always doing so within the constraints of a certain level of risk.

 

The Inability to Communicate Risk is Limiting Legal Funding

 

This is important to recognize because one of the key issues holding back litigation finance is that there are no standard risk metrics that are used broadly across the industry, contributing to the communication gap that exists between legal funders and capital providers. While there are a handful of legal funders beginning to leverage risk metrics, there is nothing even close to a consensus as to what metrics a legal funding manager should report to investors, which translates to investors’ timidity towards the asset class.

My consulting firm Morning Investments recently teamed up with the Litigation Finance Journal to examine what investors are looking for from litigation finance managers. The results below are an extract from a survey of 21,963 high net worth investors and institutions with at least $5M in available capital. These results show that while legal funding certainly still suffers from a lack of awareness by qualified investors, almost 20% of investors report that they are not willing to invest in legal funding firms because they perceive the space as being too risky.

 

 

That perception of riskiness is amplified by the lack of data about the space (something my firm and others like Mighty are working on), but the other problem is that litigation finance managers do not have a standard set of risk metrics.

In the mainstream finance world neither of these factors, data availability and standard metrics, are problems. Bond risk is often measured based on convexity and duration, topics that I discussed previously. More generally risk is usually measured with portfolio standard deviation, Sharpe Ratios, Attribution Analysis, and other niche tools like Sortino Ratios.

In the legal funding world, none of these tools are used extensively. Many litigation fund managers simply report the number of cases that have been resolved favorably and unfavorably. That approach is questionable from a risk management perspective and contributes to a distorted perception of riskiness that pervades legal funding, which in turn constrains legal funders’ ability to raise favorable capital.

 

 

Risk Metrics for Legal Funding

 

One might make an argument that commercial litigation funders who often fund only a few cases a year have limited options when it comes to risk metrics; and that personal injury funders don’t need to report such risk metrics because their businesses are “so different” from traditional investing.

The first argument is demonstrably false, and the second one is ludicrous.

Commercial litigation funders should still keep track of returns and use metrics like Sharpe Ratios for their portfolio as a whole. It also makes sense to use metrics like convexity – but with a twist – perhaps focusing on valuation of a portfolio given unit changes in success rate rather than interest rate. Most importantly, commercial litigation funders should look to Monte Carlo analysis as a tool for modeling risk in their portfolio. Some firms like Burford already do this. Many do not because of the cost and effort associated with Monte Carlo simulation. That is short-sighted. Using Monte Carlo analysis to analyze a portfolio is one of the best ways to get investors comfortable with risk. Even if the legal funding firm has to draw on outside resources, they are still well advised to use Monte Carlo simulation.

Of course, using Monte Carlo simulations introduces a different set of issues. Monte Carlo simulations are a great tool, but you can still build a bad house with a good hammer. Similarly, the important part of using Monte Carlos is to make sure they are used correctly. Again, expertise in the field matters.

For personal injury funders, Monte Carlos can also be great tools, but what is even better are various forms of regression analysis. Regressions are great because they give personal injury funders a way to both effectively measure risk in their portfolio for investors and more effectively “price” funding agreements with plaintiffs through hedonic pricing methods.

In summary, a lack of clear risk reporting is a major issue holding back funding in the legal funding space. While a consensus set of metrics for risk would be very helpful in standardizing pitches for investors to allocate funds, at a minimum funders need to present some kind of professional risk metrics. Monte Carlo and regression analysis, or even a simple Sharpe Ratio to measure a funds risk-adjusted returns, would all go a long way in helping the broader universe of investors understand the costs and benefits of investment choices in the legal funding world.

 


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About Michael McDonald

Michael McDonald is a PhD in finance, former Wall Street trader, and hedge fund quant. Currently, he is a university professor of finance and partner at the investment consulting firm Morning Investments. His firm provides services for hedge funds, asset managers, and litigation finance firms. He is also a periodic columnist for AboveTheLaw.com and the Litigation Finance Journal. He can be reached at: m.mcdonald@morninginvestmentsct.com


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