Legal funding, a.k.a. "Litigation Financing" has always appealed to me as an alternative source of returns. Whether a legal case gets settled seems relatively unrelated to the performance of the economy as a whole, and yet the asset class has historically generated high returns.
How I got into Litigation Financing
In 2016 I was searching for alternative sources of income, and found crowdfunding site Yieldstreet. YieldStreet has a range of offerings, mostly litigation finance, real estate loans, and “marine” loans for things like decommissioning ships. As of this writing, I have invested in 3 YieldStreet portfolios, all litigation finance, and all have generated significant positive and regular returns.
Overall I am happy with these passive investments.
The portfolios go by names such as “Diversified Pre-Settlement Portfolio X”. These are a bunch of loans aggregated together by a corporation that specializes in providing legal funding. For example, you might own 1% of a portfolio of 100 cases.
What exactly are you funding?
Let’s say a bike messenger gets hit by a car and gets injured. This corporation will lend the bike messenger money for his or her out of pocket expenses and possibly lost income while the case gets processed. From the bike messenger’s standpoint, it solves the problem of having to need money now vs when a case settles. From the investors standpoint, they can earn a higher than normal return backed by the success of the case. While any one case has its risk, the collective group performs in a reasonably predictable manner.
The quoted interest rates on the investments I made were between 12%-13% and all investments have met or beaten the benchmark. Because YieldStreet has been hugely successful, new and similar products are quoted as yielding closer to 11%.
Positives to YieldStreet
Not correlated to other investments. It pretty much doesn’t matter what stocks are doing.
Grouping cases lowers idiosyncratic risk. Because you are buying a pooled interest, your exposure to any one case is limited, so returns are steadier.
High interest rates 10%+.
The customer service has been very good when I’ve had questions – responsive, quick, and thorough. You get the sense they have their act together. Because this is a new asset class, the customer service helped me feel comfortable.
Things to be aware of
Timing. The timing of case resolution is a bit of a guess. One of the portfolios I invested in was called an “accelerated portfolio” designed to completely return principal within 18 months. While much of the money was returned within the promised time frame, the completion of settlements extended past the original anticipate due date. If I’d needed the money for a particular reason and was counting on the 18 months, I would have been somewhat disappointed.
Lumpy payments. You really don’t know when and how much you are going to receive in any given period. It is entirely dependent on how and when each case settles. Take a look at a sample of monthly payouts on this portfolio..
Because I had planned for this and understood it, I was completely fine with this. But by no means is this paying consistently. Overall, it can feel a bit fun to not know what’s going to get deposited in any given month! Sounds strange, but true for me.
Amortizing. The investment is inherently amortizing. When a case settles you get some principal back. Here’s what happened to my total principal over time (I made investments at two different times).
While the interest rate on the principal was high, I have not been able to redeploy money in YieldStreet so my total interest over the period was lower than expected.
Oversubscribed. New offerings get oversubscribed extremely quickly (within minutes). Therefore, although my ideal allocation would be higher, it requires constant vigilance to get into new deals and keep your principal reinvested. Once it’s back in your account, it’s just earning cash rates. So in a way the return you experience will be lower than you might expect. To YieldStreet’s credit, they appear to be working hard on trying to get more deals so that this issue gets resolved.
Liquidity is effectively zero. We've talked in previous posts about determining the purpose of a particular pool of funds. If you can handle the lack of liquidity, you are potentially getting more richly rewarded for it. Also bear in mind that you are getting some of your principal back as the months progress which acts like liquidity.
You will be taxed at ordinary interest on these kinds of loans.
My (not as good) experience with LexShares
Buoyed by my experience with YieldStreet, I decided to try another provider of litigation financing – LexShares.
LexShares finances commercial litigation. Instead of financing an already pending case, they start from the very beginning by covering the legal cost of a lawsuit and then participating in the settlement proceeds. LexShares really has its pick of the litter - I've heard various numbers, but it appears they probably reject almost 99% of people who come to them for funding. They try to just fund "slam dunks".
Many of the cases they finance feel like “David vs. Goliath” – an individual or small entity gets cheated by a big corporation and LexShares helps them make right by funding an expensive lawsuit they might not have otherwise been able to make. Examples of cases include trademark or copyright infringement, breach of contract for a real estate deal, failure to perform on a contract, and more.
Unlike YieldStreet, where you invest in groups of cases, with LexShares you are usually investing in one particular case each time. This introduces new sources of variability – in my case, I was expecting payouts starting in the first twelve months based on this provided model:
I invested in mid-2017, am a little over 24 months into the case and the returned cash has been about 20% of what is modeled here. As I mentioned with YieldStreet, timing of legal cases is inherently unreliable. What I liked about this case was that there were numerous individual actions – but I have been pretty surprised by the slow pace of action and resolution. Is this going well? Terribly? I’ve asked LexShares…but
LexShares hasn’t been as forthcoming as I would like with updates. There is no regular quarterly report or case progress update. even something as simple as “we’ve filed x claims, 3 have been settled, 27 are in this status, etc.”. Or "cases are resolving slower than predicted because we had to reaffirm x". I’ve asked a couple of times about the progress of the cases and have received very general replies that do not give me a good sense of where the case stands. I’ve pretty much been told that I’ll just get paid as the cases progress. I think given the opaque nature of the asset class, LexShares would be better served by a more regular reporting mechanism. My suspicion is that things are going well - but...I simply don't know and can't quantify.
This highlights the risk of idiosyncratically investing in just one asset. LexShares actually has a “marketplace” investment which is more similar to the YieldStreet model. I suspect this would have more consistent and relevant return metrics. Were I to do invest again with LexShares, I would invest in a pool of cases rather than one individual lawsuit, either through their marketplace investment or by investing smaller amounts in many individual cases.
I’m not sure how I feel about increasing the availability of financing for lawsuits. It seems like many of these defendants use LexShares to get their fair hearing in court, which is good. But am I also contributing to an overly litigious culture in our country? I don’t know. I haven’t quite figured this one out yet. Ask yourself whether it might bother you.
It’s hard to judge the entire platform based on one experience, but I feel that LexShares would make sense if I wanted to make a really big push into litigation financing and would spread my bets between at least 5-6 different cases. For now, I’m in wait and see mode and would be more likely to put money into YieldStreet given the more consistent payouts and better communication around what’s happening.
A third option that is highly liquid
I did want to mention a third way to get into litigation financing. If you don't like the lack of liquidity, there are companies that do this that are publicly traded. One example is Burford Capital. I don't love this idea - because the yield is pretty low, and the stock has been extremely volatile. Here's some reading if you're considering this alternative approach
Bottom line: I like litigation financing and will continue to explore it, in crowdfunded markets, for passive income where I don’t need access to the capital for 3 years or more.