For any investor, one of the biggest concerns will be identifying issues after acquiring an asset which impairs value.
In the context of property investment, those issues can be varied, ranging from environmental issues to undisclosed third party rights.
Finding unexpected issues can lead to long drawn out litigation, particularly where sellers have agreed to share some of the exposure in the sale contract. In those cases, investors may seek to recover losses from sellers if the issues present a significant impediment to realising value.
The difficulty for most investors is that litigation is expensive, distracting, and time-consuming. It introduces financial uncertainty and risks which are often not factored into the acquisition costs.
While a well-advised investor will have sought protections from a seller when buying an asset, whether through specific warranties or representations in the sale contract, this does not mean an investor anticipates ever having to claim under those provisions. Accordingly, an investor may want to consider third party financing if a claim arises.
What is litigation finance?
Litigation finance at its simplest is an equity investment by a third party in the outcome of litigation. The funder steps in to meet the costs associated with funding the dispute which are costs not usually factored into the cost of acquisition.
Third party funding is therefore a good solution to unlocking value associated with a dispute without taking on further cost and risk associated with litigation.
In today's market, litigation finance takes two forms:
1. Corporate finance.
Corporate finance investors finance litigation. Litigation funders are businesses, well supported by capital, eager and willing to finance claims for a share of the proceeds. The risks are high but then so are the rewards.
2. Law firm self-financing.
More recently there has also been a focus on law firm self-financing. Law firms have started financing cases from their own resources. Adopting a similar approach to third party funders, some law firms are increasingly prepared to fund good claims from their own resources also in exchange for a share in the overall proceeds.
What does a funder look for when deciding to invest in a case?
Funders of litigation will primarily look for good cases in which to invest. There are three aspects to this:
1. Good prospects of winning.
Good legal merits are essential. A funder will conduct extensive due diligence, reviewing and assessing the legal basis for the case and the supporting factual material.
Funders will usually engage their own legal team to assess whether the case is more likely to succeed than not. Typically funders look for a better than 60% chance that the case will win.
Being able to monetise a successful claim is critical to a funder's objectives. The funder will need to know that the defendant is sufficiently well resourced to be able to pay any judgment if the case is won.
A defendant's creditworthiness and solvency will be a significant aspect of the due diligence which a funder carries out.
3. Claim value.
Lastly, any claim needs to be large enough to be able to support investment. Litigation is expensive and the costs and risks associated with funding litigation are significant. Third party funders are often responsible not only for meeting the claimant's legal costs of the litigation, but they will usually also take on an exposure for paying the other side's costs if the case is lost.
These are potentially significant exposures and the returns need to match that risk. There is therefore a corresponding need to ensure the claim size is able both to meet the cost of capital and provide a return to the claimant party.
The usual baseline metric is a 1:10 ratio of investment to claim value. So for every £1 million of legal fees, the claim size will need to be a multiple of 10x or greater.
What does this mean for property investors?
For the property investor, litigation funding may well be a good source of capital to unlock value in any claims associated with property acquisitions.
Take environmental liabilities, for example. If an investor acquires higher risk industrial land there is a risk that there will be environmental liabilities associated with contamination. Those liabilities might arise because of the misuse of the land by the seller, or through earlier contaminating events.
In the context of high risk usage, for instance in industry usage where there are potentially harmful waste products produced and stored, there is always a question over whether those waste products were properly managed.
Leakage or spillage which has contaminated the land may result in very significant losses both in terms of value but also potential remediation costs.
Risks associated with these exposures are usually managed and can be apportioned through the contractual process, ensuring there are appropriate representations and warranties in place to ensure the risks are suitably balanced.
However, this does not address the costs of the litigation if an issue does arise. These costs themselves are significant. There is additionally the risk associated with adverse costs in litigation. All of these costs and risks can be addressed through litigation funding.
For property investors, litigation finance may well be a solution to unlocking value in claims associated with assets where unexpected issues have resulted in an impaired valuation.
So long as the legal merits are good and adequate protections have been sought in the sale documentation, then funding might be available.
The challenge will be ensuring that any judgment will be met, but if those criteria can also be met then litigation finance is a powerful tool for unlocking value.
*Nick Storrs is a partner in Taylor Wessing's disputes and investigations team