Mass Torts: When the Music Stops
The subject of Greenpoint’s March newsletter: “Litigation Finance Market Heats Up” speaks for itself with respect to the note’s perspective. There have since been multiple other data points verifying this niche’s momentum, particularly as far as new capital allocations are concerned -
Contingency Capital launches new fund targeting $1.4B; November 2020
Litigation Finance Has Surpassed $1 Billion Raised in Busy 2020
Anecdotal evidence of a host of new Sub Advisors and Independent Sponsors operating throughout the space
No doubt, investors continue to be intrigued by the promise of high risk-adjusted returns with limited correlation to the broader markets. So are we. With that said, and as it relates to law firm loans made to mass tort attorneys, there is a question that seems to quietly echo through investment committees of the most well initiated in the space: how many of these loans will perform without having to be refinanced? Indeed, one may sense an implicitly understood game of musical chairs growing in amplitude with ever-ballooning loan sizes driven by re-financed exits. The music, for now, plays on...
We hear managers rally support for the strategy using a host of platitudes that are often factually barren. One example is the promise that a large mass tort portfolio can “diversify away” its inherent risk. This is incorrect for two reasons: first, these portfolios are lumpy by nature; even in a portfolio with many borrowers, value concentration tends to coalesce around a fixed number of litigations. Second, unlike an equity portfolio where an outperforming asset can compensate for an underperforming asset, any impairment of a loan portfolio reduces portfolio performance. Alas, a portfolio of law firm loans requires the performance of nearly all of its assets to deliver on the promise of equity-like returns.
Part of the challenge is that investors typically structure law firm investments as senior secured debt, making it difficult for borrowers to raise incremental capital. Therefore, the senior lender must fund all working capital needs in support of its loan, requiring ever-increasing loan facility sizes. However, borrowers’ dockets often do not hold enough mature cases to support amortization during the term of the loan; and the compounding interest can bury mass tort borrowers under a hill of high-interest debt. Many lenders underwrite loans by showing a low loan-to-value against the full docket, including riskier, early-stage litigations. It seems to us that holding our noses when looking at large swaths of collateral and hoping to be refinanced does little to obscure the odor of wishful thinking.
We are not so presumptuous as to suggest we know how this all ends but we do think a note of caution is due, particularly as less initiated managers seem to be chasing the market’s lofty promises.
So are there ways to avail ourselves of the high expected returns and limited market correlation that mass torts offer without depending on the refinancing carousel? There are. We are executing several strategies across our businesses that solve for these challenges. And to be sure, we continue to have a highly favorable view of some mass tort litigations that underlie law firm loans. In fact, over the last several months we’ve increased our exposure to the strategy by finalizing a new partnership as Lyrix Holdings in conjunction with Chris Diamantis. Lyrix is a conglomerate of businesses focused primarily on litigation finance, including law firm lending. We are currently in the process of raising capital for several portfolio companies.
Ultimately, we believe that the exuberant behavior of market participants is likely ushering the market in a direction where those with a contrarian approach will be richly paid to help clean up whatever mess is left when the music does stop.