Most of us have a general understanding of what "litigation financing" means. Maybe we see an ethically hazy framework in which countless investors are able to inject themselves into valuable, fast-paced litigations as an investment vehicle. Or perhaps we see the overwhelming legal costs faced by a small start-up trying to seek justice for theft of its patents and other intellectual property. Regardless of context, it is clear that litigation financing (aka litigation funding) has emerged from its class action roots and is here to stay. This has caused and will continue to cause significant disruption in the legal arena for the foreseeable future – disruption from which private equity firms are well placed to benefit.

Under a traditional litigation funding arrangement, an outside investor provides a plaintiff with funds to pay legal costs and fees, in return for that investor's right to a set portion of any recovery (typically around 50%). The benefit of this arrangement for the litigant is that there is no downside risk to pursuing litigation (an investor is footing the bill), and the benefit to the investor is the incredible potential upside of the investment, which is not necessarily dependent on typical market conditions. For example, in one case (commonly known as Tienver v. Argentina), the litigation funding company invested $12.8 million in an action seeking compensation from the Argentine government for its expropriation of two airlines. Following a positive arbitration award of $324 million in plaintiffs' favor, the funder sold its interest in the litigation for $107 million. This represents a 736% return on invested capital, demonstrating that these investments can provide firms with significant monetary windfalls.

According to Buford Capital, one of the three largest litigation financing companies in the world, only 7% of U.S. law firms used litigation funding to prosecute litigations in 2013. That number grew dramatically to 36% in 2017, an increase of 414% in four years.

As additional creative uses of litigation funding are developed and the strategic advantages of funding become more well known, this number is likely to grow even further. How can private equity firms take advantage of this rapidly changing environment and obtain value from litigation?

Private equity firms can benefit from litigation funding in four ways. First, firms may invest in litigation financing companies such as Buford Capital, IMF Bentham, and Longford (currently the three largest participants), or make direct investments in specific litigations through one of these companies, as in the Tienver v. Argentina case noted above. Second, a PE firm can use litigation funding to help a company in its portfolio prosecute a claim. Third, firms can purchase interests in individual litigations or "shares" of a litigation through secondary markets. Fourth, and finally, firms can use litigation funding when acquiring a target, to reduce the cash purchase price and obtain investment without giving up valuable voting and governance rights. This creative use of litigation funding, designed specifically for private equity firms and hedge funds, takes advantage of the value underlying a target company's portfolio of litigation.

Here is a brief example of how this type of transaction works: PE Capital wants to buy XYZ Co. for a total price of $150 million but wants to front only $130 million of that cost. Traditionally, a firm would seek an additional investor, who would then have some voting rights associated with that investment. Rather than seeking a direct investor, litigation finance allows PE Capital to offer ABC Co. a percentage interest of any recovery from XYZ Co.'s litigations, for a fixed sum—here, the $20 million gap between the $150 million price of XYZ and the $130 million that PE Capital is willing to invest. In return for that $20 million investment, ABC Co. obtains a portion (typically around 50%) of any recovery from actions in XYZ Co.'s litigation portfolio, which is valued at $200 million.

While these creative investments offer plenty of upside potential, lingering ethical considerations unique to litigation merit additional scrutiny. These tend to focus on three key considerations: (1) issues relating to attorney-client privilege; (2) control of the litigation and settlement strategy decisions; and (3) ethical rules forbidding non-lawyer investments in law firms and fee-sharing arrangements with non-lawyers.

The first two issues are easily addressed. The benefit to the litigant from litigation funding is directly tied to the fact that funders ultimately have no say in directing or controlling the litigation, and have no right to obtain privileged communications or otherwise actively participate in the litigation. And while the third concern exists for some litigation funding arrangements (primarily those relating to direct investments in law firms), they do not currently implicate other "litigation portfolio" funding scenarios where the private equity firm invests in a target company's pending litigation rather than in a particular firm's litigation portfolio.

For example, in Formal Opinion 2018-5, the New York City Bar Association recently opined that Rule 5.4 of the New York Rules of Professional Conduct (which prohibits fee-sharing agreements between lawyers and non-lawyers) prohibits a financing agreement between a lawyer (or law firm) and a litigation funder "under which the lawyer's future payments to the funder are contingent on receipt of legal fees or on the amount of legal fees received in one or more matters." Although this rule is implicated only where there is a fee-sharing agreement between a firm (rather than the client) and a funder, it nonetheless demonstrates that the various state bar ethical authorities are keeping a close eye on funding issues and any potential impact on the attorney-client relationship.

Ultimately, while this quickly changing landscape can make it difficult to assess all potential risks related to litigation funding, it is apparent that PE firms can take advantage of the numerous benefits of litigation funding and can now tap into new and diversified investment vehicles that leverage litigation as an asset rather than a contingent liability.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.