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By Gretchen Lyn Koehler, Bentham IMF

Among trends predicted to affect private equity in 2018 is a potential drop in the number of active U.S. PE investors.

Firms seeking to maintain deal activity amid less capital inflow from traditional sources have a ready tool in litigation finance, which has historically been underutilized by the industry.

While PE firms routinely assess the capital structures of their acquisition targets, they rarely factor litigation as a potential revenue source, let alone a co-investment opportunity that could save them millions in the initial outlay of capital. The principal reason is a lack of in-house expertise at conducting the due diligence necessary to evaluate potential litigation claims.

PE firms could modify their organizational structures to incorporate experienced litigators into the due diligence process, but they may not want to incur the overhead expenses associated with such expansion. Likewise, the high cost of hiring outside counsel to assess the merits of cases may also deter firms from evaluating claims.

Enter the litigation funder. Funds provided by a litigation-finance firm can reduce the cost of acquiring a company without the burden of co-investing with a party that wants to play an active role in managing it.

In its most basic form, the transaction works like this: A PE firm seeks to purchase a company for $150 million, but wants to allocate only $130 million to the investment. It invites a litigation funder to invest $20 million, using the target company’s commercial-litigation claims — valued at, say, an estimated $200 million in potential damages — as collateral for the funding.

Those claims can arise from any number of business disputes, including breach of contract; breach of fiduciary duty; theft of trade secrets; infringement of copyright, trademark or patent; environmental, antitrust and complex business disputes, as well as domestic and international arbitrations. They are typically multimillion-dollar cases that involve strong liability claims and defendants with the ability to pay a judgment.

Funders effectively operate like a passive investor, except they bring specialized knowledge about how to monetize the target company’s litigation claims to achieve optimal returns.

The professionals making investment decisions at most litigation funders are skilled litigators with experience assessing the merits of commercial lawsuits. The high-risk nature of their investments, which are traditionally non-recourse, requires them to select only cases that are highly likely to result in successful outcomes for the funded parties.

Where a PE firm would be unable to value the claims and offer them as collateral for co-investment, a funder makes the transaction possible while paving the way to an enhanced overall value of the acquired company.

Funding lowers the liabilities of the acquired company (by assuming legal fees and expenses) and positions it as a more attractive investment for potential future buyers. A company with a financed litigation claim is a lower-risk investment because the buyer doesn’t face the prospect of ongoing legal fees and expenses from the litigation.

Once the funder makes its investment, it exercises no control over the strategic and settlement decisions made in the litigation claims, nor over any other aspects of the acquired company’s business.

Another distinction lies in the way that funders expect to receive returns.

Where traditional co-investors seek equity, funders take their returns solely from proceeds earned by successful outcomes. If the cases don’t result in recoveries, the funder exits the investment without a return and without repayment of the initial capital it invested.

The capital the funder deploys is typically used to pay expenses associated with pursuing the funded cases. But companies may also use it for core business purposes.

Financing litigation claims in this manner positions PE firms to convert litigation from a drag on the bottom line of an acquired company into a highly valued asset. In addition to potentially increasing the company’s market value, this can enhance its capital structure, reduce costs and improve the bottom line.

The coming year promises opportunities for PE firms to navigate many previously uncharted scenarios. Those partnering with litigation funders will benefit from co-investors who can lower the initial investments while leveraging their experience in valuing and maximizing companies’ litigation assets.

Gretchen Lyn Koehler is chief marketing officer at Bentham IMF, the U.S. arm of IMF Bentham Ltd (ASX: IMF), a provider of commercial litigation funding, with 13 offices worldwide and a portfolio that has a total claim size value of A$3.8 billion. She can be reached at [email protected] or +1 212-488-5331.