Litigation finance can optimize deal value in private equity

By Justin Brass, managing director of Burford Capital

When private equity firms analyze prospective deals, they consider everything from the industry and what the company does to the senior team and the company’s recent financial performance.

During what is otherwise an exhaustive diligence process, however, one of the most significant assets of the business is largely overlooked: litigation.

One of the most common ways PE firms analyze the extent to which they can potentially add value to a target company is to look at ways to optimize the company’s capital structure. Yet by writing off a company’s pending legal claims as nothing more than a costly, time-consuming liability, PE firms risk missing out on monetizing a potentially valuable asset.

Presumably they do so because they are adept at assessing and optimizing the value of every other corporate asset except litigation. But three crucial deal stages arguably warrant a closer review for PE firms wanting to unlock potential legal asset value.

Acquisition financing

In the early stages of a potential acquisition, PE firms can potentially leverage litigation finance to unlock the value of outstanding matters and provide access to nonrecourse capital that can be used to reduce the amount of equity the PE firm would have to put up for the transaction.

If a PE firm is prepared to purchase a company for $100 million, but the company has a portfolio of pending litigation valued at $20 million, litigation finance can provide capital against the pending litigation, reducing the PE firm’s investment at closing to $80 million.

Litigation-cost management

Following a successful acquisition, a PE firm can often view litigation as an intangible asset that is unpredictable and has a long-term duration, and therefore it won’t assign value to it. Litigation finance, however, provides a means to assess and value an asset that may otherwise have been marked a zero.

In its most basic form, litigation finance is used to finance legal fees and expenses, which has significant accounting benefits for the PE firm. Traditionally, companies pay the expenses associated with litigation out of revenue, thus reducing operating profits. By treating litigation as a financeable asset, they gain access to capital that can be used either to relieve legal expense budget pressure or for corporate purposes unrelated to the litigation matters.

In addition to simply reducing legal costs for the PE firm, litigation finance can also increase the overall value of the portfolio company. When a legal team gains access to the capital it needs to litigate to a successful conclusion, it can avoid being forced into an early settlement, thus maximizing potential awards or judgments.

Additionally, capital is provided on a nonrecourse basis, so when the capital provided exceeds the amount paid in fees, the company is entitled to book it as income received, without waiting for the result of the underlying litigation matters.

Exiting a business

A final stage for PE firms to consider litigation finance is during the exit.

As the PE firm prepares to exit an investment, it can leverage capital against litigation to increase the value of the investment. If the company has affirmative litigation in which the PE firm sees value, they have an opportunity to monetize the judgment, immediately creating value. When preparing for a sale or IPO, the PE firm can clean up a company’s balance sheet and income statement by reducing legal costs and increasing the value of assets.

Additionally, the PE firm can make an investment with complex litigation more attractive to a potential buyer, since future risks are mitigated by litigation finance.

Conclusion

When it comes to litigation, PE firms are not always extracting the potential value on the table. Bringing cases to a successful conclusion requires a significant financial investment, and evaluating and valuing each matter requires a level of expertise not often found in the typical PE firm’s staff roster.

By leveraging litigation finance, PE firms can maximize the value of their investment without incurring the significant risks associated with pursuing complex commercial litigation.

Justin Brass is a managing director at Burford Capital, a leading global finance firm focused on law.

Photo of Justin Brass courtesy of Burford Capital