About Consumer Alternative Litigation Funding
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|If you've ever been curious about Alternative Litigation Funding, the too-good-to-be-true returns some have been getting on their non-recourse loans, and its potential as a new asset class for portfolio diversification; then this page is a great place to start learning.
In May 2014, we made a financial calculator that models ALF strategies for a sales guy with a law firm in the consumer ALF business.
The following is just about everything there is to know about ALF. His brain was picked clean with dumb questions until there wasn't much else left to write about. So if you still don't get it after reading this page, then you're "overthinking it," because this is all there is to it.
Alternative litigation funding goes by many different names, but it's all pretty much the same thing. Different law firms just mix the words up to try to be different.
Other names alternative litigation fundinggoes by are: ALF, alternative litigation capital funding, consumer ALF, consumer alternative litigation capital funding, consumer alternative litigation financing, consumer lawsuit financing, consumer lawsuit settlement funding, consumer legal financing, consumer litigation financing, consumer litigation funding, lawsuit financing, lawsuit funding, lawsuit settlement funding, legal financing, litigation financing, litigation funding, settlement financing, settlement funding, third party legal funding, and third-party litigation financing.
The simplest explanation is that third party funding companies provide cash advance (in the form of non-recourse loans) to litigants in exchange for a percentage share of the judgment or settlement after the suit is resolved.
If you loan them (usually a third party funding company) money, then you're called, "a funder." So let's call this particular third party funding company, the TPF.
Here the plaintiffs get the funding, so it's the opposite of legal defense funds, which fund defendants.
All of this started in the late 90's. It's grown since then to be HUGE business.
Here's the deal with these business models in simple English:
You know those annoying TV ads that say, "If you've been hurt by a "bad" (usually medical device making) corporation, then call our lawyers NOW to see if you qualify for a huge payout!"
The TPF is one of the firms that pay the big-bucks for those ads (and is where some of the funders' money goes).
First, the gist of it is that you (an investor or an RIA investing for your clients) are lending money to the TPF company. This money is then used to pay for (fund) all of the following activities.
The big thing to remember is that these major (mostly medical product liability) lawsuits have already been won. The deal is done, the bad people / corporations have been convicted, there's no more appeals, and the court has ordered them to be punished - in the form of paying uber-money into a court-administered escrow account.
So the defendant(s) have already lost and paid their money in damages to the injured parties. This huge pot of money is now sitting in escrow waiting to be distributed to people that have been harmed. So the vast majority of the hard work has already been done.
The heavy lifting was getting the legal system to convict these corporations of wrong-doing, and to make a settlement to punish them so they won't do it again, to deter the another corporation from going down the same road, then to put the money in escrow so they can't control it anymore. So that's all a very done deal, nothing more needs to be done.
The injured parties just need to become aware that they may be entitled to their money. Then they have to do the work needed to file a claim.
Then their claim has to go before a judge to ensure it's valid, and they qualify as someone that's been harmed (AKA fitting pre-determined insurance underwriting guidelines).
When that's done and won, their part of the money that's waiting for them in escrow is paid to the attorneys. Then they pay everyone in the process. The funders get paid first, before anyone else does.
So the first step is to do things like run those annoying ads on TV to get the information out. This is also where some of the funders' money goes.
Then people that think they qualify see the ads, and call into to their call centers (which are also funded by funders).
Then a groups of screeners do their things (including paying for medical exams) to see if the potential plaintiff actually qualifies to collect some of these funds. This is expensive, so most of the funders' money goes to pay for these folks (very little goes to the partnering law firms).
They the TPF packages qualified plaintiffs / cases, and sends them to one of the nine partner law firms to litigate in court.
Center TPF law firms also pay the partner law firms an expense for each case. This is where the partners pay off the funders at the end of the process. So there's little-to-no gambling with funders' money.
Then over 90% of all cases "fund." This means everything went as planned, the plaintiff got their money from escrow, and everyone was paid.
Plaintiffs that don't qualify are screened out, and those that do qualify have individual suits filed against the escrow account. This is also where some of the funders' money goes. This is also why each case is handled as a $10,000 non-recourse loan.
When funders fund, it's in $10,000 chunks. So each chuck goes to fund an individual case (suit). So if you loan them $100,000, then you're funding ten cases.
Then if and when an individual case wins, everyone is handsomely rewarded (because the bottom-line payout to the plaintiff from escrow is usually plenty to pay everyone in the process back). This is where the funder gets their non-recourse loan paid back.
That's about it in a nutshell. There's not much more to it than that.
If you loan the TPFs money, then you're a funder. Your funds fund lawyers (that pretty much do nothing but this) to bring individual cases to court. Since the vast majority of the heavy lifting has already been done, and people have already been screened, it's basically just pushing paper through the court system (if the plaintiff qualifies, they pass medical exams, and is not screened out along the way, or they don't want to endure the process, etc.).
The screeners ensure the plaintiff qualifies before the medical exams to prove it are funded. After that, then it's sort of a well-refined paper-pushing factory that spits out money, and pays everyone off, at the end of the process.
Then the people that fronted the money (you, the funder) needed to pay the factory to push the paper, are well rewarded for taking these risks.
That's the deal in a nutshell.
So far, there's no mutual fund or ETF that one can "invest in" to have all of your loan be a part of this action. There are a few mutual funds that invest a small portion of their assets into this business (e.g., Alliance Bernstein). So if you invested in those, then less than 10% of your money would get a piece of this action. We'll post this About which exact Mutual funds, with tickers, do this here as it comes in.
So being a direct funder is the only way to put all of your money to work to get a pure piece of this action.
This is, should be, and is growing up to be, a sub-asset class all in itself; as there's nothing else like it.
Here's an analogy compared to traditional funding vehicles: Other than not being FDIC insured - it's similar to a medium-risk two- to three-year CD, usually with no early surrender charges if you chicken out and want your money back before 24 months; that pays between 125% to 150% at maturity.
The risks are higher than a CD, even with the Contractual Replacement Guarantee. There's hundreds of cases in the pipeline at any point in time, so if it looks like a case isn't going well (especially in the first 45 days), then it's replaced for free. In other words, if your $10,000 chunk looks like it's going to fail, then they'll replace it for free with a fresh one.
As you may know, there hasn't been a new asset class to use to diversify an investment portfolio come along, for what, over fifteen years now? The last one was Internet in 1996, unless you think water is a sub-asset class, then 2012.
That's reason enough why this page is here - because it could prove useful by every investor with more than $250,000 invested that wants portfolio risk reduction.
A potential win is if there's a huge catastrophe (e.g., limited nuclear war), then most all of the world's stock markets will lose more than half of their value on day one. Then they may stay down for decades. What's going to happen to your money in ALF, assuming the lawyers doing this work, the plaintiffs, and the physical courthouse in that jurisdiction are not incinerated? A whole lot of nothing.
There's not much that can stop this money-making factory from turning the crank and making money pop out at the end. There's not much anyone can do to stop lawyers from suing people and bringing cases to court. Lawyers and the legal / court systems have been out doing their things before there was electricity, so even if the world ends and there's no more electricity, this whole deal will still be turning their cranks.
So this is one of the last things that would become worthless if "the world ends." This is one of the whole points of diversifying your investments as much as you can.
In the U.S., there are a few mutual funds that invest a small part in these deals. However, there are pure funds that do nothing but this in the UK, and they've had very good results.
The bucks are much bigger on the commercial side by orders of magnitude. So commercial funders need to pony up a minimum of usually $1M to loan, whereas funders on the consumer side only have to come up with $10,000. So the difference is two orders of magnitude (X100) on average.
Big players lend much bigger dollars. The firm I worked with is for much smaller cases.
They’re not securitizing it – they're just loans – so you’re not an equity partner, you’d be a primary creditor.
Other firms (mutual funds) fractionalize the settlements. This new way of doing it cuts out the middle man (e.g., mutual fund). Cutting out all of the middlemen means much more money flows back to everyone, especially the funder (because there's nobody else needing to be paid, other than the funder, plaintiff, the sales force, and the paper-pushing factory itself).
Actually, both of these business models are considered to be "Commercial." The technical difference is that true Commercial is corporation suing corporation, whereas "Consumer" is consumer suing corporation. So the deal I learned about can be considered to be both Commercial and Consumer.
In other words, this deal is just about the only way for "small" investors to get a pure part of this action. It's also one of first to bring it directly to private investors (which is why it’s also called "alternative private capital funding").
Once securitization happens, then this will be a whole new viable asset class for everyone to invest in. It's not correlated to any other asset class, and is more of a loan than an investment - so it would fit best into the fixed income allocation of an aggressive portfolio.
So if you know how portfolio optimizers work, then you should be excited about the potential of this from both a risk-reducing diversifier, and being very viable from a total return point of view.
So at the moment, the big-time lawyers say it's not a security - it's a non-recourse loan. So if you "invested," then you'd be loaning your money to the law firm, and taking your chances that it will be a success. If not, then you could lose ALL of your money.
To minimize that, if a particular case fails, they'll replace it for free. It's also possible to get a 100% return of principle up until actual funding (prior to funding) - which is 24 months (longer if funding doesn’t happen after 24 months).
The maximum is 36 months. If so, then there are no surrender charges, document fees, or penalties. So funders usually get all of their money back if they chicken out before funding (funding means an individual plaintiff's case is actually brought to trial to claim their money waiting for them in escrow).
This is because the case the funder funded can usually be easily re-sold to another funder. All of this educes the risks, so that's another reason why this new business model is worthy of further study and attention as a distinct asset class.
Then they'll even let you roll it over and over again, so you can let your money ride. Yes, you can even use tax-qualified IRA money to fund.
All of this has only been going on for a decade or so (~1997). Ten years from now, your local financial adviser will probably be recommending you buy a regular old boring mutual fund or ETF that does nothing but fund these cases.
Then you'd be able to invest in this asset class for as little as $1,000, and get pure exposure.
When this happens, it will be an asset class used in the odd-fixed-income allocation in most all of our investor models.
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