Burford Capital recently made history: By taking a minority ownership stake in a boutique UK law firm, PCB Litigation, in July 2020, we became the first legal financier to provide capital in exchange for law firm equity. But this first for the industry continues a long Burford tradition of innovating legal finance structures that address client challenges in novel ways. It is also indicative of the growing professionalization of legal finance and its expansion to encompass not just fees and expenses financing but also monetizations, portfolio-based capital facilities and other corporate finance structures that increasingly resemble investment banking for law.
Not surprisingly, equity investments—which can be made both between a legal financier and a law firm and between a legal financier and a litigant—are sufficiently new and novel as to require some explanation of their benefits and applications.
On the most obvious level, outside equity creates significant cash—and that represents a powerful corporate finance tool to fuel law firm and business growth. And of course, cash matters now more than ever: As capital becomes constrained in an ailing global economy, equity investments will become essential considerations in the years ahead. What follows is a discussion of how law firms and companies can address their unique needs by taking advantage of innovative equity-backed financing arrangements.
Equity financing for law firms
Historically run as cash partnerships, law firms have long faced unique barriers to accessing capital, limiting their ability to grow and to offer innovative and attractive financing solutions to clients. In the last decade, legal finance has helped many firms overcome these barriers, for example by arming them with capital facilities they can use to win new business with client-friendly terms in place. And now, as law firm equity financing becomes a reality, legal finance providers can help law firms find innovative new paths to growth.
Law firm equity deals are of course limited by jurisdiction. In the UK, where outside ownership of law firms is permitted, it seems likely that more UK-based firms or global firms with UK offices will consider equity investments, just as corporations use equity as part of their capital structure. Already, nearly 1,300 law firms—roughly 10% of those in the UK—have switched to the ABS model. With Reed Smith last year becoming the first international law firm to create an ABS, other large international players may soon follow suit. In the US, there are formal regulatory constraints on non-lawyer ownership of law firms. Arizona, however, recently abolished rule 5.4, becoming the first state to allow law firms to move to ABS structures, signaling increased momentum for outside ownership in the US. With partners like Burford, law firms are exploring models that adhere to ethics and the law while providing alternative solutions—solutions that are all the more urgently attractive in today’s fraught economic climate.
As distinct from the more transactional nature of fees and expenses financing (usually in the form of law firm portfolio financing), law firm equity arrangements serve a far wider purpose. Outside equity provides an immediate infusion of capital that isn’t tied to case outcomes. Whereas capital provided in a traditional legal finance arrangement is most often used to litigate the underlying claims, capital from an equity financing arrangement is specifically intended for firms to invest in the growth of the firm and its lawyers. Capital can be used, for example, to launch or augment a potentially profitable litigation or contingency practice, for geographic expansion or otherwise expanding client service.
There is a further and game-changing benefit for law firms. Under the traditional cash partnership structure, law firm partners are the sole owners of the firm, and yet they do not have permanent equity: Upon retirement, partners give up their ownership interest. As a result, partners are incentivized to earn as much as they can during their productive working years, rather than to build up the long-term value of the firm as a business. This has significant negative consequences for law firms—and thus for their clients—because partners are incentivized to choose short term rewards over long-term investments which generate returns that may postdate their retirement or lateral move to another firm. For example, they’re incentivized to hold onto client relationships rather than passing those relationships on to a younger (and more diverse) generation.
The situation is different, of course, if partners are incentivized to think long term because they hold permanent equity in their firms. And indeed, when firms move to an ABS or other outside ownership structure, partners not only collectively retain majority ownership of the firm, they individually retain equity and cash benefits beyond their retirement—just like any hard-working business owner would expect. This provides firms with a valuable tool to cultivate partner loyalty and incentivize firm reinvestment, and in this way, equity investments thereby facilitate both short- and long-term growth.
In its deal with PCB Litigation, a Band 1 ranked boutique focused on civil fraud and asset recovery that routinely competes with full-service firms, Burford took a 32% passive equity stake in its business. To enable the equity stake, PCB converted into an ABS. The arrangement provides a cash and risk management solution enabling the firm’s continued growth.
Equity investments for companies
Though equity financing is new to law firms, hybrid equity arrangements have long been available to corporate litigants working with legal finance providers. In particular, small companies and startups have benefited from the powerful synergies of combining equity and traditional legal finance financing.
It should come as no surprise that litigation frequently influences a company’s valuation, especially when that company is young or small. But with traditional capital providers, this influence is typically negative: Banks view meritorious litigation claims not as assets but as liabilities that diminish corporate value. Legal finance providers take a more positive view: Meritorious litigation claims are assets, and thus companies like Burford are willing to pay the costs of fees and expenses financing on a non-recourse basis, with repayment predicated entirely on whether the underlying piece of litigation succeeds.
Insofar as the corporate claimant is able to shift downside risk to a third party, fees and expenses legal financing of course provides an attractive risk management tool. But it is sometimes the case that fees and expenses financing cannot unlock enough capital to meet the liquidity needs of a corporate claimant—particularly when that claimant is a startup with it cash tied up in R&D.
Equity investments, however, offer a more holistic approach that can greatly reduce the company’s cost of capital while taking advantage of the potential for litigation to improve valuation.
In an equity investment, Burford’s return is at least partly covered by the equity it receives in the company. By structuring its return to include both potential litigation proceeds and equity, Burford can offer more creative solutions and compelling deal terms because it has greater downside protection in the event of a loss, as compared to the traditional “non-recourse” financing approach.
The advantage to the company is straightforward: Holistic valuation of assets almost always equates to more competitive pricing of capital. For instance, venture capital companies are extremely unlikely to place a higher valuation on startups with extant litigation, however meritorious. Nor are banks willing to offer capital advances to companies with strong affirmative claims. Not only do legal finance providers recognize the value of companies’ legal assets, but by taking an equity investing approach, they allow companies to retain a higher share of any potential backend recoveries from litigation, which may itself raise the valuation of the company.
The qualitative benefits of equity financing
The benefits of equity investments extend beyond capital: Legal finance providers also offer extraordinary qualitative value to companies and law firms. As is the case in virtually all legal finance arrangements, equity investments are akin to partnerships, with the legal finance provider serving as a trusted advisor and second set of eyes to its counterparty. Legal finance providers do not control the cases they fund—and neither do they exert control over the companies and law firms in which they take equity. But they do offer advice that can help improve litigation outcomes, and, in the case of equity, provide a crucial platform for growth.
With continued economic uncertainty, companies and law firms will face difficult choices about how to finance affirmative litigation and generate revenue. Equity investments while not a panacea, represent a pivotal extension of traditional legal finance—the next generation of an industry that grew out of the last recession.
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Issue 4/2020 of the Burford Quarterly features new thinking on a variety of topics, including how Burford, as the leader of an evolving industry, can be a valuable partner to in-house and law firm lawyers today.