The ‘off balance sheet’ risk in litigation funding

read time: 2 min

For many businesses involved in litigation, the external view of the litigation may be as important as the litigation itself, leading to companies increasingly looking to take litigation funding ‘off book’. This article highlights the ‘off balance sheet’ risk in litigation funding.

Let’s assume a claim of £10 million, with costs to pursue the claim of £1 million and potential exposure to the opponents costs of £1 million, if the claim is not successful. Much will turn on the accounting treatment, but typically the claim value might be treated as a contingent claim, whilst the costs of litigation are a real cash flow event and the exposure to opponents costs a contingent liability.

When valuing businesses using earnings before interest, taxes, depreciation and amortisation (EBITDA) multipliers, the effect is exacerbated.

Many businesses are now choosing to use third party litigation funding to finance claims. Under this type of arrangement, the funder finances the pursuit of the claim in exchange for a percentage of the sums recovered. Insurance is typically taken out to cover the risks of having to pay the counterparty’s legal costs if the claim is not successful, with the premium only payable in the event the claim is successful.  

Under this approach, the cashflow effect of the claimant’s own costs are negated, replaced with a deduction from the proceeds of the claim, and the contingent exposure to the opponents costs is removed and replaced by an insurance policy.  If the claim is successfully pursued, the recovery will be reduced by the funders reward and the costs of the insurance cover, say £3.3m in total, making the contingent claim recordable at £6.7m.

Whilst the sums actually recovered may be significantly eroded by the use of external funding, as opposed to self-funding, the wider ramifications of the accounting treatment can significantly impact a parties willingness to investigate alternate funding strategies.

For further information, please contact Andrew Perkins.

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