Red flags

Litigation finance is binary. Losses return zero. Duration is unpredictable. These characteristics make early identification of problems essential. This guide covers red flags across four categories: deal-level, structural, manager, and regulatory. For each, you need to understand why it matters, what questions to ask, how to assess severity, and what mitigants might exist.

Deal-level red flags

Deal-level concerns relate to the specific cases or portfolios you are evaluating. These issues can impair individual investments or create concentrated losses.

Single case representing more than 25% of portfolio

Why it matters: A single case consuming more than 25% of committed capital creates unacceptable binary exposure. If that case loses, the entire portfolio may struggle to achieve target returns. Concentration also creates correlation risk if the case involves a specific legal theory or jurisdiction that affects other positions.

Questions to ask:

What is the justification for exceeding typical concentration limits?
How does the expected return on this case compare to portfolio-level targets?
What would portfolio-level MOIC be if this case returns zero?
Is there a pathway to syndicate or sell down the position?

Assessing severity: The severity depends on the quality of the concentrated case and the maturity of the portfolio. A 30% position in a case that has survived summary judgment and is weeks from trial is different from a 30% position in a freshly filed case with untested legal theories. Run scenario analysis: if this case loses, does the portfolio still return capital? If not, the concentration is too high regardless of case quality.

Potential mitigants: Syndication to reduce exposure, ATE insurance on the specific case, structural protections that limit follow-on capital requirements, and exceptionally strong case fundamentals with multiple independent bases for liability.

Single defendant exposure above 30%

Why it matters: Defendant concentration creates correlated loss risk. If the defendant enters bankruptcy or becomes judgment-proof, multiple cases can impair simultaneously. This correlation exists even across different legal theories. A defendant’s financial distress affects all claims against it.

Questions to ask:

Is this exposure to a single entity or a corporate family?
What is the defendant’s financial condition and credit quality?
Does the defendant have adequate insurance coverage across all cases?
Have you stress-tested simultaneous impairment of all cases against this defendant?

Assessing severity: Map the defendant exposure carefully, including parent companies, subsidiaries, and affiliates. A portfolio showing 25% exposure to “Company A” and 10% to “Company A Subsidiary” actually has 35% exposure to a single economic entity. Assess the defendant’s ability to satisfy multiple adverse judgments. Consider insurance limits across cases—is there enough coverage for aggregate exposure?

Potential mitigants: Defendant credit analysis demonstrating strong ability to pay, insurance coverage adequate for aggregate exposure, staggered case timing that allows sequential recovery, and diversification of plaintiff positions across the defendant’s insurance towers.

Defendant with questionable ability to pay

Why it matters: A judgment against an insolvent defendant is worth nothing. Unlike traditional credit where recovery follows default, litigation finance produces zero recovery if the defendant cannot pay. This makes defendant credit quality a hard constraint, not a yield enhancement.

Questions to ask:

What is the defendant’s current balance sheet? Debt levels? Going concern risk?
What insurance coverage applies? Policy limits? Coverage disputes?
Are there solvent parent guarantors or affiliates?
What is the enforcement jurisdiction? Are assets reachable?
Has anyone else obtained judgments against this defendant? Were they collected?

Assessing severity: Obtain current financials if possible. Review credit ratings if available. Analyze insurance coverage carefully—reservation of rights letters and coverage disputes can reduce effective coverage significantly. For cross-border defendants, assess practical enforceability in jurisdictions where assets are located. A $100M judgment enforceable only in a non-treaty jurisdiction may be worth 20 cents on the dollar after enforcement costs and delays.

Potential mitigants: Strong insurance coverage with investment-grade insurers, parent company guarantees, assets in treaty jurisdictions, judgment enforcement specialists who have successfully collected against similar defendants, and security interest or prejudgment attachment where available.

Duration already exceeding 3+ years with no resolution in sight

Why it matters: Duration destroys IRR. A case expected to resolve in 2 years generating a 2x MOIC produces a 40%+ IRR. The same case taking 5 years produces a 15% IRR. When a case has already been pending for 3+ years without resolution, duration assumptions in the original underwriting are likely wrong. Extended duration also correlates with case complexity and defendant resistance, both negative indicators.

Questions to ask:

What caused the delay? Was it anticipated?
What milestones have been achieved? What remains?
Has there been any settlement dialogue? What is the gap?
Is the defendant using procedural tactics to delay? Are those tactics exhausted?
What is the judge’s historical time to resolution for similar matters?

Assessing severity: Compare actual timeline to original projections. If the case is 3 years old but was projected to resolve in 5-7 years, you are on track. If it was projected to resolve in 18 months, something is wrong. Review the docket for evidence of defendant delay tactics, court backlogs, or case complexity that was underestimated. The question is whether the extended duration reflects foreseeable complexity or unexpected problems.

Potential mitigants: Documented case progress showing substantive milestones achieved (survived summary judgment, completed discovery, trial date set), credible settlement negotiations, and evidence that remaining duration is shorter than elapsed duration.

Multiple adverse rulings on record

Why it matters: Adverse rulings signal weakness in the plaintiff’s case that the funder’s diligence may have missed. Courts have more information than outside evaluators. Sustained adverse rulings suggest the legal theory is weaker than assessed, evidence is less compelling than believed, or plaintiff’s counsel is outmatched.

Questions to ask:

What specific rulings were adverse? Were they dispositive or procedural?
How did these rulings affect the merits or damages analysis?
Did the original underwriting anticipate these issues?
Has the case theory been adjusted in response?
What does lead counsel’s candid assessment show?

Assessing severity: Not all adverse rulings are equal. Losing a discovery motion is different from losing a partial summary judgment on a key claim. Understand what was lost and what remains. A case that loses 3 of 5 claims on summary judgment but retains the two strongest claims may still be a good investment. A case that loses the central liability theory and is proceeding on secondary claims may be terminal.

Potential mitigants: Adverse rulings on peripheral issues only, strong remaining claims, appellate options if adverse ruling was erroneous, and plaintiff’s counsel with demonstrated ability to overcome setbacks.

Structural red flags

Structural concerns relate to how the investment is documented. Poor structures can turn good cases into bad outcomes.

No settlement approval rights below invested capital plus return

Why it matters: Settlement is how most funded cases resolve. If the funder has no approval rights over settlements, the plaintiff or plaintiff’s counsel can settle a case at any time for any amount. This creates obvious conflicts: a plaintiff may prefer $5M today over $15M in 2 years, even if the funder’s economics require the larger number. Without approval rights, funders can be crammed into uneconomic settlements.

Questions to ask:

At what threshold does funder approval become required?
Is the threshold tied to invested capital only, or invested capital plus agreed return?
Who else must approve settlements? Plaintiff only, or plaintiff’s counsel as well?
What happens if parties disagree on settlement? Is there a dispute mechanism?

Assessing severity: The key question is whether the approval threshold protects your invested capital and minimum return. A threshold set at invested capital only may leave you with return of capital but no return on capital if the case settles at that level. Approval rights should require settlements to clear at least invested capital plus contractual return multiple before plaintiff or counsel can accept without funder consent.

Potential mitigants: Some structures provide approval rights above a floor but give plaintiff ultimate authority with a clawback mechanism—if plaintiff settles below a threshold against funder advice, funder receives preferential recovery from the amount available. This preserves plaintiff control while protecting funder economics.

Unlimited cost overrun obligation without dilution protection

Why it matters: Litigation costs are unpredictable. Expert fees, extended discovery, and appeals can multiply the original budget. An unlimited commitment to fund overruns creates open-ended exposure. Worse, if the funder must fund overruns while maintaining the same economic terms, the effective MOIC declines with each additional dollar.

Questions to ask:

Is there a cost cap or budget limit in the funding agreement?
What happens when costs exceed the original budget? Whose obligation?
If additional capital is required, does the funder receive enhanced economics?
Can the funder elect not to fund overruns? What are the consequences?

Assessing severity: Calculate the maximum exposure. If the original commitment is $5M but overrun obligations are unlimited, what is realistic worst-case exposure? Double the original budget is common in complex litigation. Would a $10M total investment still produce acceptable returns at original economic terms? If not, dilution protection is essential.

Potential mitigants: Budget caps limiting total funder obligation, dilution protection providing enhanced economics (higher percentage of recovery or reduced MOIC threshold) for capital above original budget, right to elect out of overrun funding with adjusted economics on capital already deployed, and ATE coverage that includes defense costs in adverse-cost jurisdictions.

No cross-collateralization in portfolio structure

Why it matters: Cross-collateralization allows gains from winning cases to offset losses from losers at the portfolio level. Without it, each case is a standalone investment, and losses on any single case reduce blended returns dollar-for-dollar. The diversification benefit of portfolio investing is largely eliminated.

Questions to ask:

How are returns calculated—at case level or portfolio level?
If a case loses, does the funder still receive returns from winners?
Are there carve-outs to cross-collateralization that could limit its effect?
How are partial recoveries allocated across the portfolio?

Assessing severity: Model the impact. In a 10-case portfolio with 80% win rate and 2x gross MOIC on winners, cross-collateralization produces approximately 1.6x blended MOIC (8 cases x 2x, 2 cases x 0, averaged). Without cross-collateralization, the same portfolio produces 1.6x on winners only, but the two losses produce 0x on committed capital—the blended return depends entirely on capital allocation. If the two losers consumed 30% of capital, blended MOIC is 1.12x. Cross-collateralization matters most when case sizing is uneven.

Potential mitigants: Strong portfolio diversification that reduces loss probability, conservative case selection that minimizes expected losses, and structure that provides cross-collateralization after a minimum return threshold on each case.

Missing ATE coverage in adverse-cost jurisdictions

Why it matters: In loser-pays jurisdictions (UK, Australia, most of Europe, international arbitration), the losing party pays the winner’s legal costs. An unfunded plaintiff in these jurisdictions faces not just loss of the case but liability for defendant’s costs—potentially millions. ATE (after-the-event) insurance covers this risk. Funding without ATE in adverse-cost jurisdictions creates catastrophic downside exposure.

Questions to ask:

Is this case in a loser-pays jurisdiction?
What is the estimated adverse-cost exposure? Defense counsel fees? Disbursements?
Is ATE coverage in place? What limits? What exclusions?
Who pays the ATE premium? Is it funded from the original budget?

Assessing severity: Adverse-cost exposure is often 50-100% of defense costs. In a complex commercial matter, this can be $5M or more. If the case loses and no ATE coverage exists, the plaintiff (or potentially the funder, depending on indemnity structures) is liable for this amount. This turns a zero-recovery outcome into a negative-recovery outcome.

Potential mitigants: Proper ATE coverage from a rated insurer with adequate limits and reasonable exclusions. Verify coverage terms—some ATE policies exclude settlement scenarios or have deductibles that reduce effective coverage. The policy should cover full adverse-cost exposure including defense expert fees and disbursements.

Manager red flags

Manager concerns relate to the people and processes behind the investment. In litigation finance, where case selection is the core skill, manager quality is paramount.

No lawyer on investment committee

Why it matters: Litigation finance is fundamentally a legal assessment business. Evaluating case merit, legal theory viability, procedural risks, and settlement dynamics requires legal expertise. An investment committee without a lawyer lacks the core competency needed to assess deal quality. Non-lawyers can evaluate economics but cannot independently validate the legal analysis that underlies return projections.

Questions to ask:

Who serves on the investment committee? What are their backgrounds?
If no lawyers on IC, how is legal diligence conducted?
Who has final authority on case selection?
What independent legal review occurs before commitment?

Assessing severity: A committee without lawyers but with a rigorous independent legal review process can partially compensate. But if the IC makes final decisions without lawyer input, legal risk assessment is not integrated into investment decisions. This is a fundamental governance gap.

Potential mitigants: Robust independent legal review by qualified outside counsel before any investment reaches the committee, IC members with extensive litigation-adjacent experience (former claims executives, expert witnesses, jury consultants), and a formal requirement that legal review must be favorable before IC approval.

Loss rate exceeding 20%

Why it matters: Given the binary nature of litigation (win or zero), a high loss rate destroys portfolio returns. At a 20% loss rate, even strong returns on winners may not compensate. If winners return 2.5x but 20% of cases return zero, blended MOIC before fees is approximately 2.0x—acceptable but with no margin for error. Higher loss rates rapidly erode returns.

Questions to ask:

What is the historical loss rate by fund vintage?
What is the loss rate by case type, jurisdiction, and case size?
How are losses defined—zero recovery only, or below capital?
What is the distribution of winning case returns?

Assessing severity: Context matters. A 25% loss rate with 3x average MOIC on winners produces 2.25x blended. A 15% loss rate with 1.8x on winners produces 1.53x blended. The acceptable loss rate depends on what winning cases return. Analyze the full distribution, not just the averages. Also distinguish between realized and unrealized losses—a young portfolio may have temporary marks that will resolve.

Potential mitigants: Strong recovery on winners that compensates for losses, demonstrated improvement in loss rates over time as processes mature, concentration of losses in a specific category the manager has since exited, and portfolio construction that limits loss impact through diversification.

Approval rate above 15%

Why it matters: Litigation funding requires extreme selectivity. Leading funders approve 2-5% of opportunities reviewed. An approval rate above 15% suggests insufficient rigor in case selection. The pipeline may be curated (only strong cases referred), but more likely the diligence process is too permissive. High approval rates correlate with higher loss rates and lower returns.

Questions to ask:

What is the historical approval rate? How has it trended?
How is the pipeline sourced? Is it pre-screened by referral sources?
What is the screening process? How many stages?
What percentage of cases are rejected at each stage?

Assessing severity: Approval rate must be understood in context. A funder with proprietary deal flow from a select group of elite law firms may approve 15% of a highly curated pipeline. A funder reviewing broad market flow should approve 3-5%. Ask about deal sourcing. If the pipeline is diverse and approval rate is high, selectivity is inadequate.

Potential mitigants: Highly curated deal flow that justifies higher approval rate, multi-stage screening that filters aggressively before IC review, approval rate that has declined as the manager has scaled and built internal capabilities, and track record demonstrating that approved cases perform well despite the high rate.

No independent case evaluation process

Why it matters: Internal analysis creates confirmation bias. Once a deal team is invested in a case, objectivity is compromised. Independent evaluation—whether from outside counsel, retired judges, or other specialists—provides a check on internal optimism. Without it, flawed cases pass through diligence because the people reviewing them want them to pass.

Questions to ask:

What independent review occurs before commitment?
Who conducts the review? What are their qualifications?
How often does independent review contradict internal assessment?
When contradiction occurs, how is it resolved?

Assessing severity: Independent review must be truly independent—not beholden to the funder for ongoing business. A law firm earning substantial fees from the funder may be reluctant to issue negative assessments. Look for structural independence: retired judges, law school clinics, or counsel with limited ongoing relationship. Ask specifically about cases where independent review was negative and the investment was declined. If this never happens, the process is not adding value.

Potential mitigants: Formal independent review process with demonstrated ability to kill deals, rotation of independent reviewers to prevent relationship capture, internal devil’s advocate role that must sign off on all investments, and documented instances where internal recommendation was overridden.

Marks that only go up without corresponding milestones

Why it matters: Litigation finance valuation is inherently subjective. Cases can be marked at cost, probability-weighted expected value, or milestone-adjusted bases. A portfolio where marks only increase suggests valuation discipline is lacking. Real portfolios have adverse developments: motions lost, discovery problems, settlement talks that collapse. If marks never reflect these, the NAV is likely overstated.

Questions to ask:

What is the valuation methodology? How are marks determined?
What percentage of cases have been marked down in the past year?
What triggers a mark-down versus a mark-up?
How do marks compare to eventual realized values?

Assessing severity: Request historical marks-to-realizations analysis. Compare the mark on cases at various points during their lifecycle to the eventual realized recovery. Systematic optimism (marks that consistently exceed realizations) indicates valuation problems. Also analyze the direction of marks—a portfolio where 90% of mark changes are positive is either extraordinarily lucky or poorly marked.

Potential mitigants: Independent valuation by a third party (though rare in litigation finance), clear milestone-based triggers that mechanically adjust marks, demonstrated track record of marks that match realizations, and willingness to write down cases with adverse developments even before final resolution.

Regulatory red flags

Regulatory concerns relate to the legal framework governing litigation funding. This is an evolving area with material uncertainty in certain jurisdictions.

Champerty law uncertainty in key jurisdictions

Why it matters: Champerty (financing litigation for a share of proceeds) was historically prohibited. While most US jurisdictions have abolished or limited these restrictions, some states retain champerty doctrine. Delaware is the most significant—the Court of Chancery has expressed skepticism about funding arrangements with strong funder control. A funding agreement found to be champertous is unenforceable, potentially resulting in total loss.

Questions to ask:

What jurisdictions govern the cases in the portfolio?
What law governs the funding agreement itself?
Have you obtained enforceability opinions in relevant jurisdictions?
What control rights does the funder have? Do they create champerty risk?

Assessing severity: Delaware matters most because significant commercial litigation, particularly corporate and M&A disputes, occurs there. Funders with substantial Delaware exposure should structure carefully: minimize control provisions, frame settlement approval as economic protection only, and consider New York governing law for the funding agreement. For other uncertain jurisdictions, case-by-case analysis is required.

Potential mitigants: New York or California governing law for funding agreements, minimal control rights that preserve plaintiff decision-making, Delaware counsel opinions confirming enforceability, and portfolio construction that limits exposure to uncertain jurisdictions.

Expanding disclosure requirements

Why it matters: Courts are increasingly requiring disclosure of funding arrangements. Federal courts, state courts, and arbitration institutions have implemented or proposed disclosure rules. Disclosure itself is manageable, but it creates several concerns: defendants may use funding information tactically in settlement negotiations, economic terms may become public, and some judges may view funded cases skeptically.

Questions to ask:

Which cases have disclosure requirements? What must be disclosed?
What have been the practical consequences of disclosure?
How do you structure for anticipated disclosure expansion?
Have any cases experienced adverse consequences from disclosure?

Assessing severity: Disclosure is a structural trend, not a transient concern. The question is not whether disclosure will expand but how quickly and to what extent. Funders should assume all arrangements will eventually be disclosed and structure accordingly. Economic terms, once disclosed, may affect competitive positioning and future negotiations. Assess whether disclosed terms are market-standard or create explanation risk.

Potential mitigants: Market-standard economic terms that do not invite scrutiny, early voluntary disclosure that removes tactical advantage for defendants, documentation that separates economic terms from case strategy, and relationships with courts that demonstrate funding benefits access to justice.

Increasing scrutiny of mass tort funding

Why it matters: Mass tort funding—supporting aggregated personal injury claims—faces heightened regulatory attention. Consumer protection concerns, advertising practices, and claimant treatment have drawn legislative scrutiny. While most regulatory proposals target consumer-facing practices, spillover to commercial mass tort funding is possible. Changes could affect claim aggregation, claimant solicitation, or economic structures.

Questions to ask:

What percentage of the portfolio is mass tort?
How are claimants solicited and aggregated?
What regulatory developments are you monitoring?
How would proposed regulations affect your business model?

Assessing severity: Portfolios with heavy mass tort concentration face greater regulatory risk than diversified commercial portfolios. The severity depends on the specific mass tort types—pharmaceutical and medical device cases face more scrutiny than environmental or consumer product cases. Monitor state attorneys general activity, federal legislative proposals, and class action bar ethics developments.

Potential mitigants: Diversification across litigation types that reduces mass tort concentration, compliance programs addressing advertising and claimant treatment, engagement with industry associations on regulatory developments, and willingness to adapt structures in response to regulatory change.

The presence of any single red flag does not necessarily disqualify an investment, but multiple red flags or severe individual concerns should prompt significant additional diligence or reconsideration. In litigation finance, where losses are total and duration is uncertain, the margin for error is smaller than in most asset classes.