Litigation finance
Valuation approaches
status: draft
Valuation approaches
Valuing litigation finance positions is one of the hardest problems in alternative assets. You’re marking positions where the underlying asset is a legal claim with binary outcomes, uncertain timing, and no observable market price. Every methodology involves judgment calls. LPs need to understand what approach the GP uses, why, and how to stress-test the marks.
Common valuation approaches
There is no standard valuation methodology for litigation finance. Different managers use different approaches, and some blend multiple methods. Here are the four primary approaches:
Cost basis (most conservative)
Mark positions at deployed capital until a case event occurs.
| Aspect | Treatment |
|---|---|
| Initial mark | Deployed capital (1.0x) |
| Adjustment trigger | Only on case resolution or material event |
| Unrealized gains | Zero until crystallized |
| Advantages | Conservative, hard to manipulate, auditor-friendly |
| Disadvantages | Masks value creation, understates NAV, poor for incentive fees |
When it makes sense: Early-stage funds with short track records. Funds with high single-case concentration where one mark-up could swing NAV materially. Managers who want to avoid any appearance of aggressive marking.
The problem: A case that has survived motion to dismiss, completed discovery, and received favorable summary judgment rulings is worth more than cost. Marking at 1.0x understates true economic value and can mislead LPs about portfolio quality.
Probability-weighted expected value
Estimate win probability, expected recovery, timing, and discount to present value.
| Input | Typical Range | Impact |
|---|---|---|
| Win probability | 50-85% | Largest driver of valuation |
| Expected recovery | Varies by claim | Sets upside bound |
| Expected duration | 2-5 years | Affects discount factor |
| Discount rate | 15-30% | Higher for riskier cases |
The calculation:
Fair Value = (Win Probability x Expected Recovery x Funder Share) / (1 + Discount Rate)^Years
Example:
- Win probability: 70%
- Expected recovery: $20M
- Funder share: 30% = $6M
- Expected duration: 3 years
- Discount rate: 20%
Fair Value = (0.70 x $6M) / (1.20)^3 = $4.2M / 1.728 = $2.43M
If deployed capital was $2M, this implies a 1.22x mark.
Advantages: Captures case-specific risk. Allows for granular adjustment as facts change. Intellectually honest about what drives value.
Disadvantages: Highly subjective inputs. Win probability estimates are hard to validate. Creates pressure to justify marks with optimistic assumptions. Discount rate selection is judgment-laden.
Milestone-based adjustment
Start at cost, adjust up or down based on case milestones.
| Milestone | Typical Adjustment |
|---|---|
| Complaint filed (baseline) | 1.0x (cost) |
| Survived motion to dismiss | +5-10% |
| Completed discovery (favorable) | +5-10% |
| Class certification granted | +10-20% |
| Favorable summary judgment | +15-25% |
| Trial date set | +5-10% |
| Favorable trial verdict | Mark to expected recovery |
| Adverse motion to dismiss | -20-40% |
| Adverse summary judgment | -30-50% or write-off |
| Unfavorable class certification | -15-30% |
| Settlement below expectations | Mark to settlement value |
Advantages: Objective triggers for adjustment. Auditable against public court records. Limits discretion while capturing real value changes. Easy to explain to LPs.
Disadvantages: Milestones don’t always reflect value changes proportionally. A favorable summary judgment might resolve 90% of the risk or 20%. Formulaic approach may miss case-specific factors.
Best practice: Use milestones as starting points, but allow committee discretion to deviate with documented rationale.
Comparable transaction
Use secondary market prices as evidence of fair value.
| Data Source | Usefulness |
|---|---|
| Actual sale of the position | Best evidence, but rare |
| Secondary market bid (third-party) | Strong evidence if arms-length |
| Comparable case sales | Useful benchmark, requires adjustment |
| Manager’s own trades | Be cautious about self-referential marks |
When it works: A growing secondary market in litigation finance positions provides transaction data. If a similar case sold at 1.5x deployed capital, that’s evidence for marking comparable cases.
Limitations: Secondary market is still thin. Cases are heterogeneous, so comparability is limited. Selection bias in what trades (often distressed or highly certain positions).
status: draft
What LPs should demand
Valuation governance matters as much as methodology. Before investing, demand the following:
Written valuation policy
The manager should have a documented policy covering:
- Primary valuation methodology
- When and how marks are adjusted
- Who has authority to adjust marks
- How conflicts of interest are managed (incentive fees create pressure to mark up)
- Frequency of valuation (quarterly is standard)
Red flag: No written policy, or policy that gives GP unconstrained discretion.
Valuation committee with independent review
| Best Practice | Why It Matters |
|---|---|
| Dedicated valuation committee | Separates marking from investment decisions |
| At least one independent member | Checks GP conflicts |
| Documented meeting minutes | Creates audit trail |
| Independent review for large positions | Third-party validation on material marks |
Managers with institutional LP bases typically have a valuation committee that includes the CFO, at least one investment professional not involved in the case, and ideally an independent advisor.
Case-by-case milestone disclosure
LPs should receive quarterly updates showing:
- Each case’s deployed capital
- Current mark and methodology
- Key milestones reached since last quarter
- Next expected milestones and timing
- Any adverse developments
Why it matters: You can’t validate marks without knowing what happened in each case. If a case was marked up 20%, what milestone justified that? If a case wasn’t marked down after a bad ruling, why not?
Sensitivity analysis
Request analysis showing how NAV changes under different assumptions:
| Scenario | Example Impact |
|---|---|
| Win probabilities 10% lower across portfolio | NAV down X% |
| Durations extend 12 months across portfolio | NAV down X% |
| Discount rate increases 5% | NAV down X% |
| Top 3 cases lose | NAV down X% |
This reveals how much of reported NAV depends on assumptions vs. crystallized value.
Third-party valuation for material positions
Any position representing more than 10% of portfolio value should have independent valuation at least annually. This is especially important for:
- Single-case concentrated funds
- Positions marked materially above cost
- Cases with unusual complexity or size
status: draft
Red flags in valuation
Watch for these warning signs that suggest aggressive or unrealistic marking:
Marks only go up
Real litigation portfolios have setbacks. If marks never decrease quarter-over-quarter, either:
- The manager isn’t adjusting for adverse developments
- Case selection is unrealistically good
- The methodology doesn’t incorporate downside events
What to ask: “Show me every case where you’ve marked down a position and why.”
Large mark-ups without milestones
A 25% mark-up should correspond to something that happened:
- Favorable ruling
- Settlement progress
- Trial date set
- Discovery revealing stronger facts
If the manager can’t point to a specific development, the mark-up is manufactured.
No mark-downs on adverse rulings
If a case loses a motion to dismiss on key claims, loses class certification, or receives adverse summary judgment, the mark should decline. Failure to mark down suggests:
- Valuation policy isn’t being followed
- Manager is hiding bad news
- Governance is weak
Win probability assumptions above 90%
Very few cases have 90%+ win probability. Even strong cases face:
- Unpredictable juries
- Appellate reversals
- Settlement pressure
- Defense resources
If multiple cases are marked at 90%+ win probability, the manager is likely overstating confidence.
Duration assumptions shortening without explanation
If expected duration keeps declining without cases actually resolving faster, the manager may be using shorter durations to inflate present value. Ask:
- What is average actual duration for resolved cases?
- How does that compare to duration assumptions on open cases?
status: draft
Realized vs. unrealized returns
This is the most important distinction for evaluating a litigation finance manager.
| Metric | Definition | Reliability |
|---|---|---|
| Realized MOIC | Total distributions from resolved cases / capital deployed in those cases | High (auditable) |
| Realized IRR | IRR on resolved cases only | High (auditable) |
| Unrealized MOIC | NAV of open cases / capital deployed in open cases | Low (subjective marks) |
| Unrealized IRR | Implied IRR assuming current marks are accurate | Very low |
| Blended (Gross) | Combines realized + unrealized | Depends on mix |
Why the split matters
A manager showing 2.5x gross MOIC might have:
- Scenario A: 2.5x realized on 80% of capital, 1.0x unrealized on 20% → Strong evidence of skill
- Scenario B: 1.5x realized on 30% of capital, 3.0x unrealized on 70% → Marks unproven
Same headline number, very different confidence levels.
What to ask
- “What percentage of reported returns are realized vs. unrealized?”
- “What is your realized MOIC/IRR on cases that have fully resolved?”
- “How have unrealized marks historically tracked to eventual realizations?”
Track record validation should weight realized returns heavily. Unrealized returns are projections, not evidence.
Vintage analysis on mature funds
For funds that are 5+ years old, you can analyze fully resolved vintages:
| Vintage Year | Capital Deployed | Final MOIC | Final IRR |
|---|---|---|---|
| 2016 | $50M | 1.9x | 22% |
| 2017 | $65M | 2.1x | 25% |
| 2018 | $80M | 1.7x | 18% |
This shows what the manager actually delivered when cases resolved, removing all mark subjectivity.
Red flag: Manager avoids vintage analysis or only shows data for best-performing years.
status: draft
Summary: valuation due diligence checklist
Before investing, verify:
- Written valuation policy exists and is reasonable
- Valuation committee includes independent oversight
- Case-by-case milestone reporting is provided quarterly
- Sensitivity analysis is available
- Third-party valuation for positions >10% of portfolio
- Realized vs. unrealized split is disclosed
- Vintage analysis on mature funds is available
- Historical marks have been validated against eventual realizations
status: draft
Related
Deep-dive articles in this guide:
- Single-Case Funding — economics and risk profile of single-case investments
- Portfolio Financing — diversification and cross-collateralization mechanics
- Legal Framework — regulatory and structural considerations
status: draft
Back to: Litigation Finance