Posted by on 03/06/2019

How to suffer loss

The following blog post was written by Bruce Packard CFA, an independent value investor and personal friend of Cormac Leech, CEO of AxiaFunder. The author is not affiliated with AxiaFunder and this post does not reflect the views of AxiaFunder. 

Bruce Packard writes about the different ways in which we should consider the risk of loss. He reflects on the lessons we can learn from the very first joint stock companies of the City of London, the St Petersburg Paradox discussed by Daniel and Nicolaus Bernoulli in 1738, and what these can tell us about the risks of loss in litigation finance.  

The idea of litigation finance is simple, legal cases cost money and sometimes a claimant is unable to afford to fight a case; so in exchange for money up front, they share the return of any settlement winnings paid out in the future. Burford Capital does this very successfully – but Cormac is trying to allow retail investors to fund smaller cases.

Bruce Packard reflects on the ways in which the idea at the core of litigation finance are actually very simple. In exchange for providing the upfront cash to fund the fees of fighting a case, a claimant agrees to share the proceeds of any settlement winnings which will be paid out in the future. He finds the appeal of it is partly due to the fact it should be lucrative but also because it reminds him of the original spirit of adventure that the City of London’s first Joint Stock Companies had. These Companies were formed to trade with overseas countries and were created to allow the risk of trading to be pooled across the members of the Company with each member contributing some money to a joint “stock”. 

Litigation finance also reminds him of the St Petersburg Paradox. This is a paradox which was discussed by Daniel Bernoulli and Nicolaus Bernoulli in 1738. This paradox was first proposed as a resolution to a dilemma initially framed as a discussion of lottery tickets, but the paradox is also applied to a discussion of merchants trying to protect themselves from the risk of their ship sinking. 

In the example, Bernoulli describes the dilemma facing the lottery ticket holder. For a very poor person who obtains a ticket, that ticket will yield either one of:
  • Nothing
  • 20,000 ducats
How should this poor person evaluate his chances of acquiring 10,000 ducats through his purchase of this lottery ticket? If, after buying it, someone offered him 9,000 ducats for that same lottery ticket should he refuse the offer? Bernoulli thinks the answer is clearly in the negative. But the risks and reward look very different from the perspective of a very rich man. A rich man should always pay the 9,000 ducats for that lottery ticket. Bernoulli concludes that it is clear to him that all men cannot evaluate a gamble using the same rule. 

Now consider the situation of someone bringing a court case. The analogies should become clear. A fixed sum of money, for example 10,000 ducats is worth much more to a poor person whose net worth is only 50 ducats than it is to a rich man who already has saved 100,000 ducats.  

The implications of this become interesting when we consider whether you should take a bet. It has the result that, though the odds are strongly in your favour, it may not make sense to take a gamble. Even if you have a very high chance, say 90%, of winning a court case for the poor person with only 50 ducats it may still not be worth it to take that gamble. If they lose (and there is always a chance of losing a court case) the case will bankrupt them entirely. Many litigation funders give quotes of win rates at 85-90%, so the parallel is applicable. A chance of 1/10 of bankruptcy isn’t a sensible gamble for most claimants.  Bruce Packard goes on to consider the ways of spreading that risk and how that gamble can make sense for investors. 

Originally posted on Bruce Packard’s blog on 12 October 2018.