Litigation finance asset-backed securities (ABS) represent only a small fraction of the overall ABS market and an even smaller portion of the broader public U.S. bond market. Despite its size, the asset class has attracted growing interest from credit investors seeking differentiated sources of alpha, strong structural protections, and cash flows that are largely independent of traditional economic cycles.

So what exactly is litigation finance, and what makes it an attractive investment opportunity?

Understanding Litigation Finance

Litigation finance is a specialized form of lending that provides plaintiffs with immediate liquidity while they await the resolution of legal claims. For many plaintiffs, these advances serve as an important financial lifeline. Borrowers are often unemployed, underemployed, or have limited access to traditional credit, frequently as a result of the underlying legal matter. Legal advances can help cover living expenses, medical bills, and other financial obligations while a case progresses, providing access to funds far sooner than waiting for an insurance claim or legal settlement to be resolved.

To meet this need, specialty finance companies advance capital against the expected proceeds of a future settlement or judgment. Funding is typically structured as non-recourse financing, meaning repayment is only required if the plaintiff receives a settlement or favorable judgment. Advances are generally limited to 10% to 15% of the expected settlement value. Importantly, plaintiffs retain the vast majority of any settlement proceeds and benefit from recoveries that exceed expectations, while the litigation finance provider's return is limited by contractual terms. As a result, litigation finance is designed to provide access to liquidity rather than transfer ownership of the legal claim or a disproportionate share of the eventual settlement.

The Economics of the Business

Litigation finance companies earn strong returns on invested capital through a combination of monthly compounded fees, application fees, and origination fees. Advances are generally structured with an initial six-month contract period that automatically extends in three-month increments until settlement, allowing fee income to accrue over time. The combination of recurring fee income, disciplined underwriting, and repayment tied to legal settlements rather than traditional economic activity can help produce compelling risk-adjusted returns for specialty finance companies.

Investors can access these economics through both corporate bonds issued by litigation finance companies and asset-backed securities backed by pools of legal advances. While corporate bonds provide exposure to the broader operating performance of the issuer, litigation finance ABS offers a more direct claim on the cash flows generated by the underlying legal advance receivables.

From Legal Claims to Asset-Backed Securities

The path from an individual legal claim to an investable asset-backed security begins with rigorous underwriting focused on the probability of a successful legal outcome, the credit quality of the defendant's insurance coverage, the historical performance of the law firm handling the case, and jurisdiction-specific legal trends and comparable case outcomes. Repayment is derived from settlement proceeds, creating cash flows that are largely independent of broader economic and credit cycles.

Legal advance providers aggregate portfolios of receivables and transfer them into bankruptcy-remote special purpose vehicles (SPVs), which issue asset-backed securities to investors. The value of these securities is ultimately tied to the amount and timing of future settlement proceeds collected from the underlying legal advances. As collections are received, cash flows are distributed to investors according to the transaction's payment structure.

As with other ABS sectors, litigation finance securitizations incorporate multiple layers of credit enhancement designed to protect investors. These structural features help mitigate losses, preserve liquidity, and support timely bondholder repayment by providing additional cash buffers and redirecting cash flows when asset performance deteriorates, thereby enhancing the transaction's resilience during periods of stress. Transactions are typically structured with multiple classes of securities that differ in seniority and risk exposure, offering investors a range of risk-return profiles. Senior tranches generally benefit from substantial credit enhancement and subordination, helping to provide greater protection against losses, while junior and subordinate tranches generally offer higher potential returns in exchange for assuming a larger share of the underlying credit risk.

The Investment Opportunity

Despite disciplined underwriting standards, substantial credit enhancement, and cash flows that are largely independent of traditional economic and credit cycles, litigation finance securities often trade at wider spreads than similarly rated corporate bonds and other ABS sectors. This pricing may reflect a meaningful liquidity premium, driven by a limited issuer base and relatively small transaction sizes, which typically range from $100 million to $150 million. Although these niche transactions may be too small to attract significant allocations from the largest institutional investors, they can be particularly attractive for specialized credit managers with the flexibility to build positions in less-followed segments of the market. For investors willing to venture beyond more heavily trafficked areas of the fixed income market, litigation finance may offer a differentiated source of yield, diversification, and risk-adjusted return potential supported by disciplined underwriting of the underlying collateral.

All investments contain risk and may lose value. This material contains the opinions of Manning & Napier, which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable but not guaranteed.