The Hidden Crisis in Litigation Finance: When Funding Portfolios Become "Zombie" Assets

Litigation finance is not immune to private equity's zombie fund phenomenon.  While litigation finance is a newer, evolving asset class, lessons can be learned from private equity funds that have operated beyond their intended lifespans.  Important for investors to understand is the ripple effects of exposure to zombie assets outweigh the alternative investment that promised uncorrelated returns and predictable timelines.

For institutional investors who allocated capital to litigation funding vehicles expecting shorter duration investment horizons, the reality is legal finance has become far more complex. Cases that were projected to settle with short durations are now stretching into multi-year litigation, creating a cascade of consequences that mirror the zombie fund dynamics plaguing broader private markets and the funders of these cases.

Understanding Zombie Funds in Litigation Finance

The term "zombie fund" traditionally describes private equity vehicles that continue operating well beyond their 10-12 year lifecycle, unable to exit portfolio companies at acceptable valuations. Portfolio managers continue collecting management fees—typically 2% annually—while limited partners watch their capital remain trapped in illiquid positions.

Litigation finance has proven vulnerable to similar dynamics, though the mechanics differ slightly. When legal cases extend beyond forecasted timelines or defense strategies prove more resilient than anticipated, general partners face difficult choices. Unlike traditional portfolio companies, litigation assets cannot be easily restructured or sold without significant haircuts, creating a peculiar form of illiquidity.

The three hallmarks of zombie positions in litigation funding include:

Duration risk: Cases extending 2-3x beyond initial projections, with legal proceedings delayed by appeals, discovery disputes, or procedural complications.

Exit constraints: Limited secondary market liquidity for partially-resolved cases, particularly those involving confidential settlements or complex multi-party disputes.

Fee accumulation: Management fees and administrative costs that compound against stagnant asset values, eroding net returns for limited partners who committed capital expecting different risk-return profiles.

Why Litigation Finance Portfolios Stall

Several structural factors have converged to create zombie dynamics within litigation funding strategies. Understanding these root causes helps investors identify which vehicles carry elevated risk and where opportunities may emerge.

Valuation opacity remains the primary challenge. Unlike publicly-traded securities with transparent pricing, litigation assets lack standardized valuation methodologies. General partners often mark cases at optimistic valuations based on settlement projections that may not materialize, creating a disconnect between reported NAV and realizable value. When cases drag on, GPs face pressure to maintain these marks rather than recognize impairments that would damage fundraising prospects.

Macroeconomic headwinds have compounded these challenges. Rising interest rates have made defendants more willing to litigate rather than settle, as the time-value of money favors delay tactics. Corporate legal departments, facing their own budget pressures, are pushing cases to trial rather than accepting early settlements. This shift has caught many litigation finance managers off-guard, as their underwriting models assumed settlement rates and timelines that no longer reflect market reality.

Misaligned incentives between general and limited partners create another friction point. GPs collecting management fees on aging portfolios may lack sufficient urgency to liquidate positions at discounts, even when doing so would serve LPs' interests by returning capital for redeployment. This agency problem intensifies as funds approach their termination dates, with GPs reluctant to crystallize losses that would harm their track records.

The LP Perspective: Trapped Capital and Eroding Returns

For institutional allocators who committed capital to litigation finance seeking portfolio diversification, the emergence of zombie positions creates multiple problems. Pension funds and insurance companies modeling liquidity needs around projected distribution schedules find themselves with capital locked in illiquid positions, unable to meet their own obligations or capitalize on more attractive opportunities.

The impact extends beyond simple illiquidity. Fees continuing to accrue on stagnant positions directly erode returns, transforming what appeared to be high-yielding alternative investments into mediocre performers. Performance reporting becomes distorted, with unrealized valuations masking true economic performance and making it difficult for allocators to assess whether to commit additional capital or seek exits.

Perhaps most concerning, distorted valuations create a false sense of security. When litigation portfolios are marked at inflated values, both GPs and LPs delay making difficult decisions about restructuring or liquidating positions. This "extend and pretend" dynamic only compounds problems, as delayed settlements and mounting legal costs further deteriorate underlying economics.

Where Sophisticated Investors Find Opportunity

Market dislocations create opportunities for investors with specialized expertise and patient capital. The secondary market for litigation finance assets—though opaque and inefficient—offers compelling entry points for those who can navigate its complexities.

Acquiring distressed litigation assets requires different skills than traditional legal finance underwriting. Investors must evaluate not just the underlying legal merits, but also the motivations of selling GPs, the remaining timeline to resolution, and the structural terms that may have contributed to the asset becoming distressed. Confidentiality requirements add another layer of complexity, as many litigation matters cannot be freely marketed without jeopardizing settlement negotiations.

"The key is recognizing that different risk profiles require different strategies," notes Roni Dersovitz, founder of Tower 3 Investments. "While traditional litigation funding bears pre-settlement uncertainty, the secondary market and post-settlement opportunities offer more predictable risk-return profiles for investors who understand how to source and structure these transactions."

Post-Settlement Strategies: Avoiding the Zombie Trap

One approach gaining traction involves focusing exclusively on post-settlement litigation finance—a strategy that sidesteps many zombie fund dynamics by eliminating case outcome uncertainty.

Post-settlement funding targets situations where liability has been established through settlement agreements or court judgments, but payment remains outstanding due to structured payment terms, appeals of damage amounts, or collection complexities. This asset-based lending approach transforms the investment proposition from binary litigation risk to credit and timing risk.

The advantages for institutional investors are meaningful. With verified liability, the primary risk factors shift from "will we win?" to "when will we collect?" This reduction in outcome uncertainty enables more accurate cash flow modeling and eliminates the tail risk of total loss that characterizes pre-settlement funding. Duration risk remains, but becomes more manageable through careful structuring and conservative underwriting of payment timelines.

Secondary market opportunities in this space arise when GPs holding post-settlement receivables need liquidity before collection dates. These situations create attractive entry points for investors who can provide immediate capital in exchange for assignment of future payment rights, often at meaningful discounts to face value.

Positioning for the Next Market Cycle

The litigation finance sector stands at an inflection point. As zombie positions accumulate and LPs demand greater transparency around valuations and liquidity, the industry will likely see increased secondary market activity and more sophisticated risk segmentation.

Forward-thinking allocators are already adjusting their approaches. Rather than committing capital to diversified pre-settlement funds with 10+ year lock-ups, institutions are exploring direct co-investment opportunities, post-settlement strategies, and secondary purchases that offer better visibility into timelines and returns.

The opportunity set will likely expand as more GPs face pressure to clean up aging portfolios and return capital to investors. For those with the expertise to evaluate these opportunities and the patience to see them through to resolution, the current dislocation could prove highly profitable.

Are you evaluating litigation finance opportunities for your portfolio? Understanding the distinction between traditional funding structures and post-settlement strategies could be critical to avoiding zombie positions while capturing alpha in this evolving alternative investment landscape.

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Roni Dersovitz is the founder of Tower 3 Investments, LLC a firm offering investment opportunities in Post-Settlement/Judgment Litigation Funding. Mr. Dersovitz has 14 years of experience as a practicing personal injury attorney and has managed portfolios of Receivables since 1998. To learn more about access to differentiated returns through litigation finance, visit www.Tower3Investments.com or contact us at info@Tower3Investments.com.