Demystifying Litigation Finance & Other Alternative Credit feat. Eva Shang

Hello, future billionaires. Welcome back to another episode of your favorite podcast, the Invest Like a Billionaire podcast. Today we've got a really fun guest joining our show. Her name is Eva Sheng. She is the CEO of Legalyst, which is an alternative credit firm and really, really fascinating conversation. We dive into the world of alternative credit. So I come from a banking background, been in credit for a lot of my life, and I'd never even heard of some of these types of credit they were doing. So she tells her whole story, the origin story. She and her co-founder dropped out of Harvard. To start this business and have since had a lot of great success in litigation finance, debtor-in-possession financing, and the last one was government receivables. So really, really interesting verticals they've got into with their technology. Be sure to check out this episode. And as always, we got to give the disclaimer when we bring people on to our podcast that are raising capital. We have not done any due diligence. You have to do your own due diligence. And, you know, this is just Purely informational. We're curious about different things and obviously would hope that you would do full due diligence if you do decide to work with them. So with that, please enjoy the show. This is the Invest Like a Billionaire podcast where we uncover the alternative investments and strategies that billionaires use to grow wealth. The tools and tactics you'll learn from this podcast will make you a better investor and help you build legacy wealth. Join us as we dive into the world of alternative investments, uncover strategies of the ultra-wealthy, discuss economics, and interview successful investors. Looking for passive investments done for you? With Aspen Funds, we help accredited investors that are looking for higher yields and diversification from the stock market. As a passive investor, we do all the work for you, making sure your money is working hard for you in alternative investments. In fact, our team invests alongside you in every deal so our interests are aligned. We focus on macro-driven alternative investments so your portfolio is best positioned for this economic environment. Get started and download your free economic report today. Welcome back to another episode of the Invest Like a Billionaire podcast. I am your co-host Ben Fraser, joined by fellow co-host Jim Maffuccio. And today we've got a really awesome guest. Very excited to get to this interview. I've been looking forward to this one with Eva Shang. She is the CEO of Legalyst, which is an alternative credit fund or just firm and doing some really cool things in the alternative investment space. So if you listen to this podcast for a while, you know, we love to just educate around alternative investing and, you know, real estate's a big part of it. We talk a lot about real estate. There's a lot of other cool things going on that people are doing, and you guys are no exception. So, Eva, welcome to the show. Thanks for coming on.

Yeah, thank you so much.

Yeah. So give us a little bit of background just on Legalist, and then I want to go back to kind of your story because obviously you're very intelligent. You went to Harvard and you made your co-founder, who I also spoke with, Christian, and just would love to hear the origin story of how you guys—

beyond intelligent, intelligent people go to Harvard, super intelligent people drop out of Harvard and say, I don't know. I was intrigued by that.

So, yeah, exactly.

Um, okay, well, uh, to give you a little bit of background on myself, I am one of the co-founders and the CEO of Legalist. So, uh, Christian, my co-founder, and I actually started Legalist when we were undergrads at Harvard. So when I was 20 and the initial incarnation of Legalist was not quite as an alternative credit firm, I mean, it's not exactly the type of idea that two 20-year-olds in a dorm room are like, oh, you know what we should do? We should start an alternative credit firm that invests in litigation finance. So it was a little bit of a circuitous path that led us there. And the initial technology that we developed, what it did was it scraped state and federal court documents and it looked for analytics, cases that were about to win, just information that you could glean from these public government records. And our intention was to package it up and to sell it to attorneys. and that was our initial product idea. And off of that idea, um, I got the Thiel Fellowship, which allows you to drop out of school. Legalist got into Y Combinator, which is a Silicon Valley startup accelerator, and that's how we ended up moving out to the West Coast. Now, as soon as we got into Y Combinator, the general counsel at Y Combinator stopped us the very first day. We had just gotten in and he was like, I hate your idea. And we were like, oh no, we just got here and you already hate our idea. And the reason that he said he hated our original idea is that lawyers hate to pay for things. And if you've ever been billed by a lawyer, uh, you know that they're actually incentivized to not know whether your case is going to be successful and they're incentivized to stretch it out for as long as possible. And they're also incentivized to be as inefficient as possible. So there are a lot of incentives kind of working against you here. And he said, well, if your technology works so well and if you can identify cases on a live basis that are primed to be successful, have you heard about this alternative asset class called litigation finance, where you can be an investor and actually take a stake in a litigation So then you can profit when the case is successful. So you can profit from your knowledge and that can be your source of alpha. And we were like, well, I haven't heard about that, but that seems reasonable. And so we took our technology and then we repackaged it up and we decided to try and raise a fund. Unfortunately, I don't, I don't think anyone told us that it would be extremely challenging for two 20-year-olds no investment track record to raise a fund. And that began one of the most difficult years of my life from 2016 to 2017 when we had, um, just this technology and we set out to raise a $10 million investment fund. Uh, eventually we managed to scrape together the money from, um, mostly, you know, high net worth family offices here in the Bay Area. And that fund ended up returning over a 2x. So it's one of those really unlikely beginnings, but that catapulted us to raising a $100 million fund, then a $300 million fund, branching out into other strategies like bankruptcy and government receivables lending, all based on this tech platform. And today Legalyst manages around $800 million, and we're about to close on another $200 million. That'll put us at around the billion of AUM mark. So I'll take a pause there and then we can dive in anywhere you guys find interesting.

That's an exciting ride in such a short time, really, relatively. So congratulations. Thanks. Yeah, I would love to kind of go back to litigation finance because I think that's kind of where you guys started and you have other verticals now, but really break down what that means and, you know, who are the counterparties? Why are they willing to you know, sounds like sell or take a settlement early and then they give you the, the back end if the case wins. Right. Break down how that actually works.

Yeah. So the premise behind litigation finance is that it's essentially an investment into the outcome of a case itself. So I'll take a pretty prototypical example of how it works. So let's take Legalist as a company. and let's say that we were to be acquired by, uh, BlackRock, right? A much larger company. And let's say that in the course of that acquisition process, uh, BlackRock promises to pay us, uh, $10 million. And after we get acquired, I've signed my entire company over. Um, they then renege on that and don't pay $10 million. Well, now as a plaintiff, not only am I out $10 million, but I also need to pay $100,000, a few hundred thousand, a million dollars for legal fees out of money that I haven't made. And that's the situation that a lot of plaintiffs and users of litigation finance find themselves in. And that's really where litigation finance becomes relevant. So you have a great attorney that you found, but they charge on an hourly basis. And so what Legalist does is we come in, we identify that the case has been started, that it's going well. That it's the type of case we like to invest in, and we reach out to the plaintiff and we say, hey, are you interested in litigation financing? We can cover that million dollars of legal fees. And then if you're successful, if you recover your $10 million, then we'll take a percentage of that. And if you're not successful, then we're just out a million dollars and that's our loss. And that's really the value prop for these companies that we invest with. We funded over 400 litigations to date. We have roughly an 80% success rate. And I think for everyone involved, the lawyers like to get paid, the investors like to get healthy returns, and the claimants really like to not have to be on the hook for the legal fees and to have a third party come in and, and really tell them whether their case is good or not.

So going back to the— going back to the $10 million case, you, you're making this commitment. Is there— is it subject to some, some, some progress benchmarks along the way? Or, you know, is it a one-time commitment upfront and say, hey, even if you like— let's say you— the case looks really good to you on the front end, but then the— but then things start to shift. A new, a new piece of information enters the equation, or, or the counsel is dropping the ball or goes south or whatever, do you have contractually the right to say, hey, we're cutting our losses, sorry guys, we can't go any further with you here. How does that work?

So we do. So a case doesn't go straight from filing to trial. There's usually a 2 or 3-year process by which there's discovery conducted, there are motions to dismiss, motion for summary judgment, motions for judgment on the pleadings. And if a case gets knocked out, before the full million dollars has been spent by the attorney, well then obviously we're, we're not on the hook for the additional $400,000, $500,000. Usually though, we're pretty good at underwriting for cases in the sense that if there's something obviously wrong with it, then it's going to get knocked out. But we don't usually fund cases that have something obviously wrong with them.

Well, during discovery, for instance, I mean, you have all kinds of information coming in and depositions and everything. Are you guys privy to that? I mean, do you have somebody sitting in or, or are you just kind of taking your side's word for it that, yeah, things are going really great or that just seems like, you know, I mean, I'm intrigued by it, but how do you, how do you navigate that?

Yeah. So we do ask for regular progress updates from the attorneys. We don't scrutinize every piece of discovery. I mean, with hundreds of litigations, that would just be too much. But when we go into a case, there's usually a factual record already pretty well laid out. So we don't go into cases where it's highly speculative. So, you know, we wouldn't fund a case where the plaintiff says, I suspect that someone has stolen from me. That's not enough to substantiate our underwriting. And that's the reason why a lot of cases we fund are halfway through their litigation process already. When you just have a suspicion that something has been kept from you, that's usually not enough to qualify for litigation funding.

And it sounds like what you said earlier, that this industry has been around a long time, this kind of transaction and the ability to come in and help, you know, get these cases to the finish line and get a portion of the profits has been around. But you have created technology initially for a different use case, but now you're leveraging that to— in your underwriting process. So it sounds like you're able to use technology, you know, scour through all these different records to identify what you think are going to be the highest probability cases to win, and then you can kind of use that as an initial filter. Am I understanding that right? Is that kind of how you're coming into the space with the new edge?

That's exactly right. So if you think about on a— if you zoom out and think about what a credit fund does on a macro scale, a credit fund is really good at structuring and underwriting investments that a normal bank wouldn't touch, right? A normal bank would not lend you money against your litigation. That would just be insane. But what a, a credit fund or a litigation funder can do is we can say, oh, we're really good at underwriting that. We have lawyers that know how to look at cases and decide whether or not to invest. But that's just the underwriting component. The way that most litigation funders are set up is they have a network of relationships. So friends of theirs, people they've known through the years who bring them cases. Um, but that's a very limited set. Whereas what Legalist has is Legalist has not only the ability to assess litigation once it's interested in funding, but we have a bird's eye view of cases as they're ongoing through state and federal court systems, and we can reach out to them proactively and say, congratulations on surviving that motion to dismiss. Um, now are you interested in litigation funding? And that opens us up to opportunities. From lawyers that are way off the beaten path, plaintiffs that are not plugged into the litigation funding scene, don't have well-connected lawyers, but have really meritorious cases.

Interesting. So what other factors are you looking at in your underwriting to kind of maintain that probability, you know, on the higher end, we said 80% success rate.

Yeah. So when people think about litigation funding and doing it in a data-driven way, they often think of us as being like D. Shaw or like a quant fund where you can say, oh, this stock is going to go up and then you can buy it. But with credit, it doesn't quite work like that. So let's say we identify a case that is going really well where liability is firmly established and it's worth $10 million. If we invest $11 million, well, then we've just lost money even though the initial tech was correct. Or if we invest $1 million and the case is worth $10 million, but the defendant doesn't have the ability to pay $10 million, well then that's still not a good investment. So we really break it down into liability. Is the case going to be successful? Damages. If so, for how much? And then collectability. If you do succeed and succeed in recovering damages, can you actually collect on those damages? So our tech can do a great job of screening for the first component, but it really can't screen for damages all that well at the higher end, and it can't tell us how much money to invest, and it can't tell us whether the defendant is collectible or not, especially if it's a private company. And so that's really where our team of expert underwriters comes in, and they actually read the contract and say, okay, under what circumstances are they meant to pay you $10 million, and how much money does this business actually make every year?

Very interesting.

Well, there's also a, uh, you know, political, uh, slash reputational motivation for you. I mean, you mentioned BlackRock before, so there's going to be certain companies that are going to be way more inclined to settle even if maybe the merits aren't as strong as they would be if it were, you know, not that, that type of a company. And they'll, you know, so you're probably going to get a faster exit, um, from somebody like that that has a reputational concern or a political concerned.

Yeah, that's true. That's one of those individual factors that we try to take into consideration.

So one last question on this, this vertical, but going back to the success rate, I'm— what are the quantitative factors that you can assess to determine if the success probabilities are high? Because I would imagine a lot of it comes down to the nuances of the case, or if they hit a certain point, the data shows that hey, most defendants are going to settle at this point and that's kind of where we come in. Or like, what are the other factors you're looking at? Because to me it seems hard to kind of quantify in a mass way unless you have in-house lawyers that are reviewing every single case, which you said obviously you can't because of the quantity of deals you're doing.

So at the initial screening stage, what our tech does is it looks for roughly 58 different variables, but the ones that interact the most are things like case type, the parties involved and what type of entity they are, and the procedural stage of the case. So I'll give you an example. There are certain types of cases like breach of contract where it's very hard to knock it out on a motion to dismiss. And then there are other types of cases like cases that are based on statutory matters where, the law is the most important thing, and most of them are knocked out on the motion to dismiss. So there are certain types of cases where we might be comfortable reaching out to them and comfortable that we're not wasting our time underwriting them as soon as they're filed. And then there are other types where we're going to have to wait until, um, they are much more procedurally advanced. And then there are still other types of cases, like patent cases, for instance, where you could have a judgment, And even at the judgment stage, 50% of patent judgments are overturned. And so those we just don't reach out to at any stage. And the interaction between those variables and the statistics on, you know, if you have a case that has this characteristic, this judge, this venue, and is at this stage, how likely it is to be successful is the basis for our initial outreach. Granted, it's not perfect, right? You can have contract cases that look the same, but the plaintiff is absolutely unhinged and that's something that can't be captured by the tech. And so we would just get rid of that at the underwriting stage. But as a whole, there are 100 million civil court cases filed every single year and we boil that down to around 500,000 that actually qualify for us to reach out and even say hi.

That's so fascinating. I imagine to I'm sorry. Go ahead.

Before you actually pull the trigger on it, say, yeah, we're going to take this case. And, and of course, here's what we're going to offer because, you know, that's, that's— there's a wide range there, I imagine. Do you have like the equivalent of like, you know, coming from the debt world, do you have like the equivalent of a loan committee or an underwriting committee that says, okay, so-and-so manager brought this deal, we've had, you know, the attorney make the first look at it. But to decide, yeah, we're going to do this one, is there some collaboration? That happens in-house, or how does that work? Are you the— are you it? Are you the one who says we're doing it?

Oh, absolutely. I mean, we have an investment committee. The cases are underwritten very carefully by a lawyer who's an underwriter. And when they get presented to investment committee, many of these factors I just outlined have been already looked at. So liability, damages, collectibility, those are kind of the table stakes. And then over time, we've layered in other things that we've realized So I'll give you an example. They say that if a jury likes a plaintiff, they will drape the law over them to make sure they get something. And if they don't like the plaintiff, they will interpret every single clause, even in a rock-solid contract case, in the way that is least favorable to them. And so now we have a section in our investment memos that's called plaintiff likability. Now, of course, this is very, This is very subjective. Yeah, but we trust our underwriters that if they just absolutely hate someone after spending an hour on the phone with them, that that can't be a good thing for their case.

That's so interesting because there is so much of a human element to this. And I would imagine as you guys continue to do this and so data-driven, you're going to build a database of like, you know, this municipality and this judge and this day of the week, you know, chances go up or whatever. And I mean, I imagine the amount of data that you're able to kind of start putting together over time will be very, very valuable as well, aside from just the, the other quantitative things you were mentioning.

Yeah, exactly. So at this point we have hundreds of realizations and we're able to put them together to learn things from our underwriting and to build up muscle memory and in-house analytics that really allow us to be get you more informed going into future investments.

Very cool. So talk about some of the other verticals that you guys have gotten into. So the first one was kind of this vertical. Actually, before we get into that, one question that did come to mind is what do you kind of view as your, say, you know, total addressable market for litigation finance and still be able to keep the same success rate that you have? Because I would imagine over time you maybe you hit a certain cap on You know, there's just these number of cases that are going to—

that are—

we like and that are going to have a high chance of success before you kind of peak out in the market, or are you still far away from that?

We're still pretty far away from that. We identify a few hundred thousand cases every year and we've only funded 400 in total. So we're getting there. We're getting there as we get more name recognition in the market, as litigation finance becomes a more commonplace occurrence. We're finding higher pickup rates from potential customers just when we reach out to them. Now, you know, taking a step back as to like how we're building the firm and how we think about scaling each of our strategies, we've always been of the opinion that there is a finite amount of alpha in every market. And so the more that you try to push a capacity-constrained market to a size that it's not well suited for, the less alpha you're going to have and the more you're just going to pick up beta. So market returns or returns for the risk that you're taking. And so we've always been of the opinion that we don't need each one of our strategies to scale to $10 billion, right? Our core innovation is this technology that underlies each and every one of our strategies. And if it's able to, um, pick up alpha in a relatively capacity-constrained strategy, if it can do that across multiple verticals, then we as a firm can be scalable even if the ultimate strategies aren't. And that's really where, um, our other two verticals came from. So our second vertical that we launched, uh, is DIP financing in bankruptcy. So bankruptcy is often a very scary word. But what DIP financing really means is that if you have a company that's filed for bankruptcy that has a bunch of assets and a bunch of liabilities, DIP financing is a type of court-approved financing that allows you to come ahead of other creditors and offer the debtor time to restructure or to liquidate its assets in an orderly fashion. So some of the companies that we've dealt with have been granite factories, they've been sawmills, uh, they've been, um, equestrian farms where they just need a little bit of time to liquidate and they can't be rushed into a fire sale process. Otherwise they'll get pennies on the dollar. But having a little bit of bridge financing during the bankruptcy process, even if it's only for 12 months or sometimes less than that, gives them the time to conduct an orderly liquidation and maximize value for all the creditors. And then our third strategy, one of our LPs actually brought to us. So by this time he had been an investor in both our litigation and our dip strategies. And he said, hey, I have this other manager that does government receivables. And I really like this asset class because it's incredibly liquid, rock solid. You get paid directly by the US government, but they can't scale it. So they just have these relationships and they're capped at whatever their relationships can bring them. So if you can find me government contracts that are run by businesses that are looking to scale up and would be interested in a credit facility specifically against that contract receivable, then I think you would deploy, deploy a lot of money here. And that's really how we got into our third strategy, the government receivables line. But the thing that undergirds all three of these, even though they look different, is that they're a type of esoteric or niche credit that exploits some type of structural alpha in the market and that investors would love to have more of if you could find them. And what our technology allows us to do is it allows us to find them.

Very cool. So I'm, on the government receivables, you're basically going in buying some sort of factoring, right? So you're basically buying the future payout from whatever U.S. government entity to whatever firm that was contracted with them at some type of discount. And then you just go and collect the difference. Is that what that line is? Or explain what the structure is on those types of deals.

So it's very similar to factoring in that we are lending against government receivables. But unlike factoring where you have a one-off purchase of a receivable, what we offer is a working capital line of credit where government payments are backed— or government receivables back up the payments that we make. So it's cross-collateralized, senior secured, and we replace their line of credit from their bank. But unlike a bank line, which is really just based on last year's P&L, the government receivables line that we advance is structured specifically for government contractors, and it's of a size that can scale up or down depending on how large their contract is and what their operating cycle looks like. So to give you an example, if a government contractor made $1 million last year, $1 million the year before, But this year they've been awarded a $50 million contract to supply toilet paper or supply airplanes. We can cut out the toilet paper part because I don't want to be on the record saying toilet paper. But let's say that they supply— although some of our contractors do actually supply toilet paper, they do maintenance work and other types of services for various agencies and naval bases. Anyway, so let's say that they're purchasing airplanes. So what we might do is we might say, oh, you just got a purchase order from the US government to deliver an airplane on Monday, 2 weeks from now. You made $1 million last year, so your bank line is roughly $100,000 in size. But as soon as you deliver this airplane, you're going to get paid a lot more than $100,000. So we'll advance you some percentage against that purchase order so that you can buy the airplane. And that's the difference between what we do and what a bank line does. A bank line is a blanket underwriting and then a blanket amount, whereas ours is specifically underwritten for the contract that they have.

Yeah, it makes sense. So how does the technology kind of help you generate, you know, alpha returns in that, in that market? Just finding the, the companies that have the best contracts or certain types of contracts or just if they're the fact that the banks won't lend purely on the asset or the collateral of the receivable, that gives you just a structural advantage in the marketplace?

That's a great question. And this is something that I think a lot of people don't understand about our technology, is that what we look for in different asset classes is different depending on what the investment mandate is. So on litigation, for instance, you really don't want to invest in the average litigation case because it's not very good. But I would love to lend against any government receivable for the most part. Like Boeing is the largest government contractor. If Boeing would be willing to take a credit line from me, then I would love to give Boeing a credit line. But Boeing does not need a credit line from me. And the only type of company that specifically needs a credit line, uh, for against their government contract where their bank line won't suffice and Don't get me wrong, the bank line is always going to come in at lower rates. It could be prime plus zero, right? We just can't do that. But what we can do is we can help those companies that are at an inflection point in their business where they make $1 million, $2 million, $3 million last year, but they're going to make $10 million next year. And that's really where this line becomes incredibly valuable. So that's what our tech looks for. We look for the size of the contracts they've gotten in the past and the size of the contracts they've recently been awarded. And we identified that need.

What kind of— if you don't mind me asking, if you can't answer, that's fine. But, you know, so you say compared to bank debt, I mean, is the cost of funds to the borrower— I mean, is it double what they pay a bank or— in our world, in our real estate syndication world, you know, the preferred equity or mezzanine debt piece it's super expensive, you know, a lot more expensive than the institutional bank money that's in first position. So, so I imagine there's a pretty good premium. I mean, you know, keep the doors open, but can you, can you speak to that at all?

So of our various strategies, we run all 3 strategies as uncorrelated strategies, but there is a range in terms of the net returns to investors that corresponds to the risk and liquidity. So at the high end, you have litigation finance, which is an equity-like investment, right? You're taking equity in the case itself and you have the risk of loss of principal. So litigation targets and has achieved historically 20% plus net IRRs. So in line with private equity and a little bit shorter than private equity durations. In the middle, you have DIP, which is essentially a real asset-backed bridge loan. and that targets returns in the mid-teens. And then finally, you have government receivables, which is a very short-term, usually the average disbursement is outstanding for 84 days, and these are revolving credit facilities. You're targeting 10 to 12%. So that's really the difference between these 3 strategies. And of course, the average is only one part of the story. We have loans that are higher priced and loans that are lower priced, but that's what we tell investors our targets are. Very cool.

I mean, that sounds pretty reasonable to me if you're having that, that inflection type growth and you're going, you know, the example that you gave was like 10 or 12% money for us to be able to actually serve the service, the contract, and keep growing and moving on. That, that's, that's pretty, that's reasonable, I think. You know, what do I know about—

Yeah, they don't really have any other options at that point, right? It's either the contract and, you know, have life-changing money or or don't, so they're probably willing to accept a much higher interest rate. Well, you know, this has been really, really great conversation. Thanks so much for sharing with us all the things you guys are doing. It's really, really fascinating. So for listeners that are curious, want to learn more about what Legalist is doing, you know, what's the best way for them to kind of reach out and, you know, get in your ecosystem mailing list? You know, if you have any kind of you know, ebooks or things that people can download to learn more?

Yeah. So our website is Legalist.com and we have a contact form on our website and our investor relations team reads and follows up with every single investor inquiry we get.

All right. Awesome. Well, thanks so much for coming on. It was a really great time.

All right. Thank you.