Legal asset‑backed securities (LABS) and legal asset‑backed notes (LABN): a comprehensive guide

Legal asset-backed securities (LABSs) and legal asset-backed notes (LABNs) are types of investments that are backed by income-generating assets, typically legal claims or portfolios of claims. They enable investors to provide funding for cases in exchange for a share of the potential proceeds from successful outcomes.

LABSs and LABNs provide non-correlated returns, portfolio diversification, attractive yields and a steady income stream – making them increasingly relevant in today’s turbulent financial landscape, particularly amongst qualified high-net-worth individuals (HNWIs).

At DFC, we’re experts in alternative investments, including those in the private debt and litigation finance sector. We seek out compelling fixed-income solutions for qualified HNW investors – helping them achieve their goals and stay ahead of the market.

In this post, we take a deep dive into LABSs and LABNs, exploring benefits, risks and more.

What Are Asset-Backed Securities (ABS)?

Asset-backed securities (ABS) are financial instruments backed by a pool of underlying assets – loans, for example – that generate income. They’re created when a company sells its loans or debts to a financial institution who packages them into a portfolio to sell to investors. The pooling process is what’s known as securitization. And the underlying assets are pledged to the holders of the securities as collateral for the payment of principal and interest on the securities.

As well as enabling issuers to raise capital, ABS offer a wide variety of benefits to investors. Key to their appeal is their ability to deliver diversified income streams. And thanks to the wide variety of options, they cater to diverse risk appetites and investment goals.

Common ABS types include:

• Mortgage-backed securities (MBS) – Formed by pooling together mortgages, they provide payments that come from borrowers’ mortgage payments.
• Collateralized debt obligations (CDO) – Encompassing debt instruments, including loans and bonds, a CDO is issued by a special purpose vehicle. CDOs are structured into tranches with varying risk and return profiles.
• Auto Loan ABS – Otherwise known as car financing, auto loan ABSs are those backed by auto loans. They provide predictable cashflows – including monthly interest payments and principal payments – tied to vehicle financing payments.
• Credit Card Receivable ABS – Based on credit card payments, these offer shorter-term cashflows that include coupon, principal payments and annual fees but don’t have fixed payment amounts.
• Legal Asset-Backed Securities – Backed by proceeds from legal cases or law firm receivables, LABS enable investors to share in litigation outcomes. Rising litigation costs and the growth of complex commercial disputes have driven demand for third-party litigation funding and created a robust pipeline of cases to securitize.

Understanding Legal Asset-Backed Securities (LABS)

Legal asset-backed securities (LABS) are financial instruments where the underlying assets are legal-related receivables such as law firm fee receivables or litigation finance agreements (where funding is provided in exchange for a share of the potential proceeds from successful outcomes.)

It works like this:

• The assets backing the securities are typically legal claims with a high probability of success and the potential for substantial payouts – commercial disputes or intellectual property cases, for example
• As part of the securitization process, a litigation financier pools multiple legal claims or law firm receivables into a portfolio – this is structured into a financial product, which is sold to investors
• By pooling cases, the risk of individual losses is mitigated – this is because the portfolio’s performance depends on the aggregate outcome

With LABS, investors receive returns based on the proceeds from successful litigation outcomes or settlements – with the potential for significant yields. However, it’s important to be aware of the inherent risks of legal cases including unfavorable rulings – due diligence on case selection is an essential element of success. Like traditional ABS, LABS can be structured into tranches with varying risk and return profiles. Some might have lower risk with others offering higher potential returns but more risk.

Legal Asset-Backed Notes (LABN): A Closer Look

So, what’s the difference between a legal asset-backed security (LABS) and a legal asset-backed note (LABN)?

LABN are a type of LABS. Both LABN and LABS are debt instruments secured by legal assets – litigation claims, for example. And both offer fixed or variable coupon payments to investors. However, whereas LABS pool legal assets into securities – and investors receive payments from the income generated by the assets – LABNs are structured as loan notes with specific maturity dates and predefined interest rates.

In other words, LABNs provide a direct investment opportunity – one with predictable cash flows. And as they’re structured, they appeal to qualified HNWIs seeking stable returns over a defined term. Typically simpler than traditional LABS – with a more straightforward repayment structure – LABN tend to have shorter maturities.

Benefits of Investing in LABS and LABN

Legal asset-backed securities and legal asset-backed notes are particularly popular in the current (turbulent) investment landscape. Here’s why:

• Diversification – as their performance is tied to the outcomes of legal cases rather than broader economic trends, litigation finance notes and securities offer uncorrelated returns that increase portfolio diversification
• Competitive yields – litigation finance securities and notes have the potential to offer higher returns than traditional fixed-income instruments
• Increased demand and a maturing market – as an industry, litigation finance is becoming more structured and transparent, and is attracting investors in growing numbers
• Risk mitigation – cases are rigorously vetted prior funding, reducing the risk of default, while the inclusion of multiple cases within a single security or note further reduces risk
• Resilience – during economic downturns, litigation tends to increase, which provides resilience to securities and notes backed by claims
• Global expansion – the litigation finance sector is growing fast, with many jurisdictions increasingly embracing third-party funding.
• Growing interest – pension funds, hedge funds and other investors are allocating more capital to litigation finance
• ESG considerations – litigation finance supports access to justice for those who might not otherwise afford, in alignment with broader environmental, social, and governance (ESG) objectives

Risks Associated with LABS and LABN

Of course, the inherent unpredictability of legal proceedings means that both LABS and LABN carry risks, which can delay or reduce cash flows. And while these instruments are secured by legal claims or settlements – which does ensure a level of protection – their value depends on case outcomes, which remain uncertain until resolution.

Bear in mind too that limited secondary markets can restrict the liquidity of opportunities and make it harder for investors to exit positions before maturity – though depending on individual investor goals and investing time horizons, this may not be relevant.

Finally, changes to legal or regulatory environments, such as the Supreme Court ruling of 2023 that litigation funding agreements are damage-based agreements, could also impact returns. So it’s important to choose a product that doesn’t focus exclusively on one jurisdiction, or solely on one type of case.

That said, the robust security mechanisms incorporated into some LABN can significantly reduce risk. For example, we partner with a litigation financier that incorporates protective structures such as debenture loans and guarantees into its products.

How HNWIs Can Leverage LABS and LABN

Traditional portfolios no longer incorporate enough potential for growth or risk mitigation for qualified HNWIs. To diversify and boost income generation, many are allocating portions of their portfolios to alternative investments such as asset-backed securities (LABS) and legal asset-backed notes (LABN). Not only do these vehicles offer attractive returns, uncorrelated with traditional markets; they offer the potential for stability and growth during uncertain times.

However, due to the complexities of legal assets – case timelines, jurisdictional differences and enforceability of claims, for example – it’s crucial to conduct sufficient due diligence. This should include assessing underlying legal cases, conducting financial analysis of interested parties, and calculating the risk-adjusted return potential.

And if that sounds intimidatingly complex, don’t worry – we’re here to help. At DFC, we’re experts at navigating this niche market, identifying high-quality opportunities in litigation finance and private debt.

Currently, our rigorous due diligence process has led us to partner with a leading litigation financier, with a meticulous approach to due diligence when selecting litigation claims for investment.

We support clients in integrating LABN into portfolios with confidence, enabling diversification while minimizing exposure to the complexities of legal assets.

Comparing LABS and LABN with Traditional ABS

Legal asset-backed securities (LABS) and legal asset-backed notes (LABN) are securitized instruments backed by legal receivables – proceeds from litigation, arbitration or other legal claims, for example. These differ significantly from traditional asset-backed securities (ABS), which are backed by cashflows from assets including mortgages, car finance or credit card receivables.

One significant area of difference relates to risk. With LABS and LABN, any risk analysis needs to consider the possibility of adverse rulings and prolonged timelines, in addition to jurisdiction and regulatory uncertainties. However, risk is uncorrelated to market fluctuations and economic cycles. On the flip side, traditional ABS risk is primarily credit-related – borrower defaults, for example. While the asset classes are firmly established, the risk is heavily influenced by economic cycles and finance market ebbs and flows.

There’s also significant difference in return potential – with LABS and LABN offering the potential for higher returns due to both the niche nature of legal receivables and the potential for significant proceeds from successful outcomes. Returns delivered by traditional ABS are typically moderate and can be impacted by stock market turbulence and economic downturns.

Our table summarizes some of the key differences between these investment types:

Unlock the Potential of Legal Asset-Backed Notes

Legal asset-backed securities (LABS) – particularly legal asset-backed notes (LABN) – are increasingly attractive to qualified HNWIs. Offering the potential for higher returns than traditional fixed-income instruments, they bring portfolio diversification and, with regular coupon payouts, a reliable source of regular income.

While litigation finance offers the potential for string returns, it’s crucial to invest in high-quality products from trusted providers. At DFC, we only source investments from established funders who demonstrate exceptional standards of governance, transparency and performance. By blending rigorous due diligence with deep sector insight, we connect qualified investors with opportunities designed to help build resilient and diversified portfolios.

Ready to find out more? Get in touch to explore ways that carefully selected alternative opportunities can bring diversification to your portfolio.