“Stalking horse” is a term that instills hope in the minds of creditors and debtors while striking fear in the hearts of other bidders. When running a § 363 sale process, identifying a stalking-horse bidder (the bidder that submits the highest and best initial bid) lays the groundwork for the rest of the proceedings. The stalking-horse bid effectively sets the floor price for the assets and is used to entice other groups to pay more and eventually participate in an auction. So why would anyone choose to be the stalking horse?
Let’s first start with the history of the word. It is an old hunting term referring to either a real horse or an image of a horse on a screen that a hunter would hide behind to conceal himself from his prey. He uses this cover to get closer to the prey, or in this case the debtor, before striking! But do not let the origin fool you. Stalking-horse bidders are far from concealed in bankruptcies and are required to disclose a significant amount of information about themselves and their offer.
The timing to select a stalking horse and sign the asset-purchase agreement (APA) can vary based on the size of the company and other mitigating factors. In general, larger companies or those that are publicly traded will try to line up a stalking horse and sign an APA and establish bid procedures prior to filing. Conversely, companies in the lower-middle market often file without a stalking-horse bidder in hand and commence the search after the bankruptcy filing. In any event, the debtor must always provide creditors with 21 days’ advance notice of the hearing to approve the stalking horse and its APA, and often the bid procedures. Creditors or other parties-in-interest can object during this 21-day notice period, and ultimately the court will decide whether the proposed sale is in the estate’s best interest.
Now that we are familiar with the term, why would some groups refuse to participate in deals if there is already a stalking-horse bidder named and others are adamant about not being the stalking horse? It is truly a polarizing position0, so let’s review some of the advantages and disadvantages.
Stalking-horse bidders will often have more time and a head start to conduct their diligence compared to other prospective bidders who wait to begin the process after formal bid procedures are approved. As noted above, the stalking horse’s bid sets the floor price and establishes the terms for the APA, which will serve as the agreement for all other prospects to use when submitting their bids. This can provide a significant advantage in some instances, as the stalking-horse bidder can choose which assets they want to include, which liabilities they may want to assume, and what executory contracts they are willing to cure and have assigned. Another group that comes along afterward essentially has to step into that agreement despite potential terms and conditions they would normally deem unacceptable.
In some cases, the stalking-horse bidder can also have a role in negotiating bid procedures (if they are not already filed), which set deadlines for competing bids and establish requirements for other bidders to adhere to in order to be deemed eligible to participate in the auction. Depending on how much say they have, establishing a compressed auction timeline and limiting additional diligence time for other bidders prior to the deadline could give them a substantial advantage. And because they are willing to move quickly, often they have already secured financing and applied for any regulatory approvals (if needed) well in advance of other prospective bidders. In situations where the debtor is the proverbial melting ice cube, the ability to limit the timing between stalking-horse selection and the auction is typically supported and may have the (un)intended impact of pushing out a competing bidder who does not have enough time to complete diligence and get comfortable enough to make a bid.
Because they have often started diligence earlier than other groups, a stalking-horse bidder will frequently enjoy prioritized due-diligence requests and an inside track with management and other key employees, as well as customers and vendors and, where applicable, landlords. The ability to negotiate with these parties ahead of other groups is a huge advantage and allows a stalking horse to bid without concern for these issues.
Finally, stalking-horse bidders are often incentivized with an expense reimbursement and/or break-up fee (commonly around 3% of the transaction value) to encourage them to submit a bid. This is to cover expected due diligence costs and professional fees in the event that the stalking-horse bidder is outbid at the auction and chooses not to bid further. Important to note here is that the payment of the expense reimbursement and/or break-up fee only occurs when a competing bid is accepted and closed, providing proceeds to cover the fee. Stalking-horse bidders should insist that the sale order (and hopefully before that in the bid-procedures order) states that payment is approved as an administrative expense of the estate to avoid the risk of it being treated as an unsecured claim.
Anecdotal evidence suggests the stalking-horse bidder is statistically the winner as much as 85% of the time.[1] So why would groups with a serious interest in a debtor hesitate to pursue the position?
The stalking-horse bidder will have to commit significant time to conduct diligence, interact with ownership and employees, and negotiate purchase agreements. And because the stalking horse cannot rely on other bidders to establish the value of the assets, it does all of this without knowing how much it eventually has to pay to complete the sale and runs the risk of making an offer higher than the market value of the assets.
All of these things cost money, and the risk of uncompensated due diligence is probably the biggest concern for potential stalking-horse bidders to weigh. Often, multiple groups are vying to be the stalking horse, so just getting in a position to submit a bid for consideration requires a substantial amount of time and money, and there is no guarantee they will be selected as the stalking horse and entitled to a break-up fee.
Assuming you are named the stalking horse, you have spent significant time, effort and money to conduct diligence, negotiate and draft a purchase agreement, and often line up funding. But nothing you have done prevents other bidders who took a wait-and-see approach from swooping in and making a topping bid. They limited their upfront costs and relied on you to conduct the financial and legal diligence on the debtor, so perhaps they are comfortable paying more. You will (assumedly) be entitled to your break-up fee, but you have to wonder whether it was worth the effort.
And finally, depending on what the bid procedures state, you may have 30-60-90 days or more between being named the stalking horse and closing. The risks of the business deteriorating, the market changing, or losing a key employee/vendor/customer are all amplified for the stalking horse, as they have made binding offers with substantial, nonrefundable deposits.
When selecting a stalking horse, the debtor and its professionals, as well as creditors, should weigh the impact the bid (and bidder) will have on the market and other potential prospects. If a strategic stalking horse with substantial financial wherewithal and incentive to close the deal is selected, other parties may be discouraged from investing time and energy into diligence because they believe the stalking-horse bidder will ultimately win the day. Conversely, selecting a financial stalking horse that is perhaps unknown in the industry or does not have a recognizable name may entice other bidders to participate. In some instances, creditors may prefer a certain stalking-horse bidder due to the relationships they may have built during the diligence process, the expectation of continuing the business, and the known ability to close the transaction in a timely fashion.
Are you ready to be the stalking horse? Well, make sure you are crystal-clear on this point: Can you credit bid your break-up fee? The bid procedures will typically spell this out, but absent that, you need to confirm in your APA that the break-up fee will be netted out of the purchase price in the event there is an auction for the assets. It is important to further clarify that the credit bid applies to all subsequent bids and not just the first overbid, as it is a “continuing cash credit toward any bid”[2] and it does not matter how many rounds of bidding or how high the price goes; every bid will result in payment of the break-up fee to you. To further avoid any ambiguity as to how the break-up fee will be handled, confirm that if there is an auction that results in a final purchase price greater than the proposed stalking-horse bid, the purchase price is calculated as follows: final bid less the good faith deposit already submitted, less the break-up fee. A final step to ensure you receive credit for the break-up fee is to announce on the record with each subsequent bid that it is comprised of $X in cash, plus the break-up fee of $Y, for a total bid of $Z.
Bankruptcy, and specifically a § 363-sale, is a useful tool to effectuate the acquisition of assets free and clear of existing liabilities. Any party that is contemplating participating in a § 363 sale process as a potential bidder should carefully consider whether the potential advantages of being the stalking-horse bidder outweigh the potential disadvantages. When in doubt, hire legal and financial advisors who are experienced in this world and can help buyers navigate the often-uncertain waters of bankruptcy.
[1] See Lynn M. LoPucki & Joseph W. Doherty, “Bankruptcy Fire Sales,” 106 Mich. L. Rev. 1, 35 (2007).