Authored By Matthew J. LoCascio | Principal, SC&H Capital, Special Situations
What is a Stalking Horse?
A “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, which others must overbid if they want to participate—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.
The term stalking horse is an old hunting reference to either a real horse or prop horse used by a hunter to conceal oneself from prey. The cover is used 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.
When is a Stalking Horse an Appropriate Option?
The timing to select a stalking horse and sign the asset-purchase agreement (APA) can vary based on the seller’s strategy and whether it is proactively pursuing a sale, or reactively ended up there after filing chapter 11.
- In general, larger companies with financial runway to complete a more orderly process will try to line up a stalking horse, sign a purchase agreement, and draft bid procedures prior to filing for bankruptcy.
- Conversely, companies in the lower-middle market tend to file chapter 11 due to some emergency or impending doom, such as a foreclosure action. Typically, without bid procedures or a stalking horse bid in hand, a company may instead choose to solicit interest after filing—ideally, under the guidance of an experienced investment banker.
In either case, once in a bankruptcy proceeding, the debtor must seek court approval of the stalking horse, the purchase agreement, and any proposed bid procedures. This generally requires giving 20-days’ notice to creditors, followed by a hearing. Parties-in-interest can object during this notice period and, ultimately, the court will decide whether naming the stalking horse and giving that bidder certain protection is in the estate’s best interest. Often, some terms of the procedures or purchase agreement are negotiated to gain consent from any objecting parties.
What Are the Advantages of Being a Stalking Horse?
Anecdotal evidence suggests the stalking horse bidder is the winner as often as 85% of the time.
It’s not uncommon for stalking horse bidders to get a head start and more time to conduct their diligence compared to other prospective bidders who have to wait to begin the process until after formal bid procedures are approved. Since the stalking horse’s bid sets the floor price and establishes the terms for the APA, it then serves as the form agreement all other prospects 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
- The executory contracts they are willing to cure and have assigned
Any group that comes along afterward must essentially 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 not already approved) which set deadlines for competing bids and adherence requirements for other bidders to be deemed eligible to participate in the auction. Depending on how much of a say the stalking horse has, establishing an abbreviated auction timeline and limiting additional diligence time for other bidders prior to the deadline could give them a substantial advantage. For these reasons, before granting approval, courts usually require that the debtor make a representation that the potential stalking horse did not unduly influence the drafting of the procedures.
Finally, stalking horse bidders are often incentivized with an expense reimbursement and/or break-up fee to encourage a bid submission. Break-up fees typically run about two to three percent of the proposed purchase price and are paid to the stalking horse if it is ready, willing, and able to close but gets outbid. It is important to note that, as a best practice, the debtor should write the procedures such 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. That said, stalking horse bidders should insist that the orders approving both the bid procedures and the ultimate sale, approve payment as a priority administrative expense of the estate to avoid the risk of it being treated as an unsecured claim. It’s even better for the stalking horse if the court approves that the break-up fee being paid out of proceeds is a cost of sale.
Why Would Groups with a Serious Interest in a Debtor Hesitate to Pursue the Position?
The stalking horse bidder will have to commit considerable time to conduct diligence, interact with ownership and employees, and negotiate purchase agreements. Since 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 must 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 likely the biggest concern for potential stalking horse bidders to weigh. Oftentimes, 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 resources, and there is no guarantee they will be selected as the stalking horse and entitled to a break-up fee.
Once named the stalking horse, nothing prevents other bidders who took a wait-and-see approach from swooping in and making a topping bid. In our experience, the stalking horse rarely wins with their original bid, and additional bidding is often required. Other bidders limited their upfront costs and relied on the stalking horse to conduct financial and legal diligence on the debtor, so perhaps they are comfortable paying more. The stalking horse will be entitled to its break-up fee but may wonder if it was worth the effort.
Depending on what the bid procedures state, the stalking horse may have as few as 30 or as long as 90 days, plus days between, to being named the stalking horse and closing. The risks of the business deteriorating, the market changing, or losing a key employee, vendor, and/or customer are all amplified for the stalking horse, as they have made a binding offer with a substantial, non-refundable deposit.
Why Might Bidders Shy Away from Bidding if There is a Stalking Horse?
Each of the advantages shared above is also a potential disadvantage for other bidders. Stalking horse bidders have frequently secured financing and applied for regulatory approvals (if needed) well in advance of other prospective bidders, giving them a leg up. 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. This 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 strong bid.
Because they have often started diligence earlier than other groups, a stalking horse bidder may 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. An experienced investment banker will work hard to ensure the playing field is level but the ability to negotiate with these parties ahead of other groups allows a stalking horse to bid sooner and with greater visibility and certainty.
How do we Choose a Stalking Horse?
When selecting a stalking horse, the debtor, its professionals, and creditors should weigh the impact the bid (and bidder) will have on the market and other potential prospects.
On the one hand, 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.
On the other hand, selecting a financial stalking horse that is 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 Considering Being a Stalking Horse?
Make sure you are crystal-clear on whether you can 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” 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 initial stalking horse bid, the purchase price is calculated as follows: final bid less the break-up fee, and the cash required at closing is that amount less the good faith deposit already submitted.
A decisive 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.
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