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Memorable Lessons From Violin Memory And Other Auctions

As Published in Law 360.

Memorable Lessons From Violin Memory And Other Auctions.

When Violin Memory filed Chapter 11 on Dec. 14, 2016, prospects for the company seemed grim. Beginning in November 2015, Violin Memory had conducted two failed prepetition sales processes that had generated no bidders. At filing, there was no debtor-in-possession financing and no “stalking horse” bid. Having only $4 million in cash, the company set a bid deadline date of Jan. 13, 2017, and an auction date of Jan. 17, 2017. The truncated sale period — 19 days after formation of the official committee of unsecured creditors (UCC) — included both Christmas and New Year’s weekends.

Aware of the severe time limitation, the UCC and the debtor refined the sales process to focus on the most likely buyers rather than the broad gauge, “blanket the market” approach used prior to the Chapter 11 filing. The process was also carefully designed for optionality. Although a “going concern” sale was likely to net the highest proceeds, the sales process was not limited to one approach. On a parallel track, the debtor simultaneously marketed the intellectual property and fixed assets to seek out viable, separate — and competitive — buyers.

The debtor and the UCC realized that to have a successful auction, it was necessary to have an alternative to a Section 363 sale. To create this alternative, rival offer methods were authorized: (1) bids under Section 363 of the Bankruptcy Code (“363 bids”) and (2) plan of reorganization bids (“plan bids”). Plan bids contemplated a closing almost three months after a 363 bid would have closed, thereby creating considerable execution risks. Moreover, the debtor lacked the cash to operate until a plan closing. Special process features creatively addressed these concerns:

  1. A risk premium was devised to compare the plan bids to the 363 bids;
  2. An $8 million DIP facility from the plan sponsor would finance the debtor’s operations until closing, which facility would convert into an exit facility under the confirmed plan.
  3. A detailed plan support agreement would resolve critical issues usually addressed for the first time in a plan and disclosure statement.
  4. A $10.7 million advance payment deposited in an escrow account offered additional protection. The advance payment would be forfeited to the debtor if the deal did not close by an outside date, except in extremely limited circumstances. This key element reduced creditor risk dramatically.

The combination of rival offer methods and these special process features resulted in an auction that exceeded all expectations:

  1. The debtor’s creditors received recoveries equivalent to $15 million pursuant to the winning plan bid.
  2. A plan sponsor affiliate received all equity interests in the reorganized debtor in lieu of cash for its claims.
  3. The reorganized debtor assumed certain employee claims and counterparty obligations (and related cure costs), and the court preserved certain avoidance actions for the benefit of unsecured creditors.

Practice Tips For Chapter 11 Auctions

David Lax and James Sebenius, in their book “3D Negotiation,” note that much negotiation study focuses on tactics at “the bargaining table.” “Bargaining table” skills are important, but they address only one dimension of negotiation. The other dimensions — setup and design — are also critical. Based on Violin Memory and other auctions, professionals should consider the following “best practices” that help address all three dimensions:

Initiate Early Negotiations: Don’t wait for the auction or even the “stalking horse” period to begin negotiations. Take time to study the landscape, identify your buying “audience” and design your approach. Plan the sequence of discussions and the participants. Buyers in strict auctions must only outbid the competition present at a given moment, under strictures that may preclude promising options. Nonbankruptcy auction studies show sellers may lose considerable value when the assets have significantly greater value to one bidder than another. In a strict auction approach, less motivated buyers bow out early and the yield potential goes unrealized. Auction professionals can mitigate this by initiating negotiations with bidders prior to auction and designing special processes to address concerns and risks and uncover unique value to particular bidders. Strategic, early negotiations afford the seller/investment banker many opportunities to discover and create value.

Before the Auction, Remove Impediments to Active Bidding: A bidder’s total cost may be greater than its total bid amount when there’s a need for the bidder to buy its way out of obstacles. The professionals can address these obstacles before the auction to maximize funds available for bidding. For example, in the sale of the Texas Rangers baseball club, one of the bidders was required to pay $75 million to secure sufficient parking for the stadium. Prior to the auction, I met with the local authorities and received tacit agreement that local parking would be made available. The bidder then had an additional $75 million for auction bidding — this helped boost the winning bid to exceed the original stalking horse bid by almost $100 million.

Educate Buyers Regarding the Assets: Marc Kuemmerlein (counsel to Farmland Industries during its reorganization) attributes the success of the high-yield Farmland Industries auctions to “the care in preparation. The prospective buyers were well-informed — particularly about the management groups. Well in advance of the auction, management teams made compelling presentations to key industry leaders, and potential bidders had the opportunity to get to know the dedicated and talented individuals who managed the assets. The groundwork was carefully laid and the parameters set — the remaining term was price.” As a result, in the nitrogen fertilizer sale alone the winning bid exceeded the original stalking horse bid by $25 million. Assessments in areas of specialty — environmental, compliance, labor relations, intellectual property, regulatory, antitrust, litigation — can also be critical in educating buyers about the assets.

Coordinate with the Company’s Operations: A series of auctions for a multitude of assets requires careful coordination with the company’s operational personnel. In the WinnDixie bankruptcy, we needed to exit hundreds of stores quickly to stanch the company’s cash drain and generate proceeds to fund new initiatives. WinnDixie sold 326 stores in only 90 days though a well-coordinated effort of real estate, construction, stores, finance and other personnel throughout the company. The actual auctions were merely the icing on a cake baked well before the public bids. The auction proceeds exceeded the expected market price and provided the company with cash to modify its remaining stores and achieve a turnaround.

Develop Alternatives to the Typically Rushed 363 Sale: The average Chapter 11 case in 2016 lasted 7.3 months, whereas in 1990 the median case length was 16.1 months. The 363 auction mechanism was designed for quick sale, but every case has its own circumstances and there may be opportunities to add value by developing alternatives to the straight 363 process. A rushed sale process places downward pressure on recoveries, and professional advisers must be creative in developing alternatives. These may include structural solutions such as in the Violin Memory case, or having investment bankers explore markets they know to discover less obvious bidders, such as foreign buyers or buyers in strategically adjacent industries.

Balance the Advantages and Costs of a Stalking Horse: The seller benefits from the stalking horse process because it sets an auction bid floor. In return, the stalking horse typically receives an expense reimbursement and a breakup fee. Auction professionals must keep these costs reasonable as they reduce net recovery. Similarly, the overbid amount must be carefully negotiated so it does not “chill” the bidding. Finally, the stalking horse contract should itself be well-drafted, comprehensive and evenhanded — a high-quality document that is lucid and “fair” frees the participants to focus on price and the value of the business. A poorly drafted and unbalanced contract is a distraction, at best.

Build a Risk Profile of Each Bidder: A bid is only as good as the buyer’s ability and willingness to close. Accordingly, auction professionals must establish and stick to sound financial metrics for bidders. Informal industry and reputational knowledge — responsible due diligence — is indispensable to proper bidder vetting. If leases are being auctioned, thorough evaluation will assist in establishing whether bidders will withstand landlord scrutiny as to “adequate assurance of future performance.”

For Each Bid, Develop a Risk Premium: If the bids differ in risk, auction professionals should devise a balanced, informed method of determining a “risk premium” — a bid with added risk will need a higher dollar value to compete with a relatively safe bid. An effective “risk premium” is derived from careful analysis of competing bids, the collective experience of the auction professionals, deliberation with respective clients and bidders, and financial modeling (see below). The “risk premium” will not necessarily be constant throughout the auction as the equilibrium may shift with each successive round. Also, at the outset (when the dollar amounts are lower), auction professionals should use a risk premium based on a graduated percentage of the bid price rather than an absolute dollar amount.

Model Financially a Comparison of the Bids and the Risk Premium: Auction professionals should build a financial model to reflect competing bids and the respective value and risk of each. In this, intellectual rigor must balance creativity. The “Prospect Theory” insights of Daniel Kahneman and Amos Tversky reveal the dangers of “heuristics,” the mental “shortcuts” that cause cognitive biases and distorted perceptions. Financial modeling professionals must carefully examine their assumptions and formulae so their evaluations reflect reality and take into account, if possible, intangibles. If there are many differences in the competing bids, the financial model should provide a switch to “toggle” among bids in the successive rounds of bidding. An auction is a dynamic process, with variables in need of constant evaluation.

Communication and Confidence: For an auction to be successful, the bidders and stakeholders must accept, even if grudgingly, the auction rules. Gaining acceptance of auction rules can be a grueling process, but bidders that believe the process is fair to them are more likely to participate in vigorous bidding. Fairness and order inspire confidence. Auction professionals must communicate with bidders and stakeholders throughout the process to avoid surprises that may quell bidding or even lead to a court challenge of the auction procedures and result.

Maintain Order: Auctions are about order. One might think of them as an extension of the order one finds in a courtroom. Or in a well-managed prize fight. The formality fends off distraction from the essential: the asset — and what buyers are willing to pay. The orderliness — and therefore the effectiveness — of an auction depends on the expertise and management skill of those conducting it.

Don’t Forget About the Business: Company executives must resist the natural inclination to wholly immerse themselves in the sale and auction process. Those who succumb to this temptation risk neglecting and possibly injuring the very business being sold. Lapses in managerial attention can create circumstances that give canny bidders the ability to drive down the price. Steadfast and savvy devotion to the business by dedicated management — particularly in adverse circumstances — is one of the best indications of managerial competence and value for any business. Auction professionals are trained to work hand in glove with management and to bring their expertise to bear on the urgent process of moving the company to a new phase in its life. Select knowledgeable and trustworthy professionals, maintain oversight and put them to work!

Sheon Karol is a managing director at The DAK Group, a boutique investment bank serving the middle market. He is an expert in the use of auctions as a value-enhancing technique. He can be reached at skarol@dakgroup.com.

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