I got a call --a referral by a mutual acquaintance-- asking if
I could spend a couple of
days looking at a privately held business this fellow was buying. This prospective buyer didn’t once use the words ‘due diligence’ but did lead off by saying that he was calling because he didn’t want to find out he was ‘buying an Autonomy’. I was happy for the call, of course, but bit my tongue and didn’t say what I really thought was probably behind the HP/Autonomy fiasco (more on that later, though).
ProForma’s
As typical, the buyer and seller had already agreed on price and terms in a ‘letter of intent.’ The buyer emailed over the offering material, which had been prepared by a boutique firm that specialized in the industry. My immediate observation was that the materials included no actual financial statements – just ‘pro forma’ financial schedules showing recent year results on some adjusted basis, and some short-term projections in the same format. Whenever I see "pro forma adjustments" I have a Star Wars flashback (these adjustments "aren't the droids your looking for"). We definitely want to have a look at those exclusions.
This kind of presentation isn’t unusual, not only for private firms, where the excuse is always that either (a) owners had sand-bagged P&L’s in some creative manner to minimize taxes (we’ll remember that that’s a seller talking, puffing up 'real' prospects) and the true economic returns require the interpretation the seller has helpfully supplied, or (b) it’s a younger company with high non-recurring costs that need to be excluded to understand the actual potential.
This is no surprise -- I’ve done the same sort of presentation spin myself when working for sellers, on the other side of the table. Whether we’re looking to sell a house, a car, or even ourselves – perhaps a job interview or first date – we often try to portray things in the best possible light. Same here.
With all this, though, I’m mindful that in two prior transactions I reviewed recently, there were sufficient lapses in logic and disclosure in those pro forma presentations that, when I laid out the facts for the buyer and seller, the initial ‘letters of intent’ were quickly renegotiated to a lower price. The buyers still wanted the companies, but through these 'due diligence' reviews they learned that the businesses just didn’t quite have the economics they thought when they agreed to that original negotiated price. The point is that when looking at any seller’s numbers, you really do have to do your own construction of the economics.
HP/Autonomy
Now Autonomy wasn’t quite like those situations, but there are some similarities. Anyone looking at their pre-acquisition financial statements sees the headline financial highlights -- ‘$377m Profit from Ops’ in large font bold on page 1 -- with no mention of the company’s actual earnings – $217m -- until page 45. Nothing wrong with that, but we are mindful of the question we always ask ourselves: ‘what would Charlie say?’ We have been warned. We also see Deloitte’s assurances in their attached audit opinion letter that the everything is presented per IFRS (more on that some other time).
But with any business we are considering, one of the first things we also want to do is look at actual cash generation – what we put in the bank, and where that money came from. Here we see that about $730m of the company’s $830m cash build-up over the last year came from net increases in debt and some issued shares, and we make a mental note of that $100m net number that came from the actual activities of the business. It took us about a minute to arrive at that $100m net cash number.
I’m being perhaps overly harsh here, but banks don’t credit your account for bookkeeping entries. That doesn’t mean you start claiming that the company only brings in $100m and crying foul, but you might start your thinking at $100m and work up. You want to be able to understand the economics – yourself – and at least be able to rationalize every dollar you are attributing over that.
Everyone reading this board is aware of the inherent potential for complex revenue reporting shenanigans in tech. It’s almost a given that self-promoting tech companies will push the limits or more. That doesn’t mean we can’t make our own assessments of business. It stretches credibility to think that a large, established company in the sector like HP should at first be oblivious, then shocked, because it didn't look into the details itself. A quick look at cash generation just grounds us a bit, for a starting point for Autonomy.
Now we have to remember at this point that HP has made scores – scores! – of tech acquisitions, including some that turned out to be headline-making disasters. We would think that they have a due diligence team and process in place. And this gets us to the crux of the Autonomy valuation and due diligence: the $10billion purchase price was not a result of earnings-based results, actual cash generation, substantial tangible assets, or anything else -- except the value assigned to extrapolated projections. The purchase price was over 10x revenue, and 100x cash flow.
That suggests that the due diligence in an acquisition like Autonomy shouldn’t ignore, but shouldn't be overly obsessed with accounting reports. Much more focus should be on high-level technical and market assessments of the products and services. That kind of pricing isn’t a function of history but on future execution. For HP management to now say that their misunderstanding of the value of the company – by $billions – on a company that had cash generation last year of $100m on $900m of revenue is based on misrepresented accounting treatments, is in itself just plain misleading. Maybe Deloitte and KPMG got lost in the forest and missed some things, and maybe they will pay the price. If that’s all that results from this mis-valuation, though, that’s a travesty. The fundamental problem with Autonomy looks very much to be on extrapolations and projections of a business the acquirer must not have properly understood.
Accounting vs. Projections
The most miserable engagement I think I ever had was for a multinational that was buying a start-up with a product that they were convinced had some promising technology. They were highly distressed that the best valuation I could muster was about 10% of the actual asking price, a price that they were otherwise comfortable with. But I was going by the numbers and not some potential that I wasn't qualified to predict. The buyer’s own R&D people were the experts on whether the product was sufficiently unique and marketable, but still, the internal acquisition people were beside themselves that they couldn’t lay off some of the responsibility for the decision to an outsider.
Part of the problem was that this team was frustrated – and no doubt their management was frustrated with them – that a couple of their competitors – the 800-pound gorillas -- had been on acquisition binges and left them with scraps. The sellers, by the way, were smart enough to pick on the buyer’s concern that they didn’t want to lose another one to the big guys again, and played on that fear. Financial due diligence was really an afterthought that was almost immaterial in the real due diligence, and in the deal pricing. It's like HP claiming that if they had realized that recent earnings were closer to $100m than $300m, they wouldn’t have paid $10 billion.
HP's Lesjack
Back to HP – here seems to be the nail in the entire board’s coffin -- it has come out now that HP CFO Cathy Lesjack made a presentation to the HP board, bucking CEO Apotheker, advising against the purchase. (We will recall that Lesjack was briefly HP’s interim CEO while HP searched for the permanent CEO, who turned out to be Apotheker).
Her objection was apparently based on her assessment of valuation. She also has now been included in a shareholder lawsuit for allowing the purchase – presumably she didn’t know about those red-herring accounting irregularities – but in any event, ahead of the purchase she made clear that she just didn’t like the deal. Pre-purchase, her objection reflected the bigger picture in the transaction, that the $10 billion purchase price was way too high for that business. The board set aside Lesjack’s recommendation and went ahead anyway.
OK. At that juncture, nobody on the board can later claim ignorance – that they were somehow duped into agreeing to a bad purchase. If perhaps the most qualified financial person in the room says no-go and you go ahead anyway, you pretty much have to take responsibility yourself for squandering your shareholder’s money. You might try to point fingers – claim accounting discrepancies, and that the seller enticed you to overpay—but at this point you can’t claim you were somehow tricked into the deal. Of course now that you see that Lesjack was right after all about over-paying, it’s helpful to find some others who also screwed up in their own roles so you can redirect some blame….but really….
An old Due Diligence Poster Child
So are practitioners – all those accountants and attorneys – unnecessary in the deal? Is ‘due diligence’ as its portrayed over-hyped? We know Buffett’s eloquently communicated thoughts on this. Well, it does have its place in a transaction, at least in some form or another. One of my favorite examples of a lapse in due diligence is Volkswagen’s purchase of Rolls Royce (…wait, that’s Bentley, right?).
A decade or so ago Volkswagen agreed to buy Rolls Royce (including Bentley, which at the time was identical to the equivalent Rolls-Royce models but with different body trim and options), both made in a century-old factory in need of extensive updating (about as much as a ground-up new plant, as it turned out). The vehicle models themselves were long overdue for modernization. Volkswagen paid about $2 billion for the acquisition. During negotiations, BMW and Daimler had also ‘kicked the tyres’ so to speak.
The ink was hardly dry on the deal when Volkswagen learned that BMW had just then made its own little $50 million deal. It turned out that Rolls Royce the car company didn’t own the Rolls Royce brand name. It licensed the name from aircraft engine maker Roll Royce. It also turned out that BMW was involved in a long-standing aircraft engine venture with that Rolls Royce, and that there happened to be a ‘change of control’ clause in the car maker’s licensing rights to the name, that automatically terminated the existing brand licensing contract. Somebody either hadn’t read the agreement, or hadn’t considered its implications.
BMW was apparently aware of the licensing issues, and immediately snapped up the rights to the name for $50 million – a detail Volkswagen obviously would have nailed down pre-closing, if it had known. BMW negotiated some tax incentives for a brand new factory in the countryside, and was off and running with Roll Royce. BMW had already been a supplier for 12-cylinder engines Rolls/Bentley, and along with its other advanced technologies and in-house skills had a running start. Volkswagen had the harder climb, and ending up having to pretty much ‘buy the company again’ in additional investment into Bentley. Anyway, the moral of the Rolls Royce trademark story isn’t hard to figure.
The Berkshire perspective
We know Buffett’s view-point on due diligence: if you can dispense with it altogether and make yourself comfortable with the general integrity of the seller, that allows you to negotiate and close deals more quickly and cleanly than any other buyer out there. It’s a selling point for doing business with Buffett, for sure. It also passes some of the trust and responsibility for forthrightness to the seller, which has its benefits.
The one issue I have with that is that if it were me, I would draw a distinction between purchases of private businesses and those of publicly traded companies. Public company purchases are.. more public.. the actual owners are usually public shareholders, and managers are often professional managers, and not the founder-owner-CEO who is negotiating the deal on his own behalf, and who is personally cashing that check. As an important distinction, public-company CEO’s have an actual fiduciary responsibility to his/her shareholders.
The sale is not presented to be for the CEO’s benefit, it’s for the shareholders’. Now that CEO can rationalize his responsibility as also being to his employees, for the future well-being of the company, find a home, preserve a legacy, etc.…but we should never forget that the public company CEO does have that fiduciary responsibility to get the best deal possible for shareholders, and not think ahead to his own position with his future boss on the other side of the table. He can be perfectly ethical and still have (and perhaps should have) different priorities from a private-company seller.
Generally speaking, that fiduciary relationship on the seller’s side is not the best back-drop for a ‘no due diligence’ buyer. And in practice, it means less in attracting potential deals than it does for private sellers. And further, also from a practical viewpoint, public company CEO’s are more likely to be professional managers, and in some cases may be less likely to be even aware of latent problems than a founder-owner. Gen Re comes to mind, where if certain details were brought to light pre-purchase, the deal might still have gone through anyway but the price might have been more reflective of reality.
A typical Due Diligence Checklist
For anyone interested in having a look, here is a sample due diligence checklist similar to the one most acquisition teams use (I have no affiliation whatsoever with these guys, but their list looks pretty representative). http://www.gt.com/staticfiles/GTCom/Advisory/Comprehensive%2...
Not every question applies, of course, and many more are added to address specific industry nuances. But it is a helpful initial starting point if you are looking to do some due diligence on a company.
days looking at a privately held business this fellow was buying. This prospective buyer didn’t once use the words ‘due diligence’ but did lead off by saying that he was calling because he didn’t want to find out he was ‘buying an Autonomy’. I was happy for the call, of course, but bit my tongue and didn’t say what I really thought was probably behind the HP/Autonomy fiasco (more on that later, though).
ProForma’s
As typical, the buyer and seller had already agreed on price and terms in a ‘letter of intent.’ The buyer emailed over the offering material, which had been prepared by a boutique firm that specialized in the industry. My immediate observation was that the materials included no actual financial statements – just ‘pro forma’ financial schedules showing recent year results on some adjusted basis, and some short-term projections in the same format. Whenever I see "pro forma adjustments" I have a Star Wars flashback (these adjustments "aren't the droids your looking for"). We definitely want to have a look at those exclusions.
This kind of presentation isn’t unusual, not only for private firms, where the excuse is always that either (a) owners had sand-bagged P&L’s in some creative manner to minimize taxes (we’ll remember that that’s a seller talking, puffing up 'real' prospects) and the true economic returns require the interpretation the seller has helpfully supplied, or (b) it’s a younger company with high non-recurring costs that need to be excluded to understand the actual potential.
This is no surprise -- I’ve done the same sort of presentation spin myself when working for sellers, on the other side of the table. Whether we’re looking to sell a house, a car, or even ourselves – perhaps a job interview or first date – we often try to portray things in the best possible light. Same here.
With all this, though, I’m mindful that in two prior transactions I reviewed recently, there were sufficient lapses in logic and disclosure in those pro forma presentations that, when I laid out the facts for the buyer and seller, the initial ‘letters of intent’ were quickly renegotiated to a lower price. The buyers still wanted the companies, but through these 'due diligence' reviews they learned that the businesses just didn’t quite have the economics they thought when they agreed to that original negotiated price. The point is that when looking at any seller’s numbers, you really do have to do your own construction of the economics.
HP/Autonomy
Now Autonomy wasn’t quite like those situations, but there are some similarities. Anyone looking at their pre-acquisition financial statements sees the headline financial highlights -- ‘$377m Profit from Ops’ in large font bold on page 1 -- with no mention of the company’s actual earnings – $217m -- until page 45. Nothing wrong with that, but we are mindful of the question we always ask ourselves: ‘what would Charlie say?’ We have been warned. We also see Deloitte’s assurances in their attached audit opinion letter that the everything is presented per IFRS (more on that some other time).
But with any business we are considering, one of the first things we also want to do is look at actual cash generation – what we put in the bank, and where that money came from. Here we see that about $730m of the company’s $830m cash build-up over the last year came from net increases in debt and some issued shares, and we make a mental note of that $100m net number that came from the actual activities of the business. It took us about a minute to arrive at that $100m net cash number.
I’m being perhaps overly harsh here, but banks don’t credit your account for bookkeeping entries. That doesn’t mean you start claiming that the company only brings in $100m and crying foul, but you might start your thinking at $100m and work up. You want to be able to understand the economics – yourself – and at least be able to rationalize every dollar you are attributing over that.
Everyone reading this board is aware of the inherent potential for complex revenue reporting shenanigans in tech. It’s almost a given that self-promoting tech companies will push the limits or more. That doesn’t mean we can’t make our own assessments of business. It stretches credibility to think that a large, established company in the sector like HP should at first be oblivious, then shocked, because it didn't look into the details itself. A quick look at cash generation just grounds us a bit, for a starting point for Autonomy.
Now we have to remember at this point that HP has made scores – scores! – of tech acquisitions, including some that turned out to be headline-making disasters. We would think that they have a due diligence team and process in place. And this gets us to the crux of the Autonomy valuation and due diligence: the $10billion purchase price was not a result of earnings-based results, actual cash generation, substantial tangible assets, or anything else -- except the value assigned to extrapolated projections. The purchase price was over 10x revenue, and 100x cash flow.
That suggests that the due diligence in an acquisition like Autonomy shouldn’t ignore, but shouldn't be overly obsessed with accounting reports. Much more focus should be on high-level technical and market assessments of the products and services. That kind of pricing isn’t a function of history but on future execution. For HP management to now say that their misunderstanding of the value of the company – by $billions – on a company that had cash generation last year of $100m on $900m of revenue is based on misrepresented accounting treatments, is in itself just plain misleading. Maybe Deloitte and KPMG got lost in the forest and missed some things, and maybe they will pay the price. If that’s all that results from this mis-valuation, though, that’s a travesty. The fundamental problem with Autonomy looks very much to be on extrapolations and projections of a business the acquirer must not have properly understood.
Accounting vs. Projections
The most miserable engagement I think I ever had was for a multinational that was buying a start-up with a product that they were convinced had some promising technology. They were highly distressed that the best valuation I could muster was about 10% of the actual asking price, a price that they were otherwise comfortable with. But I was going by the numbers and not some potential that I wasn't qualified to predict. The buyer’s own R&D people were the experts on whether the product was sufficiently unique and marketable, but still, the internal acquisition people were beside themselves that they couldn’t lay off some of the responsibility for the decision to an outsider.
Part of the problem was that this team was frustrated – and no doubt their management was frustrated with them – that a couple of their competitors – the 800-pound gorillas -- had been on acquisition binges and left them with scraps. The sellers, by the way, were smart enough to pick on the buyer’s concern that they didn’t want to lose another one to the big guys again, and played on that fear. Financial due diligence was really an afterthought that was almost immaterial in the real due diligence, and in the deal pricing. It's like HP claiming that if they had realized that recent earnings were closer to $100m than $300m, they wouldn’t have paid $10 billion.
HP's Lesjack
Back to HP – here seems to be the nail in the entire board’s coffin -- it has come out now that HP CFO Cathy Lesjack made a presentation to the HP board, bucking CEO Apotheker, advising against the purchase. (We will recall that Lesjack was briefly HP’s interim CEO while HP searched for the permanent CEO, who turned out to be Apotheker).
Her objection was apparently based on her assessment of valuation. She also has now been included in a shareholder lawsuit for allowing the purchase – presumably she didn’t know about those red-herring accounting irregularities – but in any event, ahead of the purchase she made clear that she just didn’t like the deal. Pre-purchase, her objection reflected the bigger picture in the transaction, that the $10 billion purchase price was way too high for that business. The board set aside Lesjack’s recommendation and went ahead anyway.
OK. At that juncture, nobody on the board can later claim ignorance – that they were somehow duped into agreeing to a bad purchase. If perhaps the most qualified financial person in the room says no-go and you go ahead anyway, you pretty much have to take responsibility yourself for squandering your shareholder’s money. You might try to point fingers – claim accounting discrepancies, and that the seller enticed you to overpay—but at this point you can’t claim you were somehow tricked into the deal. Of course now that you see that Lesjack was right after all about over-paying, it’s helpful to find some others who also screwed up in their own roles so you can redirect some blame….but really….
An old Due Diligence Poster Child
So are practitioners – all those accountants and attorneys – unnecessary in the deal? Is ‘due diligence’ as its portrayed over-hyped? We know Buffett’s eloquently communicated thoughts on this. Well, it does have its place in a transaction, at least in some form or another. One of my favorite examples of a lapse in due diligence is Volkswagen’s purchase of Rolls Royce (…wait, that’s Bentley, right?).
A decade or so ago Volkswagen agreed to buy Rolls Royce (including Bentley, which at the time was identical to the equivalent Rolls-Royce models but with different body trim and options), both made in a century-old factory in need of extensive updating (about as much as a ground-up new plant, as it turned out). The vehicle models themselves were long overdue for modernization. Volkswagen paid about $2 billion for the acquisition. During negotiations, BMW and Daimler had also ‘kicked the tyres’ so to speak.
The ink was hardly dry on the deal when Volkswagen learned that BMW had just then made its own little $50 million deal. It turned out that Rolls Royce the car company didn’t own the Rolls Royce brand name. It licensed the name from aircraft engine maker Roll Royce. It also turned out that BMW was involved in a long-standing aircraft engine venture with that Rolls Royce, and that there happened to be a ‘change of control’ clause in the car maker’s licensing rights to the name, that automatically terminated the existing brand licensing contract. Somebody either hadn’t read the agreement, or hadn’t considered its implications.
BMW was apparently aware of the licensing issues, and immediately snapped up the rights to the name for $50 million – a detail Volkswagen obviously would have nailed down pre-closing, if it had known. BMW negotiated some tax incentives for a brand new factory in the countryside, and was off and running with Roll Royce. BMW had already been a supplier for 12-cylinder engines Rolls/Bentley, and along with its other advanced technologies and in-house skills had a running start. Volkswagen had the harder climb, and ending up having to pretty much ‘buy the company again’ in additional investment into Bentley. Anyway, the moral of the Rolls Royce trademark story isn’t hard to figure.
The Berkshire perspective
We know Buffett’s view-point on due diligence: if you can dispense with it altogether and make yourself comfortable with the general integrity of the seller, that allows you to negotiate and close deals more quickly and cleanly than any other buyer out there. It’s a selling point for doing business with Buffett, for sure. It also passes some of the trust and responsibility for forthrightness to the seller, which has its benefits.
The one issue I have with that is that if it were me, I would draw a distinction between purchases of private businesses and those of publicly traded companies. Public company purchases are.. more public.. the actual owners are usually public shareholders, and managers are often professional managers, and not the founder-owner-CEO who is negotiating the deal on his own behalf, and who is personally cashing that check. As an important distinction, public-company CEO’s have an actual fiduciary responsibility to his/her shareholders.
The sale is not presented to be for the CEO’s benefit, it’s for the shareholders’. Now that CEO can rationalize his responsibility as also being to his employees, for the future well-being of the company, find a home, preserve a legacy, etc.…but we should never forget that the public company CEO does have that fiduciary responsibility to get the best deal possible for shareholders, and not think ahead to his own position with his future boss on the other side of the table. He can be perfectly ethical and still have (and perhaps should have) different priorities from a private-company seller.
Generally speaking, that fiduciary relationship on the seller’s side is not the best back-drop for a ‘no due diligence’ buyer. And in practice, it means less in attracting potential deals than it does for private sellers. And further, also from a practical viewpoint, public company CEO’s are more likely to be professional managers, and in some cases may be less likely to be even aware of latent problems than a founder-owner. Gen Re comes to mind, where if certain details were brought to light pre-purchase, the deal might still have gone through anyway but the price might have been more reflective of reality.
A typical Due Diligence Checklist
For anyone interested in having a look, here is a sample due diligence checklist similar to the one most acquisition teams use (I have no affiliation whatsoever with these guys, but their list looks pretty representative). http://www.gt.com/staticfiles/GTCom/Advisory/Comprehensive%2...
Not every question applies, of course, and many more are added to address specific industry nuances. But it is a helpful initial starting point if you are looking to do some due diligence on a company.
