How HP’s Disastrous Deal Blows a Hole in Consulting
Let’s say you want to make a big buy—not an engagement ring, not a Lamborghini, not even a beachfront villa. Bigger. You want to buy an $11 billion business: say, a software company based in the sleepy collegiate hamlet of Cambridge, England. Before you sign on the dotted line, you probably want to make sure you’re not getting a lemon. For a Lamborghini, you might kick the tires and have a trusted mechanic look at it. For a villa, you might secure a sharp appraiser. But for that $11 billion business, you’re likely to rely on a series of advisers—investment banks, consultants, accountants, lawyers—to make sure all is shipshape.
When Hewlett-Packard bought English software company Autonomy for $11.1 billion last year, it relied on Deloitte and KPMG, two of the “Big Four” global audit and consulting firms. They had checked, double-checked, and septuple-check all the numbers. And for their services -- as Autonomy's auditor -- they got a nice fee. On average, at M&A rates, about 0.5 percent of a deal’s closing price goes to advisors, according to Reuters. (If that ratio held true in this deal, the fee could have been as much as $55 million.) That may seem like a lot of money for a little advice—most of it rendered by 20-something analysts, who may have just met your business and the British one last week. But can you really put a price on feeling safe?
Now, let’s say that Deloitte and KPMG both gave Autonomy's financials a clean bill of health—despite objections from investors who say the company is overpriced, and despite software-giant Oracle questioning the honesty of Autonomy management. A year later, an executive at your British-bought company comes clean and tells your board that all their numbers were fudged: massive accounting fraud. You’re forced to write down the value of your purchase, and lose a whopping $8.8 billion, erasing all the money you made last quarter, and cratering your hopes at recovery. That’s exactly what happened to Hewlett-Packard, despite its army of high-paid advisers. If you were HP CEO Meg Whitman, how would you feel about the whiz-kid consultants?
Now, both KPMG and Deloitte are downplaying their role in the Autonomy debacle, saying that though they both looked through the British company's financials, they had no role in green-lighting the deal. But in a statement yesterday, ex-Autonomy CEO Mike Lynch said that "HP's due diligence review was intensive, overseen on behalf of HP by KPMG, Barclays, and Perella Weinberg."
For 90 percent of Autonomy’s value to evaporate overnight, the scale of numerical fakery and fudging must have been enormous—large enough, one would think, for a multimillion-dollar, three-company search to sniff out. As Mark Williams, a former Federal Reserve Bank examiner and finance professor at Boston University, put it, “proper deal due diligence requires understanding what you are buying before writing the check. Autonomy's [alleged] accounting fraud was extensive and proper due diligence would have uncovered the trickery.” HP surely deserves a lot of the blame: haste makes waste. But what about Deloitte and KPMG?
For its part, a representative from Deloitte UK told me that "Deloitte was not an adviser to HP on this deal and did not carry out the due diligence work on the acquisition," though it was Autonomy's prime auditor before it, and HP CEO Meg Whitman says her company "relied on audited financials, audited by Deloitte." In a further statement, Deloitte insisted that it "was not engaged by HP, or by Autonomy, to provide any due diligence in relation to the acquisition," though "Deloitte UK was auditor to Autonomy at the time of its acquisition." The company said its audit opinion, which gave the company a clean bill of health, was signed in February 2011 -- that is, just over two months before H-P bought it. Deloitte denied “that it had any knowledge of” or “was complicit in any accounting improprieties or any misrepresentations.”
KPMG is also trying to distance itself from the scandal, denying HP's assertion that it performed a full audit of Autonomy. "Contrary to media reports," said head of media relations Manny Goncalves, "KPMG performed limited, non-audit work for HP on this matter. Because of our professional obligations and client confidentiality, we cannot discuss our engagement further without HP’s consent." That explanation seems to contradict HP, which said that KPMG had extensively "audit[ed]" the work done by Deloitte."
The SEC and the U.K.’s Serious Fraud Office both intend to investigate Autonomy’s alleged fraud, and HP plans to sue. (Autonomy’s former chief has “flatly” denied the allegations to Reuters.)
Talking to shareholders, HP says it relied on the work of these advisors. The advisors themselves are downplaying their role. But under possible litigation, the question may become: what did Deloitte and KPMG know, and when? It’s entirely possible that, despite their hordes of analysts and fact checkers, the firms completely glazed over the alleged massive accounting fraud. But if the consultants did catch wind, and still endorsed the deal, they could be on the hook as well. As Williams says, “poor due diligence has distorted significant amounts of company good will and shareholder value have been distorted.” HP is already holding the bag for $8.8 billion, but the market’s response to the botched-yet-vetted deal will be far worse.
Part of the problem may lie in the way high-powered executives, keen on an acquisition, approach their well-paid consultant consiglieres. Often, an outside perspective can uncover new data, or potentially lucrative synergies. But just as often, a CEO will bring in the consultant corps simply to endorse a strategy that he or she wants to sell to his board or shareholders: essentially, to smile, nod, and approve an existing idea. As one chief executive, the head of a major tech company that has closed more than a dozen acquisitions in the last 10 years, told me, “Overall, the buyer is seldom keen for the accountants to do much more than rubber-stamp.”
HP wanted the deal to work—badly. With personal computers losing marketshare to phones and tablets, its key business is in danger. “Paying $10 billion for Autonomy was HP's solution to regain market position and profitability,” says Williams. And of course, Autonomy wanted to look safe for any potential buyers. But the hoped-for “magic acquisition” is now a lot to of a curse. “KPMG and Deloitte are brought in to do accounting and financial due diligence,” added the technology CEO I spoke with, “but it is sometimes useful if they find minor issues so that the buyer has levers to negotiate on price, other terms, warranties, and indemnities.”
This isn’t the first time Deloitte has run into trouble over questionable vetting. In August, New York regulators accused Deloitte of helping British bank Standard Chartered hide $250 billion of illegal transactions with the embargoed Iranian government. (Deloitte denied the accusations.) In June, the company settled for $19.9 million over claims that it misled investors about the financial health of Bear Stearns before its implosion and sale to JPMorgan Chase. (Deloitte admitted no wrongdoing.) And according to The Wall Street Journal, last month, the Public Company Accounting Oversight Board—the major audit watchdog—made public criticisms of Deloitte’s quality control, alleging that the firm was too credulous with clients’ numbers. For its own part, KPMG missed a $1.7 billion accounting scandal at Japanese company Olympus.
The cozy relationship between deal makers and deal brokers is a classic principal-agent problem: sometimes, it’s hard to be brutally honest with the guy who’s writing your multimillion-dollar paycheck. But click over to HP’s website, and you’ll see how chummy its relationship with Deloitte became over the course of their long advisory clientship. The pair even embarked on a joint “HP and Deloitte Consulting Alliance.” Deloitte’s own M&A PR is aggressive: “Bring in some help,” concludes a point-counterpoint on hiring Deloitte, hosted on Deloitte’s website. “Just be smart about how you deploy them.” Said Garrett Herbert, a partner in Deloitte’s M&A transaction-services division, “When it comes to due diligence, we’ve found the best model is usually one of hands-on collaboration.”
Much of the blame has to fall on HP for rushing into an overpriced purchase. But Silicon Valley’s founding father isn’t an accounting expert, or staffed up with M&A gurus. And even after using data from one Big Four accounting firm, Deloitte, for many millions, it hired another, KPMG, for a second opinion.
HP relied on Deloitte and KPMG for advice that turned out to be problematic. The question now is whether—and how much—the two firms will have to pay HP.