A due diligence should check whether a company is a suitable target for an acquisition. Of course, you also make sure that the previous accounting is perfect. How else could a thorough examination be carried out? And yet even the best due diligence always has a major weakness, namely the client. If the client of the due diligence shows little interest in the result of the audit, because he is already determined to acquire the company under audit, then the result is practically without significance. This may go well in individual cases, but for HP this weakness of due diligence in the form of their own CEO and CFO came expensive. We report retrospectively.

1. Due diligence weak point – introduction

Anyone who has already made a corporate transaction knows the importance of due diligence. It is especially important for the buyer side, because the decision to take over or at its price depends on their assessment. The medium- to long-term projections of the future business are also based on the due diligence report. Only in this way can it be reasonably reliably estimated how the company can and should deal with the potential subsidiary.

But also has a careful examination as part of a due diligence weaknesses. On the one hand, the management of the potential acquisition target can have some influence on the books and documents to be audited in order to present it more positively than it may be. On the other hand, the examiners can also miss details or make mistakes in their investigations and analyses in many places. Of course, this also means that they allow themselves to be misled by unreliable figures and data from the books they examine, although this is precisely the core of the examination. However, should certain risks actually occur, this can lead to fatal consequences despite the due diligence examination. Why this is possible, we explain on the basis of such a case.

2nd Due Diligence: The case of Autonomy Corporation plc.

Michael Lynch was already a highly gifted programmer in the late 1980s when he graduated from the University of Cambridge in the UK. So he realized quite early on that Bayesian statistics is the key for machine learning. After completing his doctorate, he subsequently founded Autonomy Corporated plc. as a holding company for several operating subsidiaries whose goal was to develop and sell the corresponding software. And in fact, the demand was enormous. As a result, Autonomy soon made the jump to the London Stock Exchange, where its stock traded with ever-increasing profits. Everyone wanted to participate in the success of the English flagship company. And so Autonomy soon aroused great interest on the other side of the Atlantic.

We were also aware of this in the boardroom of Autonomy. Since one apparently already at this time an exit was planned, one thought well how one could bring the best possible price. This was also based on questionable options. Although Autonomy was now regularly monitored by auditors, this did not seem to have been a really big enough obstacle. Because in the following period, some bets were put on keeping the profit at least with the expectations of the analysts, better still to exceed. Even if this should have already been noticed by the auditors, the seed for legitimate doubt was already sown in these beginnings in the context of a thorough due diligence.

3. Due Diligence: Autonomy’s dubious business practices

As CEO of Autonomy, Michael Lynch was Chief Executive of CFO Sushovan Hussain. As chief financial officer, Hussain was responsible for many details of the company’s business. He was thus able to influence negotiations with customers and agree terms with them. This also included, for example, when a purchase contract should become valid.

When new business figures were to be published at the end of a quarter, and the reality was contrary to the demand for increasing profit, it often happened that the CFO secretly agreed with customers to backdate purchase contracts and this was also somewhat costly. In any case, Autonomy was able to shine with excellent results.

Another practice was to increasingly distribute hardware in addition to their software. On the outside, however, Autonomy insisted on being a pure software company. In fact, the disguised hardware business served on the one hand to sell the software directly to buyers with the necessary hardware component in order to increase the prices for the supposedly pure software products. On the other hand, the hardware was sold partly at a loss to ensure that the sales continued with the desired external effect.

Another practice was to buy back products you had previously sold to dealers at lower prices. For dealers, of course, this was a welcome deal, but for Autonomy it was basically a deficit. Nevertheless, it was worth it, because it could increase sales. And with sales, Autonomy’s returns also seemed shiny.

In some cases, even pure sham transactions with dealers were concluded, whereby the payment was waived despite the delivered goods. Because the books of Autonomy showed the agreed instead of the received proceeds.

Incredible, but in the end, all these measures are said to have inflated Autonomy’s sales by an estimated USD 700 million. It was an enormous weakness that due diligence should have revealed.

4. Due Diligence: Why HP Autonomy wanted to take over

4.1. The initial situation

To understand the overall situation, we need to go back to 2008. The fall of the Lehman Bros. Bank in the US first a real cascade of further bank failures and then the world economic crisis, which for many years heavily burdened the international economy. Nevertheless, Autonomy was able to maintain the appearance of being spared from the global economic downward trend at that time, but only because of their manipulations. But the time was ripe for investors to reorient themselves and discover new lucrative fields of business.

The global economic crisis had also hit such an investor hard: HP. Originally founded as Hewlett Packard in the 1960s, HP had over time become a heavyweight in California’s Silicon Valley. But now the demand for hardware was declining. In addition, the global economic crisis brought further disaster. A change in trend, it seemed, would take place in the medium term at the earliest. For HP, this was a difficult situation. After all, they had sufficient liquidity.

What also made HP’s situation more difficult was that the management floor was under reconstruction. First, Marc Hurd was hired, but soon had to go for compliance reasons. In addition, it had tried without much success to get involved in the emerging market with mobile phones and tablets. Then the German Léo Apotheker was hired as CEO, who previously led the German software giant SAP for a long time. Léo Apotheker now looked at HP’s figures and the market. He quickly realized that the hardware business did not allow great hopes to keep investors happy. But what still brought a higher return was the software business. Because unlike hardware as a product, you do not need to procure raw materials for production when distributing software.

4.2. The takeover decision: origin of the due diligence weak point

So Léo Apotheker made the surprising decision to stop the mobile and tablet business altogether and instead look for an investment in an emerging software company. And quickly his eye fell on Autonomy, which stood out with brilliant returns and thus promised to solve HP’s problems. Léo Apotheker then met with Michael Lynch in July 2011 and negotiated terms for a possible takeover by HP. Somehow, it managed to convince Micheal Lynch Léo Apotheker to accept a purchase price of USD 42.11 per share. That was a whopping 60% above the market price at the time! But Léo Apotheker seemed to have considered this justified.

5. Due diligence by HP: the weak point

Of course Léo Apotheker could not draw up a purchase contract with Michael Lynch. Even as CEO, he had to have a due diligence audit carried out and wait for its result. This took place over about six weeks until August 2011. The auditors of KPMG had reviewed both the books of Autonomy and various inquiries. The fact that there were dubious practices behind Autonomy’s businesses, they noticed at best in a few points. These were mentioned in the report on due diligence, but the report itself should be of little importance.

Because the report, it became known later, neither the CEO nor the CFO of HP had read. Both went to the decisive meeting of the board with the firm intention of buying Autonomy. Arguments from both external and internal analysts that the purchase price of USD 11.7 billion was excessive were ignored, as were other warning signs. After a short time, the session was over, so the purchase was decided.

However, this quickly had unexpected consequences. Before the end of a year at the head of HP, Léo Apotheker had to take his hat. Amazingly, he still received a lush severance and other bonuses totaling $13 million. What was not yet known at the time was the truth about Autonomy and that Léo Apotheker was to prove to be the weak point of due diligence.

6th weakness due diligence: the legal consequences

6.1. First consequences

After HP acquired Autonomy, the profit and sales of the previously hyped model boy were surprisingly poor. Logically, the matter was investigated, but first had to acknowledge that Autonomy did not meet expectations. Consequently, a partial write-down was made, which amounted to a fabulous USD 8.8 billion, of which only USD 5 billion was due to the debacle with Autonomy. Another measure was the dismissal of 27,000 employees. One of them was Michael Lynch, who was still with Autonomy. He was initially assumed to have performed below average, which is why sales at Autonomy had declined. Michael Lynch replied that HP had integrated Autonomy with a lot of mishap and that this was the reason for the debacle.

6.2 Initiation of legal action

The impact on HP’s stock market value was in any case enormous. Many investors even sued HP for making the deal with Autonomy despite the excessively high purchase price. HP, on the other hand, also examined legal action, intervening on the one hand the FBI and the US stock exchange supervisory authority, on the other hand the responsible British fraud authority SFO (Serious Fraud Office). After the British authority had found too few indications that a conviction seemed successful, the investigation was soon stopped there. HP filed a civil case against Michael Lynch and Sushovan Hussain in London.

6.3. Legal consequences

And in fact, after many years, the London court ruled in the spirit of HP, but announced that the damage amount was significantly less than the over $ 5 billion claimed by HP. However, the court has not yet made a decision on the amount of damages.

This was followed by criminal proceedings against Sushovan Hussain and later Michael Lynch and his then vice director Stephen Chamberlain in the USA. While Chamberlain surrendered to the US authorities, Lynch fought back for several years. However, after the London judgment, the British Minister of Justice ordered his extradition. It was firmly assumed that a guilty verdict would also be made in this case. But the jury surprisingly acquitted the two defendants. The CFO of Autonomy, Sushovan Hussain, who was also previously convicted in the USA, had to serve a five-year prison sentence, which ended in early 2024.

7. Due Diligence: Aftermath of the weakness of auditing

During the period when Michael Lynch, Sushovan Hussain and other confidants were inflating Autonomy’s balance sheets, the accounting firm Deloitte, one of the so-called Big Four in this industry, had been auditing the books. The extent and severity of the manipulations were actually so great that Deloitte should not have drawn a certificate here. And yet that's exactly what happened.

Were the auditors entrusted with this task merely incompetent or did they fail to fulfil their obligations for other reasons? An investigation at the level of the British Financial Reporting Council (FRC) should clarify this question. It revealed that dependence on the mandate led to a conflict of interest, which ultimately resulted in an inadequate examination procedure. Those responsible for this process had to accept severe penalties afterwards. An auditor had to accept a fine of GBP 500,000 and a five-year professional ban. Another got away with a severe rebuke and a fine of GBP 250,000 relatively mildly. On the other hand, Deloitte himself was hit particularly hard with a penalty of GBP 15 million.

But KPMG, another member of the Big Four, was also on the defensive for its due diligence because it insufficiently pointed out the weaknesses of Autonomy. Since the clients were working towards concluding the company transaction as soon as possible, the auditors at KPMG were apparently pressed for time. In order to satisfy their client HP, they prepared the final due diligence report within the scheduled time, although this apparently affected the thoroughness of the investigations. The auditors are said to have only clarified some telephone questions with representatives of Autonomy. In any case, for example, the scope of hardware businesses has been insufficiently communicated. But this was a big reason why Léo Apotheker had just chosen Autonomy as a software company to expand HP’s product range, thinking it was a pure software developer, not a hardware seller.

8th weaknesses in due diligence – Conclusion

Due diligence is only good if you consider all weak points. Potential weaknesses, however, lie both on the side of the target and in the area of the acquiring acquirer. As a rule, the consideration in the context of a due diligence is limited solely to the company to be acquired. After all, you act on behalf of the acquirer, so you can assume that he takes the reports on due diligence accordingly seriously. HP was probably a special case. For example, the assumption arose that the due diligence examination of Autonomy should virtually confirm your own wishful thinking and that you were therefore also aiming for an unrealistic wishful date. With proper due diligence, you would probably have identified Autonomy’s bloated balance sheets as a weak point and averted major damage, damage from which due diligence should actually protect.