What do you think of this?
Meanwhile, the most controversial banker involved in the HP-Autonomy deal, Frank Quattrone of Qatalyst, represented Autonomy and played a key role in getting HP to pay a high price. … Analysts almost uniformly deemed the $11.1 billion he got HP to pay for Autonomy as overly rich – a compliment to him at the time, but possibly a hollow success if HP’s allegations prove true.
True or false, re: “hollow success”? The article is about how the eight zillion bankers and lawyers and auditors and, I dunno, PR firms swarming around the HP-Autonomy deal failed to notice that Autonomy was a giant fraud due to (1) it not being a giant fraud, (2) it not being their job to notice that it was a giant fraud, and/or (3) their not being good at their jobs.1 Was it Quattrone’s job?2 The capital-markets gatekeeping function, whether in sell-side M&A or in IPOs, exists in irresolvable tension between “getting the best possible price for your client” and “maintaining some credibility with the buy side.” If I were selling my company – fraud or otherwise! – I’d be pretty psyched to hire someone talented enough to get $11 billion for a giant fraud; on the other hand, once you get a reputation for getting top dollar for giant frauds, it becomes hard for you to get any dollar for anything.3
A while back we talked about a sort of amusing article saying that M&A lawyers provide no value because (1) their job is to negotiate the conditions in which a merger will and will not close, (2) mergers always close, so (3) their job is purely decorative. You could take issue with that for a number of reasons; at the time I suggested that one of those reasons would be “well they also add value by doing due diligence” and, heh, so much for that.
To add back some value, the authors recommended changing the role of lawyers from negotiating closing conditions to negotiating variable consideration: instead of just “you close the deal for $40 unless there’s a material adverse change, in which case everyone freaks out,” it’s “you close the deal always, but you pay $40 ± ($1 x percentage change in revenues)” or whatever. This too has some dubiousness in terms of lawyer-value-adding: it requires lawyers to do math, for one thing, which in turn I guess requires a mean joke about lawyers’ math ability here4.
Would that have helped HP with Autonomy? In theory, kind of, yes? If you’re an acquirer bound to close unless there’s a material adverse effect, and if you know that proving that sort of thing is close to impossible, then you spend your time between signing and closing congratulating yourself on what a good deal you’ve gotten. What else are you going to do? If you find a small or medium or medium-large problem with the target, it’s your problem now, so best for your peace of mind not to look for problems. (If you find a giant problem, you can call a MAC, but what are the odds.)
If on the other hand you get a dollar-for-dollar (or whatever) discount for every problem you find, then a good use of your time is to look for problems. In some loose sense this is true before you sign the deal – your diligence helps you find reasons to argue for a lower valuation, the target tries to argue for a higher valuation, you argue, minds meet – but market prices and auction dynamics and negotiating leverage and various other whatnots interfere. If you’ve got a contract, and the contract says “$1 off for every $1 of accounting fraud you find,” then your incentives to find fraud are at their highest.
Meh, it’s a theory. But it also shows you why this wouldn’t work. HP signed its deal to acquire Autonomy in mid-August 2011, went out with a fixed-price offer to shareholders, and closed in early October. Building in more time to dig into Autonomy’s performance, and turning the consideration from a fixed price to “fixed price minus whatever fraud we find,” might in hindsight have helped out HP. But why would Autonomy agree to it? If you want to be exposed to price risk for a long time, just don’t sell yourself.
The whole point of M&A, for the target, is to use all your negotiating power and auction dynamics and competitive pressures and whatever else to get the acquirer to overpay by as much as possible and to close as quickly and certainly as possible. Autonomy’s advisors did a great job for Autonomy, if for no one else. You can question whether Frank Quattrone did himself any favors by maximizing the price, but it’s hard to argue with its lawyers for maximizing certainty and speed.
Software companies sell stuff that is barely tangible – they sell it up front and for cash. They have very few receiveables. They do however have an obligation to service that software for a long time after they sell it – so the unearned income is relatively large (usually a multiple of receiveables). Autonomy was booking as income lots of cash it had not received (which is why the receiveables were large) and not booking any obligation to provide future services for that income. This is prima-facie suspect (and you could tell simply by looking at the balance sheet). All it required was basic applied accounting.
2. Narrowly/legalistically no, right? The sell-side banker probably has even less of a diligence obligation than the buy-side one: his obligation is to get the highest price, not find problems. Unless I guess he actually knew about fraud? One assumes that even if Autonomy was a giant fraud they wouldn’t bother to make Quattrone aware of it at the org meeting. “Well, Frank, let’s talk about our strategy for addressing the fact that our entire company is built on recognizing revenue that we haven’t earned,” etc. Or maybe?
3. Does this prove too much? If you get a reputation for getting top dollar even for non-frauds, people should be less willing to give you top dollar.
4. For the record, I don’t buy it. Corporate equity derivatives, where I used to work, is pretty much lawyers doing math. Also mathematicians doing securities law.