All the credit to our QA guy (Dan) - we found the root cause for this! Even natively in vmware, we cannot successfully clone a powered on win2008R2 VM with guest tools installed. Dan found this link which describes the exact problem we hit when cloning natively, which also somehow seems to affect us in winpe boots where the OS volume is missing it's drive letter: http://kb.vmware.com/selfservice/microsites/search.do?language=en_US&cmd=displayKC&externalId=2004505 We tried the workaround suggested in this link, which is basically this: To workaround this issue on previous versions of ESX/ESXi 4.1 and ESXi 5.0: Power down the source virtual machine. Backup the .vmx file of the source virtual machine. Change the value of the disk.EnableUUID parameter to False. For more information, see Tips for editing a .vmx file (1714). Save the changes made to the .vmx file. Clone the virtual machine again. After doing this, the problem is gone! VMware fixed this problem in esx5 update1: https://www.vmware.com/support/vsphere5/doc/vsp_esxi50_u1_rel_notes.html#resolvedissues In there you can see this is resolved: Customization of a virtual machine hot clone running Windows 2008 R2 guest operating system fails and the clone reboots continuously The customization of the hot clone of a Windows 2008 R2 guest operating system fails with the auto check not found error message, and the virtual machine reboots continuously. This issue is resolved in this release. I'd like to take this opportunity to sincerely thank all those who replied - in the process we learned some new stuff and discovered this great forum with good folks in it!