Acquired — Enron

Why Listen To This?

• Hosts
  • Ben Gilbert, CEO of Pioneer Square Labs — Startup Studio
  • David Rosenthal an Angel Investor

Learnings

• ‘7 — Quote:
  • This then is more than the tale of one company’s fall from grace. It is at its base, a story of a wrenching period of economic and political tumult as revealed through a single corporate scandal. It is a portrait of an America in upheaval at the turn of the 21st century, a country torn between a warship and its zeal for truth between greed and high-mindedness, between Wall Street and Main Street. Ultimately, it is the story of the untold damage wreaked by a nation’s folly, a folly that in time, we are all but certain to see again.
    • — Kurt Eichenwald, Conspiracy of Fools
• ‘8 — The Setting:
  • The 1970s,
    • A series of oil embargos(1973 and 1979) by the Arabs shock the US and the energy markets worldwide.
  • Inflation reaches 12% compared to 5%-6% now.
  • The US govt starts deregulating the energy markets.
    • In 1978 President James Carter passes The National Energy Act to this effect.
      • It opened up parts of energy markets in the US for free market competition.
        • The first part to open up is the Natural Gas Market.
• ‘13 — Enter Ken Lay
  • Born in 1942 to a Baptist Preacher
    • Grew up poor.
    • From an early age, discovers his love for economics.
    • After graduation, goes on to work in the Oil Industry.
    • Gets his Ph.D. in Economics.
  • In mid-1975, one of his old professors gets nominated to Federal Power Commission.
    • He asks Ken to join him; Lay goes on to serve as the Deputy-Under secretary of Energy in the Department of the Interior.
  • After a few years, goes back to the industry to Florida Gas — a pipeline company in Florida as the President and the no.2 in the company.
  • In 1982, his former boss goes to a bigger company called Transco Energy in Houston Texas.
    • Deregulation is in full swing.
• ‘17 — The Creation of the Energy Spot Market
  • In 1982, energy prices fall for the first time in a decade and Transco has contracts to buy locked in at a higher price than the market rate.
  • Lay puts forward the idea of creating a trading market for Oil and Gas Transco has contracted to buy.
    • Rather than being a pipeline company that buys, they’ll operate the pipeline and facilitate a market for the end consumers to buy from them and producers and charge a fee for it, effectively creating a spot market.
    • It let companies with energy needs to buy oil and gas at real-time prices rather than prices decided in the past through futures contracts.
  • Before this, the financialization of energy assets was not possible as they were regulated.
  • Lay becomes a legend.
• ‘21 — Lay Moves to a Bigger Ship:
  • In 1984, he is offered a job at Houston Natural Gas(HNG), a bigger public-traded company.
  • In 1985, gets a call from another bigger competitor called Inter-North — the largest pipeline company in the US.
    • Inter-north was in the process of a hostile takeover by a corporate Raider.
    • They wanted to merge with HNG as a poison pill move.
    • Inter North ends up buying HNG for $2.3 Billion, a 40% premium.
      • HNG is given more board seats. Lay becomes the No.2 person.
        • Inter North Pipeline — A very valuable Hard Asset
      • There is some culture clash.
      • They hire McKinsey
      • In the Board Meeting, Lay performs a coup, and takes over as Chairman and CEO.
  • ‘26 — Enter Jeffrey Skilling.
    • Skilling is the consultant from McKinsey.
    • Ken asks him to be their Strategy Consultant from McKinsey.
  • ‘32 — The Brand Rejig.
    • Lay wants to change the face of the brand.
    • Logo Design — Hires Paul Rand.
      • Has designed the logos for IBM, Morning Star etc.
      • Enron is the last logo he designed.
    • The Name:
      • The name consultants suggest Enteron:
        • En → Energy
        • Ter → a no to Inter North
        • On → Sounds Cool
      • They didn’t check the dictionary, actually it is a medical term for the digestive tract.
        • They get dragged in the news.
        • Name changed to Enron.
  • ‘35 — The Valhalla Scandal:
    • In 1987, 2 traders at the new Enron embezzels money for the company.
      • Filing fake trades, fake tax returns, creating false bank accounts etc.
        • One such account being a Lebenese speculator no one could find — M. Yass.
      • The issue is brought to Lay’s attention.
        • Everyone including Arthur Anderson recommend the board to fire the traders.
        • Lay refuses to fire them because they made good money for the company.
        • He sends a memo wherein he says
          • please keep making us millions.
    • Within a few months, the traders again go risk on and end up making over $1 Billion in losses.
      • Lay fires them.
      • This happens in the early stages of the quarter and they were able to cover some of the losses, eventually reporting $100 Million in losses.
• ‘39 — Jeff Skilling is consulted to develop a strategic plan for the new financing and trading operation of Enron.
• ‘39 — Ken has an Idea:
  • Move from being a facilitator of the energy market to being a “bank for gas”:
    • They will go to natural gas producers and buy a lot of their future production.
    • Then they will repackage it and sell it to buyers i.e. securitize it.
• ‘42 — Skilling’s idea
  • Create a full-fledged energy derivatives market
• ‘44 — The financing part.
  • Enron will fund producers and will lock up the rights to securitize future production from the producers.
• ‘46 — Ken Lay convinces Skilling to join Enron and create Enron Finance Division.
• ‘48 — MTM Accounting:
  • Financial Assets held are recorded in the Balance Sheet at the market price, even if not realised in cash.
• ‘50 — Skilling made CEO of EFD:
  • EFD is set up as a proper Wall Street Investment Bank with trading floors
  • Brings in
    • Lou Pai.
    • Andrew Fastow:
      • Former Banker; worked in structured finance.
• ‘55 — Special Purpose Entities:
  • Enron finances the producers.
    • They don’t want them in appearing in their books.
  • With advice from Arthur Anderson, they spin off these investments to SPEs.
  • SPE:
    • Separate Legal Entity
    • A minimum 3% investment should be from outsiders.
      • The company can still own 97% of the entity and then push the investments to that entity.
• ‘59 — Arthur Anderson is skeptical of MTM accounting
  • Skilling convinces the SEC to allow MTM accounting
• ‘58 — MTM Accounting Application:
  • Enron will go to every oil and gas producers they can find, invest in them and blow out of proportion the cash flow these producers make and discount these to the present value, and will record investments at those values.
    • Future cash flows for the next 20 years was allowed to be discounted to PV and recorded as Revenue by the SEC
  • Their investments in the producers are pushed to the SPEs so even it doesn’t affect Enron’s Bottomline if it’s written off.
    • Though no cash is generated, the income statement will show huge profit.
• ‘62 — Arthur Anderson:
  • Pre-Sarbanes Oxley, All accounting and audit firms had consulting arms attached to them.
  • After the demise of AA, their consulting arm — Anderson Consulting was spun off as Accenture.
  • Enron was their biggest client and they made $50 million per year from Enron:
    • 50% in Audit Fees
    • 50% in Consulting Fees
• ‘65 — The Double Dipping:
  • Enron invested in producers and recorded the investments by Discounting the FCF for long periods in the future.
  • It then sold these investmenst to the SPEs at high prices and recorded huge profits, though there are no cash flows.
• ‘66 — The problem with MTM
  • The revenue was recorded only one time.
  • To keep the Topline high, more deals had to be made.
  • Once this is done and they report the conflated earnings, it catches the investor’s attention.
    • Period after period they have to move markets to keep the stock price from falling
• ‘69 — The result of the Devilish Flywheel
  • The Devilish Flywheel → the combination of MTM and SPE.
  • Started in 1996.
  • During the 5 years run from 1996 to 2001 when Enron blew up,
    • Revenues grew 750% → $13.5 Billion to more than $100 Billion.
    • During this period, Fortune Magazine names them:
      • The most innovative company
      • In 2000, name them America’s Most Well-Managed Company!
• ‘70 — In mid-90s,:
  • Skilling is promoted from:
    • CEO of Finance Division → President and COO of the entire Enron Corporation
  • Fastow is promoted from:
    • A mid-level executive → CFO of the Finance Division
• ‘72 — Enron goes worldwide:
  • Builds power plants across the world, in developed and developing countries.
• ‘75 — Funding the SPEs:
  • The 97%:
    • They did so many deals that it became difficult to create the SPEs.
    • So when the stock is rallying, Enron goes on for new issues to raise capital for this.
  • The 3%:
    • It was difficult to find people to invest in the 3% also.
    • Fastow and Skilling devise a plan to set up a fund within Enron that will put up the 3% capital.
• ‘77 — Fastow’s Fund — LJM Capital
  • Fastow sets up the fund with himself as the GP.
  • AA asks to get approval from the Board:
    • Fastow convinces the Board as if he was taking a hit for the team.
      • But the fund was set up in a proper PE fund fashion — with management fees and carry — and Fastow made decent money with it.
      • The employees are on Enron’s payroll and the fund didn’t have to incur any expenses.
  • LJM Capital → Liya, Jefferey, and Mathew — Names of Fastow’s wife and children
• ‘82 — In 1999, CFO Magazine gave its Excellence Award to Fastow in the category of Capital Structure Management.
• ‘83 — All pervasive Fastow:
  • He is the CFO of EFD → Negotiates on behalf of EFD to LJM and other outsiders.
  • He is the GP of LJM → Finds good deals for LJM.
• ‘83 — The quiet disclosure:
  • Somewhere they disclose that Enron does deals with a fund run by someone from the management team.
  • When things really start to crumble down, they refer to the “quiet disclosure” made earlier.
    • The Enron management throws Fastow under the bus when press asks about the fund
    • Many people hated Fastow as he was making ridiculous amounts of money both being the CFO of EFD and GP of LJM.
    • Skilling brings this concern to Fastow’s notice.
• ‘86 — Fastow sells his interest in LJM.
  • Fastow came to an understanding with a person from EFD named Michael Kopper.
  • Earlier in 1992,
    • Enron had a fund called Joint Energy Development Investments 1(JEDI 1)
      • California State Pension Retirement Fund(CalPERS) was an investor in this.
      • Skilling wanted to do a bigger deal with CalPERS
      • CalPERS agreed on the condition that they move their capital from JEDI1 to another fund JEDI2
      • Fastow and Kopper set up a company called Chewco.
        • Chewco had to be independent but Fastow and Kopper worked for Enron.
          • Kopper was Gay — Gay marriage was not allowed in the 1990s — and was living with his partner Bill Dodson.
        • Dodson was set up as the outside investor in Chewco to buy out CalPERS’ JEDI assets against the debt secured by Enron!
      • Kopper pays checks to Liya Fastow for the money Dodson makes at Chewco.
  • Now when Fastow has to sell his interest in LJM, he sells it to Kopper.
• ‘94 — Enron expands to trading in everything possible
  • Weather, Freight, Metals etc. eventually they stumble upon the treasure:
    • Internet Bandwidth → Fibre Optic Bandwidth,
      • Enron — The Internet Company
    • The stock goes nuts!
• ‘105 — Enron Online
  • Launched in November 1999
    • Here, Enron runs the exchange and is the counterparty to most trade.
    • So?:
      • They generate Spreads
      • Get the best deals as they have access the data regarding all the transactions happening there.
• ‘109 — The beginnning of the end
  • Sep 2000:
    • Shortseller Jim Chanos makes noise.:
      • There is a lot of stuff happening.
      • What do they actually do?
      • How do they make money?
    • Jim Chanos approaches Bethany McLean — a reporter from Fortune(the same magazine that praised Enron to be the best-managed company in America).
  • March 2001:
    • Bethany McLean publishes an article titled —
      • Is Enron Overpriced?
        • It’s in a bunch of complex businesses. Its financial statements are nearly impenetrable. So why is Enron trading at such a huge multiple?
    • Side notes:
      • In Jan 2001, Enron rebranded from
        • World’s Leading Energy Company → World’s Leading Company.
      • The Company slogan used in commercials — “Ask Why?”
      • In March 2000, Enron was trading at 55x TTM Earnings.
        • For comparison:
          • Enron is mainly an energy company — The multiple for Duke Energy, a competitor, was 22x.
          • It can also be considered as a trading company — The earnings multiple of Goldman Sachs was 17x and the earnings shows up in cash.
            • Whereas Enron had awful cash flow and most of the times, the Return on Invested Capital was less than the Cost of Capital.
    • ‘116 — 17th April 2001:
      • The Earnings call:
        • Richard Grubman of High Fields Capital, a Hedge Fund that has a short position on Enron, asks a question:
          • Why does Enron, unlike all the other companies, publish only the income statement when they report earnings and publish the Balance Sheet and Cash Flow statement during the SEC filing, weeks or months later?
        • Skilling:
          • First of all, Thank you Very Much…..
            • ASSHOLE(quietly)
        • Things start to go bad:
          • Enron Stock falls from $90 in the previous year to less than $40.
      • ‘121 — August 2001:
        • Skilling Quits after being CEO for just 6 months.
  • ‘122 — The Selling Spree:
    • Skilling:
      • Around the time he quits, he sells over 500,000 shares of Enron making over $16 Million.
    • Ken Lay:
      • He had received advice from his money manager asking him to diversify:
        • He took margin loans from banks against Enron Stock.
        • He took a cash loan from Enron.
        • When the Enron stocks began to crash, he got a margin called and his Enron stocks were sold.
        • Lay sells about $300 Million worth of Enron stock.
      • Lay at Employee All-hands gets a question card asking whether to invest in Enron, he says to go all in, the stock will grow 2-3x while he was unloading his stocks in the meanwhile.
  • ‘129 — Ken Lay becomes the CEO after Skilling quits.
    • Asks Fastow for the actual debt figure.
    • Fastow comes up with $34 Billion.
      • The debt on the BS was $12.8 Billion
  • ‘120 — Sharron Watkins hints whistleblowing
  • ‘121 — 9/11
    • The next day Enron’s overnight commercial paper has no buyer
    • 9/11 being the bigger news, overshadowed this news
    • A few weeks pass by
  • ‘134 — October 12 2001
    • AA Legal sends an email to the Houston Office, sends an email
      • to start destroying any and all non-finalised documents related to Enron both physical and digital in accordance with the firm’s documents retention policy
  • ‘136 — AA downfall
    • In the middle of Oct 2002, SEC revokes the CPA License of AA.
  • ‘140 — Fastow Fired
  • ‘143 — Possibility of Merger
    • Enron goes to their competitor Dynergy to get acquired
      • Dynergy decides to acquire Enron for $8 Billion and signed the deal in early Nov 2001
      • Enron took a loan of $1 Billion from Dynergy against its Pipeline —the only thing that has some tangible value — to have some liquidity.
      • In the intervening period, AA finds out that Chewco is not independent, Kopper and Dodson are in a relationship
      • Orders to reconsolidate the financials of Chewco to Enron going back all the way to 1997
      • On November 20, 2001, Dynergy walks away from the deal
        • The news is to hit the markets at 10.30 AM
          • At 10, Ken Lay’s wife sells 500,000 Enron shares
            • The share crashes to $0.61/share from $45, 6 months before.
            • Enron goes bankrupt.
• Side note:
  • The chair of the Audit Committee of Enron before its downfall was the dean of Stanford Business School who was an accounting professor.
  • Fastow can be hired as a speaker on corporate culture
• ‘162 — May 2006
  • Ken Lay and Jeff Skilling found guilty.
• ‘168 — The settlement
  • The post-bankruptcy shell corporation of Enron has settled all the creditors
  • They decide the best option for shareholders to recover would be to sue the banks involved.
  • The banks settle for $7.2 Billion
    • Every shareholder got $6.79/share → 10x the price as on Nov 28 2001!

Slides