How ex-CEO Jeff Skilling's strategy grew
so complex that even his boss couldn't get a handle on it
To former Enron (ENE ) CEO Jeffrey K. Skilling,
there were two kinds of people in the world: those who got it and those who
didn't. "It" was Enron's complex strategy for minting rich profits and returns
from a trading and risk-management business built essentially on assets owned by
others. Vertically integrated behemoths like ExxonMobil Corp. (XOM ), whose balance sheet was
rich with oil reserves, gas stations, and other assets, were dinosaurs to a
contemptuous Skilling. "In the old days, people worked for the assets," Skilling
mused in an interview last January. "We've turned it around--what we've said is
the assets work for the people."
But who looks like Tyrannosaurus Rex
now? As Enron Corp. struggles to salvage something from the nation's largest
bankruptcy case, filed on Dec. 2, it's clear that the real Enron was a far cry
from the nimble "asset light" market maker that Skilling proclaimed. And the
financial maneuvering and off-balance-sheet partnerships that he and ex-Chief
Financial Officer Andrew S. Fastow perfected to remove everything from telecom
fiber to water companies from Enron's debt-heavy balance sheet helped spark the
company's implosion. "Jeff's theory was assets were bad, intellectual capital
was good," says one former senior executive. Employees readily embraced the
rhetoric, the executive says, but they "didn't understand how it was
funded."
Neither did many others. Bankers, stock analysts, auditors, and
Enron's own board failed to comprehend the risks in this heavily leveraged
trading giant. Enron's bankruptcy filings show $13.1 billion in debt for the
parent company and an additional $18.1 billion for affiliates. But that doesn't
include at least $20 billion more estimated to exist off the balance sheet.
Kenneth L. Lay, 59, who had nurtured Skilling, 48, as his successor, sparked the
first wave of panic when he revealed in an Oct. 16 conference call with analysts
that deals involving partnerships run by his CFO would knock $1.2 billion off
shareholder equity. Lay, who had been out of day-to-day management for years,
was never able to clearly explain how the partnerships worked or why anyone
shouldn't assume the worst--that they were set up to hide Enron's problems,
inflate earnings, and personally benefit the executives who managed some of
them.
That uncertainty ultimately scuttled Enron's best hope for a
rescue: its deal to be acquired by its smaller but healthier rival, Dynegy Inc.
(DYN ) Now Enron is
frantically seeking a rock-solid banking partner to help maintain some shred of
its once-mighty trading empire. Already, 4,000 Enron workers in Houston have
lost their jobs. And hundreds of creditors, from banks to telecoms to
construction companies, are trying to recover part of the billions they're
owed.
From the beginning, Lay had a vision for Enron that went far beyond
that of a traditional energy company. When Lay formed Enron from the merger of
two pipeline companies in 1985, he understood that deregulation of the business
would offer vast new opportunities. To exploit them, he turned to Skilling, then
a McKinsey & Co. consultant. Skilling was the chief nuts-and-bolts-operator
from 1997 until his departure last summer, and the architect of an increasingly
byzantine financial structure. After he abruptly quit in August, citing personal
reasons, and his right-hand financier Fastow was ousted Oct. 24, there was no
one left to explain it.
Much of the blame for Enron's collapse has
focused on the partnerships, but the seeds of its destruction were planted well
before the October surprises. According to former insiders and other sources
close to Enron, it was already on shaky financial ground from a slew of bad
investments, including overseas projects ranging from a water business in
England to a power distributor in Brazil. "You make enough billion-dollar
mistakes, and they add up," says one source close to Enron's top executives. In
June, Standard & Poor's analysts put the company on notice that its
underperforming international assets were of growing concern. But S&P, which
like BusinessWeek is a unit of The McGraw-Hill companies, ultimately
reaffirmed the credit ratings, based on Enron's apparent willingness to sell
assets and take other steps.
Behind all the analyses of Enron was the
assumption that the core energy business was thriving. It was still growing
rapidly, but margins were inevitably coming down as the market matured. "Once
that growth slowed, any weakness would start becoming more apparent," says
Standard & Poor's Corp. director Todd A. Shipman. "They were not the best at
watching their cost." Indeed, the tight risk controls that seemed to work well
in the trading business apparently didn't apply to other parts of the
company.
Skilling's answer to growing competition in energy trading was
to push Enron's innovative techniques into new arenas, everything from broadband
to metals, steel, and even advertising time and space. Skilling knew he had to
find a way to finance his big growth plans and manage the international problems
without killing the company's critical investment-grade credit rating. Without a
clever solution, trading partners would flee, or the cost of doing deals would
become insurmountable.
"HE'S HEARTBROKEN." No one ever disputed
that Skilling was clever. The Pittsburgh-born son of a sales manager for an
Illinois valve company, he took over as production director at a startup Aurora
(Ill.) TV station at age 13 when an older staffer quit and he was the only one
who knew how to operate the equipment. Skilling landed a full-tuition
scholarship to Southern Methodist University in Dallas to study engineering, but
quickly changed to business. After graduation, he went to work for a Houston
bank. The bank later went bust while Skilling was at Harvard Business School.
Skilling said that fiasco made him determined to keep strict risk controls on
Enron's trading business. He once told BusinessWeek that "I've never not
been successful in business or work, ever." Skilling now declines to comment,
but his brother Tom, a Chicago TV weatherman, says of him: "He's heartbroken
over what's going on there.... We were not raised to look on these kinds of
things absent emotion."
Enron's "intellectual capital" was Skilling's
pride and joy. He recruited more than 250 newly minted MBAs each year from the
nation's top business schools. Meteorologists and PhDs in math and economics
helped analyze and model the vast amounts of data that Enron used in its trading
operations. A forced ranking system weeded out the poor performers. "It was as
competitive internally as it was externally," says one former
executive.
It was no surprise then that Skilling would turn to a bright
young finance wizard, Fastow, to help him find capital for his rapidly expanding
empire. Boasting an MBA from Northwestern University, Fastow was recruited to
Enron in 1990 from Continental Bank, where he worked on leveraged buyouts.
Articulate, handsome, and mature beyond his years, he became Enron's CFO at age
36. In October, 1999, he earned CFO Magazine's CFO Excellence Award for
Capital Structure Management. An effusive Skilling crowed to the magazine: "We
didn't want someone stuck in the past, since the industry of yesterday is no
longer. Andy has the intelligence and the youthful exuberance to think in new
ways."
But Skilling's fondness for the buttoned-down Fastow was not
widely shared. Many colleagues considered him a prickly, even vindictive man,
prone to attacking those he didn't like in Enron's group performance reviews.
Fastow, through his attorney, declined to comment for this story. When he formed
and took a personal stake in the LJM partnerships that blew up in October, the
conflict of interest inherent in those deals only added to his colleagues'
distaste for him. Enron admits Fastow earned more than $30 million from the
partnerships. The Enron CFO wasn't any more popular on Wall Street, where
investment bankers bristled at the finance group's "we're smarter than you guys"
attitude. Indeed, that came back to haunt Enron when it needed capital
commitments to stem the liquidity crisis. "It's the sort of organization about
which people said, `Screw them. We don't really owe them anything,"' says one
investment banker.
While LJM--and Fastow's direct personal involvement
and enrichment--shocked many, the deal was just the latest version of a
financing strategy that Skilling and Fastow had used to good effect many times
since the mid-'90s to fund investments with private equity while keeping assets
and debt off the balance sheet. Keeping the debt off Enron's books depended on a
steady or rising stock price and an investment- grade credit rating. "They were
put together with good intentions to offset some risk," says S&P analyst Ron
M. Barone. "It's conceivable that it got away from them."
Did it ever.
The off-balance-sheet structures grew increasingly complex and risky, according
to insiders and others who have studied the deals. Some, with names like Osprey,
Whitewing, and Marlin, were revealed in Enron's financial filings and even rated
by the big credit-rating agencies. But almost no one seemed to have a clear
picture of Enron's total debt, what triggers might hasten repayment, or how some
of the deals could dilute shareholder equity. "No one ever sat down and added up
how many liabilities would come due if this company got downgraded," says one
lender involved with Enron. Many investors were unaware of provisions in some
deals that could essentially dump the debts back on Enron. In some cases, if
Enron's stock fell below a certain price and the credit rating dropped below
investment grade--once unimaginable--nearly $4 billion in partnership debt would
have to be covered by Enron. At the same time, the value of the assets in many
of these partnerships was dropping, making it even harder for Enron to cover the
debt.
HIGH HOPES. Skilling tried to accelerate the sale of
international assets after becoming chief operating officer in 1997, but the
efforts were arduous and time-consuming. Even as tech stocks melted down,
Skilling was determined not to scale back his grandiose broadband trading dreams
or the resulting price-to-earnings multiple of almost 60 that they helped create
for Enron's stock. At its peak in August, 2000, about a third of the stock's $90
price was attributable to expectations for growth of broadband trading,
executives estimate.
That rapidly rising stock price--up 55% in '99 and
87% in 2000--gave Skilling and Fastow a hot currency for luring investors into
their off-balance-sheet deals. They quickly became dependent on such deals to
finance their expansion efforts. "It was like crack," says a company insider.
Trouble is, Enron's stock came tumbling back to earth when market valuations
fell this year. By April, its price had fallen to about 55. And its far-flung
operational troubles were taking their own toll. In its much-hyped broadband
business, for instance, a capacity glut and financial meltdown made it hard to
find creditworthy counterparties for trading. And after spending some $1.2
billion to build and operate a fiber-optic network, Enron found itself with an
asset whose value was rapidly deteriorating. Even last year, company executives
could see the need to cut back an operation that had 1,700 employees and a cash
burn rate of $700 million a year.
"SOMETHING TO PROVE." And the
international problems weren't going away. Enron's 65% stake in the $3 billion
Dabhol power plant in India was mired in a dispute with its largest customer,
which refused to pay for electricity. Some Indian politicians have despised the
deal for years, claiming that cunning and even corrupt Enron executives cut a
deal that charged India too much for its power.
Enron's ill-fated 1998
investment in the water-services business was another drag on earnings. Many saw
the purchase of Wessex Water in England as a "consolation prize" for Rebecca P.
Mark, the hard-charging Enron executive who had negotiated the Dabhol deal and
other investments around the world. With Skilling having won out as Lay's clear
heir apparent, top executives wanted to move her out of the way, say former
insiders. A narrowly split board approved the Wessex deal, which formed the core
of Azurix Corp., to be run by Mark. But Enron was blindsided by British
regulators who slashed the rates the utility could charge. Meanwhile, Mark piled
on more high-priced water assets. "Once [Skilling] put her there, he let her go
wild," says a former executive. "And she's going to go wild because she has
something to prove." Mark spent too much on a water concession in Brazil and ran
into political obstacles. She declined to comment for this story.
But if
Azurix was a prime example of Enron's sketchy investment strategy, it also
demonstrated how the company tried to disguise its problems with financial
alchemy. To set up the company, Enron formed a partnership called the Atlantic
Water Trust, in which it held a 50% stake. That kept Wessex off Enron's balance
sheet. Enron's partner in the joint venture was Marlin Water Trust, which
consisted of institutional investors. To help attract them, Enron promised to
back up the debt with its own stock if necessary. But if Enron's credit rating
fell below investment grade and the stock fell below a certain point, Enron
could be on the hook for the partnership's $915 million in debt.
The end
for Enron came when its murky finances and less-than-forthright disclosures
spooked investors and Dynegy. The clincher came when Dynegy's bankers spent
hours sifting through a supposedly final draft of Enron's about-to-be-released
10Q--only to discover two pages of damning new numbers when the quarterly
statement was made publicly available. Debt coming due in the fourth quarter had
leapt from under $1 billion to $2.8 billion. Even worse, cash on hand--to which
Dynegy had recently contributed $1.5 billion--shrunk from $3 billion to $1.2
billion. Dynegy "had a two-hour meeting with the new treasurer of Enron, who had
been in that seat for two weeks," said a source close to the deal. "He had no
clue where the numbers came from."
RESPECT FOR ASSETS. Skilling
and Fastow face most of the wrath of reeling employees. "Someone told me
yesterday if they see Jeff Skilling on the street, they would scratch out his
eyes," says a former executive. One of Fastow's lawyers, David B. Gerger, says
his client has been the subject of death threats and anti-Semitic tirades in
Internet chat rooms. "Naturally people look for scapegoats, but it would be
wrong to scapegoat Mr. Fastow," says Gerger.
He confirms that Fastow has
hired a big gun to handle his civil litigation: David Boies's firm, which
represented the Justice Dept. in its suit against Microsoft Corp. On Dec. 5,
Milberg Weiss Bershad Hynes & Lerach filed a suit against Fastow, Skilling,
and 27 other Enron executives, saying they illegally made more than $1 billion
off stock sales before Enron tanked. And a source at the Securities &
Exchange Commission says four U.S. Attorney Offices are considering whether to
pursue criminal charges against Enron and its officers.
Would the cash
squeeze have caught up to Enron, even without Skilling's and Fastow's fancy
financing? Credit analysts still argue that the debt would have been manageable,
absent the crisis of confidence that dried up Enron's trading business and
access to the capital markets. But even they have a new respect for
old-fashioned, high-quality assets. "When things get really tough, hard assets
are the kind you can depend upon," says S&P's Shipman. That's something
Enron's whiz-kid financiers failed to appreciate.
By Wendy Zellner and Stephanie
Anderson Forest in Dallas with Emily Thornton, Peter Coy, Heather Timmons, Louis
Lavelle, and David Henry in New York, and bureau reports
