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Warren Buffett is famous for saying, “Only when the tide goes out do you discover who’s been swimming naked.” With the exception of Q1 2020, markets have been in an unprecedented 10+ year “high tide” bull market. At some point, though who can say win, the tide will come out and we will see who has been swimming naked.
Every recession tends to have its share of frauds and “zombie” companies that finally collapse. There is, perhaps, no better example than Enron.
It’s somewhat hard to understand just how big a deal this was in retrospect. In 2002, Enron was listed as the #5 company in Fortune 500’s list of largest companies. In 2019, that same #5 spot was occupied by Amazon so you can almost imagine the impact as almost akin to Amazon blowing up in 2019. This seems inconceivable and, indeed, that is the point.
What lessons can we draw from the story of the greatest blow-up of a single company in U.S. history?
The common narrative around Enron casts it as a giant fraud where the people at the top – Ken Lay (CEO), Jeff Skilling (COO then CEO) and Andy Fastow (CFO) – were knowingly misleading the many employees and investors that ended up losing vast amounts of money. That’s part of it, but, as usual, the story, I think, is more complicated than that.
It’s impossible to know what was going through Skilling, Lay and Fastow’s heads to know what is true but my impression is that it didn’t seem like a fraud to them. From the outside looking in, it seems that there is so much evidence of what was going on that they must have been willfully harming people, but I am not so sure.
It reminded me of a great story from Charlie Munger about a gallbladder surgeon in Lincoln, Nebraska that did far too much surgery which ended up resulting in unnecessary deaths.
Here, my early experience was a doctor who sent bushel baskets full of normal gallbladders down to the pathology lab in the leading hospital in Lincoln, Nebraska. And with that quality control for which community hospitals are famous, about five years after he should’ve been removed from the staff, he was.
And one of the old doctors who participated in the removal was also a family friend, and I asked him, I said, “Tell me, did he think, here’s a way for me to exercise my talents,” this guy was very skilled technically, “And make a high living by doing a few maimings and murders every year, along with some frauds?”
And he said, “Hell no, Charlie. He thought that the gallbladder was the source of all medical evil, and if you really love your patients, you couldn’t get that organ out rapidly enough.”
My sense is that Enron executives were similar to the gallbladder surgeon. They were becoming fabulously wealthy and they thought Enron was the source of all that was good and well in the world. They believed they were doing God’s work.
I think Enron was directionally correct in most of their moves. Probably the most seemingly “far out” business was the trading of broadband. However, I think that we will see this emerge as a viable business within the next decade or two, probably facilitated by the reduced transaction costs of public blockchains. As the title of McLean’s book, The Smartest Guys in the Room, suggests: the people at the head of Enron were no dummies.
So what went wrong and what can be learned?
Besides the obvious, “don’t commit massive accounting fraud,” here are 5 big lessons that I think can be drawn.
1. Poor Incentives Rule Everything Around Me
Most obviously, poor incentives were part of the problem. Early in the company’s life, Enron received the ability to use mark-to-market accounting. What that means is basically that the company executives get to make up a number for the value of any deal they did and book that in their official financial statements filed with the SEC.
So if they signed an agreement to build a power plant and provide power for thirty years and the lifetime revenue expected from that contract was $100 million, they could recognize all that revenue on day 1 even though it would be years before they saw a dime.
The result of this was that the company became very focused on doing deals that made hypothetical future money as opposed to real present money.
What one former international executive called the “fatal flaw” in the business was the compensation structure. Developers got bonuses on a project-by-project basis. The developers would calculate the present value of all the expected future cash flow from a project. This was also the model the banks used to lend money. When the project reached financial close—that is, when the banks lent money but before a single pipe was laid or foundation was poured—they were paid.
This would be something equivalent to if you ran a marketing agency and sold a customer on a 10-year contract and booked the entire value of the contract value on day 1.
This seems insane, but the thinking was that auditors would catch this. However, the incentives for the auditors were equally problematic. Auditors are paid by the company, not the investors and Enron was a great client. This led to their auditor, Arthur Anderson, bending the rules.
Here’s how another former employee describes the process [of working with auditors]: “Say you have a dog, but you need to create a duck on the financial statements. Fortunately, there are specific accounting rules for what constitutes a duck: yellow feet, white covering, orange beak. So you take the dog and paint its feet yellow and its fur white and you paste an orange plastic beak on its nose, and then you say to your accountants, ‘This is a duck! Don’t you agree that it’s a duck?’ And the accountants say, ‘Yes, according to the rules, this is a duck.’ Everybody knows that it’s a dog, not a duck, but that doesn’t matter, because you’ve met the rules for calling it a duck.”
Similarly, many of the banks loaning money to Enron were making tons of money off Enron in other parts of their business and so were willing to extend more credit than they would have otherwise.
Indeed one of the reasons that we often don’t see who is swimming naked until the tide flows out is that very few players are incentivized to stop the party – everyone involved was making a lot of money.
2. Operational Competence Matters More Than Big Ideas
Probably the biggest thing I changed my mind on reading The Smartest Guys in the Room was that a good deal of Enron’s problems just stemmed from bad operations and a lack of respect in the company’s leadership for people willing to roll up their sleeves.
Up until 1996, the company was operated by CEO Rich Kinder. Kinder was an operator, and by all accounts, a very good one – he went on to start another energy company that eventually made him over $11 billion.
Unlike CEO Ken Lay, Kinder was an utterly practical businessman who saw his job as solving problems and making sure Enron delivered on the earnings targets it promised to Wall Street.
Every year, he created a list of Enron’s top ten problems—its alligators—and spent the rest of the year working relentlessly to kill the alligators. He understood the innards of Enron’s various businesses, even the new one Skilling was building. And he commanded respect from Enron’s top executives in a way that Lay never did.
“Lay was not a good manager,” says one former executive flatly. “Kinder was a good manager.” Although they got along, there was always some underlying tension between the two men. Lay seemed to look down his nose at Kinder, according his talents limited value, and viewing him as having too many rough edges. “Ken was the visionary, and Rich was the deep-down operator, who would go beat up people,” says a former high-ranking executive.
After Kinder left though, the operational competency of Enron completely deteriorated.
Jeff Skilling, who replaced Kinder as COO after his departure in 1996, had a totally different view. Skilling started his career as a management consultant and even as he stepped into an operator’s seat, he still thought like a consultant. He was enamored, always, of the Big Idea. He had surprisingly little appreciation for how one got things done in the real world. He had zero interest in the nuts and bolts of operations.
You can’t help but wonder in the alternate universe where Kinder stayed on and played a major force in the company if Enron wouldn’t have pulled through in the end.
Operations is not sexy and rarely talked about so I think a lot of people tend to have a bias against it. To this I can only point to a company like Amazon which I would argue is an operations-focused company at its core and that seems to be working out pretty well.
3. Company Culture Matters and Is Hard
One of the common criticisms of Enron is that the culture looked like a cult.
Skilling loved to say that in trying to create a new kind of energy company. He literally said Enron was doing “the Lord’s work.” Executive Rebecca Mark struck a similar tone in talking about her business. “We are brought together with a certain amount of missionary zeal,” she told Harvard for a case study. “We are bringing a market mentality and spreading the privatization gospel in countries that desperately need this kind of thinking.”
I can imagine the Enron executive retreats involved sitting around and doing lines of cocaine off a first edition of Atlas Shrugged book then smelling their own farts.
What’s tricky about this is that it’s hard to really condemn this as a purely negative thing.
There’s a dichotomy that the most successful companies and the most fraudulent all look like cults. Accounts of Amazon’s early days don’t sound too different from Enron’s in terms of the missionary zeal that permeated the company (however, the respect or and focus on operations at Amazon was the complete opposite of Enron’s disregard).
If the distinction between a cult and a religion is popularity, the difference between a company culture that is judged by outsiders as successful and a company culture that is judged as a failure is often just market cap rather than some other qualitative features.
So, it’s sort of hard to condemn the cultiness. Indeed, the Enron’s culture was widely touted as a great benefit when the price was going up.
More problematically and easier to condemn, there was certainly a crony culture component. As a boss, Skilling was intensely loyal to his inner circle, and those who came through for him in the early 1990s could later do no wrong. He gave them mind-blowing piles of cash and stock options.
A lot of ink has been spilled about how to build a company culture, but I think a pretty simple version is just to think of it in Pavlovian terms: you get more of what gets rewarded and less of what gets punished.
If sucking up to the boss and playing politics gets you promoted, then eventually everyone that stays at the company will be the type of person that sucks up to the boss and plays politics. If keeping your head down and getting stuff done is rewarded, then you’ll end up with those people. Enron was very much the former, a sycophantic culture rather than a meritocratic one.
4. Reality Has a Surprising Amount of Detail
Part of Skilling’s theory was that if you hired smart people, it didn’t matter whether they had any experience. In fact, it didn’t even matter if they stayed in one job long enough to learn it. Job assignments at Enron under Skilling could change from month to month. The company started and folded new businesses—and reorganized old ones—constantly.
This is a version of what James C Scott calls high modernism. It is the notion that the world is made up of legible, platonic forms. If you just get a bunch of smart people in the room with a spreadsheet then you can figure anything out.
The truth, as Enron discovered, is that the world is messy and reality has a surprising amount of detail. Instead of relying on pure intellectual “smarts”, domain knowledge is incredibly nuanced and valuable.
There is very little about understanding how to build oil pipelines that translates into how to trade natural gas, despite some surface similarity of them both being energy-related.
One of my business maxims is to never go more than one step away from your existing business or skill set. There is always this tendency to think that some other business is so much easier and more profitable than yours. This is basically never the case.
Markets aren’t perfectly efficient but they are pretty darn efficient and if there is some very profitable, easy business you can bet it will get crowded pretty durn fast.
5. Every Single Company Has a Surprising Amount of Detail
Many people who work in business get interested in public market stock picking.
The Warren Buffett line of thinking is simple and persuasive: buying a stock is just buying a fractional piece of a business. So, if you understand business then you will be good at buying stocks.
Entrepreneurs or other business people often seem to have a certain cognitive dissonance that they recognize the incredibly subtlety and complexity of what drives their business but forget that every other business has just the same level of detail and nuance.
Many executives running a 20 person business can talk for hours about the subtle complexities and nuances of their business and how no one else understands it. And, indeed, they are pretty much always right about this and it takes most people 12-24 months working in a business to really get a good understanding.
And yet this same person looks at a 20,000 business spanning multiple continents and divisions and thinks that in a couple of hours a week of research that they can understand the company’s prospects better than the market. Uh, good luck with that.
Enron is a helpful reminder of this – many of the most sophisticated investors in the world that have teams of 160 IQ analysts looked at Enron and concluded it was fine. On the surface, Enron said all the right things about their ability to manage the risks of their business and the investing public bought it hook line and sinker.
We rely heavily on Enron’s risk-management ability,” Todd Shipman, an analyst with the Standard & Poor’s credit-rating agency, told Fortune. “You can’t overemphasize how important that is. It’s the underpinning to everything. . . . It gives you a nice, warm, fuzzy feeling. . . . Even though they’re taking more risk, their market presence and risk-management skills allow them to get away with it. . . . Enron has such extraordinary risk-management capabilities that we look at them differently.”
The reality of how the risk management department worked, as witnessed by people there day-to-day, was vastly different.
The part about RAC, [the risk management department], being a serious force within the company, able to stop bad deals dead in their tracks: that part wasn’t even close to the truth. And everyone in the company knew it.
“RAC was a hurdle, a speed bump, but not an obstacle,” says a former Enron managing director. “If a deal had overwhelming commercial support, it got done. I treated them like dogs, and they couldn’t do anything about me. The process was there, sure, but the support wasn’t. If RAC had complained about me and I got paid $100,000 less bonus, I would have changed. Never happened. I told my guys to fuck ’em.”
A former RAC vice president agrees: “We didn’t approve shit,” he says.
According to RAC employees, the deal makers were often allowed to set absurdly optimistic assumptions for the complex models that spat out the likelihood of various outcomes for a transaction.
So the “extraordinary risk-management capabilities” that all the analysts that were studying Enron full time thought existed was literally the salespeople making up numbers of how much they thought the deal was worth and then booking that as revenue.
It’s easy to fault the analysts for this (and to the point of poor incentives – there is very little incentive for analysts to be bearish and a lot of incentive to be bullish so they tend to be bullish), but these sorts of details and dynamics are incredibly difficult to understand if you are not immersed in the business full time.
For investors then, I think the main lessons to be drawn from Enron are”
- Have some Hubris about your ability to pick individual securities and utilize diversification.
- Gaine a deep understanding of the internal incentives and culture of a company.
- Value operational competence over a compelling vision (though you want both).
For operators, I think the main lessons are:
- Understand the incentives in your company and what the potential 2nd and 3rd order consequences of them may be.
- Create a culture of operations-focused execution rather than “big idea brainstorming”.
- Focus on your core business and expand slowly to closely related businesses rather than making huge pivots.
Last Updated on July 6, 2021 by Taylor Pearson