PDF Summary:The Smartest Guys in the Room, by Bethany McLean and Peter Elkind
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The failure of Enron in the early 2000s is one of the largest bankruptcies in US history. Shareholders were wiped out, and tens of thousands of employees left with worthless retirement accounts. This book recounts the rise and fall of Enron, and how the company constructed a massively complex accounting scandal that was doomed to failure.
Enron’s downfall is the predictable mixture of greed, poorly structured incentives, and lack of sanity checks when everyone has their fingers in the pie. In smaller ways, we too are subject to the same pulls as Enron managers and employees. The warning: If we were put into the same situation, we might not have behaved any differently.
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Its second failed venture was Enron Broadband, which tried to cash in on the late ’90s internet boom. However, the infrastructure projects and new router technology it promised never happened, and its attempt to partner with Blockbuster to build a content streaming service never landed. Nevertheless, in classic Enron fashion, it immediately claimed $110 million in profits from its Blockbuster deal before any actual revenue materialized.
Risky Business
With no profits from actual customer-facing business, Enron had to lean even more heavily on making bets in the volatile futures market. Its dominant position and proprietary information let Enron manipulate markets to move prices in its favor. Enron’s hubris in energy trading led it to launch trading ventures in a host of other commodities, such as steel, paper, lumber, metals, and bandwidth, but none of these launched to much success. To keep itself afloat, the company continued taking progressively riskier positions.
Despite all the problems bubbling under its surface, Enron stock exploded in price in 1999 and 2000, outperforming the S&P by over 200%. This is a testament to how powerfully its accounting distortions disguised its lack of real revenue. Enron was paraded as a visionary company, and to the public, Enron only ever expressed its certainty of being a juggernaut, claiming it would inevitably own 20% of every major market. After making just such an announcement in Jan 2000, Enron’s stock rose 26% in a single day.
The Bill Comes Due
Despite Enron’s best efforts to conceal its losses, by late 2000, skepticism started mounting. The dot-com bubble had fallen from its peak, and investors began to question the company’s fundamentals. In March 2001, McLean (this book’s author) published the article “Is Enron Overpriced?” in Forbes, which showed that professional analysts had no idea how Enron made money. More research came out that revealed Enron’s paucity of cash flow, and by July, even its own employees started questioning Enron’s ability to make money.
As a result, Enron’s stock price fell dramatically. All the deals it had made based on future earnings began to unwind, forcing it to book a massive debt on its balance sheet. This would downgrade Enron’s credit and trigger provisions in its debt agreements to pay back loans early with cash it didn’t have. In October 2001, Enron ran out of operating money to pay its day-to-day expenses. In November, it tried to save itself by merging with another energy company, but that failed to produce enough capital. By the end of the year, every ratings agency listed Enron stock as “junk,” the merger fell through, and the business shut down, filing for bankruptcy on December 2.
The Lessons of Enron’s Fall
Throughout the book, McLean and Elkind catalog the management and financial sins that led to Enron’s collapse even as it appeared to be an unassailable juggernaut on paper. From these the authors draw several conclusions about how to avoid such a catastrophe in the future.
Accounting Gone Wrong
The authors’ first lesson is to resist the temptation to use clever accounting tricks, even if they’re technically legal. You may eventually deceive even yourself on your business’s fundamental strengths or weaknesses. This was the most fundamental root of Enron’s problems. These tricks let Enron keep losses and debt off its balance sheets, but if they’d been disallowed, the business’s financial woes would have been apparent far sooner—perhaps soon enough to stave off bankruptcy or formulate a more sustainable business model.
As it was, Enron’s financial structure became so convoluted that no one could piece together the dependencies between Enron’s deals, and how the dominoes would fall if Enron’s stock price fell. According to McLean and Elkind, Enron’s accounting tricks were meant as short-term bridges to its future money-makers, but Enron’s read on the market and its industry was wrong. Which brings us to the second lesson: Don’t delay accountability and bet on a big future deal to save your business. Take moves to de-risk your situation from moment to moment, and take a big financial write-down earlier if you have to. Be even more wary if this is an existential risk, to avoid having to take more desperate steps later.
Bad Incentives
McLean and Elkind write that it was nearly impossible for Enron to have followed a better course of action than it did, since it routinely promoted and incentivized the wrong people for the wrong reasons. The lesson here is to hire people with the right kind of ambition—who want to grow the long-term success of the company. The people Enron promoted, on the other hand, were more invested in themselves than in the fundamental health of the company. These included Andy Fastow, who was known for creating complex financial structures rather than for exercising prudence, and Ken Lay, who was more interested in being a public figure than in managing the business properly.
Management problems are compounded if incentives and compensation reward short-term behaviors without concern for long-term value (such as prioritizing closing deals over profitability). At Enron, however, deal makers were given bonuses for a deal’s value when it closed, not on the generation of actual cash flow. Employees got bonuses for short-term stock prices, thus incentivizing bad behavior to prop up Enron’s stock price. This also prompted over-optimistic projections to Wall Street. The lesson: Make sure your compensation structures align with the fundamental goals of the business.
Turning a Blind Eye
McLean and Elkind write that during Enron’s meteoric rise and fall, many people who could have stepped in and intervened didn’t, often because they had a large personal stake in Enron’s success. The company’s shareholders didn’t look very hard as long as the stock price rose and employees got bonuses. Enron’s accountants didn’t want to lose it as a client, so they tolerated its financial practices despite internal skepticism. Bankers earned large fees from Enron’s complicated deals, even when they knew they were skirting the intent of the law. The majority of these participants suffered when Enron collapsed, so the lesson here is to correct for your own incentive bias when you analyze a situation, even when it seems to be in your favor.
Most of all, in the business world, don’t trust other people’s due diligence. Assume they’re incentivized to overlook problems, and do your own due diligence from first principles. In the case of Enron, everyone involved thought that everyone else had analyzed the company’s value already. Employees thought the board and accountants would keep bad behavior in check, and thought public markets were heavily incented to detect bad behavior. The board trusted the internal risk department, which in reality thought their only job was to sign off on deals and approve whatever the company wanted.
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