The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron by Bethany McLean
My rating: 4 of 5 stars

Great Expectations

This is the definitive case history of the demise of the most admired company in America. What it demonstrates is that the failure of Enron, although facilitated by the greed and moral indifference that is typical in corporate life, was at root down to its excellence in precisely that set of skills for which it was most admired: corporate finance.

Jeff Skilling, a former McKinsey colleague of mine, was the 'vector' by which the infectious scourge of financial theory found its way into the company and eventually killed it. Corporate finance is what passed, and still passes, for intelligent business practice and spread like a cancer to every level of the company. Widespread corporate organ failure was triggered by an almost insignificant mutation in a rather insignificant limb.

What McLean and Elkins show is that Skilling, who received top honours from the Harvard Business School and rose to an exceptionally young partnership at McKinsey, had a devotion to corporate finance of religious intensity. He established it as the pervasive ethos of the company. He also sold this ethos to the people who provided finance to Enron, the investment banks, analysts and advisors who set the fashion for business rationality.

Skilling did not have to sell very hard. He merely had to push on the door that had been unlocked by years of academic indoctrination of the young MBA's in all these institutions who were eager to show just how savvy they were in the theory of corporate finance. On the face of it this theory is as esoteric as quantum mechanics. But this is of course is part of its charm: only the insiders, the experts, can understand it. Those who can't can be ignored as relics of business-past.

But in truth the modern theory of finance is based on a very simple, and as it turns out, a very stupid idea: value is prospective. That is, it doesn't have to do with whats in the bank, or in the warehouse, or, in general, what's been achieved; those things are matters for the stodgy accountants. Value is a function of expectations, of what is expected to come about because of our business plans. Specifically its about the cash flows that are anticipated far into the future.

The fly in this business ointment, of course, is whose expectations count and how reliable are they? It doesn't take much thought to realise that the only people who have the capacity to formulate expectations are the managers of the company. It is they, after all, who make the decisions and have access to the detailed information on things like operating costs and likely sales, etc. All the managers have to do is convince the banks and analysts and advisors that their numbers are credible. At this Skilling was a pro. They bought it.

But what goes around comes around. If you pay people down the line based on the expected value of what they do, they too hold most of the cards. And the house of cards grows and grows. Estimates of expected value expand, as it were, to meet the internal as well as external market demand.

The maximum level of these expectations was never touched simply because the finance director made a small error. In order to be able to get expected values into the accounts, the company set up a complex network of shell companies which became co-investors in Enron businesses. As long as these shell companies were less than 50% owned by Enron they didn't appear in the company's consolidated accounts. More importantly Enron could sell these companies parts of Enron investments at prices based on Enron's valuations. These sales could enter the audited accounts. Hey presto, corporate finance is baptised by accounting.

So far everything is legally kosher. But the FD got a little careless. One of the hundreds of shell companies technically controlled by friendly investment banks and their customers, was owned at slightly more than 50% by Enron. This is the snowflake that caused the avalanche of disaster. At one go the entire facade of valuation based on management expectations became visible and all came tumbling down.

Without doubt, Skilling had created the boldest experiment in corporate finance ever seen. Until it was seen to be what it actually was, an irrational game of chicken which could only have one outcome. Surprisingly, as far as I am aware neither McLean nor Elkind, despite their follow-on book on the crash of 2008, have generalised their analysis to a full-blown critique of corporate finance. We live in hope.

Postscript: Arguably the most influential populariser of corporate financial theory is Al Rappaport, a former professor of business at Northwestern University. His book, Creating Shareholder Value, is still in print after more than three decades (https://www.goodreads.com/book/show/1...). Rappaport and several others started a financial consulting firm to commercialise his ideas. This firm was bought out by myself and two other partners in the mid-90’s. To my great and lasting shame I helped peddle these daft ideas to a number of banks and commercial companies. Despite the growing evidence of their destructiveness, my former partners maintain a virtually religious devotion to them. This is proof to me that human beings can rationalise even the most damaging and stupid behaviour.

View all my reviews