The Firm: The Story of McKinsey and Its Secret Influence on American Business

by Duff McDonald

  John Sawhill, who was head of the firm’s energy practice at the time, asked Skilling to help McKinsey client Enron, the product of a merger between Houston Natural Gas and Omaha-based InterNorth, decide whether it ought to move its headquarters from Omaha to Houston. Skilling refused to work on the project, knowing that whatever he recommended would make him an enemy of one faction within the company. “How do you win this one, John? How do you decide this? I want nothing to do with it,” he said.5

  A typical young McKinseyite would never be able to get away with turning down an assignment. But Skilling was anything but typical. He was already a star at the firm, and Sawhill didn’t make an issue of it, instead pushing the firm’s Washington office to help Enron make the call. (Houston was the final answer.) And Skilling, who eventually took Sawhill’s place as head of the firm’s worldwide energy practice, continued to advise Enron; his work included an assignment in the late 1980s on how to use derivative contracts to “smooth” the energy company’s earnings.6

  The singular insight of Skilling’s McKinsey career was the one that launched Enron into the stratosphere. As the natural gas industry grappled with deregulation and its attendant uncertainty, the largest players moved from predominantly long-term contracts to using the so-called spot market for 75 percent of gas trading. The change left both buyers and sellers vulnerable to rapid swings in the price of gas. Skilling suggested Enron step into the breach, creating a “gas bank” to buy gas from producers and sell it to customers, capturing the spread between the two. Before Skilling’s revelation, Enron had been a humdrum operator of gas pipelines. With the gas bank, he had helped turn it into a financial wheeler-dealer.7

  “The concept was pure intellectually,” Skilling later said, sounding very McKinsey-like. When he presented the idea to Enron’s top twenty-five executives in 1987, he used just a single slide—also very McKinsey-like.8 In large part due to his success with Enron, Skilling was elected a director at McKinsey in the summer of 1989. That December, Enron president Rich Kinder asked him to join Enron. At first he demurred, but he later reconsidered. This was his chance to go big, to show he could do, and not just tell. He jumped ship and had soon replaced Kinder as president of Enron.

  Enron chief financial officer Andy Fastow was flabbergasted at the move. “You walked away from McKinsey?” he asked Skilling. “I did,” the latter replied. “Why?” “Hey,” Skilling replied. “How often do you get a chance to change the world?”9

  Skilling turned Enron into a new economy darling that darted from market to market with blazing speed. It became the most celebrated company in the country, with revenues topping $60 billion in 2000. As Bethany McLean and Peter Elkind pointed out in The Smartest Guys in the Room, Enron was beloved by all: “Fortune magazine named it ‘America’s most innovative company’ six years running. Washington luminaries like Henry Kissinger and James Baker were on its lobbying payroll. Nobel Laureate Nelson Mandela came to Houston to receive the Enron Prize. The president of the United States called Enron chairman Kenneth Lay ‘Kenny Boy.’ ”10

  Skilling took the McKinsey ethos with him to Enron. A description of him by McLean and Elkind reads like that of a typical McKinseyite: “He could process information and conceptualize new ideas with blazing speed. He could instantly simplify highly complex issues into a sparkling, compelling image. And he presented his ideas with a certainty that bordered on arrogance and brooked no dissent. He used his brainpower not just to persuade, but to intimidate. . . . But he also had qualities that were disastrous for someone running a big company. For all his brilliance, Skilling had dangerous blind spots. His management skills were appalling, in large part because he didn’t really understand people. He expected people to behave according to the imperatives of pure intellectual logic, but of course nobody does that. . . . He was often too slow—even unwilling—to recognize when the reality didn’t match the theory. Over time his arrogance hardened, and he became so sure that he was the smartest guy in the room that anyone who disagreed with him was summarily dismissed as just not bright enough to ‘get it.’ ”11

  Skilling paid homage to his former employer on countless occasions, including one time when he decried Wall Street’s value system to BusinessWeek. “Given the financial churning many investment banks do, I’m not sure I’d feel real good about it when I went home at night,” he said. “[McKinsey] has its values in the right place. You feel like you’re doing God’s work when you’re there.”12 He spoke of Enron in similarly reverential terms. “If you walk the halls here, people have a mission,” he said. “The mission is we’re on the side of angels. We’re taking on the entrenched monopolies. In every business we’ve been in, we’re the good guys.”13 He also took time out of an extremely busy schedule to have more than twenty meetings with McKinsey partners Ron Hulme and Suzanne Nimocks between May 2000 and December 2001—this while also sitting for nearly twenty photo shoots for publications as varied as Industry Standard and Architectural Digest.14

  Skilling had spent twenty-one years at McKinsey. Like many who’d left before him, he kept the connection strong. He tried unsuccessfully to lure McKinsey consultant Ron Hulme to come join him as Enron’s chief financial officer, though that hardly damaged his relationship with his old firm. Enron remained the Houston office’s most important—and lucrative—client. Hulme, who took over Skilling’s role heading the consulting firm’s energy practice, became a star in his own right. “Despite his young age, [Hulme] had a tremendously high standing and power that derived from the Enron relationship,” a former McKinseyite told BusinessWeek in 2002.15 At one point, his name was bandied about as a potential successor to Gupta.

  McKinsey didn’t just cash Enron’s checks; it fully believed in the cult and helped spread the gospel, celebrating the company’s “petropreneurs.” As John Byrne pointed out in BusinessWeek, McKinsey was knee-deep with Enron in pretty much everything that made the firm distinctive, “[stamping its] imprimatur on many of Enron’s strategies and practices, helping to position the energy giant as a corporate innovator worthy of emulation.”16

  In just six years, the McKinsey Quarterly mentioned Enron 127 times. Here’s how much McKinsey loved Enron.

  One: The firm endorsed Enron’s asset-light strategy. In a 1997 edition of the Quarterly, consultants wrote that “Enron was not distinctive at building and operating power stations, but it didn’t matter; these skills could be contracted out. Rather, it was good at negotiating contracts, financing, and government guarantee—precisely the skills that distinguished successful players.”

  Two: The firm endorsed Enron’s “loose-tight” culture. Or, more precisely, McKinsey endorsed Enron’s use of a term that came straight out of In Search of Excellence. In a 1998 Quarterly, the consultants peripherally praised Enron’s culture of “[allowing executives] to make decisions without seeking constant approval from above; a clear link between daily activities and business results (even if not a P&L); something new to work on as often as possible.”

  Three: The firm endorsed Enron’s use of off–balance-sheet financing. In that same 1997 Quarterly, the consultants wrote that “the deployment of off–balance-sheet funds using institutional investment money fostered [Enron’s] securitization skills and granted it access to capital at below the hurdle rates of major oil companies.” McKinsey heavyweight Lowell Bryan—godfather of the firm’s financial institutions practice—put it another way: “Securitization’s potential is great because it removes capital and balance sheets as constraints on growth.”

  Four: The firm endorsed Enron’s approach to “atomization.” In a 2001 Quarterly, the consultants wrote: “Enron has built a reputation as one of the world’s most innovative companies by attacking and atomizing traditional industry structures—first in natural gas and later in such diverse businesses as electric power, Internet bandwidth, and pulp and paper. In each case, Enron focused on the business sliver of intermediation while avoiding the incumbency problems created by a large asset base and vert
ical integration.”

  As critics of Enron emerged and started to question the firm’s accounting methods, McKinsey issued ever more ringing endorsements. As far as McKinsey was concerned, “[deal-making] skills have become more important than scale or scope, and strategic insight and foresight more important than structural position.”17 It’s a statement that is baffling in its implication—that what matters is not what you actually are, but what you want to be. At Enron, the concept had finally trumped reality. This was nothing short of a McKinsey consultant’s dream result.

  Nearly all of Enron’s allegedly innovative approaches ended up playing a significant role in the firm’s collapse. Being asset-light left Enron with unsustainable debts. Being loose-tight excused a laissez-faire culture in which executives acted without oversight. Off-balance-sheet financing turned out to be a way to deceive investors and the IRS.

  Enron was a transformational player in the natural gas industry. It was successful because it was a first mover in the newly deregulated field of energy trading. When Enron tried to replicate that success in other markets—broadband, weather, even advertising—it failed utterly, despite cheerleading from McKinsey. (At one point the consultants predicted that Enron would control 50 percent of the video-on-demand market.)18

  Enron used a technique similar to McKinsey’s “ ‘up-or-out”—except under Skilling it was “rank and yank.” The churn of executives in the company left it with little of the accountability that comes with continuity. Skilling’s McKinsey-like lack of interest in actual execution also meant that no one at the top was focused on whether the firm could actually pull off its grand visions as it lurched from one new business idea to the next. What’s more, a 2004 survey of human resource professionals reported that “forced ranking” had resulted in “lower production, skepticism, damaged morale, and reduced collaboration.” Up-or-out might work for McKinsey, but the implicit social Darwinism sowed chaos both at Enron and elsewhere.19

  “It was a given, of course, that [Skilling] was brilliant and that he could get to the essence of an issue faster than anybody,” wrote McLean and Elkind in Smartest Guys. “But once he felt he understood the strategy, he lost interest. Execution bored him. ‘Just do it!’ he’d tell his subordinates with a dismissive wave of his hand. ‘Just get it done!’ The details were irrelevant.”

  Under Skilling, Enron even departed from lessons McKinsey had itself taught other clients long before. For example, Enron followed the unwise practice of paying bonuses based on forecasted profits, not actual cash flows, a system that posed a problem remarkably similar to the R&D issues Gluck and his colleagues had solved at Northern Electric years earlier. In short: You can forecast anything. Delivering actual results is a different story. The emphasis on forecasts also neutralized Enron’s so-called risk-management group, which became a shrinking violet in the face of ever more outrageous estimates. The utter failure of the risk managers stood as the most egregious of its type for nearly a decade, until Wall Street’s own risk-management divisions showed their inadequacy in the face of the profits offered by the real estate boom—another crisis, it should be noted, that was in large part due to the obfuscations of off–balance-sheet financing and securitization.

  One former McKinsey partner remembered attending a partners conference in Barcelona on October 11, 2000. Two things stuck out in his mind. The first was that ex-McKinseyite Lukas Muhlemann, who by that point was CEO of Credit Suisse, stayed only for cocktails before jetting out again. The idea that he was too important to eat dinner with his former colleagues enraged them. The other thing: Jeff Skilling’s presentation on how he had turned an energy company into a financial company. “All anyone was talking about was how dazzling Skilling was,” said the ex-partner. “The analytics he showed! Everyone was having little orgasms in the elevator!”

  Enron’s success was McKinsey’s success. More precisely, Skilling’s success was McKinsey’s success. By the end, Enron was spending upwards of $750 million a year on a combination of consultants and other professional services.20 It was as if the consultants had burrowed inside the place and were ripping its guts out. The shock came only at the very end, and it was revealed that there were no guts left. What had once been a powerful and real competitor in the natural gas business had been turned into little more than a facade.

  Ultimately, it was Skilling’s disavowal of hard assets in favor of trading that doomed the enterprise. “All that trading and marketing is wonderful,” said a former Enron executive, “but if you’re going to be in the energy business, sooner or later you need to be turning on a generator or producing gas or oil.” What Skilling had created was a trading firm. And because his marketing had also been top-shelf, the pressures became immense. Goldman Sachs, the longtime darling of the financial services community, usually traded for sixteen or seventeen times earnings. At the height of its glory—and despite being in pretty much the same business as Goldman—Enron was trading for sixty times earnings. When the opportunities in gas trading ran out and the new endeavors in broadband and weather failed to pan out, there were two choices for Enron: Dial back the market’s expectations or do something to keep the fiction going. Skilling and Enron CFO Andy Fastow chose the latter route and engaged in outright accounting fraud.

  The end came swiftly and brutally. In early 2001 short-seller Jim Chanos started sounding the alarm that something was amiss with Enron’s accounting. The Wall Street Journal was soon on the case. After years of praising the company, Fortune jumped in with its own skeptical analysis. Skilling suddenly retired that August. And then the roof fell in, as much of the company’s financial success was revealed as nothing more than accounting fraud of the most basic kind. Using so-called special purpose vehicles, the company had pretended to be far less indebted than it actually was. Enron’s balance sheet at the end showed debts of $13 billion. Add in the off-balance-sheet liabilities, though, and the total nearly tripled, to $38 billion. The collapse of the firm was the largest bankruptcy in U.S. history at the time. And McKinsey’s Houston office saw its revenues fall off a cliff.

  • • •

  The whole episode raised three very important questions. First, did McKinsey stray from its core values by effectively hyping Enron during the fraudulent rise? Second, was the firm liable for any of Enron’s misdeeds? And third, would other clients care? The short answers: Yes, No, and No.

  “Did we push hard enough?” asked one former partner. “There is evidence from McKinsey partners saying, ‘This is not going right.’ Did McKinsey stop it? No. Writing memos is not enough. So it did damage us. On the other hand, the liquidation value of Enron was still $12 billion. It was a great business that just got out of hand.”

  BusinessWeek went so far as to suggest that McKinsey had deliberately turned a “blind eye to signs of trouble” in order to perpetuate the lucrative relationship.21 It was also perpetuating McKinsey’s self-image as the cutting-edge intellectuals of the corporate suite. McKinsey partner Richard Foster’s 2001 book, Creative Destruction, was nothing short of a big wet kiss to Enron’s way of doing business. It was also a mere repackaging of economist Joseph Schumpeter’s own work on the strengths of capitalism a half century before, but with a crucial twist: It was celebrating the worst instincts of laissez-faire capitalism, not the best.

  The War for Talent, a 2001 book by McKinsey consultants Ed Michaels, Helen Handfield-Jones, and Beth Axelrod (now head of HR at eBay), might have been an even wetter kiss for Enron than Creative Destruction. The book set off a worldwide craze for a raft of flimsy ideas, many of which were based on simple observation of Skilling’s management style and practices, a large part of which had come out of McKinsey itself. (This was indeed the snake eating its own tail.)

  An important part of the whole talent mind-set was the dissemination of McKinsey’s cutthroat personnel policy to any companies that wanted to claim they cared about winning. Its advice: Identify your bottom 10 percent or 25 percent or 33 percent, and get rid of them as soon
as possible. This was up-or-out writ large, the extension of a philosophy that had worked well enough for McKinsey into other companies in which such a system might not be such a great idea. It also provided convenient cover for layoffs, as a ready-made explanation for massive turnover even in the best of times. It simultaneously provided a quasi-academic foundation for defending the absurd levels of compensation the top 1 percent was paying itself for doing the same thing it had been doing all along.

  The War for Talent was perhaps the most dangerous book to come out of McKinsey other than Race for the World—by Lowell Bryan, Jane Fraser, Jeremy Oppenheim, and Wilheim Rall—a manifesto for deregulation and a celebration of the likes of Citigroup that helped usher in a large financial crisis. It also contained, as McKinsey had long been wont to propagate, a regurgitation of the firm’s own internal structure recast as the business model of the future. Mimic McKinsey, the inevitable conclusion went, and you would be celebrated, just as Enron was.

  During McKinsey’s nearly eighteen-year relationship with Enron, the consultants worked on over twenty different projects, including formulating pricing and strategy for new products, advising on M&A, and doing preparatory work on entering new markets, including Enron’s much-vaunted broadband trading platform.22 One former Enron executive later remarked that the consultants were “all over the place.” At any point, there were between five and twenty McKinsey consultants working out of Enron’s offices, and Richard Foster, a director, had attended six of the company’s board meetings in the year leading up to its collapse.23 In those meetings, Andy Fastow had laid out the off–balance-sheet arrangements that eventually bankrupted Enron. That same executive claimed he was “ordered” to check with McKinsey when making an investment in a gas transmission business, but McKinsey denied any role in actual decision making or that it acted as a review body of any sort.24