Enron Raptors: The Dirty SPE Scheme Falls Apart

This article is an excerpt from the Shortform summary of "The Smartest Guys in the Room" by Bethany McLean and Peter Elkind. Shortform has the world's best summaries of books you should be reading.

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What were the Enron Raptors? Did they have anything to do with the downfall of Enron?

Enron Raptors were a type of SPE (special purpose entity). In a complicated process, Enron Raptors would buy underperforming Enron assets, creating a positive loop that looked good for Enron. Read more about Enron Raptors below, and why they didn’t work.

Enron Raptors: SPEs, Again

Despite Enron’s best efforts to conceal their losses, by late 2000, skepticism started mounting. The dotcom bubble had fallen from its peak, and company fundamentals were being questioned.

On December 2000, Jeff Skilling was announced to succeed Ken Lay as CEO, taking place in February. This was already planned well in advance – his contract had a trigger – if he weren’t named CEO by end of 2000, he could leave and be paid over $20MM.

Enron embarked on new schemes to lock in gains while avoiding booking losses.

In 2000, SPEs called Enron Raptors would buy underperforming Enron assets. If the assets continued to decline in value, the Raptors would pay Enron, thus giving Enron a gain that would offset the loss.

In reality, these transactions were grounded on Enron stock. This led to positive feedback loops:

An increasing Enron stock price would allow further ability to keep losses from public view, which would in turn increase stock price.
However, if Enron shares fell, the Raptors would be less able to pay back Enron, which would cause further share cratering.

By late 2000, the assets in SPEs declined in value, and Enron needed its stock to continue climbing to cover losses. Because the stock price stalled, Enron would have to declare losses, which defeated the purpose of the vehicles. An emergency solution cross-collateralized the four Raptors, allowing healthy vehicles to support sick ones.

Concerns Mount

There started to be mounting external and internal concern about the reality of the losses after the Enron Raptors scheme.

By spring 2000, the dotcom bull market was over. Analysts were now questioning business plans and looking for fundamental cashflow and revenue. Momentum investors were selling instead of buying.

Stories ran about how energy companies used mark-to-market accounting, and no outsider knew the assumptions they used to book earnings.
Short sellers were gaining credibility and wielding larger sticks. Investor Chanos was skeptical Enron’s broadband business could be doing so well when the rest of the industry was getting slaughtered.

More negative signs cast doubt on Enron:

Unclear disclosures about dealings with a related party
Lay and Skilling were selling shares
Debt was climbing when Enron was supposed to be profitable
No one could explain how Enron made money
Redeployments/layoffs were happening at the broadband business.
In April 2001, on an earnings call, Skilling famously called a skeptical short-seller an “asshole” for saying Enron was the only firm who couldn’t release a balance sheet or cashflow statement. Said a stunned analyst, “any CEO should be able to handle the hardest of questions from the most aggressive of shorts.”

In February 2001, an Enron accountant, Wanda Curry, saw that EES (the retail division) had over-optimistic valuations of deals and bad trades that, on inspection, actually put the division in the red by $500MM.

Enron’s solution was to merge the trading losses with the wholesale traders’ profits, eking out a mild profit in total. However, Enron didn’t properly report the combination of the two.

In March 2001, this book’s author (Bethany McLean) published a landmark article, “Is Enron Overpriced”, which showed the public that professional analysts had no idea how Enron made money. The Enron Raptors helped reveal this.

In May 2001, a researcher wrote a paper deconstructing Enron’s cash flow. Of Enron’s reported $4.8 billion in operating cash flow, $2 billion was from customer deposits (which would be paid back if energy prices fell); $1 billion was from a onetime sale of inventory, and another $1.5 billion was the result of prepay. This showed a dramatically different story than the idea that Enron’s cash flow was stable and recurring.

In July 2001, internal concern over LJM’s dealings with Enron prompted Fastow to sell his interest in the LJM funds to Michael Kopper, who left Enron to take over.

Even employees started questioning Skilling publicly: “You say we’re going to make half a billion a year. What’s your strategy?” Skilling replied: “that’s what you guys are for.”

The Dominoes Start to Fall

As a result, Enron’s stock price fell dramatically: from a height of $82 after their investor conference in Jan 2001, down to $68.50 in Feb 28 and $55 in March 21.

Even in July 2001, when Skilling announced Enron had beaten earnings per share, share prices didn’t budge. The market had become too skeptical.

In August 2001, Skilling resigned as CEO.

Reasons: The pressures of maintaining a rosy public facade while dealing with internal turmoil ate at him. For someone obsessed with the stock price, its decline represented a personal failure. He hated getting his hands dirty, and his job was now about fixing problems.
Skilling’s resignation fueled suspicion that something was wrong inside Enron.

Ken Lay returned to a hero’s welcome, like the company’s savior. But having been a non-operator for years, he wasn’t helpful.

He announced a onetime options grant of 5% of salary. The stock was at the bottom of the cycle, and “we want you to enjoy the ride back up.” The stock was at $38.
He announced Greg Whalley, head of wholesale trading, as COO. Whalley quickly dug in and pressed for clear financials.
Tidbit: Ken Lay himself was paying off creditors. Despite having a net worth at its peak in the 9 digits, he had “diversified” by taking out loans with Enron stock as collateral, and with terms to face margin calls at lower Enron stock prices. The loans were then put into ill-fated investments.

Here was the nightmare dominoes scenario – where all the intricately connected layers would fail because of their dependencies:

If Enron missed earnings, its stock price would fall.
If its stock fell, its SPE deals (including Enron Raptors) would unwind (since they were predicated on Enron stock prices rising), causing Enron to have to book massive debt on its balance sheet or issue new shares. This would cause further stock price falls.
This increased debt would cause a downgrade of Enron’s creditworthiness.
This would trigger provisions in Enron’s debt agreements to pay back loans early, and trading partners to demand cash collateral.
Since Enron didn’t actually have cash, its ability to pay would progressively worsen, causing it to go bankrupt.
Senior managers predicted the likelihood of this at less than 25%.

Enron Raptors were part of a precarious game Enron played. The Enron Raptors were also an important part of why analysts finally noticed the issues with Enron.

Enron Raptors: The Dirty SPE Scheme Falls Apart