Infectious Greed by Frank Partnoy Page A

be disclosed in Enron’s financial statements. By agreeing to buy its own shares in the future, Enron—and its executives—had made a huge, secret bet on Enron stock, without using any of Enron’s precious cash.
    Unfortunately, beginning in 1997, Enron lost most of the risky bets it made, costing the firm billions of dollars. First, Enron bet on the Internet by setting up a venture-capital firm to invest in Internet-related companies, and by putting its own trading operations on an Internet platform. Second, Enron expanded its trading from natural-gas and electricity derivatives—its primary areas of expertise—to new products such as fiber-optic capacity for telecommunications and even derivatives based on the weather. Third, Enron permitted employees to create and invest in new partnerships that did business with Enron, and to use these partnerships to manipulate Enron’s financial statements. For Enron, these deals were three strikes.
    The great paradox of Enron was that, notwithstanding these awful decisions, Enron’s core business—natural-gas and electricity derivatives trading—generated enough money to offset its other failed efforts, including billions of dollars in profits during Enron’s last years. By August 1999, Enron had withdrawn entirely from oil and natural-gas production. Instead, Enron made money by exchanging billions of dollars of long-term natural-gas and electricity derivatives, in which it committed to buy or sell energy products of various types for up to ten or more years. Enron’s traders routinely took speculative positions that were much riskier than those Louis Borget and Thomas Mastroeni had taken at Enron Oil more than a decade earlier. In the developing energy markets, Enron’s traders were in basically the same position Andy Krieger had been in years earlier: there were no organized exchanges for trading long-term energy contracts, and Enron traders could make huge sums trading with relatively less sophisticated market participants and taking advantage of market inefficiencies. Enron shareholders supposedly didn’t need to worry too much about the risks of these trading operations, because Ken Lay had learned his lesson about trading risks with Enron Oil, and had committed to improved controls.
    From the managers’ perspective, the problem with Enron’s derivatives trading was that even successful trading firms were not highly valued in the market. Investors generally believed that markets were efficient, and that trading made big money only when traders took on substantial risks.
Simply put, investors didn’t value firms that took on substantial trading risks. Whereas a trading firm might have a price/earnings ratio of 10 or perhaps 15, a typical technology firm had a P/E ratio of 60 or more. To maximize its stock price, Enron executives needed to make it appear to investors that earnings were increasing because of the firm’s successes in a range of technology businesses, not because of profits from its core business of derivatives trading. To the extent Enron appeared to be a technology firm, not a trading firm, its stock price would rise, and the executives’ options would be worth more money.
    As Enron shifted to new technology businesses, while hiding its derivatives trading, the perception of the firm’s technology investments and the reality of its trading business were in intractable conflict. As a technology firm, Enron needed to borrow billions of dollars to pay for new investments and infrastructure. But as a trading firm, it needed to keep debt low, to maintain a high credit rating. This conflict eventually would tear Enron apart.
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    I n the late 1990s, Enron Capital, the company’s venture-capital fund, began investing in start-up technology companies, just as Frank Quattrone’s fund at CS First Boston had bought shares of his clients’ start-up companies before they did IPOs.