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Category: CAPITAL STRUCTURE MANAGEMENT How Enron financed its amazing transformation from pipelines to piping hot.
Russ Banham, CFO Magazine
October 1, 1999
When Andrew S. Fastow, the 37-year-old CFO of Enron Corp., boasts that "our story is one of a kind," he's not kidding. In just 14 years, Enron has grown from a heavily regulated domestic natural-gas pipeline business to a fully integrated global energy company with thriving activities in natural gas, electricity, infrastructure development, marketing and trading, energy financing, and risk management. And much of that growth has been fueled by unique financing techniques pioneered by Fastow.
"When I came here in 1990, Enron was a company with a $3.5 billion market capitalization," says Fastow. "Today, we're around $35 billion, and that's without issuing a whole lot of equity. We've increased shareholder value, grown the balance sheet, maintained a stable outlook from the rating agencies, and achieved a low cost of capital."
In fact, when energy stock analysts look for paradigm companies to vaunt, they point resolutely in the direction of Houston-based Enron, with $31 billion in revenues last year. And when they seek to explain how Enron has remade itself so completely, they point to "remarkably innovative financing." Says Ted A. Izatt, senior vice president at Lehman Brothers Inc. in New York: "Thanks to Andy Fastow, Enron has been able to develop all these different businesses, which require huge amounts of capital, without diluting the stock price or deteriorating its credit quality-- both of which actually have gone up. He has invented a groundbreaking strategy."
Fastow's expert balancing act, in fact, has earned him this year's CFO Excellence Award for Capital Structure Management. "We needed someone to rethink the entire financing structure at Enron from soup to nuts," says Jeffrey K. Skilling, Enron president and chief operating officer. "We didn't want someone stuck in the past, since the industry of yesterday is no longer. Andy has the intelligence and the youthful exuberance to think in new ways. He deserves every accolade tossed his way."
Enron's challenge in entering multiple deregulating energy markets has been to secure the necessary capital without sacrificing its credit rating. And that challenge was particularly apparent in 1997 when the company's debt load, as a result of enormous growth, was higher than was consistent with its BBB+ credit rating. "Retaining a high investment grade rating was critical to the success of our energy franchises," Skilling says. "If we were downgraded, we could lose critical market share in North America."
One option was to post significant collateral to continue doing deals, anathema to both Skilling and CEO Kenneth L. Lay. So instead Fastow, who at the time was the company's senior vice president of finance, reorganized finance into an internal capital-raising machine. "We transformed finance into a merchant organization, one engaged in the intermediation of both commodity and capital risk positions," he recalls, adding "Essentially, we would buy and sell risk positions."
Such a transformation, however, required a team of finance personnel with the skill sets to develop capital structuring and structured finance deals. Consequently, Fastow tripled the staffing devoted to the company's financing activities to more than 100, culling a diverse group of financial experts from commercial banking, investment banking, corporate finance, and the rating agencies. Their mandate: sell capital risk so it becomes a competitive advantage.
The upside potential of such an endeavor--for both the company and the team--were huge. The natural-gas and electricity industry, in all practical respects, is the largest and fastest- growing industry in the world today, in terms of both capital investment and revenue. But to launch an energy trading operation required a reservoir of capital just to get started. And therein lay the rub: Conventional financing techniques would jeopardize its BBB+ rating from Standard & Poor's and other agencies, raising the cost of capital.
"We couldn't just issue equity and dilute shareholders in the near term," he says. "On the other hand, we couldn't jeopardize our rating by issuing debt, which would raise the cost of capital and hinder our energy trading operations." Plus, he says, "there was a one- to-three-year lag time" before Enron would receive any cash flow from its investments.
"Here we were, this big company by any standard," he says, "with $31 billion of assets on the balance sheet and $50 million off the balance sheet, yet we were anemic relative to the opportunities."
Walking the Tightrope
To solve the dilemma, Fastow first decided to capture the attention of the rating agencies, sending a message that Enron placed a high importance on its credit rating. The way he would do that, he planned, was to issue equity. Two months after he was named CFO in March 1998, Fastow delivered the strategy to Enron's senior management. At first, they were disinclined. "Historically, we had been a company that traded on an earnings-per-share multiple," Skilling notes. "Frankly, we were reluctant to dilute the share price. But Andy convinced us--and, ultimately, the market-- that issuing equity would be accretive to shareholders if a comprehensive road show was organized."
Subsequently, Enron issued 17.2 million shares to raise more than $800 million in equity, its first significant public offering of common stock in five years, with no share-price dilution. The rating agencies responded enthusiastically. "Andy has made it clear that maintaining the credit quality of the company is job one," says Ron Barone, a director at New Yorkbased Standard & Poor's. "He's been able to get the company to focus on cash flow to maintain credit quality, as opposed to managing the balance sheet, which Enron does well anyway. Cash is king, and Andy knows that."
The second part of the action plan was the sale of assets. Under Fastow's direction, each business unit was required to identify strategic assets that would remain in the portfolio. Others determined to be nonstrategic were put on the block. In 1998, Enron reduced its portfolio by a third, selling more than $1 billion of assets--a mix of power plants, pipelines, and subordinated- debt investments--with no negative earnings impact. "For every dollar I sold down, I reinvested it easily in a manner to generate higher returns, which then increased the return on equity and earnings," Fastow says.
He then turned his attention to new forms of capital raising, creating an asset- securitization program in mid-1998. The first target was CoGen Technologies, a $1.1 billion acquisition. "This was a unique idea," Skilling says. "Andy saw that the off-take contracts provided enough headroom to pay for the entire acquisition via a securitization of the contracts. This enabled the company to achieve an incredibly low cost of capital, while allowing 100 percent debt financing with no negative credit impact."
Other innovative financing deals followed. Fastow financed two acquisitions--the $1.3 billion purchase of Elektro, Brazil's sixth- largest electricity distributor, and the $2.2 billion purchase of Wessex Water Plc, a U.K.- based water company--through a contingent equity issue that was used as collateral for a nonrecourse debt issue. Shareholders were informed that the acquisition financing for Wessex would be replaced with permanent financing on terms that would maintain the company's capital structure. "Under Andy's direction, we issued mandatory convertible preferred shares into a trust," Skilling explains. "Those trust assets were then used as collateral for a $1.5 billion 144A debt offering."
Enron then committed to issue an initial public offering on the water company, or the trust would sell securities within three years. As a result, the company received equity treatment from the rating agencies, while raising capital at debt pricing in one of the largest 144A transactions ever executed. Astonishingly to all but Fastow, the company achieved debtlike financing on an equity issue that was nondilutive. And an IPO was filed within six months of the Wessex acquisition.
Numbers Tell the Story
Despite the traditional rules of financing, Fastow reduced the balance-sheet debt, maintained the credit rating, and reduced the cost of capital while simultaneously growing the balance sheet. In just the last two years, Enron has nearly doubled its total assets from $16 billion to $30 billion--without shareholder dilution and without a drop in the company's credit rating. "He has successfully financed billions of dollars in a manner that has held credit quality," says S&P's Barone. "And that is not an easy thing to do. It is a testament to Andy's focus on cash flow and his ability to think outside the box."