CalPERS Doubted Enron Partnership
California pension officials raised concerns about Enron Corp.’s off-the-books partnerships more than two years ago, long before the deals came under investigative scrutiny, records and interviews show.
The California Public Employees’ Retirement System, or CalPERS, had invested since 1993 in the partnerships, which Enron used to move debt and liabilities off its books to boost its credit rating and bottom line.
In 1999, former Enron Chief Financial Officer Andrew S. Fastow offered the pension fund a chance to invest in a new Enron partnership, LJM2 Co-Investment. CalPERS officials immediately spotted a problem: Fastow would be wearing two hats, acting as general partner of LJM2 while continuing to hold his position as chief financial officer of Enron.
With a shot at partnership profit that could dwarf his hefty Enron paycheck, Fastow would have an obvious conflict of interest, CalPERS officials told him. In transactions between Enron and LJM2, Fastow might be tempted to favor the partnership.
According to people familiar with the deal, the arrangement was rejected by CalPERS officials led by Sheryl Pressler, the fund’s chief investment officer, and Barry Gonder, the head of its fast-growing alternative-investments program.
Both have since left CalPERS for private-sector investment firms and could not be reached for comment.
CalPERS at the time already had a profitable six-year relationship with Enron, the Houston-based kingpin of energy trading.
In 1993, it invested $250 million to become a 50-50 partner with Enron in a natural-gas venture called Joint Energy Development Investments, or Jedi, like the intergalactic knights from “Star Wars.”
That deal had produced a $132.5-million gain for CalPERS in four years, and a successor partnership, Jedi 2, seemed on its way to making another killing in the oil and gas markets.
But LJM2 was something different. In the earlier deals, Enron executives didn’t have any “personal economics,” as CalPERS spokeswoman Patricia K. Macht put it in recent interviews. The company itself was the investor and reaped the profit.
Ultimately, Fastow would earn more than $30 million in management fees and investment gains from his unusual partnership roles with LJM2 and its smaller predecessor, LJM Cayman.
The Securities and Exchange Commission, congressional panels and an internal committee at Enron all are investigating whether similar arrangements involving Enron executives might have tainted more of Enron’s 3,000-plus partnerships and affiliates.
The size of Fastow’s gains came to light only on Nov. 8, in a filing with the SEC in which Enron restated five years’ worth of financial results and slashed its previously reported profit by $586 million, citing improper accounting in its partnership deals.
It was one of the most explosive revelations during Enron’s slide toward America’s biggest corporate bankruptcy.
Fastow, 40, was forced out of his job in October and now is considered by congressional investigators to have played a key role in developing ways for Enron to hide the massive losses and debt associated with its soured investments in areas including water and broadband communications fiber.
Fastow has declined to comment, but spokesman Gordon Andrew said that the limited-partnership structures were above board and that the credit-rating agencies fully understood that their purpose was to keep debt off Enron’s balance sheet.
As for the questionable accounting treatment that the partnerships received, “Mr. Fastow was not responsible for accounting at Enron,” Andrew said Friday. “He never even took an accounting course.”
Andrew acknowledged that much of the public blame for the scandal is falling on Fastow, “and there’s probably more on the way.”
That’s today. But in the fall of 1999, Fastow was on a roll. While he made his sales pitch to CalPERS, newsstands were displaying the October issue of CFO Magazine, touting the young financier as winner of the 1999 CFO Excellence Award for Capital Structure Management.
In a rare interview with CFO, Fastow boasted that he had used the partnerships to keep nearly $1 billion of debt off Enron’s balance sheet. That, he said, was the key to maintaining the firm’s triple-B-plus credit rating, which in turn was crucial for Enron’s core energy-trading business.
More than bad publicity or the SEC investigation launched in October, it was ratings downgrades by Standard & Poor’s and Moody’s Investors Service that caused Enron’s trading partners to stop extending it credit, sparking a kind of “run on the bank” that ultimately triggered its Dec. 2 bankruptcy.
None of that could be foreseen by any of the participants in that 1999 meeting. Pressler and Gonder declined Fastow’s offer, but they hardly slammed the door.
Just three months later, CalPERS was saying yes to another Enron proposal, this one a $15-million investment in a start-up called New Power Co., whose goal was to take advantage of the national deregulation wave by selling electricity directly to consumers and small businesses over the Internet.
In that case, however, CalPERS saw no conflicts because New Power was an actual subsidiary, with no shared responsibilities for management.
CalPERS ponied up an additional $25 million in a second round of financing for New Power the following July. Along with other early investors, CalPERS received stock and warrants in New Power when the company had an initial public offering in October 2000.
CalPERS officials could not quantify the fund’s losses on its 7million shares and warrants. However, the loss appears considerable. The initial public offering price was $21 a share. Since then, blaming problems with regulators, falling natural-gas prices and other factors, the company has reported nothing but losses, and the stock has plunged to less than $1.
CalPERS manages the retirement funds of 1.2 million Californians--state, school and local public agency employees and their families. As of October, nearly 370,000 retirees and other beneficiaries were receiving monthly checks from the fund.
For CalPERS, the Enron deals were part of an ambitious push into the rock ‘n’ roll side of investing: high-risk, high-reward private-equity deals available only to big institutional investors and super-wealthy individuals.
The far bigger but blander side of CalPERS is its portfolio of publicly traded stocks, bonds and real estate, worth $139 billion as of Oct.31. The private-equity assets were worth $7.5 billion, or 5% of the total.
CalPERS doesn’t employ analysts to pick its regular stocks. It decided years ago that it could perform just as well and save millions of dollars in fees by turning itself into an index fund, buying stocks to mirror the proportions of the Wilshire 2,500 index, a barometer of the 2,500 largest public companies.
That’s why CalPERS today holds 2.7 million nearly worthless shares of Enron common stock, not to mention large stakes in Global Crossing Ltd. and Kmart Corp., both of which filed for bankruptcy in January. CalPERS held on through the bad news of last fall and swallowed a $40-million loss on Enron because, as a matter of policy, it doesn’t buy or sell on news events. If Enron is in the Wilshire 2,500, it’s in the CalPERS fund.
“That’s our discipline,” spokeswoman Macht said.
But the private-equity fund, now known as the Alternative Investment Management, or Aim, program, scrutinizes its deals to the nth degree, Macht said.
“Some partners don’t want to work with us because we’re too slow, and we deliberate about everything,” she said.
Jedi 1 was CalPERS’ first big private-equity venture, and the fund remained cautious even as the partnership exceeded expectations, generating annual returns of more than 22% over four years--far higher than CalPERS’ overall investment return in those years. In 1997, when Enron came back with a proposal to launch Jedi 2, a bigger, more diversified partnership, CalPERS agreed but insisted on first selling Jedi 1.
It was that decision by CalPERS that inadvertently triggered some financial machinations by Enron that it would have to reverse four years later in its humiliating earnings restatement.
To buy out CalPERS’ stake for $382.5 million, Enron created another partnership, Chewco Investments. Ultimately, an internal investigation by Enron disclosed that Chewco’s investors lacked sufficient independence from Enron for the transaction to be kept off the Enron balance sheet.
In a domino effect, Chewco’s disqualification disqualified Jedi 1, and both entities, losses and debts together, had to be bought back onto Enron’s books.
Not all investors were put off by LJM2, however. According to court filings, the partnership’s big-name investors included Citicorp, Primerica Life Insurance Co., Travelers Insurance Co. and Leon Levy, the Wall Street legend who founded investment firm Odyssey Partners.
These investors were given Enron’s assurance that the deal--and specifically Fastow’s dual role--had received the blessing of outside legal counsel and of Enron’s blue-chip board of directors, including luminaries such as Wendy Lee Gramm, former head of the federal Commodity Futures Trading Commission and wife of Sen. Phil Gramm (R-Texas).
None of that was enough to satisfy CalPERS, which long has been one of the loudest advocates for good corporate behavior. CalPERS lends its name, and the muscle of the voting shares it can wield in a proxy fight, to campaigns to assure the independence of corporate boards and auditors.
CalPERS, for example, backed former SEC Chairman Arthur Levitt’s unsuccessful attempt to bar accounting firms from doing certain kinds of consulting work for the companies whose books they audit.
Critics in Congress have said the Andersen accounting firm, Enron’s chief auditor, may have relaxed its standards because of the $1 million a week in fees it was earning from Enron, more than half of it for consulting work--a charge Andersen has denied.
CalPERS’ Macht contends that the fund saw nothing amiss in its earlier dealings with Enron and, although it was concerned over the way LJM2 was set up, it had no way of knowing its ultimate effect on the company.
For years, the fund’s practice has been to examine the worst-performing stocks in its portfolio and investigate whether improprieties at the board level or sloppy accounting might have contributed to the bad results. Only then has CalPERS singled out such a company for criticism, Macht said.
Enron in the late 1990s was such a solid performer in terms of stock gains that a slip-up such as LJM2 wouldn’t have brought the company in for extra scrutiny, she said.
“We did what made sense for our investment program: We passed on the investment and told Enron why,” Mark Anson, CalPERS chief investment officer, said Friday.
Nevertheless, the Enron experience has caused CalPERS to do some soul searching. The fund is reexamining its policies and considering whether, for example, it might extend its corporate evaluations to more than just the poorest performers.
Securities experts are inclined to cut CalPERS some slack for not publicly voicing its concerns with LJM2. “I would not think that any investor has an obligation to speak out on such an issue, certainly not a legal obligation,” said David S. Ruder, a securities law professor at Northwestern University and former SEC chairman.
