In October 1999, LJM2 was formed by Andrew Fastow. The Raptors were financed and managed by LJM2. There were finally four SPEs called Raptor. Enron’s Board of Directors waived its rules to allow Andrew Fastow to serve as LJM2’s general partner. Investors were told that they could expect to earn annual returns of 30% or more.
JEDI had returned 20% in excess per year for CALPERS. Earnings were to be distributed as they were earned with the result that the equity investor’s risk was reduced with these distributions. LJM2 had approximately 50 limited partners. The partners invested $394 mil- lion. The LJM partnerships entered into more than 20 transactions with Enron. If Fastow controlled either LJM1 or LJM2, the controlled unit(s) should have been consolidated from the date of initiation.
Fastow was the CFO of Enron. LJM2 provided the “independent”
equity to avoid consolidation of the Raptors, but since there was no independence they should have been consolidated.
The Raptors sold Enron puts on many of its merchant investments.
Enron “sold” its stock (or stock contracts) to three of the Raptors at a discount (it was restricted stock). Also, Raptor III received from Enron shares of the TNPC stock held as an investment by Enron. The transactions with the Raptors affected Enron’s reported incomes of the two years, 2000 and 2001. One estimate is that $1.1 billion should
∗All the page references in this chapter are to the Powers Report unless otherwise indicated.
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be deducted from Enron’s reported 2000–2001 income to adjust for Raptor transactions. This deduction would reduce the 2000–2001 incomes to $429 million (before tax).
Merrill Lynch, in 1999, was chosen to raise capital for LJM2 and it raised $394 million. Investors expected to earn 30% a year or more.
Some of the returns exceeded 100%. The general partners did even better. Kopper was also given a $3.8 million management fee (which was contested). Kopper’s participation had not been approved by the Board.
Winokur was a member of Enron’s board of directors. His testi- mony (7 February 2002) regarding Raptors included the following (“Report” refers to the Powers Report):
“The Report makes clear that this transaction was materially and deliberately misrepresented to the Board.
Throughout the Board minutes and in the presentation materials, the Board was assured that the projected return for this transaction was 30%. In fact, as is evident from Deal Approval sheets signed by Ben Glisan, and Scott Sefton, management of the company knew that LJM’s pro- jected return was, in fact, a minimum of 76%. Mr Fastow also must have known these facts, because they were pre- sented to the partners of LJM2 at their annual meeting.
Both Mr Gilsan and Mr Fastow attended the Board meet- ing where Raptor was presented. Neither of them told us the true rate of return they had projected”.
Significant returns were earned by LJM2 by buying assets from Enron and selling them back at higher prices. Fastow, of course, was involved with setting both prices. The fact that Fastow would be involved was used by Merrill to sell the partnership to outside investors (the list of outside investors includes many, but not all, of Wall Street’s finest).
Even though the Raptor deals ultimately lost money (by selling puts on assets that decreased in value), by then LJM2 had already returned cash to its investors so that the investors made extremely
large returns. One of the most valuable assets owned by the part- nership was a natural gas pipeline between Canada and the United States.
It would be interesting to know exactly how Merrill was able to attract $394 million from very sophisticated investors for a partner- ship that was going to own a few real assets with very volatile value and was going to sell puts on other (or the same) volatile assets. Obvi- ously, Merrill promised the expectation of high returns, but how were these returns to be earned?
The New York Times(4 January 2002, p. 13) presented an excerpt from a document used by Merrill to attract investors to consider LJM2:
“Due to their active involvement in the investment activ- ities of Enron, the Principals will be in an advantageous position to analyze potential investments for LJM2. The Principals, as senior financial officers of Enron, will typ- ically be familiar with the investment opportunities the Partnership considers. The Principals believe that their access to Enron’s information pertaining to potential investments will contribute to superior returns”.
LJM2 is destined to be the highpoint of the Enron collapse for those seeking villains. It would appear that a material amount of Enron’s value was drained off by the LJM2 partnership. The outside investors merely cashed their checks. The inside investors made sure that the cash flowed.
Let us consider the magnitude of the cash drain from Enron. Start- ing with the initial $394 million equity investment and assume a 40%
return payable in each of the 2 years.
0.40(394) =$158 million
×2
$316 million
A 20% return for the 2 years would be one half of $316 million or $158 million.
The New York Times(31 March 2002, p. 20) estimated that the limited partners earned an annual return of 43%. This 43% return was earned during a time period when corporate bonds yielded less than 10%.
LJM2 was a significant factor in Enron’s collapse.
The Raptors
An internal document circulated at Enron in the first quarter of 2001 stated “The new Raptor structure transferred risk in the form of stock dilution”. Sherron Watkins in a note to Lay added (handwritten)
“There it is! That is the smoking gun. You cannot do this!” (The New York Times, 15 February 2002, p. C6).
There is no reason to conclude Lay should have understood Watkins’ note or the basic document.
The thought that the Raptor “structure transferred risk in the form of stock dilution” is not exactly correct but it is not completely wrong.
The Raptors held Enron stock. If this stock was issued to the mar- ket, there would be stock dilution. The Raptors sold puts to Enron, this could be a transfer of risk. The puts were on Enron’s merchant assets.
A problem arises if the value of the asset for which the put was written falls greatly and the value of the Enron stock also falls. The value of the Raptor’s assets decrease at the same time its put liability increases. Then, the Raptor will not be able to pay the put liability.
When Miss Watkins writes “You cannot do this!” she is correct if she means that Enron is not protected if there are large losses in the value of its “protected” assets.
Thus, both the basic message being circulated and Miss Watkins’
note that was added need extensive explanations. It would be surpris- ing if Ken Lay understood either the basic message or Miss Watkins’
note. They are not clearly written.