$A From: Rick L Carson 11/14(2000 04:58 PM To: Steve W Y0UnQILON/ECT@ECT. Ted Murphy/HOU/ECT@ECT, Cassandra SchultzINAIEnron@Enron, Bradford L8fSOflHOUIECT§ECT, Randy PetersenIHOUIECT@ECT, Michael TriboletlCorpiEnron@Enron, Chip SchnetderlNNEnmn@Enron Connie F EstremsiNA~Enron~Enron, William S Bradford/HOUIECT~ECT, Mark RUeneII-iOUIECTQECT cc: Rick BuYIHOUjECT~ECT* David GoIteIHOUIECT@ECT Subject Lessons Learned Attached is a draft of the presentation that Rick Buy will be reviewing with Jeff Skilling concerning 'lessons learned" frurn some of our unfavorable merchant investment experiences. Until Rick and Jeff decide how the presentation will be distributed, please keep the report confidential. Call me at x 3-3905 if you have questions. Regardsl Rio k C. Forwarded by Rick L Carsonfl-IOUIECT on 11114/2000 05:48 PM From: StephanIe McGinnIs PM To: cc: Subject Lessons Learned 11/14/200005:37 Rick L CarsonIHOU(ECTr~ECT Lessons Learned 1-landouts SKM rev 111400 I GOVERNMENT EXHIBIT 24599 Cr,m No H 04-0025 f~WNOI ECTeOO775841 0 I investment Portfolio Lessons Learned November 2000 1 ECTeOO775841 I - - S Investment Performance - Assets SoJd or Disposed 1992- 2000 Realized Rates of Return by Industry - Cash Basis __ 2%~ - pa...., c..i oii & a.. 2 80 UtEty Piip/ ScM~e. P.p~' 1 7 low ~th, 0~.raK S LCOd..I. 1~ iOq~ ~tidSw P.~1I~N. ReO..~ h ftflWl r4x00 8Ildg~ ~ II 6* ft.t~.m It q.Mnta I 4% p~t,.ae ~ It 2 a... t.i. d~d.d Il (8 .8. ,4maIN.sg) Enron North America Merchant Portfolio Rate of Return Matrix Industry Investment T e Debt Private Equity Public Equity ENE Stock Power Coal Oil & Gas ENE Stock Energy Subtotal Utility Services Paper& Pulp Steel Other Grand Total 2 6 6 7 10. 8 34 34 (5) (5) 243 13 (47) 46 2 16 34 (5) RETURNS BY INVESTMENT ON FOLLOWING PAGE Note that included in these cash flows are sales of assets to Merlin. Any cost of credit derivatives or any additional support has not been included to date and would only reduce returns. 2 ECTeOO7758412 REALIZED Grand Total 7 2 9 (5) 8 243 13 (47) 46 10 Investment Performance - Curient Equity Portfolio Actual Performance is's. Expectations Cost Basis $6.5 Bn Carrying Value $7.4 Bn + 59% of originally expended capital is not meeting expectations. ~ Enron has $3.8 Bn of earnings exposure on assets performing below expectations. + 81 out of 167 equIty transactions are underperformingl SUPPORT FOR EQUITY PERFORMANCE COST CARRY TROUBLED Nojth Amalca 275,079 EGH ElM EBS 5,000 Intem~ioneL regIc~s ~il~,000 TOTAL BELOW Noflh Ameilca 203,019 EG14 24,342 ElM 5,000 EBS 7,000 225,520 19000 195,663 27,153 4,105 3,000 MEETS Noi1~ Amesica 266,774 458,806 EG14 22,~0 18,906 ElM 2,853 EBS 55,530 56,960 IttemtJonal ,-egloris ~ 1 019000 TOrAL~~~T~. EXCEEDS Nolib Anieflca 98,880 630,846 EQ.I - - ElM 12,690 23,898 EBS 20,000 186,010 bt6n~onM re~orw il~Z~ TUTAL~1~ TOTAL SHill America S33,752 EON 46,842 UN 17,ffO 37,130 h~gniaUanaI r.oIonS,5~5,I3Oe TOTAL. 1,510,835 46,830 30,856 245,970 3 EGTeOO775841 3 CONCLUSIONS LISTING OF DEALS ON FOLLOWING PAGE SUPPORT FOR DEBT PERFORMANCE COST NON-PERFORMING North America EGM ElM 144,488 Merlin - North AmerIca 95,000 International regions ____________ TOTAL -...........239 488..: ISSUES North America EGH 5,365 ElM Merlin - North America 127,382 International regions 37,000 TOTAL PERFORMING North America 310,547 EGM 2,335 ElM 771 Mrlln - North AmerIca 104,451 International regions 124,000 TOTAL 542~W4 TOTAL North America EGM ElM Merlin - North America Intern*Ionai regions TOTAL 5,402 127,382 37,000 4 k~, .10 LISTING OF DEALS ON FOLLOWING PAGE 330,402 2,313 848 104,451 124,000 455,035 380,907 7,700 7,715 771 343 326,833 326,833 161000 4 ECTeOO775841 4 Investment Performance - Current Debt Portfolio Actual Performance vs. Expectations Coet Basis $0.95 Sn Carrying Value $0.88 Bn CONCLUStONS + 43% of originally expended debt Capital is not performing or has Issues. + Enron has $315 MM of earnings exposure on debt that is non-performing or has issues. ~ 31 out of 55 debt transaCtions are non-performing or have issuesi CARRY 50,505 95,000 4550 5 ECTeOO775841 5 Why has Enron '5 investment portfolio performance not met our expectations? linderperforming Deals Major Factors Quality of Management Incentives & Accountability Excessive Risk Market Corroboration and Terms Preparation for the "Worst Case" E~nitori~/~k of Monitoring 6 ECTeOO775841 6 I 7 ECTeOO77584i7 Quality of Management The most critical factor in the success of an investment is the quality of the investee's management. This quality needs to be measured in terms of personal integrity and manage,Iai skills; both are equally important. Management experience should also be evaluated in relation to the transaction. An executive may have many years of Industry experience with a large established company hut no experience in successfully launching a new venture. Quality of Management - Case Study The above example is Kafus Industries - The CEO Ken Swaisland and President Mike McCabe also had some questionable expenditures on personal type items (i.e., lavish expense accounts, vacations, summer homes, etc) Other examDles of poor manaaement include: Costilla Energy - $5OMM equity - Management team Mike Grella and Cadell Liedtke; paid too much for numerous O&G acquisitions and couldn't close on Pioneer transaction. Ultimately tanked company. Noram Rig (Ocean Buy) - $16MM loan - Noram CEO Ronvald Gabrielsen; sold loan collateral in violation of loan agreement and moved $5MM of Enron's money out of the country Earl P Burke - $38MM loan - spent all of his money (and ours) drilling risky exploration wells in South Louisiana with no partners Ecogas - $48MM debt & equity - CEO Jerrill Branson entangled company in numerous lawsuits, also had issue regarding personal conduct. 8 ECTeOO775841 8 Eaton invested approximately $119 million in equity and debt in a global inanul~cturer of commodity material made from sustainable resources. This 'eco-lrlendly company enjoyed a tremendous Increase In their stock price In large part due to favorable media splo' engineered by Management as a result of frequent positive press releases. In reality, the company was floundering financially and technologically but this I~ct was bIdden Iron? Investors as well as their Independent outside auditors. The Company Is now in bankruptcy. Incentives & Accountability 9 FCTeOO775B41 9 Immediate recognition of MTM earnings, assuming flawless execution, has not Incentivized commercial personnel to aggressively manage deal execution through exit for value. Incentives to assure that actual performance meets projections have been inadequate. Total I Deal Name Peak MT?4 Actual MTM CostlIla 0 (53) Kafus / CanFlbr~ 103 (65) * Qualitech Steel 26 (48) Brigham 0 *(36) NSM 0 (31) Repap 0 (21) CarrIzo 2 (20) Hughes Rawls 0 (14)~ OEDC 0 (14) Queen Sand Resources 73 (11) Belco 00 & Gas 1 (8) Crown 2 (5) Lyco Energy 7 (5) EnSerCo Offshore/Horam 0 (5) Inland Resources 7 (4) Aillance Resources/LaTex 0 (4) C-Gas 37 (3) Browning Exploration 0 (3) Hogan ExploratIon 0 (3) ICE DrillIng 0 (2) Basic Energy Services/Sierra Well ServIce 3 (1) * WB Oil Company 0 (1) Neutmlysls 0 (1) Industrial HoldIngs 0 (1) Gasco 0 (1) Earl P Burke/Peltex/Magellan/3TEC/Eugene 0 (0) Beau Canada 12 (0) TransCoastal Marine 1 (0) * TnPoint 1 (0) Forcenergy - VPP 0 0 Heartland Steel 29 14* Totals 304 348 10 * AdditIonal MTM write downs are likely for these Investments ECTeOO7758420 ~,K Incentives & Account:ability - Case Study The chart below shows the combined historical fair value marks thro ugh time of 31 transactions which have appeared as "Troubled" or 'Loss" on the hi-weekly Watch List Report since Its inception in ian uary 1999. The tact that as much as $304 million in MTN income was credited to these tailed projects causes con wns that proper incentives for long term execution are absent from our current structure and that execution risk has been Inadequately modeled and priced by RAC. *1 Excessive Risk 11 ECTeOO7758421 Intease pressure to close deals driven by earnings considerations has motivated Enroll to assume extraordinary Investment risks. Enron either didn't recognize or understand risks or they were ignored once Identifled. RAC shares the responsibility for not adequately assessing and modeling transaction risks or increasing the capital pike to retied these risks. ~,; Excessive Risk - Case Study Oil and gas drilling partnerships are examples of extremely high risk investments. Despite Uuis, Enron has invested aver $352 million lo 23 partnerships slnco 1994. Twelve at these partnerships have been complete failures with nearly $75 million written off, Of the 'eniaining eleven partnerships, six are currently on the "Watch or Troubled Deal List" with cost/carrying values as follows: Cost Basis: $185 million Carrying Value: $228 million __- ASSET '..'..'pirLETE FAILuKt PAKi 1 BrownIng 2 Grand Gulf 3 Guifstar-MidGuif 4 Hogan 5 Hughes Rawis 6 Magellan LIC 7 Meridian I 8 MichIgan 9 OEDC 10 Rockspilngs 11 Sweetwater 12 WBOII&Gas 91.b 23.9 73.7 approx = $75MM REMAINING PARTNERSHIPS: 1 Amerltex 6.9 2 LewIs Energy 15 3 MeridIan II 3 4 Texiand 11 5 Vastar 34 7.6 16 5.4 12 29 69.9 70 -0.1 6 Bonne Terre 7 Cypress Explor 8 JunIper 9 Llnder Petroleum 10 Sacramento 11 Venoco 32 16 51 52 24 28 17 24 1 0 60 108 185 228 -43 352.5 321.9 30.6 -0.7 performIng -1 performIng -2.4 perftrmlng -1 performing 5 perft~rming 16 Watch List -1 Watch List -4 Watch Ust L -7 Watch Ust r 1 Watch List -48 Watch List J per snapshots count = 6 per 10/3 1 Watch Ust 12 ECTeOO7758422 COST CARRY FV 0 3.5 9 7 3.5 14 8 3.1 21 4.3 1.4 15.8 16 4 4 2.5 5 1 0 1.2 2.8 0 8 3 0.5 1 1.4 3.1 19.8 1.5 1.4 7.8 13 3.5 3 1.1 Market Corroboration and Terms 13 ECTeOO7758423 Investment assumptions have not been sufficiently validated by third party participation or use of current market Input to maximize the ability to syndicate. This consideration is increasingly important to Enron in order to increase the velocity of capital and, in turn, to increase returns on invested cap itaL Market Corroboration and Terms - Case Study Beau Canada - $42.1MM zero coupon © 7.50/0 - half of the DASH projected IRR was attributed to warrants (which never traded above strike price); Beau's e-credit rating was 11 Hughes Rawis - $2OMM debt financed exploratory operations In Bay Marchand at 10%; such financing rarely financed in capital markets through debt; debt financing would carry coupon rated indicative of equity type returns Costulla Energy - $5OMM Series A cumulative convertible preferred stock was subordinate to Costilla's bank and high yield unsecured debt; quarterly dividend of 7~8O/o was not priced to reflect subordinate position; when transaction closed the Costilla high yield unsecured notes were trading at a discount to par due to insufficient collateral coverage 14 ECTeOO7758424 A study of a number of Htroubled~ investments where Enron did not have third party participation indicates that a major area where we may have differed from current market Is In growth assumptions. Often our mezzanine debt was priced below market because we had received warrants, which were highly valued Internally because of our aggressive growth assumptions. .11 third party Investors had Company K sale. Fo#Gcagt participated, it Is likely that growth and other fundamental assumptions would have been more conservative. Start-Up I Execution Risk 15 ECTeOO7758425 We have a dismal record of Investment performance ID start-up entities involving technology and constructioD risks due primarily to the significant inherent risks of start-up businesses, our counterpart ies' lack of management expertise, as well as passive execution oversight by Enron. These risks have been exacerbated by investments in l~dustries where Enron had limited expertise, so pitfalls obvious to experienced investors were not avoided. Start-Up I Execution Risk - Case Study The above steel Deal Name facilities include: Invested (Write-Offs') Current Value Qualitech Steel NSM Heartland Steel Totals $48.3MM 31.3MM 43.7MM $123.3MM ($48.3MM) (313MM) 15.0MM ($64.6MM) $ -0- -0- 58.7MM $58.7MM Other examDles of startuDs/new industry Droblem assets include: City Forest - $29.OMM loan - Greenfield construction of tissue mill Ecogas - $48.OOMM - construction of landfill gas facilities Industrial Holdings - $15MM debt - manufacturer of various goods (fasteners, valves, tanks) LSI - $9.7MM debt & equity - distributor of electric cable for drilling rigs TransCoastal Marine - $2OMM debt - offshore oil service company 18 ~Tn77J~%~A~ Construction of start- up steel mills and processing facilities Lu an area where Enron has Invested over $123 million despite our lack of expertise ja the area. To date, $64 million has been lost and the remaining $59 million IS In serious jeopardy. Adequate Capitalization 17 ECTeOO7758427 Zavestees have been undercapitalized and have experienced liquidity crises In so,-ne Instances due to our failure to Insist on both third party financing and a source of "rainy day" liquidity before making our investment. Adequate Capitalization - Case Study The above example relates to Ecogas, the landfill gas company in which Enron acquired an 850/0 interest and provided debt financing. Other examples of portfolio companies that have experienced severe liquidity problems include: Beau Canada Brigham Exploration Carrizo Oil & Gas Costilia Energy Crown Energy Gasco Distribution Heartland Steel Hogan Exploration Hughes Rawis Industrial Holdings Kafus/ CanFibre entities Linder Petroleum LSI Lyco NSM Oconto Falls Qualitech Steel Queen Sand Resources Repap Enterprises Sierra Well Service TransCoastal Marine TnPoint, Inc. WBOiI&Gas 18 ECTeOO7758428 -rn Enron acquired a majority equity interest in a landfill gas company in 1999. It was reco gnized prior to deal dosing that substantial external project financing was necessary for the Company to be viable. The acquisition warn dosed with the representation that a financing commitment was In place with a recognized financial institution. Apparently the financing commibnent was mud, more tentative than originally represented and fell through soon after dosing. Ejvon had to provide "life support'~ working capital because we failed to ensure ~f2i1 making our Investment that appropriate third party financing was in place~~ Preparation for the "Worst Case" Because of Earon 's aggressive Investment policies, "troubled dea is" should h expected; we have Inadequately planned for 'troubled deais~ in terms of our legal documentation, our monitoring procedures and ability to react to these transactions with a "quick response" tam. 19 ECTeOO775B429 - - Preparation for the "Worst Case" - Case Study The above example relates to the cash flow test of Carrizo Oil & Gas Other examDles of leaal documentation issues include: Ilainan Island - we failed to negotiate an exit strategy if a government policy changed Noram - we were "hoodwinked" by the client when the dealmaker agreed (for some reason) not to file a lien against some collateral which was later moved out of the country resulting in a loss for Enron Midwest Gas Storage - we failed to file a writ of garnishment against lawsuit proceeds which would have covered a large portion of a defaulted loan; we settled for a lesser amount after lengthy negotiations 20 FCTeAfl77!5R43fl A study of a number of deals that have become alrOubIedw indicates that legal documentation providing Enron rights in a distress sftuation were never Included or were negotiated away by dealmakers. In one pro toned stock Invesbnent~ Enron resoiv.d additional rights it the company tailed a cash flow feeL Unto,runataly, cash flow" was not adequately defined and the company was able to avoid our assertion at additional rights. Monitoring / Lack of Monitoring 21 ECTeOO775843I While Information about dealperformane. has improved somewhat due to better reporting, there is a still a problem with passive management of Investments by Enron. There is a tendency to not act decisively until the transaction becomes very problematic, which, In most cases, is too late to effect needed changes. Monitoring / Lack of Monitoring - Case Study The above relates to Heartland Steel Other examDles include: CGAS - prior to Don Rollins' intervention, the commercial team had little involvement despite the fact that the asset was not performing Crown Energy - involved construction and new technology that failed; complete lack of monitoring by deal team Bonne Terre Exploration - confusion organizationally within Enron as to monitoring responsibilities; company spent almost $4OMM on land and seismic leaving little money to drill Kafus I CanFibre - tack of in depth monitoring failed to detect major performance and management issues Midwest Gas Storage loan advances were sent out the door without any documentation that costs were incurred and contractors paid (which they were NOT) Ecogas - deal team failed to inform management that critical external financing fell through 22 Fr~TMfl77~Ak~9 Effect We deal monitoring and management must extend beyond simply reporting what Is represented by company management. In a start-up ste el processing plant where Enron has a substantial Investment, the Commercial team was in frequent contact with plant management which represented for several months that the project was performing well and was on schedule and within budget. When a shortfall in YTD EBITDA developed, Eaton initiated a detailed review whkh revealed that the project was actually nine months behind schedule due to major technical Issues and the Company was experiencing a severe liquidity crIsis. 23 FCT~flA77F~SW..~ How do we improve our in vestment performance? 24 FCTflhl77~&~4 Recommendations 25 ECTeOO7758435 Investment Performance Improvement Recommendations # I - A more rigorous assessment of the qualifications of investee management should be made including the requirement that Senior Management of the Enron Business Unit meet with and assess the competence of the management team. 26 ECTeOO7758436 Investment Performance Improvement Recommendations #2- RAC will more accurately reflect risks previously underestimated based on our "lessons learned." Drilling, exploration, construction, start-up, counterparty management and other execution risks shall be considered when arriving at the RAC capital price and probabilistic model. 27 ECTeOO7758437 Investment Performance Improvement Recommendations #3- Segregate commercial responsibilities into two groups8 One should be responsible for transaction origination and the other for transaction execution and asset management. There should be a definitive transfer of the asset to the Execution group at closing. 2$ ECTeOO7758438 Investment Performance Improvement Recommendations #4 - PRC rankings and compensation should be based on bath current transactions and historical performance of previous transactions. 29 ECTeOO7758439 Investment Performance Improvement Recommendations #5- Deals must be developed using current market terms (Or better) or third party participation to corroborate pricing and provide the ability to syndicate or maximize the probability of a successful exit. 30 ECTeOO775844O Investment Pea-Iormance Improvement Recommendations #6 - Investments in start-up entities will not be approved without the following: * Independent consultant / engineering reports prepared for Enros~, not another entity (as overeen by. Enron personnel with relevant expestis. with feW exceptIons) * Detailed plans for design, constructIon, and commissioning of flew asset * Assessment of the capabilities of management and staff with a plan to conuct defidenvies * Detailed cash flow budget and liquidity plan In the event of project delay or cost overruns * Deal "milestones' and established due dates to monitor the above 31 ECTdfl77SR44I Investment Performance Improvement Recommendations #7- Initiation of an independent legal review of transaction documents (in addition to the deal attorney) to ensure that Enron is not assuming undue legal risks and has maximized its rights in the event of a distress situation. 32 ECTeOO 7768442 Summary If Enron is to be successful in its investing activities it m~t: * Assess and price risks more realistically * Devote additional resources to deal monitoring and execution * Insist on accountability for performance