“A federal investment tax credit was enacted just as the project was being completed, adding 10 percent to the rate of return. Accelerated depreciation in the same law further sheltered profits from income taxes. Thank you, political capitalism.”
“Cogen Technologies would go on to become one of the very top independent power developers in the nation. The sale of CTI’s major asset to Enron in 1999 (McNair took cash, not stock) would make McNair one of Houston’s wealthiest men and provided the means to buy an NFL football team for his hometown, a deal that was also made possible by a new taxpayer-supported stadium, in no small part the result of an intense lobbying effort by Ken Lay and Enron several years before.”
Last Friday, the owner of the Houston Texans, Robert C. “Bob” McNair, died at age 81. Obituaries abound, which all refer to the great wealth created by McNair in the energy industry, specifically electrical cogeneration, as the prelude to his fame in professional sports.
McNair made his fortune just several years after declaring bankruptcy in the trucking business. How did such a reversal–and in a wholly new industry–happen? Alas, a unique regulatory opportunity was responsible, one where extraordinary events turned high profits into phenomenally high profits.
The story relates to a 1978 federal law, the Public Utility Regulatory Policies Act (PURPA), which required electric utilities to buy power from independent generators building a “qualifying facility” at a regulatory-determined “avoided cost”–and a very generous cost at that. The intent was to create competition to the monopolistic utilities and to encourage more efficient generation, and compared to a traditional gas plant, cogeneration (the simultaneous production of power and steam) was that.
This story is told in chapters 3 and 5 of my Enron Ascending; The Forgotten Years (2018):
Another cogen project that Enron wanted to do—even with its own scarce capital—did not originate from Northern Resources. It was a project that Howard Hawks told Mick Seidl he would not authorize without renegotiating its terms, creating a rift between Houston and Omaha. The project concerned a proposed $120 million, 165 MW plant in Bayonne, New Jersey, sponsored by Cogen Technologies Inc. (CTI), a company founded by Robert C. “Bob” McNair.
McNair was new to the business. He had precious little equity, coming off a setback in which one of his trucking companies declared bankruptcy amid the industry-wide retrenchment that followed deregulation.[1] But McNair was smart, diligent, likable, and an able negotiator. He would eventually repay his creditors, exit trucking, and enter a field that would turn out to be phenomenally successful. He would also eventually sell his company to Enron and go on to bigger things.[2]
McNair originally presented a 22 MW cogeneration project to Mick Seidl, who sent him to John Wing. The two met, but McNair’s 50/50 profit-sharing proposal was a nonstarter given that HNG would be putting up the equity. Talks were suspended when Wing was pulled away to consummate the merger between HNG and InterNorth.
Postmerger, Wing was out and Hawks in. But McNair was not going to fly to Omaha to negotiate with Hawks. Wing was the key to getting a deal done, something he agreed to do for a 1 percent personal-interest carry, given that things were falling into place with a gas provider, steam buyer, power purchaser, and project constructor (GE). Better yet, the project was growing well beyond its original size, and McNair was proving adept at resolving the politics of siting and permit issues.
It was a strange situation—Wing as McNair’s consultant, negotiating with Enron, where he also consulted. Enron’s board had to approve this arrangement given the conflict of interest. But far from fooling anyone, Wing’s contract required that he give Enron the right of first refusal to invest in any of his new projects. This became moot given Enron’s capital constraints, but it showed to what extent Wing had Lay’s ear.
While negotiating on behalf of HNG, Wing had wanted 85 percent of the free-cash flow to go to Enron, not 50 percent as McNair proposed. That was still a good starting point. Now, wearing three hats—his own, McNair’s, and Enron’s—Wing saw a compromise to flip from 85/15 to 50/50 should the project’s return on investment (ROI) reach 23 percent.
This was doable and good for all sides. But given how well the project was coming together, McNair, in return for the 85 percent concession on the front end, wanted a second flip in his favor should the project reach a still higher profit threshold. Maybe it was because few really thought that a 30 percent ROI was possible.
Maybe it was McNair’s likability and effective one-on-one negotiations with Lay and Seidl at a Young Presidents’ Organization retreat. Maybe it was Wing’s strong support of the deal and Lay and Seidl’s respect—or fear—of Wing. But whatever the reasons, McNair got the Houston brass to agree. If Bayonne’s ROI reached 30 percent, Cogen Technologies would receive 85 percent of the free cash, leaving Enron with 15 percent for the life of the project.
It was this three-tiered proposal that Howard Hawks wanted to renegotiate—not approve as Mick Seidl, Enron’s president, wanted him to do. Thus the Bayonne project was in stalemate in the spring of 1986.
———- Chapter 5 ———-
Building and operating steam and power plants utilizing the very latest in technology required technical expertise and precise, urgent management. Cogeneration could be the highest return-on-equity (ROE) opportunity for an energy company, offering estimated pretax returns of 18–20 percent, but only if the projects were done right. And the competition was getting intense, as utilities and regulators tightened up the rules [pursuant to PURPA]….
Newly formed Enron Cogeneration Company (ECC) signed the deal [for a 42 percent interest] in a $120 million, 165 MW plant in Bayonne, New Jersey] with Cogen Technologies Inc. (CTI), an upstart private company majority owned by Robert McNair. The agreement began with 85 percent of profits going to Enron, the major equity investor. But then profit sharing flipped: a 50/50 split if and when the project’s ROE reached 23 percent and then another readjustment, to a 15/85 split (in favor of CTI), should the project reach a 30 percent return.
Entering service in September 1988, Bayonne quickly reached and exceeded these thresholds, making tens of millions of dollars for McNair and CTI. But how did something so extraordinary happen?
Working closely with GE—the prime contractor and the turbine supplier—McNair and [John] Wing brought the plant into service ahead of schedule and below budget. But this was just the start of something extraordinary. A federal investment tax credit was enacted just as the project was being completed, adding 10 percent to the rate of return. Accelerated depreciation in the same law further sheltered profits from income taxes. Thank you, political capitalism.
A fourth factor concerning risk versus reward came out all roses for McNair and his other private investors (including Wing). Anticipating rising gas prices, the major electricity purchaser, Jersey Central Power & Light, required CTI to enter into a power-sales contract based on a spread reflecting fixed gas prices as of 1985.
Without forward markets for natural gas to lock in prices, McNair could not effectively hedge his exposure under his sales contract. Jersey Central, meanwhile, was impervious to (falling) price risk because its power-purchase contract was approved by its state regulators. A floating power price, alternatively, which McNair’s CTI preferred, would have locked in a spread with a market-price purchase contract. As it was, a big bet on the future price of gas was made at the power buyer’s insistence.
Jersey Central guessed wrong—badly. Instead of escalating, gas prices plunged in 1986 and stayed low. Bayonne’s profit margins increased by one-third after the project came on stream, with spot gas purchased at well below 1985 levels.[3] Continuing low prices well into the 1990s would add to the win for McNair—and the loss for customers of a monopolist utility that, as the customers’ agent, bet wrong.
All said, Bayonne achieved its 23 percent rate of return in two years and 30 percent return in three, leaving CTI with 85 percent of the profit for the life of the plant. So, with McNair putting up the sweat equity and several million dollars in development costs versus Enron’s $14 million, McNair found himself making more money from the project each month than Ken Lay made in a year as Enron’s CEO.
“You’re making so much money!” Ken complained to Bob. But Enron had received a handsome return from the project, and a deal was a deal, even if Wing and McNair bested Lay and Seidl—and the man caught in the middle, Robert Kelly, who was now heading Enron Cogeneration Company.
Cogen Technologies would go on to become one of the very top independent power developers in the nation. The sale of CTI’s major asset to Enron in 1999 (McNair took cash, not stock) would make McNair one of Houston’s wealthiest men and provided the means to buy an NFL football team for his hometown, a deal that was also made possible by a new taxpayer-supported stadium, in no small part the result of an intense lobbying effort by Ken Lay and Enron several years before.
[1] The federal Motor Carrier Act of 1980 eased entry restrictions and liberalized rates for interstate trucking companies. “By 1984, hundreds of firms, including some of the biggest names in the industry, entered bankruptcy proceedings.” McNair’s truck-leasing company was also felled by a recession that hit in 1982.
[2] McNair sold Cogen Technologies to Enron in 1998 for $1.1 billion, which enabled him to start a new NFL franchise, the Houston Texans, to replace the departed Houston Oilers. McNair’s effort was enabled by a taxpayer-supported stadium that resulted from a come-from-behind effort led by Enron and Ken Lay personally to get voter approval for such public monies. (See chapter 15, pp. 612–618)
[3] “We were scared to death,” recalled McNair, “so we ran the numbers out to see how high the price of natural gas would have to go in 1986 before it wiped our profit out…. So, they really tried to take advantage of us. Well, as it turned out, the delivered gas was about $4.20 per Mcf in 1985 and dropped to $3.00. So our profit margin increased about 30 to 35 percent.”
Thanks. I am always interested by “back stories.”
Warren Buffett’s correct assessment of Ken Lay’s character fascinated me. In that singular case, Buffett made an exception to his rule of “praise individually, criticize generally.”