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After the electricity markets cooled in California, the business was never quite so white-hot again. Melissa Beckett ended up transferring to another trading desk, this time in fertilizer markets. But this isn’t to say that profits quit flowing from Koch’s trading desks in Houston. When one market cooled, several others began to heat up. Over the next decade, Koch traded derivatives based on housing mortgages, interest rates, and other exotic financial instruments. Koch even opened a special unit that traded stock in public companies, buying and selling several million shares of different firms and developing algorithms to find the best value.
The trading desks, however, were far more important to Koch Industries’ business than as simple profit centers. The money from trading was important. But, as always, the lifeblood of the trading group was information. The desks sucked in giant stores of data from about every corner of the American economy and used their superior knowledge to trade on it. This trove of information and analysis was put to use throughout the corporation. The trading desks became a source not just of cash, but of market intelligence. The traders were like scouts in the marketplace, identifying places where Koch could invest.
Charles Koch took the techniques learned in abstract markets and applied them to the real-world industries he knew so well. He talked repeatedly not about trading but about a trading mind-set. The world was filled with assets and filled with opportunities to buy and sell. Superior information would allow Koch to make superior acquisitions. The massive amounts of cash that Koch generated across its operations would be put to use buying and selling assets in the real world.
In 2003, the wave of acquisitions would begin.
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I. A megawatt-hour is the amount of electricity needed to power roughly 330 homes for an hour.
II. At least, this is what the viewer is left to gather. The screenwriting isn’t exactly airtight.
III. Or today, for the most part.
IV. ALEC’s board meeting documents make multiple references to the loan. The most specific source for the loan is given as “the Koch Foundation,” presumably referring to the Charles G. Koch Charitable Foundation or the Charles Koch Foundation.
CHAPTER 14
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Trading the Real World
(2002–2005)
Back in the early 1970s, when Charles Koch took over the Pine Bend refinery, Koch Industries’ habit of buying and selling other companies was still something of a rarity in corporate America. Koch was an outlier, a quirky family-owned firm willing to spend huge sums of cash to buy out other companies and take them private. By 2003, however, the rest of corporate America had followed suit. There was a growing wave of so-called private equity firms that were on the march across the American economic landscape, searching for companies to buy and take private.
To the private equity world, America’s entire business community was a game board, a financial market where companies could be bought and sold like oil futures. Private equity deals became a defining feature of American economic life during the 2000s. There were $91 billion in private deals at the dawn of the century. The deal flow rose to $133 billion in 2003, and to $197 billion in 2004. Thousands of companies were taken private each year. Dozens of new private equity funds sprang up in New York, Chicago, and San Francisco. Some of these private equity firms were run by nameplate financial firms like Lehman Brothers and Barclays Capital. Others were little-known start-ups with names like Oaktree Capital Management. One of the better-known private equity firms, Cerberus Capital Management, named itself after the mythical three-headed dog that guarded the gates of hell, for reasons that were not entirely clear.
Koch Industries, although it had almost zero name recognition, put itself aggressively into the hunt, competing directly with the largest firms on Wall Street. Koch had an edge over the competition. The company was flush with cash, had only two shareholders to answer to, and was willing to close deals that scared away other companies. In a matter of just a few years, Koch Industries would execute some of the largest private equity deals in America, with acquisitions worth nearly $30 billion.
Charles Koch made it abundantly clear to his team that they would work toward one goal: to maximize Koch’s long-term return on investment. The firm wasn’t looking for quick returns. Koch would press the advantage of Charles Koch’s patience, looking for deals that other investors might avoid because the payouts wouldn’t come for years. Charles Koch institutionalized the company’s “trading mentality” by embedding it in a new, secretive group that was formed on the third floor of the Tower, near Charles Koch’s office. This group rivaled any private equity firm in the nation. It was called the Corporate Development Board.
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Charles Koch sat on the Corporate Development Board, and directed it. He was joined by a small cadre of his top leaders. This small group of men would direct a series of acquisitions between 2002 and 2006 that would fundamentally transform Koch Industries, while also more than doubling its size. In 2001, Koch’s annual sales were about $40.7 billion. By 2006, they would be $90 billion.
The Corporate Development Board was essentially a reincarnation of the development group that Brad Hall had led in the late 1990s. Hall was replaced as head of the group in 2002 by Ron Vaupel, who had been president of the Koch Hydrocarbon Division. But Vaupel was not working alone. In its new incarnation, the Corporate Development Board was closely controlled by the company’s most senior executives. The board included Joe Moeller, the president of Koch Industries, and Steven Feilmeier, who had recently been named as Koch’s chief financial officer. Sam Soliman, the previous CFO, who now led a massive trading operation at Koch’s Houston office, also sat on the development board. The final board member was John Pittenger, the Harvard MBA graduate who helped drive Koch’s Value Creation Strategies back in the 1990s.
The board didn’t tend to meet in a formal manner. It didn’t gather every month in Koch’s boardroom and hold a meeting where minutes were kept, as did Koch’s formal board of directors. Sometimes the board met in a smaller conference room on the third floor, near Charles Koch’s office, with some members calling in and participating over speakerphone. The timing was improvisational and reactive to conditions in the market. There was a time sensitivity to the meetings; the board often considered acquisition deals that were the subject of intense competitive bidding. There wasn’t time to pay heed to formality and scheduling.
By 2002, the board had access to multiple, ultra-high-value flows of information that fed into it from every arm of the company. The board sat at the center of Koch’s black box. Charles Koch, for example, was privy to detailed updates from every major division in Koch Industries because the division leaders came to Wichita quarterly to report their results. He had the chance, at those meetings, to quiz them on whatever topic he wished. The board could also draw on the vast pools of data and analysis being generated every minute on the company’s trading floors in Houston.
The development board drew on other important sources of information. It was constructed as the center hub that had spokes reaching out to smaller development groups that were embedded in Koch’s various divisions. For example, divisions like Koch Minerals and Flint Hills Resources had development groups analyzing potential deals in their respective industries at a ground level. They fed important information and bid ideas back to the Corporate Development Board.
When employees in one of Koch’s various development groups saw a potential acquisition that was large enough, they were called in front of the board to present it. This was not pleasant. Everyone knew that there was a profound asymmetry between what the development board knew and what anyone else at the company knew. An ambitious Koch employee who thought they had a good idea never knew how it might be received by the board.
If going before the board was intimidating to business leaders at Koch, it might have been doubly intimidating to Steve Packebush. He was a thirty-eight-year-old marketing guy who grew
up on a Kansas farm. He attended K-State and joined Koch Industries straight out of college, in 1987. He had never worked anywhere else. In 2003, Packebush was a marketing guy with Koch’s small fertilizer division, called Koch Nitrogen.
If all of Koch Industries’ business units were a professional sports league, then the Koch Nitrogen team would be in last place. The division was small, losing money and cutting production at its primary fertilizer plant in Louisiana, where it had laid off about half its workforce. Koch Nitrogen had sold off its ammonia pipeline network and seemed to be a caretaking unit whose main job was to babysit a handful of assets that were left behind after the now-legendary collapse of Koch Agriculture back in 1999. If an up-and-comer at Koch Industries was looking to make a name for himself, he would have stayed away from Koch Nitrogen.
But in 2003, Steve Packebush and a team from Koch Nitrogen made an appointment to appear before Charles Koch and senior executives at the Corporate Development Board. The nitrogen team wanted to convince Charles Koch to give them hundreds of millions of dollars to buy a group of money-losing fertilizer plants.
As it turned out, this would be one of the first deals considered under Koch’s new acquisition regime. It would also be a test. It would determine how well Koch could export its trading mentality into the real world.
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The Koch Nitrogen team filed into the boardroom in Wichita and took their places. The team included Steve Packebush and his boss, Jeff Walker. They had prepared their case, and this was their moment to pitch it directly to Charles Koch.
During such meetings, Charles Koch sat and listened to the presentations, statue-like. He let the presenters talk, often without interjecting. When it came time for him to ask questions, Koch was, almost invariably, soft-spoken and utterly unsentimental. He looked for weak spots. He tried to smoke out any executives who were inflating the prospects of a deal, or, conversely, those who might be too timid to realize the upside of taking a bigger risk.
Packebush’s investment thesis might have seemed ripe for puncturing. The thesis was first developed around the year 2000, when natural gas prices spiked. This volatile surge had exposed the terrible weakness of many high-cost fertilizer producers in the fertilizer business. Natural gas was the primary ingredient of nitrogen fertilizer, accounting for roughly 80 percent of its production cost. One of the fertilizer plants that was punished by the spike in gas prices was Koch’s plant, in Louisiana. All of the US fertilizer plants, in fact, were exposed as being the weakest animals of the global herd. Natural gas wells were relatively scarce and unproductive in the United States. Other countries, with more plentiful gas supplies, could make fertilizer much cheaper. Imported fertilizer had an edge that seemed like it would be permanent.
Packebush and his colleagues responded to the crisis in a very Koch way—rather than panic, they launched an in-depth study of their situation. When they studied the fertilizer markets, Packebush’s team confirmed that Koch’s Louisiana plant was a permanent loser. But that didn’t mean that all fertilizer factories were permanent losers. His team believed that the bloodletting would only go so far, and then the market would stabilize. When that happened, a small island of winners would be left behind. These winners would be supported by strong local demand for their product. Modern US farmers were a lot like modern motorists: they had become utterly dependent on fossil fuels. Without nitrogen-based fertilizers, US food production would decrease substantially, maybe as much as 40 percent. There was no plausible future wherein nitrogen fertilizer demand would drop to zero, or anywhere near zero.
Packebush and his team began mapping out what the postapocalyptic fertilizer industry might look like. They figured that after half the US fertilizer production was wiped out, then the remaining plants would be in the best competitive position. The Koch Nitrogen team believed it would be smart to buy any fertilizer plants in the United States that went up for sale, but only if Koch could pay the price of replacement value—meaning the amount of money that it would take to rebuild the plant if it were destroyed. In other words, it would be smart to buy the plants for the cost of their physical equipment and not much more. At that price, the plants could stay in business for years, even if they didn’t exactly thrive.
The Koch Nitrogen team had to figure out which plants to buy. They settled on an unlikely target: one of the largest fertilizer producers in the United States and a powerhouse of modern agriculture, a gigantic, farmer-owned co-op based in Kansas City called Farmland Industries.
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Koch Industries had been closely scrutinizing Farmland Industries since at least the 1990s. This was only natural for Koch—Farmland was a big competitor in fertilizer, grain, and other markets. Koch didn’t just want to compete against Farmland—it wanted to understand Farmland better than Farmland understood itself. Koch put together a small team that X-rayed Farmland’s business. A team at Koch studied every piece of publicly available data about Farmland and then reverse engineered the data to figure out what was happening inside the giant cooperative. Koch used the data to figure out Farmland’s cost structure, profit margins, and cash flows.
It didn’t take long for Koch to grasp a truth that was well known to Farmland executives, which was that nitrogen fertilizer sales were pivotal to the company’s business model in 1995. Koch also detected a weakness in Farmland’s business model. Farmland was a co-op, meaning that it was owned by thousands of members who also sold their products through the firm. It was a uniquely midwestern form of capitalism that blended community control with industrial scale. In this way, Farmland was the opposite of Koch Industries, which was tightly held by Charles and David Koch. Farmland was owned by thousands of farm families and small business owners who shared in Farmland’s annual profits and voted on its actions. But it also hindered Farmland—decisions were influenced by its member-owners, who considered factors beyond the simple return on investment.
“It was Socialism,” as Koch Agriculture president Dean Watson put it. And Koch’s traders believed that Socialism was always destined to fail.
Farmland would, in fact, collapse. And the company’s fertilizer plants were the catalyst that destroyed it. During the 1990s, Farmland’s fertilizer plants were immensely profitable, dispensing waves of cash. Farmland’s member-owners used this money to expand, buying pork processing plants, grain elevators, and even an oil refinery. Free cash flow from nitrogen fertilizer helped fund it all. This was possible because natural gas was cheap. By the end of the 1990s, Farmland was one of the largest purchasers of natural gas in the United States; it was buying all the supplies it could get to stoke the fertilizer money machine. In doing so, Farmland had become an energy company without even realizing it. Farmland had gotten deeply entrenched with a commodities business during an upcycle, without thinking too hard about what life might look like during the inevitable down cycle.
When the crash came, it decimated the profits in Farmland’s nitrogen division. This sapped the cash flow to every other division. The whole co-op machine began to falter. Farmland couldn’t pay its debt obligations, which increased its debt obligations as creditors demanded repayment. In 2002, Farmland was trying to raise as much capital as possible by selling off its businesses. Bankruptcy looked imminent.
Packebush and his team studied Farmland’s network of fertilizer plants, and they identified something that no one else saw. Farmland owned a constellation of plants that zigzagged through the Corn Belt in a crooked line that looked a little bit like the Big Dipper turned on its side. The long handle of the Dipper started up in Fort Dodge, Iowa, and ran in a long slope down through some of the most fertile cropland on earth, down through the town of Beatrice, Nebraska, where there was a large nitrogen plant, and then bending to meet Dodge City, Kansas. At the edge of the Dipper’s cup was Farmland’s crown jewel—the company’s massive fertilizer plant in Enid, Oklahoma.
Farmland’s plants had a key advantage: they were located right next door to their customers—the farmers. T
his gave them an edge on transportation costs. If these plants closed, there would be a dramatic fertilizer shortage. It would be simply impossible to import all the fertilizer that midwestern farmers needed.
The Farmland plants were similar to Koch’s oil refinery in Pine Bend. They were perched on exclusive real estate, giving them an advantage over their competitors. Demand wasn’t going to disappear, and it wasn’t feasible for new competitors to set up shop nearby.
Perhaps most important, nobody else in the marketplace attributed this value to the Farmland plants. When Farmland put the plants up for sale, the co-op got very little interest. There were two big, publicly traded fertilizer companies that seemed like natural buyers, called Agrium and CF Industries. But these companies were also embroiled in the natural gas crisis and seemed obsessed with their quarterly losses and the near-term economics of the fertilizer business. These companies had to explain themselves to investors every quarter and focused on the losses that were likely to occur this year and next.
The Koch Nitrogen team made its pitch to Charles Koch and the development board. The team wanted Koch to spend somewhere in the neighborhood of $270 million for a group of fertilizer plants—that could produce about 1.8 million metric tons of fertilizer a year—at the very moment when those plants were delivering absolutely gruesome quarterly reports to their current owner.
The plan seemed preposterous in many ways, and Charles Koch wasn’t convinced at first. As he and the development board considered the plan, they applied a set of rules that would help usher in years of future growth:
1. The Target Company Had to Be Distressed
Koch was only interested in buying companies or assets that had fallen on hard times. Part of the logic behind this was simple: distressed companies were cheaper. They could be purchased at a discount. But the company had to be distressed in the right kind of way. Ideally, the firm should to be distressed because of managerial negligence or poor decision-making. That way, Koch could reverse the poor strategies when it was the owner. The goal was to improve operations and profits at the distressed firm to boost its value. When that happened, Koch could hold on to its new profit-making machine or sell it.
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