The Firm: The Story of McKinsey and Its Secret Influence on American Business

by Duff McDonald

  “In all the work we did with Enron, we did not do anything that is related to financial structuring or disclosure or any of the issues that got them in trouble,” Rajat Gupta told BusinessWeek in the wake of the scandal. That was not entirely true. Whether or not McKinsey actually worked on Enron’s off–balance-sheet financings, the firm was nevertheless enthusiastically applauding such pracrices in its own writings.

  “We stand by all the work we did,” Gupta said. “Beyond that, we can only empathize with the trouble they are going through. It’s a sad thing to see.”25 And then he delivered the age-old dodge: “[McKinsey only advises] clients on their strategy. They are responsible for what action they take.”26

  The courts (and plaintiffs in lawsuits) appeared to take that in stride. McKinsey was never named as a civil or criminal defendant, nor were any of its employees asked to testify in congressional hearings.27 That shocked many industry observers. “I’m surprised that they haven’t been subpoenaed as a witness, at least,” Wayne E. Cooper, CEO of Kennedy Information, a research and publishing firm, told reporter John Byrne. “There was so much smoke coming out of the Andersen smoking gun that all the firefighters went after that one. McKinsey was lucky. They dodged a bullet.”28 Luck, though, may have had nothing to do with it: For a firm as large as it is, and with such extensive global business, McKinsey has been party to lawsuits a remarkably small number of times. The reason seems an obvious one: Sue McKinsey, and lose access to the firm. A few ex-employees and a few bankruptcy lawyers have sued the firm, but McKinsey has rarely found itself on the losing end of a scandalous or expensive lawsuit.

  Despite the fact that Ron Hulme ran the Enron relationship, Rajat Gupta protected him. “Ron was his blue-eyed boy,” said one former McKinsey partner. Dick Foster, on the other hand, was hung out to dry and shoved out of the firm after a highly successful and inspiring thirty-year career. Foster had built the firm’s chemical practice as well as its pharmaceutical practice. He’d maintained Johnson & Johnson as a client for more than two decades. His 1986 book, Innovation: The Attacker’s Advantage, is considered one of the most influential on the topic. But the New York mafia decided that he was to be the fall guy.

  “We were adamant that we had nothing to do with any criminality,” said a former partner. “The business model was successful and then it wasn’t. That said, a lot of the mud did stick to McKinsey, and deservedly so. We may say publicly that we don’t take credit for our work, but when our clients do well, we do take credit for it.”

  Enron was, briefly, a terrible experience for the firm. Both the technology practice and the Houston office suffered. Most of the partners involved left the firm. (Most, but not all. Enron broke in 2001; Suzanne Nimocks stayed on at McKinsey for almost a decade, despite playing an extremely intimate role in the Enron relationship, perhaps even more than did Hulme.)

  But when McKinsey tries to argue that Enron was an isolated case, it is right. Even if Andersen suffered an immediate implosion due to criminal behavior on the part of some of its partners, there was no reason for the Enron work to taint the entire McKinsey enterprise—unless McKinsey had been associated with those crimes, and it wasn’t. The consultants were merely giving advice, the same thing they have always done.

  In July 2002, BusinessWeek ran a scathing cover story by John Byrne about McKinsey and Enron. But aside from that, the biggest public relations problem was that the business media just ignored McKinsey for a while. In the two years leading up to Enron’s collapse, McKinsey had been cited eighty-six times in the business press, and twenty-five of the citations were quotes from McKinsey experts. In the two years after the scandal, total citations fell to fifty-six, with just seventeen expert quotes. But even that was short-lived pain: By 2005 the number of McKinsey mentions in BusinessWeek had returned to pre-Enron levels.29

  McKinsey consultants even showed defiance in the face of all the criticism. When they were offered a chance to remove any of their favorable Enron citations from the company’s website, not a single consultant did so.30 The most noticeable change in the McKinsey culture—possibly the only one—was a pronounced increase in papers and studies produced on the issue of effective corporate governance.31

  “The major barrier to an Enron-like scandal damaging the reputation of the consulting industry at large is that the selection and management of consultants is seen, by clients, to be their responsibility,” analyst Fiona Czerniawska wrote in her 2002 report, “Consulting on the Brink.”32 There was that “perfect business” thing again: You’re right when you’re right, and they’re wrong when you’re wrong. As far as the outside world was concerned, McKinsey could do no wrong. “Like children, they are not perceived to be ultimately responsible for their actions,” wrote Lewis Pinault in Consulting Demons.33

  The official McKinsey line of defense boiled down to this: that its consultants, along with everyone else, were just dupes. They had no idea what was really going on at one of their largest clients. They were not the smartest guys in that room.

  A study by Swedish academic Lars Engwall showed that in the decade before the Enron collapse, the firm dispensed similar advice to Swedish banks.34 Acting partly on guidance from their consultants, Swedish banks reduced the number of people engaged in auditing and review by 12 percent between 1983 and 1990, while increasing the number focused on marketing and selling by 65 percent. The emphasis, clearly, was on market share and growth instead of prudent balance-sheet control. By 1992, after an orgy of speculative investment—a large part of which was in real estate—the Swedish banking industry blew up, causing a full-scale financial crisis. Fortunately for the world, Sweden is a small country and there was no contagion. McKinsey too was unharmed. In fact, it was one of the firms called in to help the banks untangle themselves. And who was running McKinsey’s Scandinavian operation at the time? Rajat Gupta.

  The Enron debacle had a similar perverse result for McKinsey. Among other things, it helped spur the creation of the Sarbanes-Oxley Act, which put executives and boards of directors more squarely in the gun sights of prosecutors. Whom have those boards hired to help shield themselves from liability? Consultants, of course. McKinsey’s failures at Enron contributed, in a roundabout way, to its continuing success.

  More Missteps

  Enron wasn’t the only blowup of the Rajat Gupta era. In its quest for growth and profits, the firm not only took on clients it wouldn’t have considered in decades past but also found itself on the defensive for giving fundamentally flawed advice.

  McKinsey, for example, was one of the primary advocates of Swiss bank takeovers of American financial institutions, such as the acquisition by Credit Suisse of New York investment banks First Boston and Donaldson, Lukfin & Jenrette. “It was a particularly bad strategy,” admitted one Swiss banking expert. “The Swiss banks lost a lot of money on those purchases. Interestingly, too, they started trying to make all the banks look the same. McKinsey only had one model for a bank, so it all started converging.”

  Lowell Bryan, the firm’s financial institutions guru, had predicted that investment banking was due for a secular decline in the mid-1990s, and banks were rushing to consolidate—in richly priced deals—to prepare for the downturn. When investment banking remained buoyant, the Swiss companies found themselves at a disadvantage as they contended with expensive integrations of new properties they didn’t need. Lukas Muhlemann, the former head of McKinsey’s Swiss office, was running Credit Suisse when it bought DLJ. Ex-McKinseyite Peter Wuffli ran UBS during much of the same decade.

  The firm’s advice even bordered on the preposterous. In 1995 McKinsey advised JP Morgan that its competitive troubles could be solved by getting out of the lending business. The consultants said this to a bank. “It was like telling McDonald’s to stop making hamburgers,” said a former executive of the client. Yet the bank—headed at the time by Sandy Warner—at least partly followed the consultants’ advice and dialed back on lending. Smelling opportunity, Chase Manhattan’s Jimmy Lee cr
anked his own bank’s corporate lending into high gear. When JP Morgan floundered, Chase Manhattan swooped in and bought it in 2000.

  McKinsey was also on the scene when Time Warner completed its notorious merger with AOL that same year. According to ex-McKinsey consultant Yves Smith, McKinsey pushed the board of Time Warner to consider the merger on five separate occasions.35 “They traded half of Time Warner for a box of air,” exclaimed a rival consultant. Just over a year later, the consultants earned $9 million as advisers to then–Hewlett-Packard CEO Carly Fiorina in her quixotic acquisition of Compaq that eventually cost Fiorina her job and brought the technology firm to its knees. These were not merely bad judgment calls; they were two of the most disastrous deals of the era.

  The firm served as an adviser to Kmart from 1994 through 2000, a period during which the once-iconic retailer got thoroughly waxed by Walmart. The consultants’ big idea at the time was selling groceries. It wasn’t necessarily stupid—Walmart eventually moved into groceries and did extremely well—but Kmart just didn’t have the expertise to pull it off. Ex-CEO Joseph Antonini, who stepped down in 1995, has kept McKinsey’s code of omertà, and he won’t even talk about the consultants’ advice. Antonini’s successor, Charles Conway, worked with the consultants for a time: McKinsey played a large part in Blue-Light.com, meant to be Kmart’s triumphant Internet land grab, but a planned initial public offering never happened.36 Conway eventually disagreed with the consultants over strategy, and they parted ways in 2000, shortly before the company weakened further.

  McKinsey also played an intimate part in a deal that was eventually seen as one of the signature M&A blunders leading up to the 2008 financial panic. In 2006 the relatively conservative, healthy Wachovia Corporation paid a whopping $25.5 billion for Golden West Financial, a leading subprime lender. “McKinsey was Wachovia’s house consultant,” said a rival, who estimated that the firm made at least $50 million from the relationship. “[Wachovia CEO Ken] Thompson wouldn’t have made a big move without McKinsey.” And no wonder: Peter Sidebottom, the former head of McKinsey’s Charlotte office, was at that point head of planning and strategic initiatives at Wachovia, then the nation’s fourth-largest bank.

  Edward Crutchfield, Thompson’s predecessor at Wachovia, had once compared the mortgage business to crossing five lanes of traffic to pick up a nickel. Thompson thought otherwise. Four years later, Wachovia collapsed under Golden West’s toxic book of adjustable-rate mortgages and was forced to sell out to Wells Fargo. Does McKinsey bear responsibility? No. Thompson pulled the trigger. But McKinsey certainly didn’t convince him not to make the deal.

  Flying Blind and Driving Without a Net

  In 1993, after a possible joint venture with Scandinavian Airline Systems (SAS), KLM Royal Dutch Airlines, and Austrian Airlines had fallen apart, Swissair found itself in a jam and sought out McKinsey to help come up with a new plan. The consultants offered two-pronged advice. First, they advised the Swiss company to expand vertically, by buying minority stakes in smaller European airlines. Second, the airline should expand horizontally into aviation services: food, maintenance, and the like.

  McKinsey had predicted that in the future, airlines would fall into one of three categories—network managers, capacity providers, and service providers. The sweet spot was to be the network manager, the airline that controlled a hub, and could use marketing and cost management to wring profits not only out of its own operations, but also out of those of the capacity providers drawn to the hub.37

  So in 1995 Swissair restructured into four new divisions—SAirLines, SAirLogistics, SAirServices, and SAirRelations. By 1997 the nonpassenger businesses accounted for 60 percent of group revenues of $7.6 billion, up from just 24 percent in 1990. That year, McKinsey proposed to Swissair a multipartnership plan known as the “hunter” strategy—a Swissair-led equity-based alliance with an ultimate goal of 20 percent market share in Europe. CEO Philippe Bruggisser began buying equity stakes in other carriers pell-mell, including Austrian Airlines; AOM, Air Liberté, and Air Littoral of France; charter carrier LTU of Germany; LOT (Polish Airlines); and South African Airlines.

  On paper, it all looked perfect. There was just one problem: The real world intervened. A spike in oil prices in 1999 and 2000 slaughtered the entire airline industry. McKinsey was brought in to estimate the costs of Swissair’s financing commitments to its minority investments. The estimates: between SFr 3.25 billion and SFr 4.45 billion. The board abandoned the hunter strategy and fired Bruggisser. In March 2001, nine of the board’s ten members announced that they too would resign. By midyear, the company’s balance sheet was 5 percent equity and 95 percent debt; the total debt was a staggering SFr 17 billion. By October, the airline was bankrupt.

  McKinsey has a compelling case when it suggests the failure was not of strategy but of execution. With the exception of LOT, none of the acquired stakes were in target markets identified by McKinsey.38 What’s more, the consultants had suggested equity stakes of 10 to 30 percent; but with one exception, every single investment made by Bruggisser had been in excess of 30 percent, all the way up to 49 percent. McKinsey had suggested a mere $194 million in investments in alliance partners; Bruggisser’s shopping spree had totaled $3.4 billion. Without operating control of the more poorly performing airlines, Swissair had no ability to attempt any turnaround. In 2000 McKinsey made a presentation—code-named “Shield”—that was an effort to alert the board and management of Swissair that there was a crisis at hand. It was ignored.

  The blame for destroying the extremely valuable Swissair brand that had taken decades to build belongs chiefly to Bruggisser and his management team, no doubt about it. But just as with Enron, nobody involved in such an epic destruction of value should be allowed to escape without some reputational damage. Regardless of Bruggisser’s profligacy, the acquisitive strategy, for one, would have run into trouble. The Swiss media certainly weren’t willing to let McKinsey off the hook. The firm was pilloried in the press, and the rest of McKinsey’s business in Switzerland nose-dived. Swissair’s assets were absorbed by Lufthansa in 2005 and a national icon ceased to be.

  As the accusations mounted, McKinsey offered little or no public defense. “The Swissair experience was unfair to McKinsey,” said former managing director Ian Davis. “That’s where we learned that there are certain situations where if you don’t talk about your clients and the work you did, you become the whipping boy for everyone. That is something we debate.”39

  McKinsey’s historians have this to say about Swissair. “Fortunately, while the failure sent shockwaves through the [firm], the impact on clients outside Switzerland was negligible. Other European airlines continued to work with McKinsey. As with similar crises . . . in the years before, the reputational damage was contained within national borders.”40

  Still, the entire episode showed something of the McKinsey man’s ruthlessness. Whereas Swissair had kept McKinsey on as an adviser through the depth of its troubles, when former McKinsey consultant Lukas Muhlemann took the reins at Credit Suisse, he essentially shut the struggling airline off from the bank’s lifeline, despite his having been involved in the Swissair strategy from the get-go.

  • • •

  When you’re in the business of predicting the future, it’s not a crime to be wrong. McKinsey may have steered Swissair right into a storm, but such advice isn’t shameful, it’s merely bad advice. On the other hand, the work McKinsey did for the insurance giant Allstate in the mid-1990s stands among the most questionable it has ever done for a client.

  Allstate management initially brought in McKinsey to help improve “efficiency,” which basically meant reducing the amount it paid out in claims. The insurer, known by its slogan “You’re in Good Hands with Allstate,” began ratcheting down payments to policyholders in 1996. The results were dramatic: In 1987 the insurer had paid 71 percent of its premium income to claimants. In 2006 that proportion was just 48 percent. Operating income rose thirtyfold as a result, the stock more than
quadrupled, and company executives paid themselves extravagantly. Edward Liddy, who was chief operating officer of Allstate and then later CEO, made a fortune as a result of Allstate’s skyrocketing stock price, pulling down $54 million in compensation between 2001 and 2005 alone. (It’s no wonder that when he was brought in as CEO of AIG in 2008, one of the first things he did was hire McKinsey. His successor, Robert Benmosche, showed the consultants the door.)

  New Mexico attorney David Berardinelli sued Allstate on behalf of one of its policyholders and subsequently became embroiled in a multiyear lawsuit that forced Allstate to release what became known as “the McKinsey documents.” One McKinsey slide advising Allstate to take a more combative stance with claimants had the title “From Good Hands to Boxing Gloves,” a phrase Berardinelli later used as the title of a book. An industry that once prided itself on helping people in need had become just another executive money grab, aided and abetted by its fancy consultants.

  Another slide produced in court proceedings against Allstate was called “Alligator One” and had the caption “Sit and Wait,” which suggested that payments to claimants be stalled for as long as possible so that they might accept a lowball settlement. Another, titled “McKinsey Perspective on Claims,” suggested that “the potential for economic improvement is substantial, typically 5 to 15 percent reduction in severities and 10 to 20 percent reduction in expenses.” The basic idea: to pretty much stop paying Allstate’s policyholders at all.

  “What if you discovered a secret set of construction plans for the Mother’s Peas factory, proving that the company designed the machines to under-fill every can of peas by 30 percent?” asked Berardinelli. “What if you also had proof that the Mother’s Peas Company did this to generate windfall profits for their shareholders and huge bonuses for their executives? Then you’d probably think you were the victim of a fraud.”41