Strategic Errors

Corporate Research E-Letter No. 29, November 2002


by Philip Mattera

When the question is asked as to who was responsible for the Enron scandal, fingers are generally pointed at greedy executives, compliant auditors, gullible security analysts and clueless regulators. Yet there was another player--arguably the most significant influence in the formation of Enron’s no-holds-barred culture--that has so far gotten off scot-free. That player is McKinsey & Company, the most prominent management consulting firm in the world.

McKinsey has been spared the fate of Enron’s accounting company Arthur Andersen, which was found guilty of federal obstruction of justice charges and is now all but defunct. Yet McKinsey’s role in the Enron debacle has been a major embarrassment for a firm that counts among its clients about three-quarters of all large corporations as well as many governments and other institutions. It has also focused attention on the general crisis of the once high-flying management consulting business.


 “Enron is the house that McKinsey rebuilt. The brightest minds at the world’s most prestigious consulting firm helped turn the lumbering old-economy gas distribution dinosaur into a new-economy success story envied by every corporation in America.” So wrote the British newspaper The Observer (March 24, 2002), which went on to wonder if McKinsey would suffer “collateral damage” from Enron’s collapse.

 McKinsey’s relationship with Enron started in the 1980s, early in the life of the company created by the merger of InterNorth and Houston Natural Gas. Enron so valued the advice provided by McKinsey that in 1990 it hired the lead partner on the account, Jeffrey Skilling, to be its chief executive. Skilling, following the practice of numerous McKinsey alumni who took executive positions with clients, used his new post to continue giving consulting contracts to the firm. During the 1990s, McKinsey played a key role in helping Enron fashion its plan for transforming energy markets. By 2000, one of the firm’s senior partners was regularly attending Enron board meetings.

 In addition to its internal work, McKinsey publicly held up Enron as a model of a new way to do business. A 1997 article in the firm’s journal, McKinsey Quarterly, celebrated Enron’s “new breed of tightly focused and vertically specialized ‘petropreneurs.’” A 2001 article in the same publication praised Enron for having “built a reputation as one of the world’s most innovative companies by attacking and atomizing traditional industry structures.”

 The big question is what involvement McKinsey may have had in the practices that brought Enron down. In a cover story on McKinsey in its July 8, 2002 issue, Business Week quoted McKinsey Managing Partner Rajat Gupta as saying that “we did not do anything that is related to financial restructuring or disclosure or any of the issues that got them into trouble.” Yet as Business Week and other publications have pointed out, the McKinsey Quarterly published a 1997 article favorably describing Enron’s use of off-balance-sheet financing--the practice that the company took to extremes and that played a central part in its downfall.

 A discussion of McKinsey and Enron is not complete without mentioning another questionable connection: In 1999 Texas Gov. George W. Bush appointed McKinsey veteran Brett Perlman (whose clients had included Enron) to the state’s Public Utilities Commission. Last May, dozens of cities in Texas sued the Commission, charging that Perlman and former PUC chairman Max Yzaguirre (who had once worked for Enron) should not have been making decisions on electricity rate increases that especially benefited Enron.


Even before the Enron scandal put McKinsey on the hot seat, all was not well in the rarefied world of management consulting. The past two years have seen an interruption in a decades-long expansion of a business that had its origins in the mid-1920s, when accounting professor James McKinsey and two partners, Marvin Bower and A.T. Kearney, opened a consulting office in Chicago. These men did not invent consulting. The first consulting company is said to be Arthur D. Little Inc., which had its origins in the 1880s, but it focused on technology. Frederick Winslow Taylor opened a consulting firm in the 1890s to promote factory time-and-motion studies under the rubric of “scientific management.” Booz Allen Hamilton dates back to 1914, but it originally did only statistical analysis.

 It was in the 1930s that McKinsey (and its offshoot A.T. Kearney & Co.) began doing what is typically thought of as management consulting: advising executives of large corporations on how to manage. That business grew at a handsome rate, some 15 percent a year, during the 1950s and 1960s. During these decades, McKinsey was the unchallenged leader of the business, so highly respected that companies would not think twice about paying huge sums for its assistance.

 In the 1970s McKinsey’s reign was challenged by a new breed of firms--led by Boston Consulting Group and Bain & Co.--that claimed to have more sophisticated strategic analyses of business dynamics. It was also during this period that the consulting arms of the big accounting firms, which had previously stuck to giving advice on information technology, began to move into the general management consulting field.

 Still, there seemed to be plenty of work to go around. Although a few critics wondered why well-paid executives needed to bring in consultants to tell them how to do their job, there was a general sense in the business world that capitalism had become a lot more complicated. This made the use of consultants seem the prudent thing to do. One consultant told Fortune magazine, “The more uncertainty there is, the more people are likely to look for outside help.” Also contributing to the demand for consultants was the transformation of management theory into a kind of religion--due in no small part to the phenomenally successful 1982 book In Search of Excellence, written by McKinsey veterans Tom Peters and Robert Waterman.

 The demand for consulting reached unprecedented heights during the boom, when virtually every high-level corporate executive was persuaded that his or her business had to be totally transformed to adapt to the digital revolution. The old line consultancies had to scramble to get up to speed on web matters, but soon they were riding the e-business wave.


 It turned out to be a short ride. By 2001 the e-biz bust and the general weakening of the economy were hammering the consulting firms. In July of that year, McKinsey took the extraordinary step of asking its partners to contribute as much as $200,000 each to bolster the firm’s financial resources. Kearney (which was purchased by Electronic Data Systems in 1995), Booz Allen and the consulting arms of the accounting firms all began to eliminate jobs; McKinsey and Boston Consulting Group later followed suit.

 In February 2002, the venerable Arthur D. Little Inc., facing a cash shortage caused by a slump in demand and the collapse of plans for an initial public offering spin-off of its high-tech operations, filed for Chapter 11 bankruptcy and put itself up for sale.

 This year the staff cuts have been continuing, and the consultants have been trying to avoid being tainted by the spate of corporate scandals. The widespread discussion of conflicts of interest between Arthur Andersen’s consulting work and its auditing practice have prompted the consulting branches of the other big accounting firms to distance themselves from their parents.

 In July 2002 the consulting operation of Deloitte Touche Tohmatsu announced that it was changing its name to Braxton Associates. Last month, KPMG Consulting, which was spun off from KPMG in 2000, changed its name to BearingPoint Inc. Around the same time, IBM completed its acquisition of the consulting business of PricewaterhouseCoopers, which is being absorbed into IBM Business Consulting Services. The consulting operation of the last of the remaining Big Four accountants, Ernst & Young, was sold to the French computer services firm Cap Gemini back in 2000.

 The former consulting wing of Arthur Andersen, now known as Accenture Ltd., is enjoying the fact that it split off from its parent in 2000 and appears to have escaped the fallout from Enron.

 McKinsey, meanwhile, has been criticized not only for its Enron ties but also because some of its other clients--including Global Crossing, Kmart and Swissair--have been in serious financial trouble. Bain & Co. is facing an embarrassing lawsuit filed by Serge Trigano, former chairman of resort company Club Med, who is alleging that the firm supported the efforts of a group of shareholders to force him out of office.

 Worst of all for the business is what a recent (November 2) article in The Economist called a “crisis of confidence in consulting”--a growing sense that what the industry has to offer may no longer be worth the high price. The magazine speculated that consulting firms could end up like think-tanks--places with lots of ideas but little in the way of profit. Another possibility is a fragmentation of big firms into smaller operations that specialize in narrow fields where demand remains reasonably strong. Avoiding these fates will require the big strategy consultants to come up with a killer new strategy for themselves.