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Shortly after Enron Corp. tumbled into bankruptcy last December, McKinsey & Co. Managing Partner Rajat Gupta was worried. It wasn't only because former Enron CEO Jeffrey K. Skilling was once a McKinsey & Co. partner and loyal alum. Or that his firm had advised the giant energy trader for nearly 18 years on basic strategy, even sitting in on boardroom presentations to Enron's directors. Or even that many of the underlying principles of Enron's transformation, including its "asset-light" strategy, its "loose-tight" culture, and the securitization of debt, were eagerly promoted by McKinsey consultants.

Gupta was worried about something much more immediate: Had McKinsey crossed a legal line that would drag it into the unfolding morass? In a stunning exercise for the world's whitest of white-shoe management consultants, Gupta dispatched his chief legal counsel to McKinsey's offices in Houston to review the firm's work at Enron. The mission was to find any evidence linking McKinsey to the massive fraud behind Enron's business model.

The lawyer came back with good news: There were no shredded documents, a la Arthur Andersen LLP, and, more important, says Gupta, there was nothing in the files to show that McKinsey ever helped Enron engineer its controversial off-balance-sheet financing or its financial reporting strategy. "In all the work we did with Enron," maintains Gupta, "we did not do anything that is related to financial structuring or disclosure or any of the issues that got them into trouble. We stand by all the work we did. Beyond that, we can only empathize with the trouble they are going through. It's a sad thing to see."

Still, outsiders marvel that the secretive partnership has not been drawn into the debacle, given its extensive involvement at Enron. "I'm surprised that they haven't been subpoenaed as a witness, at least," says Wayne E. Cooper, CEO of Kennedy Information, a research and publishing firm that keeps tabs on consultants. "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."

The bad news, however, is that Enron, which was paying McKinsey as much as $10 million in annual fees, is just one of an unusual number of embarrassing client failures for the elite consulting firm. Besides Enron, there's Swiss-air, Kmart, and Global Crossing--all McKinsey clients that have filed for bankruptcy in relatively short order. And those are just the biggest. McKinsey also finds itself improbably lining up with other creditors to collect unpaid fees from recently bankrupt companies that soared during the late '90s only to crash later. Battery maker Exide Technologies and NorthPoint Communications Group Inc., an upstart telecom provider, are two such examples.

All of which raises uncomfortable questions about the world's most prestigious--and enigmatic--consulting firm. Did McKinsey's partners get caught up in the euphoria of the late '90s and suffer lapses of judgment? And if so, what does that say about the quality of its expensive advice? Did it stray from its core values? What accountability does it--or any consulting firm--have for the ideas and concepts it launches into a company?

After all, McKinsey was a key architect of the strategic thinking that made Enron a Wall Street darling. In books, articles, and essays, its partners regularly stamped their imprimatur on many of Enron's strategies and practices, helping to position the energy giant as a corporate innovator worthy of emulation. The firm may not be the subject of any investigations, but its close involvement with Enron raises the question of whether McKinsey, like some other professional firms, ignored warning flags in order to keep an important account.

The breakdowns of such visible clients could not have come at a more trying time. Instead of celebrating the end of his third and final three-year term as managing director, Gupta, 53, finds his firm roiled by a rare and potentially disruptive downturn in its business. Like most other consulting firms, McKinsey rode the e-business wave to record revenues--and record partner payouts--in 2000. When the boom turned to bust, the firm was stuck with far too many consultants and not nearly enough assignments. The utilization rate, or billable time, of its consultants has fallen to its lowest level in more than 32 years: just 52%, vs. the heady 64% level during the dot-com boom.

That's not to say that McKinsey has lost its standing. The firm remains the high priest of high-level consulting, with the most formidable intellectual firepower, the classiest client portfolio, and the greatest global reach of any adviser to management in the world. Most of the firm's top clients pay $10 million a year and up in fees, while McKinsey's largest client--which it declines to name--doled out $60 million for its advice last year. McKinsey serves 147 of the world's 200 largest corporations, including 80 of the top 120 financial-services firms, 9 of the 11 largest chemical companies, and 15 of the 22 biggest health-care and pharmaceutical concerns.

McKinsey partners learn early on to protect and cultivate their client relationships. The firm says that it has served more than 400 active clients for 15 years or longer. It may be the priciest of the management consultants, but longtime clients say it gives top service. "McKinsey will bring its most senior people in to discuss the things they would do if they were in our shoes," says Klaus Kleinfeld, CEO of Siemens Corp., a longstanding client. "You have lunch. You have dinner. And then projects evolve. Very often, competitive bidding doesn't happen."

Gupta shows little concern over the meltdown of high-profile clients. "In these turbulent times, with our serving more than half the Fortune 500 companies, there are bound to be some clients that get into trouble," he says matter-of-factly. "We wouldn't have as many ongoing client situations if we didn't do good-quality work." And to be fair, McKinsey was hardly the only consultant to tie up with some high-flying upstarts in the '90s that later crashed.

When he became McKinsey's managing partner in 1994, Gupta's challenge was clear: He had to keep up McKinsey's growth while ensuring that size would not destroy the ethos of the close-knit partnership or undermine the firm's guiding principles. McKinseyites refer to these precepts, laid down by the firm's early leader, Marvin Bower, with near-religious conviction. Among the high-minded goals: Hire the best people and urge them to always put the client first--ahead of the interests of the firm.

In Gupta's early days as managing partner, some colleagues argued for keeping McKinsey small, to safeguard its culture and quality. Gupta was of another mind: He aggressively expanded abroad, opening up far-flung branches throughout Asia and Eastern Europe. In all, he expanded McKinsey's network to 84 worldwide locations from 58, boosted the consulting staff to 7,700 from 2,900, and lifted revenues to $3.4 billion from $1.2 billion in 1993. Meanwhile, the number of partners grew from 427 to 891. "It's a less personal place than it used to be," says Nancy Killefer, a senior partner in Washington, D.C. "In the old days, you knew everybody. That's not possible anymore."

Some observers believe the changes in McKinsey's culture went even deeper. Quietly, some current and former McKinsey consultants say the firm strayed from some of the ingrained values that have long guided the firm. Through the dot-com boom, for example, McKinsey allowed its focus on building agenda-shaping relationships with top management at leading companies to slip, as the firm took on some distinctly downmarket clients and projects. Increasingly, McKinsey began advising upstarts and divisional managers at less prestigious companies.

Worse, some argue, there was a noticeable tilt toward bringing in revenue at the expense of developing knowledge--a claim McKinsey vehemently disputes. "In [an earlier] era, the whole place had this tremendous focus on ideas," recalls a former McKinsey consultant. "I think knowledge has taken a backseat to revenue generation. The more revenues you create, the more your compensation and standing in the firm increases."

Gupta downplays any shift in priorities. "The pendulum does swing a little bit. I'd say that client development in the last year or two is more in the forefront, simply because that is the biggest need right now," he says, using McKinsey-speak for bringing in new business.

Perhaps the most visible example of this shift, say observers, was the rise of Ron Hulme, an affable, low-key senior partner and a leader of its energy practice, who managed the Enron account from McKinsey's Houston offices. Like many of the firm's consultants, Hulme penned essays extolling the virtues of Enron. As McKinsey's annual billings climbed higher and higher at Enron--at one recent point exceeding $10 million--Hulme commanded greater influence in the firm, helping to lead partner conferences and key initiatives. Some insiders even considered him a potential successor to Gupta, though that's now an unlikely prospect, given Enron's collapse. "Despite his young age, he had tremendously high standing and power that derived from the Enron relationship," says a former McKinseyite. Hulme declined to comment.

Hulme did not initiate McKinsey's Enron business. Like many of the deepest and most lucrative corporate relationships, it began with one consultant who instantly impressed a client with his brilliance and insights. Jeffrey Skilling, then McKinsey's partner in charge of the worldwide energy practice, began advising Enron in the late '80s, but the relationship was cemented when he joined Enron in 1990 with the mandate to create a new way of doing business. Skilling, who once said he felt as if he were "doing God's work" at McKinsey, had proposed that Enron create a portfolio of fixed-price purchase and supply contracts that would supposedly eliminate supply risks and minimize the price fluctuations of the spot market for trading natural gas.

After joining Enron, Skilling repeatedly turned to McKinsey teams for analytical help and advice. "They infiltrated Enron with Jeff, and he was just the tip of the iceberg," says a former McKinsey consultant who worked at Enron. "There were all sorts of McKinsey people who went in over the years. They were so happy they had Enron locked up."

Indeed, several other prominent McKinsey consultants migrated to Enron as employees, including partner Doug Woodham, who left the firm in 1994 for a four-year stint as vice-president at Enron Capital & Trade Resources, where he led a team that developed an electric power and natural gas hedge fund. As Enron work became more financially driven, McKinsey teams there increasingly drew on partners with expertise in trading, risk management, and investment banking. At any given time, McKinsey had as many as 20 consultants at the energy company, several stationed in Enron's offices.

By and large, most of McKinsey's assignments at Enron were tactical or technical in nature: doing the prep work for entering new markets, formulating strategy for new products and services, and deciding whether Enron should acquire or partner with another company to gain access to a pipeline. But McKinsey also helped Enron formulate its now-discredited broadband strategy, in which it built a high-speed fiber network to support the trading of communications capacity. Among other things, McKinsey, over about six months, helped to gauge the size and growth of the market. And, like Enron and many others, it didn't see the telecom meltdown coming. McKinsey also helped to set up the finance subsidiary that Enron later portrayed as its growth engine, and also assisted the firm with its commodity risk management operations.

A former Enron senior executive says McKinsey consultants wielded influence throughout the organization. "They were all over the place," he says. "They were sitting with us every step of the way. They thought, `This thing could be big, and we want credit for it."' The extent of its work there and its access to senior management exposed the firm to much of Enron's inner workings. Over the years, McKinsey partners Hulme and Suzanne Nimocks had numerous one-on-one discussions with Skilling, according to former Enron executives.

Richard N. Foster, a senior partner, even became an adviser to Enron's board, attending a half-dozen board meetings in the 12 months up until October, 2001. Foster was frequently asked to step out of those meetings while the partners conferred with company lawyers over confidential matters. Competitors privately gloat that the title of Foster's most recent book, Creative Destruction, aptly captures what went wrong at Enron. Embarrassingly, the book, published in April, 2001, is filled with glowing references to Enron. "Dick Foster was very happy to see practice that enforced his theories of creative destruction at Enron," says a partner at another consulting firm. "McKinsey seems to have partners who develop academic theories and then run clinical trials on their clients." Foster declined to comment.

Some insiders offer a less benign interpretation of what went wrong at Enron. They don't claim McKinsey did anything illegal but do suggest it might have turned a blind eye to signs of trouble to preserve a lucrative relationship. "The problem for McKinsey with Enron isn't Andersen-type issues," says the former McKinsey consultant who worked at Enron. "Rather, it's `Could they have seen the organization malfunctioning and spoken up?' The answer is yes. When you have a mega-client, `This is what the client should hear' is twisted into, `This is what is going to let us stay at the boardroom level."'

Gupta won't be drawn into a detailed conversation on Enron. "Our view is not so much to have a public point of view here," he says. "I won't specifically talk about our work at Enron. We're constantly assessing whether we served everybody in the right way. I think we have."

Perhaps so. But many of the intellectual underpinnings of Enron's transformation from pipeline company to trading colossus can be traced directly to McKinsey thinking. Senior partner Lowell Bryan, one of the most influential of the firm's big thinkers today, has written extensively on securitized credit--the process of converting loans or receivables into securities. As far back as 1987, just after McKinsey began consulting for Enron, Bryan was writing that "securitization's potentialis great because it removes capital and balance sheets as constraints on growth." It was Bryan, too, who has written and spoken extensively on how capital-intensive companies such as Enron can generate greater value by finding ways to run low-asset businesses--what Skilling referred to as his "asset-light" strategy. Bryan was brought into Enron to convey these ideas to the company's top 100 executives. But he insists his ideas are not to blame. "I never said anything about fraud, accounting, or any of those issues."

If McKinsey has been humbled by the Enron experience, it certainly doesn't show it. When New York headquarters asked all consultants who favorably mentioned Enron in articles whether they wanted their citations taken off McKinsey's Web site, not a single consultant said yes. So all of the nearly 30 separate references to Enron in McKinsey-authored articles remain on the site.

As things began to unravel at Enron, some other important clients were also going off the rails. At Kmart, McKinsey produced work supporting the retailer's decision to sell more groceries in a bid to get shoppers to visit stores. It also was instrumental in creating BlueLight.com, which was intended to be spun off in an initial public offering but never made it to market.

McKinsey began consulting for the retailer in 1994. In the ensuing years, Kmart's competitive position steadily eroded. "That is a long enough time for a firm to know if its advice has impact," says an ex-McKinsey consultant. "But senior partners need to show revenue growth, so they are willing to continue to work with clients even if they feel there is no light at the end of the tunnel." McKinsey ended its relationship in 2000 after disagreeing with new CEO Charles Conaway, who pursued a disastrous price war against Wal-Mart. Still, McKinsey's involvement through the mid- to late 1990s, when Kmart swiftly and steadily lost ground to Wal-Mart, did not serve either client or consultant well.

At Swissair Group, McKinsey advised a major shift in strategy that led the once highly regarded airline to spend nearly $2 billion buying stakes in many small and troubled European airlines. The idea was for Swissair to expand into aviation services, providing everything from maintenance to food for other airlines as a way to increase revenues and profits. The strategy backfired, causing massive losses and a bankruptcy filing last October. McKinsey maintains it can't be held responsible for the outcome because it wasn't involved in the implementation of the strategy. At Global Crossing Ltd., McKinsey says its work was limited to only three projects, two of which involved information-technology outsourcing, so it cannot be blamed for the telecom provider's implosion.

The Internet boom posed an especially difficult challenge for McKinsey. The blanket assumption was that the rules of the game were changing, and many McKinseyites saw their former MBA classmates emerge overnight as multimillion-dollar entrepreneurial celebrities. Inside the firm, Gupta was faced with all kinds of new pressures: whether McKinsey should start a venture-capital fund, or go public itself, or start its own dot-com ventures as offshoots of the firm's consulting business; whether to accept equity instead of cash for an assignment with a startup. The partnership declined to sell shares, as Goldman Sachs had done, but in other important ways it veered from the course it had long followed.

One of the most noticeable changes was a drift away from its longstanding policy of not linking its fees to client performance. Bower believed alternative fee arrangements could tempt consultants to focus on the wrong things. During the past 18 months, McKinsey has been structuring dozens of deals with blue-chip companies that call for the payment of an assignment-ending bonus if a client is satisfied with the results. In the past three years, it also began accepting payment in stock from approximately 150 upstart companies, though Mc-Kinsey points out that this is a small percentage of its 12,000 engagements in that time. Gupta says the change allowed the firm to serve smaller, innovative companies that didn't have the cash to pay McKinsey's standard fees of $275,000 to $350,000 a month. The equity was then sunk into a blind trust and liquidated as soon as possible into a profit pool for its partners. In another case, that of Spain's Telefonica, it added a clause in its contract giving it a cash kicker based on the rising stock price of an Internet offshoot McKinsey was advising. The firm collected a $6.8 million bonus.

Yet even these concessions to the bonanza mentality during the boom's height didn't prevent defections. Many McKinsey consultants left for dot-com startups with names like Pet Quarters, Cyber Dialogue, Virtual Communities, and CarsDirect.com, many of which are now relegated to the junk heap of irrational exuberance. Across the firm, attrition rose only slightly during the boom, to over 22% a year in 1999 and 2000 from more typical levels of 18%. But some of the best people left, and some offices were hit hard by the exodus. In San Francisco, where McKinsey employs 150 professionals, a full third of the staff departed for other opportunities in 1999. "There was a whole group of people in the bubble who lost their way," says Larry Mendonca, the McKinsey partner who manages the San Francisco office. "They were trying to get their share of the bubble."

McKinsey got its share, of course. In its quest for revenue growth, it pursued a whole new class of clientele. Demand for consulting soared from both startups and large corporate clients, many of which had grown fearful that they were falling behind the Internet curve. During the peak two years of the dot-com boom, McKinsey alone did more than 1,000 e-commerce assignments, even as partners internally debated the true impact of the Net on clients. "I was in the room saying, `You're smoking dope here on this dot-com stuff,"' recalls Roger Kline, a longtime McKinsey partner who oversees the financial-services practice.

But the firm even set up "accelerators," or facilities, to help entrepreneurs launch new dot-coms with direct McKinsey help. "Maybe we should have been a little more circumspect than we were," concedes Gupta. "But I don't think we made any big errors or excesses."

Not surprisingly, some of McKinsey's dot-com clients fared little better than Pets.com Inc. EB2B Commerce Inc. (EBTB), which engaged McKinsey in early 2000 to help it develop a strategy after a merger, was recently warned by Nasdaq that its stock could be delisted. The company's shares have plummeted to 15 cents from $190 when McKinsey started working with it. Another high-tech client, Applied Digital Solutions Inc. (ADSXE), which McKinsey helped in exchange for equity, is in the midst of a meltdown, with first-quarter losses of $17 million. Applied Digital's auditors resigned the account in May after an accounting dispute with the company, which describes itself as a developer of "life-enhancing personal safeguard technologies." Shares of Applied Digital now trade for 57 cents.

To be sure, McKinsey's core blue-chip clients, which range from General Motors Corp. (GM) to Johnson & Johnson (JNJ), remain the firm's true bread and butter--partly because only those big companies can afford its fees. "McKinsey is expensive," says Ralph Larsen, former CEO of J&J. "But what they provide is a fresh look at our thinking and a certain detachment. We use them carefully for selected projects, things of great significance, and they have been valuable to us."

In managing the firm through the boom and the bust, Gupta now finds himself caught in a classic supply-demand squeeze, the sort of management dilemma for which a client would turn to McKinsey for advice: He hired too many people just as demand began to plummet. In an average year, McKinsey will offer consulting jobs to 3,100 MBAs and professionals in the expectation of getting roughly 2,000 acceptances. In 2000, however, more than 2,700 people accepted offers to join the firm. They apparently knew what McKinsey didn't yet get: The boom was over. By the following year, with the bubble clearly burst, the firm's attrition rate fell to only 5%. Suddenly, just as demand for business started falling off, McKinsey had too many consultants on the payroll, with fewer leaving for other opportunities. "We honored every offer and didn't push people out," says Gupta, "and we had no professional layoffs other than our traditional up-or-out stuff."

As McKinsey begins its months-long process early next year to elect a new managing partner, the firm will likely toast Gupta as the man who led the firm to new growth records in new markets around the world. "In every generation, there are issues that come up that define the firm," he says. "We've had our share in the last decade. But I feel very proud of where we've come out." The question for his successor is whether he expanded the firm at the cost of the culture and values that made McKinsey tower above its peers. By John A. Byrne

With Joann Muller in Detroit and Wendy Zellner in Dallas


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