Inside D.E. Shaw
This secretive high-tech equity trading firm has grand ambitions as a hedge fund, investment bank,
money manager and venture capitalist. A new alliance with Bank of America may make it all work.
In 1988, David Shaw quit his day job to follow a quirky dream. The former computer science professor at Columbia University had helped set up Morgan Stanley's quantitative trading operations, but became frustrated working in a big firm. His goal was to build a quantitative trading shop run by the quants themselves, free of the political and business friction of a large investment bank. Founded with $28 million in startup capital, D.E. Shaw & Co. began life as an equity hedge fund, trading for its own account using statistical arbitrage and other quantitative techniques.
The firm grew rapidly. In 1992, the partners looked ahead and realized that they couldn't pour unlimited amounts of capital into their statistical arbitrage strategies without ruining the inefficiencies they were trying to exploit. At the same time, they saw that some of the technology and proprietary trading techniques they had developed could be applied in other areas. They set out to use the firm's know-how to build a variety of new customer businesses.
The strategy worked. Today, less than 10 years after its founding, the company has six offices with about 800 employees and more than $1.3 billion in capital. In addition to its proprietary trading activity, Shaw is now the largest market-maker in Japanese warrants and Euro-convertible bonds and is a leading player in other Asian equity-linked securities as well. The firm is also one of the most significant dealers in U.S. securities, making markets in more than 3,000 U.S. stocks. It has a thriving equity basket-trading business, where it trades entire portfolios as principal and agent for pension plan sponsors and investment managers. It also has an equity-linked business that trades equity-linked securities in European, Asian and Japanese securities for U.S. institutions. And just to keep busy, the firm has become involved in some high-tech venture capital investments, including Juno, the free e-mail service.
The firm's next goal is to expand dramatically its customer businesses worldwide. To help it do so, it recently established an innovative "strategic alliance” with the Bank of America designed to give both partners access to each other's areas of expertise.
The desire for a big brother in the banking world emerged gradually. In the course of developing its customer businesses, Shaw became acutely aware of the significant advantages bulge bracket firms had in the financial markets—the name recognition, the infrastructure, the customer relationships, the access to funding and even the physical presence in geographic locations.
"Our vision was to build customer businesses based on our core technological expertise,” explains Richard Kleinberg, Shaw senior vice president and architect of the alliance with Bank of America. "It wouldn't really be consistent with that plan to replicate the nuts-and-bolts infrastructure that has made the traditional firms great. We wanted to find a way to retain our computational approach, including the flexibility and leverage of our relatively small size, yet still extend our reach—let's say a hundred-fold.”
The company guessed that there might be banks, insurance companies or other entities that had a complementary position in the market—institutions that had financial strength, physical presence, operational support and customer franchise, but that had not historically been involved in the more quantitative or highly transactional areas of the capital markets.
In 1994, the firm set out to form relationships with about 20 global financial institutions, looking for a potential fit. Kleinberg met with people at all levels, from the chairmen down to the traders on their equity desks, and, in 1996, began having serious discussions with BofA.
A number of institutions were interested in purchasing investment banks or boutiques, but Shaw wanted to remain independent. "Bank of America understood that we needed to maintain our culture and our flexibility,” explains Kleinberg. "It saw the logic of a strategic alliance that would enable us to work together closely while maintaining our separate identities.” The alliance was finally consummated in March 1997, after a year of negotiations.
|"We wanted to find a way to retain our computational approach, including the flexibility and leverage of our relatively small size, yet still extend our reach—let's say a hundred-fold.”
The alliance allowed BofA to take a giant leap forward in the equity derivatives market. In many situations, access to the Shaw trading and pricing facility has allowed the bank to win business it otherwise would have lost. That expertise has also allowed the bank to be much more competitive and flexible in the way its equity derivatives transactions are structured, priced and traded.
The alliance gave Shaw access to the bank's relationships with corporates and financial institutions around the world. "BofA has a strong client franchise,” says Kleinberg. During the first six months of the alliance, Shaw was able to complete more than 50 new transactions that originated from BofA—even before there was time to develop a sustained marketing or product development effort.
Shaw's alliance with BofA also allows it to enter new market areas that would have been difficult or impossible to penetrate on its own. In the past, Shaw would be a counterparty to its customers on over-the-counter equity derivatives deals. While that was good enough for certain types of deals, a stronger issuing credit is critical when it comes to issuing guaranteed products or long-dated deals. Now, deals are structured in back-to-back mirrored transactions: Shaw issues a particular derivative to the bank, and the bank in turn issues an identical structure to the client. From the client's point of view, it is a deal issued by a double-A credit.
Although other investment banks have set up similar arrangements through special purpose vehicles for swaps, BofA's arrangement is notable because it's done with an independent entity. Why didn't Shaw allocate a couple hundred million dollars to forming its own triple-A vehicle? "We'd considered that and several other approaches, but we found it to be a burdensome and operations-intensive setup,” says Kleinberg. "At a strategic level, our goal was to maintain our flexibility and to stay as lean as we could, and it seemed like a better arrangement to mirror these transactions through the bank.” In many cases, moreover, the deals are being done with the bank's clients, who already have credit lines and documentation set up with the bank.
Commercial banks that have tried to develop their investor business have traditionally focused on selling fixed-income products such as swaps. But BofA's preference with Shaw, at least at this early stage of the alliance, is to focus on selling equity derivatives to the corporate market, where the bank has strong relationships and where it has seen a lot of interest in structured equity transactions. Most of these transactions are highly customized company-specific deals that focus on tax and accounting issues. The deals also attempt to tackle other treasury-related administration issues such as employee compensation plans, retirement plans, the issuance and repurchase of shares, and other typical corporate finance functions.
"Equity derivatives are now joining fixed-income derivatives as accepted tools for managing the corporate balance sheet,” explains Kleinberg. "The transactions allow CFOs to add structures that might not be feasible in the primary markets, such as allowing the mix of equity or debt to be changed according to certain preset market conditions or other events or parameters. We're working with BofA to add equity derivatives to the tool kit of the corporate finance specialists who discuss solutions with corporate treasurers.”
Another big area for Shaw is its equity-linked business, which it launched in 1993 by dealing in Japanese warrants. In a typical deal, a Japanese company would issue a fixed-income security denominated in a European currency such as Swiss francs. Attached to the bond might be a warrant to purchase stock, typically struck out of the money with three to five years to run. There has been an active market in those warrants for 10 years or more and a lot of paper has been issued. The warrants are in many cases an attractive alternative to owning the shares. They're held by a wide variety of European investors, from private portfolio managers to hedge funds and institutional investors. Because the warrants are usually detachable from the bonds, they're traded separately. There are also conventional convertible bonds, many with highly complex terms, and Shaw shares some of its analytical tools with clients to help them manage their portfolios. "We are now acknowledged as the dominant market-maker in these Japanese securities,” says Kleinberg.
In the last year or so, Shaw has expanded into convertibles issued by companies in Korea, Thailand, Malaysia, India and other Southeast Asian countries. Last year, it began to make markets in European issues, and intends to extend the scope of its business in Europe and Eastern Europe over the next year or so.
Yet the company has even greater ambitions. As its presence in the market has grown, it's been included in virtually every syndication of Japanese warrants and Euro-convertibles. "Now that we've demonstrated that underwriters will come to us for distribution, we would like to get closer to the origination of that business,” explains Kleinberg. "We'll be approaching the issuers to be the lead underwriters rather than participating only in a syndicate role.” Together with BofA corporate finance specialists in Asia, it won a mandate to lead-underwrite its first primary offering there last fall before the recent market turmoil led to postponements.
Kleinberg notes that while the pace of issuance within Europe has accelerated, it has also spread east. BofA is now aggressively moving into Poland and Russia and other Eastern European countries as part of its overall capital markets strategy for Europe, and Shaw is working with the BofA and Russian companies to bring new convertible issues to market as an underwriter.