Cyber profits add up to secretive success story

Introduction

The story of David Shaw and his company begins far from Wall Street and Washington, on the West Coast. Born in Chicago and raised in California, Shaw attended Stanford and earned his Ph.D. in computer science in 1980. Many of his peers at Stanford would later become the core innovators of the information boom of the 1990s, from the Internet and e-commerce to Shaw’s blend of computer-based finance. From Stanford he made his first shift to the East Coast, taking a teaching position in Columbia’s computer science department. In 1986, Shaw took his first plunge into the world of finance, accepting a position at Morgan Stanley in its analytical and proprietary trading group, which at the time was headed by the famous quantitative trader Nunzio Tartaglia. In a 1996 interview, Shaw described the transition from computers to dollars as a very natural one: “Finance is really a wonderfully pure information-processing business.”

After a few years with Morgan Stanley, however, Shaw decided to strike out on his own, and by 1989 he had started his own quantitative trading shop, D.E. Shaw & Co., which had initial capital of $28 million. The premise of his new company, Shaw said, was to create a company “designed from the beginning from a computer science perspective.” Another of Shaw’s goals was to stock his company with the most brilliant minds he could find in science, math, and computers. Charles Ardai, Shaw’s former head of recruitment, once described the type of people Shaw wanted to bring in: “We want people who make our jaws drop. We know a D.E. Shaw hire when we say, ‘I can’t believe this person did this at age 25.’

D.E. Shaw’s success was, for a time, virtually unparalleled. Although the returns Shaw produced for his limited partners were kept a secret – and still are – one estimate in 1996 put them at 18 percent per year, which for a hedge fund designed to be market neutral is excellent. The funny thing, however, was that those who invested their money with Shaw rarely had an understanding of how exactly he made their investments grow. One of Shaw’s earliest investors told The Public i he had absolutely no idea what Shaw did with his money.

They’re not to blame; Shaw’s business is a strange one. D.E. Shaw & Co. utilizes the latest in computer and mathematical algorithms to exploit variances in the financial world where others wouldn’t think to look for profits. One technique used by Shaw is statistical arbitrage, a process that exploits temporary differences in prices between markets. For instance, if you notice that a particular stock is selling for $50 in New York but $49.50 in Paris, you could buy it in Paris and sell it immediately in New York, thereby making a gain of $.50, minus transaction costs. As long as those transaction costs are less than the $.50 gain, you’ve made a profit. The trick is to be able to monitor markets and securities constantly and act instantly, while accounting for variables like exchange rates and interest rates along the way. That’s where Shaw’s computers come in; they continually crunch numbers and exploit opportunities for arbitrage more efficiently than any human could ever hope to. In the long-term, Shaw is able to offer his partners and clients a very attractive return on investment that theoretically does not depend on the direction of markets.

D.E. Shaw & Co. engages in other activities besides arbitrage, one of them being venture capital investments. The most notable of these is Juno Online Services, Inc., a well-known free e-mail service that has recently begun offering Web access to paid subscribers. Juno, whose board of directors is chaired by Shaw, went public this past May, bringing in $84.5 million in IPO capital. Shaw has additionally put money into two firms that specialize in computer-aided chemical design, Molecular Simulations, Inc. (which was subsequently bought by Pharmacopeia, Inc.), and Schrdinger, Inc. Shaw is chairman of Schrdinger as well. Beyond venture capital, D.E. Shaw and its affiliate companies have held significant stakes in a variety of companies over the years, including Airtouch Communications, Boise Cascade, First USA, Mattel, and Reynolds Metals.

The company has also explored expanding its business onto the Internet. In the early 1990’s, one of Shaw’s top executives was Jeff Bezos, who left D.E. Shaw to found Amazon.com. The company tried to jump onto the Internet bandwagon when it created FarSight and D.E. Shaw Financial Technology, two Internet-based financial services upstarts. While they were acknowledged as technologically advanced, D.E. Shaw sold off both affiliates this past spring as part of a financial restructuring following a failed joint venture with BankAmerica. Beyond these details, the rest of the company’s activities, however successful or interesting, are shrouded in secrecy.

D.E. Shaw requires all employees who leave the company to abide by a gag order. Shaw himself is reluctant to share any details about the company’s business, and during one interview checked with a staff member to see whether giving out D.E. Shaw’s number of employees could reveal a competitive advantage. One of Shaw’s investors told The Public i that Shaw “is always secretive,” and Shaw once commented that, “we really do treat it with the same sort of seriousness that the CIA and NSA would.”

Apart from the stealthy nature of the company, another characteristic that defines D.E. Shaw is the nontraditional, un-Wall Street-like attitude that pervades this oddest of Wall Street juggernauts (several estimates suggest D.E. Shaw’s trading can account for 5% of all volume on the New York Stock Exchange on a given day). D.E. Shaw’s Manhattan offices have been featured at the Museum of Modern Art for their cutting-edge contemporary design, and the standard dress code for the company with $1.1 billion in capital is khakis and polo shirts. Louis Salkind, one of Shaw’s top executives, is a former U.S. foosball champion and keeps a small foosball table in his office. Employees have also been known to roll out sleeping bags in their offices and bed down for the night, which seems to indicate that the company’s policy of unlimited vacation time is often underutilized.

Timeline

1986: David Shaw leaves his computer-science professorship at Columbia University, and joins Morgan Stanley & Co. as its vice president in charge of automated analytical trading technology.

1988: Shaw founds D.E. Shaw & Co., with $28 million from the Tisch family and Paloma Partners. The Tisch family and Paloma founder S. Donald Sussman are major Democratic donors.

1992: Shaw writes a so-called “White Paper” on reforming the U.S. Commerce Department for Presidential candidate Bill Clinton.

August 13, 1992: Shaw gives $50,000 in soft money to the DNC. Over the next seven years, he will give more than $700,000 in hard and soft money to the DNC and its affiliated committees.

December 14, 1992: Shaw participates in the Clinton-Gore economic conference in Little Rock, designed to build support for the Clinton economic program. One of several focused topics is investment in new technologies.

January, 1993: A scaled-down version of Shaws White Paper is included in a book of Progressive possibilities for the Clinton Administration. Shaw recommends increased funding for technology research; reforming the U.S. patent system; and several other policies intended to foster technological innovation and increase American economic competitiveness. In his Endnotes, Shaw thanks “Governor Bill Clinton,” among others, for providing “valuable feedback.”

November 23, 1993: Clinton establishes the Presidents Committee of Advisors on Science and Technology (PCAST) by executive order. This private-sector advisory group will advise the White House Office of Science and Technology Policy.

August 4, 1994: Shaw is one of 19 members appointed to PCAST. Eight of the 19 have contributed either to Clintons campaigns, Gores campaigns, or the Democratic Party. The group begins meeting in November

1994: Jeff Bezos leaves D.E. Shaw & Co. and founds Amazon.com.

February 15, 1996: President Clinton proposes his “Technology Literacy Challenge Fund“; a $2 billion, five-year program that would focus on teacher technology training; educational software development; access to modern hardware; and universal access to the Internet for all K-12 students and classrooms.

April 22, 1996: Juno Online, an Internet company organized and financed by D.E. Shaw & Co., is launched. It advertises itself as “the nations first free Internet e-mail service.” By 1998, it is the 2nd largest Internet Service Provider, trailing only America Online.

January, 1997: Wired magazine describes David Shaw as “determined to make Wall Street obsolete.” March, 1997 An alliance with BankAmerica brings a $1.4 billion loan to D.E. Shaw & Co.

March, 1997: PCASTs Panel on Educational Technology, chaired by David Shaw, issues its “Report to the President on the Use of Technology to Strengthen K-12 Education in the United States.” Recommendations include increasing research on how computers can be used most effectively in the classroom; ensuring universal technology access for all American students; and earmarking at least five percent of all K-12 education spending for technology-related expenses.

July 7, 1997: Juno is labeled one of the “25 Cool Technology companies of 1997” by Fortune magazine.

January, 1998: The “E-Rate” program, created in the Telecommunications Act of 1996, is finally initiated, providing publicly financed discounts for schools and libraries to connect to the Internet. Over the next 14 months, $1.7 billion in federal funds are committed toward this effort.

July 20, 1998: Juno announces the launch of Juno Web, a full Internet access service. Now, paying Juno subscribers will also be able to browse the World Wide Web (and participate in E-Commerce) through their Juno membership.

July 21, 1998: Shaw, eight of his employees, and seven of his family members contribute $5,000 each to Al Gores PAC, Leadership 98.

August, 1998: Gore invites Wall Street minds to a White House breakfast to discuss the implications of Russia defaulting on its loan payments. Heavyweights from the Street, such as Jonathan Tisch, Steve Rattner, Orin Kramer, George Soros, and David Shaw, attend the breakfast.

December 14, 1998: The Learning Company agrees to merge with Mattel, Inc. The Learning Company is a major manufacturer of consumer and educational software. Its Cyber Patrol software is touted as one of the most widely used filtering programs. The Learning Company is also one of Gores biggest career patrons. The merger is finalized in the Spring of 1999.

December 31, 1998: D.E. Shaw & Co. obtains beneficial ownership of approximately 9.82 percent of Mattel, Inc.s oustanding shares, making it the third largest shareholder. D.E. Shaw & Co. investor Paloma Partners is the second largest Mattel shareholder.

February 22, 1999: Gore asks PCAST to prepare a report for him on “how science and technology contributes to the economy, and the betterment of our lives.”

March 31, 1999: Shaw and eight family members give $1,000 each to Gore’s Presidential campaign. Six days later, the same nine people give $1,000 each to Gores Legal & Accounting Fund.

May 5, 1999: Gore announces the creation of the Parents Protection Page, a web page to be maintained by Internet companies that “will feature a comprehensive guide containing tools, tips, and resources for safe surfing on the Internet.” One of the recommended products on this page: The Learning Companys CyberPatrol.

July 17, 1999: Juno Advocacy Network, part of Juno Online, completes a huge Internet political campaign, conducted on behalf of the Heritage Forests Campaign. Using its targeted mailing lists, Juno contacts 1.5 million Juno subscribers, urging them to email Gore and request protection for certain National Forest areas. Gores office receives 171,000 emails on this subject.

August 2, 1999: Gore releases the newest PCAST report, Powerful Partnership: The Federal Role in International Cooperation on Energy Innovation.