D.E. Shaw & Co.

Andrew Frankel

Jeff Koskinen

Bruce Kember

Joel Lipsitch

Foundations of Strategy

Professor Moore

Term 4

Teaching Note

Case Objective

This case centers on the analysis of competitive advantage and value creation in the context of a decision faced by D. E. Shaw & Co. The case is written to allow students to determine whether D.E. Shaw can leverage its core competencies to create competitive advantage in the context of a new business venture—online book sales. The case illustrates the importance of analyzing a new business opportunity strategically in order to determine what changes in the company’s business model are required and what those changes mean for the company going forward.

Students will apply business design tools to determine the core competencies of D.E. Shaw and how the company creates value for its investors in order to determine how well this potential new business fits with D. E. Shaw. In addition, the case requires students to consider the future prospects of an online bookstore, including the size and potential of this new opportunity. Finally, an analysis of the opportunity’s effects on D.E. Shaw’s current business model allows students to make their decision as to whether or not D. E. Shaw should pursue the online bookstore idea and how David Shaw should respond to Jeff Bezos’ interest in leaving the company.

Pursuing a new strategy will radically alter the current business model of D.E. Shaw, and although the business opportunity may be attractive, it is necessary to determine whether it is an attractive business for D.E. Shaw. Although D.E. Shaw senses the need to find other business opportunities, an online bookstore may lie outside of its current business model and present few synergies with its current operations. In other words, an online bookstore may be a “positive NPV” project for some companies, but the relevant question is whether it is a positive NPV project for D. E. Shaw. Alternatively, one might argue that D. E. Shaw’s competencies lie in training exceptionally intelligent people to exploit business opportunities. In this case, the firm may possess the competencies to create a competitive advantage in the online bookstore industry.

Positioning the Case Within the Course

This case is designed to fit into the section of the course that focuses on competitive analysis and value creation. The tools utilized in analyzing value creation will be especially crucial for understanding D.E. Shaw’s business model and ability to transfer the skills into other areas. We have outlined comparisons to other cases below and see many similarities between this situation and others covered in the course.

Comparison with other cases

There are several parallels between the D.E. Shaw case and the other cases in the course. Most of these parallels relate to the costs and benefits of expanding and evolving a business and product / business diversification.

  • GE and D.E. Shaw: One of the major criticisms of GE’s business model is that it is a conglomerate. According to portfolio theory, a company does not create shareholder value simply by managing a diverse portfolio of businesses. Investors can diversify their own portfolios. In response Jack Welch argues that GE is more than a portfolio of businesses, and the company creates value through the intelligent allocation of capital to existing businesses and acquisitions.

If D.E. Shaw enters the online book business directly or through venture capital investment, it risks becoming a non-value added conglomerate. There is not a clear link between D. E. Shaw’s core competencies and the online book business. The online book business requires operational skills (warehousing, shipping, purchasing) and marketing skills. One could argue that D.E. Shaw’s employees are essentially very intelligent generalists who could sell books online as well as they exploit arbitrage opportunities. However, the firm as a whole does not have competencies relevant to the online book market.

  • Cisco and D. E. Shaw: In the Cisco case the company must choose between preserving its horizontally-integrated business model and vertically integrating a consulting business. At a higher level, Cisco must decide how much to continue to exploit its current business model and to what extent it should explore new business models. This second issue is directly relevant to the D. E. Shaw case.

There is evidence in the case that D.E. Shaw sees a limit to the growth and sustainability of its current business. Online books represent a radical change in the company’s strategy. What are the criteria with which the company should evaluate the strategic shift and the new business model? To what extent should the company continue to exploit its current business model? To extent should D.E. Shaw focus on exploring new businesses?

  • Walt Disney and D. E. Shaw: The Disney case focuses on a challenge by corporate raiders who argue that Disney’s management is destroying shareholder value in part due to its broad diversification. The argument is that Disney’s component parts are more valuable than the business as a whole. This same concern could be raised if D. E. Shaw invests in a new business venture outside of its core competencies (e.g. online books). In the follow up to the Disney case, Michael Eisner is able to unlock some of the value in the components of the Disney empire by focusing on the untapped profitability in businesses such as films. Perhaps D. E. Shaw can find new sources of value in its current business.

Suggestions for Teaching the Case

We present a proposed discussion outline designed to pose the major questions for analysis to lead toward an eventual conclusion.

What is D.E. Shaw?

D.E. Shaw is an investment fund ($350M in 1995) that specializes in mathematical algorithm-based hedged derivatives trading. The firm achieved “above-normal” returns of approximately 25% annually by hiring highly intelligent mathematicians and computer scientists, training them in financial theory, and letting them apply that theory to create proprietary trading algorithms.

  • Core competencies: 1) proprietary trading algorithms developed and executed by mathematicians and computer scientists; 2) ability to train non-business people in finance while leveraging their superior intellectual ability.
  • Value creation: 1) “above average returns” through application of proprietary trading technology; 2) market neutral positions lead to low risk/return ratio.
  • Culture: 1) academic and quantitative; 2) informal but secretive; 3) decentralized but strong direction from David Shaw.
  • Sustainability / Growth potential: 1) increasingly sophisticated investors and technology decrease arbitrage opportunities and, therefore, limit sustainability; 2) exploring trade finance, investments in former Soviet Union, custom derivatives (in line with core competencies).

What are D.E. Shaw’s Criteria for New Business Ventures?

  • Low Risk

1)D.E. Shaw’s current business is by definition low-risk. They take only market neutral positions. David Shaw wanted to continue to pursue low risk ventures.

2)Evidence of Shaw’s commitment to low risk ventures is the fact that he rejected nine out of ten proposals for new business ventures.

3)Investors have enjoyed very low risk/return ratio; pursuing a much riskier business would require significant change in investor expectations.

  • Profitability

1)D.E. Shaw has consistently produced returns of 25% since its creation.

2)David Shaw expected similar returns in any new business.

The fundamental question of the case is whether Jeff Bezos’ idea to sell books on the Internet meets the criteria that D.E. Shaw had established.

What is attractive about an online Bookstore? (1994)

This application of Porter’s Five Forces model will determine the attractiveness of the online book industry. Through this analysis students will create an opinion of the attractiveness of the online book industry and begin to see if it is a suitable model for D.E. Shaw to pursue. In addition to the standard analysis, the critical analysis should focus on defining the online book market and how it fits it is different from the current marketplace.

Does this fit D.E. Shaw’s core competencies?

Through the application of the Five Forces analysis, students will be able to determine if D.E. Shaw should move forward with this business plan. If the core competencies of D.E. Shaw match the skills required in the online book business and give D.E. Shaw a sustainable competitive advantage, then D.E. Shaw should proceed. If this falls outside of D.E. Shaw’s key abilities and the skills are not easily transferable, then the online book business should not be pursued.

Alternatives to Entering the Online Book Business

  • D. E. Shaw allows Bezos to leave but takes an equity stake in his new company.
  • D. E. Shaw allows Bezos to leave and tries to capture some of the value of the intellectual property created during his time at the firm (i.e., the idea for Amazon.com).

Takeaways

  • Core competencies matter. Companies must consider whether their core competencies will allow them to create a sustainable competitive advantage before entering a new business.
  • Attractive business opportunities are not necessarily appropriate business opportunities. Can a company do something better than its competitors?
  • How attractive is the new industry? What are its boundaries? (Porter’s Five Forces)
  • Expansion into a new industry may add value for shareholders or simply diversify risk that investors can diversify for themselves.
  • How should companies think about the value of intellectual property created within their organization given that their employees make take it and profit from it outside of the company?