Well-Groomed Nerds Brandish Protractors in F.A.O.’s Sale

On a recent evening at F.A.O. Schwarz’s flagship Fifth Avenue store, giant “Entire Store on Sale!” signs were dangling from the ceiling. The floor was streaked with shredded tutus and tissue paper, and the G.I. Joe Motorized Missile Launcher was 40 percent off.

“They’re closing F.A.O. Schwarz?” gasped one thick-limbed child as he stumbled through the crowded entranceway before beelining toward a $4,800 stuffed bull (now 50 percent off). His parents cringed, even at the greatly reduced prices, no doubt plotting a later trip to a New Jersey Wal-Mart.

F.A.O. Inc., the parent company that owns F.A.O. Schwarz, The Right Start and the Zany Brainy chain (142 locations in total), filed for bankruptcy-court protection on Dec. 4, for the second time within a year. Analysts have one explanation for the decimation of the toy business, which has also driven KB Toys and Toys “R” Us under a dark cloud: Wal-Mart. According to one former toy designer, “Parents want to spend as little money as possible on stuff for their kids, since they get bored of it so quickly-as long as it doesn’t kill them.”

Then, on Dec. 26, an unexpected player entered the doomed world of toy retailing. F.A.O. announced an agreement for the sale of its two most prestigious locations, the New York and Las Vegas stores, as well as its Internet and catalog businesses, the store’s clock towers and its “intellectual property rights,” for $20 million.

The proposed buyer is D.E. Shaw Laminar Portfolios, a unit of the $6 billion New York hedge fund and investment bank D.E. Shaw and Co. Inc., which is headed by the computer scientist and financier David Elliot Shaw. Mr. Shaw established the firm in 1988 as a “black box” or “quant” shop, which means it uses mathematical and computer models to exploit tiny inefficiencies in the stock market, and to dictate when and how to trade. Now housed in a West 45th Street skyscraper, its operations and its patron saint are shrouded in a secrecy that borders on paranoia. Mr. Shaw is obsessive about privacy, and thick nondisclosure agreements are standard for his employees, according to people who have been inside. Many hedge-fund managers are highly secretive when it comes to protecting their proprietary technology, which they believe gives them an advantage in the market. Mr. Shaw declined to be interviewed for this story.

Running toy stores in a miserable sales environment is an unlikely goal for a group of press-shy Wall Street technology geeks; one hedge-fund manager suggested that F.A.O. might be a “trophy acquisition” due to its lack of compatibility with Shaw’s typical investments.

Others familiar with the way Mr. Shaw operates his company disagree.

“My experience with David Shaw is, he doesn’t do trophy stuff,” said Mark Lipton, a New School professor who worked as a consultant for D.E. Shaw in the 1990’s. “That’s not who he is. It’s got to make money, there’s got to be an angle, and it may be an angle that none of the other analysts out there have figured out yet. But it’s gotta make money.”

The fund’s performance numbers are a closely guarded secret, but it is believed that the firm does make money, with above-average returns in an increasingly tight hedge-fund environment. “It’s one of the most successfulquantitative investment-management companies in the history of the business,” said Andrew Lo, a finance professor at M.I.T.’s business school who studies hedge funds.

He’s not referring to a period in 1998, when the company encountered what might be described as a “hiccup.” That was the year Long-Term Capital Management, a giant Greenwich, Conn., hedge fund, imploded and had to be rescued by the Federal Reserve to avoid bringing down the entire American banking system. At the time, D.E. Shaw was using some investment methods that were similar to LTCM’s, such as fixed-income arbitrage (the buying and shorting of bonds), with what one report estimated to be 19-to-1 leverage. Huge trading losses forced Bank of America, which had invested money with D.E. Shaw, to write off hundreds of millions of dollars; Bank of America faced shareholder lawsuits, and there was much acrimony.

Mr. Shaw opened for business 10 years prior to those dark days with $28 million from several investors, including Donald Sussman of Paloma Partners, another Greenwich, Conn., hedge fund. The company has since grown to $6 billion in aggregate capital, which makes the $20 million F.A.O. investment relatively small change.

Mr. Shaw has crafted the company in his own image, creating trading systems and developing technology-oriented business ventures-basically anything related to “the economic implications of technological innovation,” according to the company’s Web site. In 1996, D.E. Shaw decided that it wanted to own an Internet start-up, so it created Juno Online, designing and staffing the start-up itself. It’s the venture most often compared to the F.A.O. acquisition, with Mr. Shaw and his employees confidently taking on an industry foreign to them.

“My guess is David would say, ‘We’re really smart and we’ll figure this out. We’ll learn the business.’ It borders on hubris and arrogance, but they believe that,” Mr. Lipton said, adding: “And I don’t think there’s anything wrong with that.”

Michael Lebowitz, a technology manager at Morgan Stanley who began his career there with Mr. Shaw, wasn’t surprised by the firm’s latest move. “David’s a guy who has ideas,” he said. “I mean, heck, he started his own investment bank.”

D.E. Shaw trades every type of security imaginable, employing strategies both familiar and obscure-including investments in bankrupt companies-but “statistical arbitrage is the strategy they made their name on,” said Mr. Lo, referring to the buying and selling of equities on different markets, usually in very large scale, to take advantage of price differences in those markets. Recently, according to Mr. Lo, the firm has become interested in computational chemistry, which he described as the ability to “predict certain geometrical outcomes of molecules that combine with each other” in different compounds. “A lot of these predictions require very intensive computations,” he explained. The technology could be useful in drug research and other scientific applications.

To ensure that its people are up to the task of heavy math and computer programming, D.E. Shaw seeks only the smartest students. One former employee said that Shaw requested SAT scores from job applicants; the investment bank’s Web site states that they are “extremely selective, with less than one candidate in 250 ultimately invited to join the firm.”

“It’s almost impossible, they’re so selective,” said one administration official from Columbia University’s computer-science department, where Shaw occasionally recruits students. “I’ve had people with a Ph.D. in economics and a Ph.D. in computer science-very bright people-but they still might not fit into their mold.”

Online communities are devoted to the subject of securing an interview. One lively exchange on the online M.B.A. forum Vault.com started with: “Can anyone tell me if D.E. Shaw is all about Ivy Leaguers?”

“Not exactly,” began one response, “they are elitist as hell, and love well groomed super-nerds …. If you are a) just about done with a seriously quantitative PhD/Master’s, b) ridiculously well-versed in what delta’s, gamma’s, theta’s, etc. are, c) only showed up for the final in Calc 3 and got an A++++ in the class, d) learned C++ when you were three, and e) preferably all of the above … you’ll do fine.”

The office environment is known for being laid-back and Silicon Valley–esque, with a lax dress code and ultra-modern design. According to one person who visited recently, “You can tell as soon as you walk into the building lobby who the D.E. Shaw employees are.” They’re the ones in jeans and khakis.

The mathematicians and “well groomed super-nerds”thatMr. Shaw seeks out are essentially people like himself, when he was fresh out of Stanford with a Ph.D. in computer science in the early 80’s, building fifth-generationsupercomputers at Columbia University as a young associate professor. He is the author of scholarly publications with titles like “A ParallelMachineArchitecturefor Knowledge-Based Information Processing” and “A Hierarchical Associative Architecture for the Parallel Evaluation of Relational Algebraic Database Primitives.”

Colleagues from Columbia regard him with perhaps a trace of envy, as he has successfully made the transition to a more moneyed future.

A computer-science professor at Columbia who taught with Mr. Shaw, Salvatore Stolfo, said that he was generally well liked, adding that “the most eccentric thing about David was this surfboard he had hanging in his living room”-a throwback to his roots in Los Angeles, where he grew up.

Mr. Shaw has more recently presented papers on the role of computers and computer scientists in the management of financial assets, essentially promoting his own strategy of using “advanced quantitative and computational techniques … to identify securities that are ‘mispriced’ relative to other issues.”

Now in his early 50’s, appearing dark-haired, youthful and earnest in photographs, he is one of the handful of hedge-fund managers who are actually Democrats. A big-money liberal who is friendly with Bill Clinton, Mr. Shaw was appointed in 1994 to the President’s Committee of Advisors on Science and Technology, which was focused on technology spending in public schools, and which had the lofty goal of wiring every classroom in the country. Mother Jones ranked Mr. Shaw (along with Beth Kobliner Shaw) as No. 43 in the top 400 individual political donors for the 1999-2000 election cycle, with $512,568 in contributions to Democratic causes. Federal records indicate $2,000 donations to Al Gore in 1999 from Mr. Shaw and his wife (along with thousands more from other D.E. Shaw employees in 1998), and $1,000 contributions to Hillary Rodham Clinton, Edward Kennedy and others. In 2003, Mr. Shaw continued this tradition, donating thousands to the Democratic National Committee, Charles Schumer and Tom Daschle.

If no other bidders emerge for the F.A.O. assets-and provided a bankruptcy-court judge oversees a final auction, which is expected around Jan. 22-David E. Shaw and those who work for him will be applying their political and economic talents to resuscitating the F.A.O. brand name, after a planned six months of renovations are complete at the New York emporium.

Theories on how to accomplish this task are divided. In one camp is the group who believes that F.A.O. Schwarz was badly mismanaged by its parent company, which lost its focus on the luxury-shopping experience that differentiated the stores from their low-brow suburban cousins.

“F.A.O. was a high-end toy retailer,” said Bill Sims, a retail analyst with Smith Barney Citigroup. “What they tried to do in order to keep up their growth was to start to attract a lower-end customer, to sell more commoditized products, lower-end toys, and they started competing with Toys ‘R’ Us and Wal-Mart. And their profitability suffered.”

If this is the case, the solution is simple: return the stores to their more glamorous roots and leave the price wars to the big chains. Another industry watcher, Jim Silver, who publishes toy-industry trade magazines, agreed. “F.A.O. Schwarz should be the Tiffany’s of the toy business,” he said. “You’re going to go in there and find toys you’re not going to see anywhere else. That’s the reason Donald Trump was interested in it-it has great prestige.” (Mr. Trump appeared on an early list of rumored bidders for the property, along with Saks and Macklowe Properties, the owners of the General Motors building at 767 Fifth Avenue that houses the F.A.O. Schwarz store.)

Another approach was put forth by Ken Hakuta, a toy inventor and entrepreneur- he created the Wacky WallWalker, a rubbery octopus that was popular in the 1980’s-who expressed interest publicly in saving the Manhattan F.A.O. store early in the process. In his opinion, any profitable F.A.O. investment is a straight “real-estate play,” structured to take advantage of the store’s long-term lease to increase the rent for a new tenant.

“At $90 a square foot, which is the average rent [the store is paying] now, they were losing money. And if the new rent is going to be double that, which is the market rate, how can they make money? It’s a difficult proposition,” he said. “What would happen if, in June, the retail environment in toys continues to be bad, and they decide they cannot reopen the store? Then what?”

The expectation for the time being is that the store will reopen, and in all likelihood D.E. Shaw will have found some way to make money from the investment, by discovering some inefficiency in the market that others overlooked. In the meantime, the fire sale at F.A.O.’s Manhattan store-which has occupied the same slice of real estate since 1931-will continue until every last G.I. Joe is gone.

Well-Groomed Nerds Brandish Protractors in F.A.O.’s Sale