Internal crises plague one of the largest hedge funds – 11/07/2023 – Market

Two Sigma, one of the largest hedge funds in the world, has always prided itself on two things — the sophisticated in-house algorithms that power its trading and its commitment to confidentiality. But recent internal problems have forced Two Sigma to expose its problems.

In March, the New York company with $60 billion in assets took the unusual step of informing its investors in a document that the relationship between David M. Siegel and John A. Overdeck, the billionaires who co-founded and run the company, it had become so toxic that it could harm Two Sigma’s future.

In October, there was more bad news — an employee had changed some trading models without the company’s knowledge, affecting its returns and leaving it in the crosshairs of regulators.

And in late October, Overdeck’s personal life was exposed after his wife alleged in a lawsuit related to their impending divorce that, without her knowledge, he and the couple’s lawyers had transferred billions of dollars of their joint assets into trusts that would protect them from her, the couple’s three children and the IRS [a Receita Federal dos EUA].

It’s the kind of mess that any investment firm wants to avoid for fear of losing clients and talent — and especially one that has avoided the spotlight for much of its 22-year existence.

In a 2015 profile of Two Sigma, Forbes magazine said the two founders were “obsessed with avoiding publicity and keeping company secrets private.”

The disclosures raised questions from investors and regulators about Two Sigma’s internal controls. The company’s compliance and governance functions struggled to keep up with rapid growth in the number of employees and funds under its management, some former employees said.

Jeff Sonnenfeld, a professor at the Yale School of Management, said the problems at Two Sigma could make investors wary of putting their money into the company or keeping it there. “There are many other places to invest,” Sonnenfeld said. “There’s no reason to put money there.”

Founded in 2001 by Siegel, Overdeck and Mark Pickard, who has since retired, Two Sigma is one of the few “quant” companies that apply a quantitative approach — the use of mathematical models rather than human decision-making to find patterns on historical data and other financial information—to trade stocks, bonds, and more esoteric assets.

Siegel, 62, has a doctorate in computer science from MIT, and Overdeck, 53, is a math whiz who graduated from Stanford University at age 19 and was Jeff Bezos’ top lieutenant in the early days of Amazon.

Two Sigma quickly accumulated tens of billions of dollars in assets, achieving consistent, above-average returns for clients.

Their success has allowed them to recruit top mathematicians and engineers to build their proprietary trading models.

Consistently ranked among the world’s top 10 hedge funds, Two Sigma has more than 2,200 employees, compared with about 500 in the mid-2010s. The firm has 12 offices spread across the United States, Europe and Asia.

In addition to its main hedge fund, Two Sigma also manages real estate funds, venture capital funds and other businesses.

Based in New York’s fashionable SoHo neighborhood rather than the Midtown business district, Two Sigma built a culture that sought to emulate some of the elements of Silicon Valley technology companies, including chess and ping pong tournaments.

Siegel and Overdeck each have an estimated net worth of more than $7 billion, according to Forbes.

But over the past decade, the partnership has soured. Although the origins of the dispute are uncertain, some observers have attributed it to the competitive nature of the two. The rivalry worsened to the point where they barely spoke to each other. Because they can’t be in the same room, even simple process and personnel decisions become complicated, according to current and former employees.

Former employees described having to go back and forth between the two men to reach a decision. Two Sigma doesn’t hold all-hands meetings because the founders refuse to address employees or investors together at events, said two people with knowledge of the company’s inner workings.

The dispute so undermined basic management that Two Sigma first disclosed it in a US CVM document in March as a “material” risk, noting that disagreements between the co-founders affected the definition of senior executives’ roles, the succession planning and the management structure of the company’s various teams.

The dispute could affect Two Sigma’s “ability to retain or attract employees,” including more experienced ones, the document said, and make it difficult for it to perform key aspects of its work, such as research, engineering and corporate business.

If disagreements continue, Two Sigma added that its “ability to meet customer demands may be impacted over time.”

“It’s a reminder that you shouldn’t put your trust in algorithms and artificial intelligence,” Sonnenfeld said. “They are still subject to human weaknesses.”

In early October, the company sent two letters to investors revealing that one of its employees, who built research models used in certain trading books, made changes to them without the company’s permission.

In one of the letters, Two Sigma stated that these changes resulted in positive impacts of US$450 million and negative impacts of US$170 million on various funds, making it difficult for investors to evaluate the actual returns provided by the company. The company informed investors that it would maintain unexpected gains but offset unexpected losses.

The SEC is investigating these events at Two Sigma, according to a person with knowledge of the situation. The Wall Street Journal previously reported the regulatory investigation.

At least one Two Sigma client is trying to determine whether the hedge fund’s returns so far for 2023 are legitimate, according to someone who works for the client.