How Schonfeld fell into Millennium’s embrace

In March 2020 Schonfeld Strategic Advisors was rocked by the market turmoil unleashed by the pandemic.

The New York-based firm’s flagship hedge fund was down about 16 per cent and its prime brokers were asking it to put up more collateral, according to three people with direct knowledge of the matter. 

Needing to provide cash in response to a routine margin call as markets moved against it, Schonfeld considered its options. It had previously held informal discussions with Millennium Management about a potential tie-up, and one idea put on the table that month was for its much larger rival to provide some capital, two of the people said.  

While the talks with Millennium did not come to fruition, Schonfeld managed to shore up its position. That spring it raised about $2bn from investors, including in the Middle East and Asia, who had attributed the drawdown to growing pains.  

But now, following a lacklustre period of performance and third-quarter redemptions of $1bn, Schonfeld has restarted discussions with Millennium.

The Financial Times reported this week that the firms were in advanced talks over a tie-up that would see Millennium put billions of dollars to work with its smaller rival. The transaction, the largest deal of its kind, would be without precedent in the $4tn hedge fund industry.

“Is this a rescue act for Schonfeld?”, asked a senior executive at one London-based rival. “It’s quite a big step to take that much money from a peer. It’s not what you’d do if you had free choice.”  

The two firms declined to comment.

Schonfeld’s capitulation to Millennium reflects the changing fortunes of a hedge fund manager that has struggled to keep up with large rivals. Neither of Schonfeld’s two funds have made money this year, adding to an underwhelming 2022 in which the firm lagged far behind the likes of Ken Griffin’s Citadel and Millennium. 

Between them the two best-performing names in the multi-manager universe employ hundreds of teams of autonomous and highly specialist risk-takers, which trade a range of different strategies and operate within strict risk limits. 

Schonfeld began life in 1988 as a family office managing the money of founder Steven Schonfeld, a former stockbroker, and did not open up to external investors until 2015. Since then its assets have grown dramatically, as the multi-manager model it runs rose in popularity among investors.

The firm was among those that picked up inflows when bigger managers such as Millennium and Citadel were closed to new money with long waiting lists to get in. Schonfeld’s assets have doubled in the past two years, from about $6bn to $12bn. 

As assets have swelled, Schonfeld has expanded beyond its roots in computer-driven trading, adding discretionary macro, fundamental equity and fixed income strategies. It hired Colin Lancaster in May 2021 as global co-head of discretionary macro and fixed income to build out a business in this area. But the firm’s crown jewel is still its statistical arbitrage strategy, which uses algorithms to exploit patterns in securities pricing, investors say.

Schonfeld’s rapid expansion was partly enabled by the “pass-through” expenses model that is a defining characteristic of the multi-manager platforms. Instead of an annual management fee, the manager passes on all costs — including office rents, technology and data, salaries, bonuses and even client entertainment — to their end investors. The idea is that managers can invest heavily in areas such as staff and technology, with the cost more than offset by the resulting performance improvements.

One prime broker said Schonfeld had been “one of the biggest payers of sign-on bonuses” that can run into millions of dollars and are one of the tools employed to lure portfolio managers in the war for talent that is sweeping across this part of the industry. In the past two years, Schonfeld’s headcount has grown from about 600 to more than 1,000.

Schonfeld’s experiences reflect another key dynamic among the platforms. The multi-manager model is significantly more headcount-intensive than traditional hedge funds, and appears to have less operating leverage as firms grow bigger.

“As assets scale, headcount (and with it their cost base) tends to grow on a linear basis,” said a report last year by Goldman Sachs prime brokerage, which estimates that multi-managers account for just 8 per cent of the hedge fund industry’s assets but roughly a quarter of total headcount.

But crucially, if the amount of money a firm manages declines, costs do not fall in line with the decrease because it is hard for managers to cut spending at the same pace. That means fewer investors end up footing a larger bill that eats into returns, which could trigger more cash being pulled out.

“If assets start getting redeemed, the investors that are left behind get left with the brunt of the costs,” the prime broker says. This incentivises clients to “redeem quickly and not get stuck,” he added. “You don’t want to be the last person left holding the bag.” 

According to investors, the issue for Schonfeld is that it has doubled its assets and increased its cost base through a hiring spree — without putting up the performance figures to match.

Schonfeld is the third best-performing name in the multi-manager universe over the past three decades, behind only Citadel and Millennium. But its returns have tailed off over the past two years. In the first eight months of this year both its flagship fund and its fundamental equity strategy are roughly flat, and last year they returned just 4.5 per cent and 3 per cent respectively, according to investors. 

Millennium, meanwhile, recorded double-digit returns last year and is up 7.6 per cent in the first three quarters of 2023, while Citadel broke records with a $16bn profit in 2022 and gained 12.6 per cent per cent in the first nine months of the year. 

As returns have dwindled, the terms with which Schonfeld secured money have paved the way for future challenges. 

Since it opened to external investors, Schonfeld has offered clients monthly liquidity, which allows them to pull their money out once a month. This leaves the business vulnerable to mass redemptions, particularly with returns having declined and a higher-interest rate environment meaning investors can park their money in safer assets for a healthy return. 

To ensure the longer-term security of its business, Schonfeld has recently been offering clients a fee discount in return for new terms under which it would take them as long as two years to withdraw all their capital. More than half its capital is now locked up until the end of 2024, according to a person close to the firm.

In contrast, Millennium has been earlier and more proactive in taking steps to stabilise its business and prevent large-scale redemptions after suffering mass outflows during the financial crisis. In 2021 it returned money from a shorter-term share class that let clients exit in full in a year, and moved money to a longer-term share class that would take investors five years to exit in full.

Schonfeld’s 2020 experience prompted it to invest heavily in its risk management process and diversify away from its large equity exposure, according to one investor, who said what sets the firm apart from other multi-managers is its transparency.

Chief executive Ryan Tolkin “is very approachable”, they said. “If I wanted to talk to any of them I could and I value that because you don’t really get it from other large platforms.”

Tolkin has been credited with helping to build a business that has less of an eat-what-you-kill mentality than other multi-manager rivals. But investors say he is also adjusting to a rapidly growing firm that under his watch has expanded beyond its core DNA in systematic trading.

The 37-year-old, whose father Brad is close friends with Steven Schonfeld, according to a recent Business Insider article, joined the firm as chief investment officer in 2013 from Goldman, where he was a part of the investment bank’s corporate credit team and worked with Justin Gmelich, now a co-chief investment officer at Millennium. He was named to Schonfeld’s newly created role of chief executive in January 2021 while retaining his CIO title. 

Since news of the tie-up leaked, the two firms have been inundated with calls from clients. Their message to investors is that nothing has been finalised and they are still working out what the partnership will look like. But several options are being considered. 

Among them is a separately managed account for Millennium, or the larger firm taking all of Schonfeld’s capacity and kicking out its existing investors, according to people familiar with the situation. One of the people said it was important to preserve Schonfeld as an independent company given its distinct brand and culture.

People who know Izzy Englander, Millennium’s founder, say the 75-year-old will ultimately be keeping a close eye on the money invested with Schonfeld. He will want to make sure that “whatever money is running through them is going to be under Millennium risk controls,” said one person who worked alongside him for several years. “It’s a huge muscle flex by Millennium, they have capital and they’re neutralising a competitor.” 

For Millennium, a tie-up makes sense, according to several people familiar with the firm. The hedge fund has billions of dollars in long-term capital and by teaming up with Schonfeld it can quickly put money to work without the cost, time and complexity of hiring Schonfeld’s more than 100 investment teams. “If Schonfeld accelerates downwards quickly, Millennium will already have a hand in the pot and can see who is good,” said the prime broker.

For Schonfeld, a tie-up with Millennium brings it stable capital and economies of scale that come from tapping into the larger and more established firm’s infrastructure and systems. Millennium is wagering that this will help Schonfeld reboot its performance.  

“The existing portfolio managers at Schonfeld are probably fine with a tie-up,” said one top industry insider. “What’s the alternative, get fired soon and then get a job at Millennium anyway?”