D.E. Shaw is going to trial over the sale of a litigation finance subsidiary, shining a light on a side-pocket deal at the secretive hedge fund firm.

D.E. Shaw

D.E. Shaw was founded by David Shaw more than 30 years ago.

• A new lawsuit between D.E. Shaw and a former subsidiary unveils the complicated dealmaking that has come to be a part of many large-scale hedge funds, and the difficulties in valuing private companies.
• The suit alleges that the $50 billion hedge fund sold off a litigation finance unit at a discount, and that the unit's founder did not receive the same payout as other equity holders.
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An ongoing legal battle between high-powered hedge fund D.E. Shaw and a former executive is shining light on the difficulty of valuing private companies.

Gary Chodes, founder of Oasis Financial, a player in the booming litigation finance space, is suing the $50 billion hedge fund, claiming that it sold Oasis in a hurry for less than what it was worth. D.E. Shaw bought a majority stake in Oasis in 2007 through a fund known as D.E. Shaw Composite Side Pocket, and sold the company to private equity manager Parthenon in 2016.

Side pocket funds are used by hedge funds as their own internal private equity vehicle, which have a longer timelines than many funds' traditional strategies. These funds are not meant to be long-lasting products - they often close once an investment thesis plays out.

Chodes also claims that equity holders in the side pocket fund D.E. Shaw used to buy Oasis improperly received payouts from the deal and he got nothing, even though he still had a chunk of equity and an Oasis board seat.

The lawsuit was filed in February 2018, and has not previously been reported. Recently, an Illinois judge rejected a motion to dismiss the suit from the defendants, pushing the suit closer to trial. Currently, a date is set for November 18, though it is expected to be delayed, according to sources close to the defendants.

The side pocket fund, which worked like a private equity fund within D.E. Shaw, is one of several ways large asset managers known for their hedge funds have gotten exposure to the private markets. Funds like Two Sigma, Tiger Global, Coatue, and Point72 have built out venture capital-like arms to evaluate investments outside the public sphere.

The lawsuit is an example of the difficulties in evaluating private companies. While valuations for unicorns like WeWork are now under scrutiny, private companies at all sizes can be tough to peg.

See more: A Viking Global hedge fund is helping startups turn into unicorns. Now it's hiring more people to ramp up investments.

Private investments are booming

A growing number of asset managers, from Fidelity to D.E. Shaw have gotten into the business of making private investments as outperforming in stocks alone has become more difficult.

Litigation finance, of which Oasis is a key player, is an area that alternative asset managers like hedge funds have turned to for returns. The growing niche strategy lends money to people looking to sue corporations or other individuals, and receives a portion of whatever settlement is won. Oasis had reportedly underwritten more than 100,000 lawsuits as of 2016, and lawsuits funded by third parties are expected to grow by 20 to 30 percent annually the next few years, according to Vannin Capital.

The lawsuit claims that prior to the sale to Parthenon, Raymond James bankers hired by D.E. Shaw pegged Oasis' valuation at more than $140 million - roughly double what it ended up selling for. Sources familiar with the deal also said that Chicago-based private equity company GTCR made a preliminary bid for Oasis that was between $105 million to $125 million.

Chodes argues in the suit that the main parties driving the sale - D.E. Shaw and Raymond James - were motivated to get a deal done quickly, which is why the company was sold for such a discount.

The lawsuit also noted that the Raymond James bankers working the deal were also in the process of negotiating their departure from the firm to Stifel's Keefe, Bruyette, & Woods, and their exit was announced roughly a month after the deal closed.

"Notwithstanding having market information and professional analyses available to them showing even better economic times in 2017 (which they considered for the good of their own companies but not for Oasis), the defendants pushed for the immediate sale of the Oasis Companies to Parthenon for an undervalued price and ignored obvious alternative options," the lawsuit reads.

The lawsuit claims that the D.E. Shaw Side Pocket owning the majority stake had become a "zombie fund" that held onto its assets longer than it had wanted, and that the hedge fund wanted to be done with the side project.

However, the bankers working on the sale of Oasis may have initially overshot its worth, according to details in the suit. The litigation finance firm had seen its debt skyrocket since Chodes was removed as CEO in 2013, deflating its valuation.

Raymond James, D.E. Shaw, Chodes, and GTCR all declined to comment.

Many legal battles ahead

The suit is the latest in a long-running legal battle between Chodes and his former company.

There are ongoing cases alleging Chodes misappropriated trade secrets when he started his new litigation finance firm, Signal Funding. Employees that worked for Chodes at Oasis and since joined Signal have also sued Oasis for "overbroad" non-compete contracts that prevented them from working at a competitor for more than two years.

See more: D.E. Shaw asked staff to sign a take-it-or-leave noncompete, and the deadline is weeks away. Insiders say some people could walk even after management improved the payout.

The lawsuit also states that D.E. Shaw's Side Pocket investors received $7.2 million for its equity stake in Oasis, while Chodes, who still held a chunk of equity and a board seat despite being relieved of his CEO position in 2013, did not. Chodes, the lawsuit states, was told that no equity holder was going to receive any payout because the money from the merger was going to be used to pay down Oasis's debt, which had ballooned in the years prior to the sale.

Yet equity holders in the Side Pocket fund still profited off the sale, according to a letter from James Witz, a lawyer representing the defendants, that is cited in the lawsuit.

"Witz indicated that Chodes' or Group's portion of the side deal transfer had 'always' been available for equity owners. Yet for over a year, Witz and the defendants had lied, telling Plaintiffs that there were no sale proceeds available for equity owners," the suit states.

Sources close to the defendants said the allegation that equity holders were treated differently will be challenged during the litigation and that Chodes lost his board seat when he was removed as the CEO of Oasis in 2013.

See more: Inside D.E. Shaw's special relationship with Blackstone, which shines a light on the power the hedge fund industry's largest investors have