On April 20, 2018, Source Code Capital’s 2018 Annual Code Class Conference themed “Opening Sources, Decoding the Future” convened in Beijing. Mr. Guo Ruyi, Founding Partner of Taihe Venture Capital, shared a wonderful speech entitled “Face the Cycle Head-on and Become More Sustainable with Every Iteration.”
Guo Ruyi said that prior to 2017, the velocity of the market and the concentrated investment focuses together provided a nice rhythm to the use of capital and investing. In 2017, the window of investment opportunity was short-lived and capital became more cautiously used. Capital became more rationality and policy was tightening. In Q1 2018, we witnessed a new trend that can be summed up in these words: “Capital reshuffling, renewed opportunities, embrace integration, and continuous iterations.”
Guo Ruyi believes that in order to remain calm during this objective cycle, entrepreneurs should achieve “four iterations” at the cognitive level: strategic iteration, organizational iteration, capital iteration, and policy iteration.
Guo Ruyi’s full speech is as follows:
Thank you to my friends at Source Code for the invitation.
I just listened to Mr. Hu’s speech and I felt very emotional. Huawei’s growth curve over the past 30 years, since its establishment in 1987, is the kind of curve we would like to draw for the entrepreneurs we are helping. The most poignant thing is that after many twists and turns and cycles, Huawei can still maintain a steep growth curve, with thanks to the continuous iteration of the entire organization. There is a saying that “there is no great enterprise, only the enterprise of the time.”
How does one keep pace with the times, how does one deal with the peaks and lows of the economic cycle – these are all issues we must be prepared for.
First, let me take a few minutes to introduce Taihe Venture Capital. Since our establishment more than five years ago, we have completed 60 projects and more than 80 financing rounds, with a total financing amount of RMB 55 billion. In 2017, we relied on a team of 20 people to complete the private equity financing amount of RMB 20 billion. To provide a simple benchmark comparison, in terms of the public market IPO financing scale, our performance is second only to CITIC Securities (which has RMB 21 billion in its IPO underwriting). We serve customers in the mid-to-late TMT industry, usually with an average single financing amount between $50 million and $100 million. Taihe Venture Capital is the least typical Financial Advisor (FA) in the industry. Some people say that we are the brains behind enterprises. Some people say that we are also friends with entrepreneurs. Our mission is to be the future business leader and partner with the most pioneering entrepreneurs and investors in the new economy. In addition to helping each round of financing, we also hope to see the fundamentals of a company’s own value, hope to see entrepreneurs grow into business leaders, and hope that the cooperation we bring to entrepreneurs can generate lasting impact.
Now that our introduction is out of the way, let me now share with you our perspective on the capital market situation in 2018. Prior to 2017, the velocity of the market and the concentrated investment focuses together provided a nice rhythm to the use of capital and investing. In 2017, the window of investment opportunity was short-lived and capital became more cautiously used. Capital became more rationality and policy was tightening. In Q1 2018, we witnessed a new trend that can be summed up in these words: “Capital reshuffling, renewed opportunities, embrace integration, and continuous iterations.”
1. The U.S. stock market has settled into a new normal state, and the return rate of A shares continue to decline.
For a long time, Taihe Venture Capital has liked to look at the market through the lens of finalization. In the end, the financing purpose of the primary market is ultimately to achieve exits, and IPO listings are one of the key indicators. In the past six months, of the 15 TMT-related companies that listed on the U.S. stock exchange with a market value of over USD $500 million, 12-13 are unicorns worth over USD $1 billion. Yet the most popular word used in the media at the time of listing was “stock price slumps below IPO price.”
Based on the data, more than 30% of listed companies achieved “breakthroughs” with its IPO price at debut, while more than 75% traded below their issue price on the same day. Of the three or four companies that did not see a breakthrough, the share prices only exceeded their issue price by less than 10%. The average share price of 15 companies fell by more than 20%, and the unicorn companies fell by nearly 30%. This is a terrible thing. This means that the public market valuations are decreasing rapidly. If you invest in a higher price in the primary market, the listing may become visible. In particular, after the latest compliance policies and regulations for individual investors, the return for individual investors has gradually shrunk and regulation has become increasingly strict. Financial capital has become increasingly difficult to invest in emerging GP companies. These signs have worried investment institutions.
Looking at the A-share market, returns have fallen by more than 70% since the end of 2015. The average daily limit also reflects the fact that the state of the A-share market tends to be rational. In 2017, it was obvious that the growth of A-share market was accelerating, and a large amount of capital poured in. Beginning in Q1 2018, the A-share approval rate had slowed significantly. The number of IPOs dropped by 70% as compared to Q1 2017. The tightening of the IPO exit channels due to regulations caused a large number of GPs to take a more cautious view regarding exits. By optimistic estimates, the adjustment period would take at least 1-2 years, or more conservatively, 4 years. Most GPs have a duration of only 8-10 years. Given that the uncertainty in the domestic IPO market intensified, the expected rate of return also had to be lowered. This consequently increased the sensitivity to the valuations and pricing of investment assets.
2. The Matthews Effect is prominent. Investment firms will survive the winter, but the transmission mechanisms still lag behind.
The scale of annual fundraising (in VC and PE) continued to rise over the past three years, and the total fundraising amount exceeded USD $260 billion in 2017. In 2016, over 13,000 venture capital funds were registered in over ten countries. There are more than 2,000 institutions in Taihe’s database. When any company connects with its 100th firm in its financing process, it generally means that financing has been quite difficult. So it would seem that the investment firms are redundant. In Q1 2018, the fundraising scale fell by two-thirds year-on-year, but it eventually returned to normal. What impact will this have on the primary market?
In absolute terms, the investment scale seen in Q1 2018 is up year-on-year, and it seems that there is no direct impact. First, Q1 2017 was affected by the cold winter of the prior year, and capital recovery lagged behind. Second, in the second half of 2017, many leading capital institutions raised funds and were well-capitalized for 2018, and actually accelerated making their investments in Q1 2018. Third, many of the deals disclosed in Q1 2018 were actually completed at the end of 2017, and there were certain data deviations. We think that over the next six months, or at the end of this year, the shrinking capital market will lead to more cautious investments. Due to the difficulty of fundraising for a large number of GPs, existing GPs must be disciplined and value returns on investment.
3. Face this market cycle, iterate organization, strategy, capital and increase policy awareness
How should entrepreneurs respond to the trend of tighter fundraising and more cautious investment?
First, acknowledge the existence of the cycle. In several financial crises over the past 30 years, it is difficult for us to grasp the inducing factors or make regular pre-judgments in advance, but the expectations must be the key factors affecting the capital market. Why is it that the fluctuation of U.S. stocks or even Trump’s Twitter have begun to affect the markets? It is because the market sentiment is very sensitive, leading to expectations of caution and transmission to the capital market. Many investors have asked us why U.S. stocks have continued to rise for 10 years, higher than the high point of the Dot Com bubble period. Will it fall soon? From a fundamental point of view, we don’t think there is much of a bubble, but the downside expectation does exist. Another interesting small cycle, or window period, is the window period of TMT. From NetEase, Sina, Baidu, Focus, in the early 2000s, to Qihoo360, Youku and SouFun around 2005, to Alibaba, and JD.com in 2014, to the more recent iQiyi, and clear expectations of Xiaomi, Ant Financial, Meituan and so on – we can keep these key moments in mind because the capital market and the company’s development are marked by a certain period of time. The emergence of each good quality asset takes time. After the good assets are concentrated in that window of time, there will be an empty period of three to five years. Therefore, we must be rationally aware that the cycle is objective, and only bad assets fail to emerge.
Second, there are four aspects of cognitive iteration.
1. Strategic cognition iteration
Practice internal strengths and efficiency, deepen and expand boundaries. For entrepreneurs in all fields, we must practice our internal strengths. The technical team needs to be commercialized as soon as possible, and the business team should optimize efficiency in order to prove itself with data as soon as possible. From our 2017 internal data, not all projects are as hot as we might think. In the field of intelligence, the average financing period of an AI project in its middle and later period is 6.5 months, and big data projects are more popular. Why? Regardless of commercialization, big data projects are showing clear breakthroughs, which is a fundamental improvement. Some AI projects have good technology and good teams. When you are financing, you will still see your scenario’s penetration rate, commercial landing and commercialization. This is similar for the consumer sector. New retail is a hot topic, but still, one cannot be fully certain of its long-term future. The investor judgment cycle takes more than 6 months. It needs to look at very fine indicators such as single store output, scale verification, and human effect – consumption upgrade and so on. Education projects have a financing cycle of only three months, because they have ushered in an incredible explosion of online and offline activity. Opportunities for liquidation have emerged, and the efficiency of liquidation has increased. Many projects have been accounted for, or have been verified by scale, and investors naturally like that.
Growth is no longer the only criterion for testing projects – it is important to be efficient. According to our internal statistics, low quality projects will receive an average of 2-3 term sheets. Everyone likes the strong projects, but there will be concerns about their growth, and the efficiency of accounting growth, such as every dollar of growth – GMV and how much it costs. In the process of growth, losses gradually shrink, efficiency is improved, and the scale effect is achieved. Such projects cannot be held back by investors. Beyond just scale indicators, you should pay more attention to efficiency indicators. If entrepreneurs find that their business is growing rapidly, they must find the core driving factors of business growth in time and grasp these common factors to see whether they can replicate them.
In the upstream, downstream, and capital levels of the industry, we will get deeper and expand our boundaries. Over the past six months, more than 60% of the projects we have served have begun to expand their business or capital cooperation both upstream and downstream from the industry. Some companies invest in a more traditional field and complete a closed loop of transactions. For example, logistics projects are conducting mergers and acquisitions across the country, which is an interesting trend. Entrepreneurs must not only make a single breakthrough in their business as the key, but also work hard in the strategic direction and strategic rhythm. They must have an elevated mechanism to expand boundaries, use resources to open borders, and cooperate with upstream and downstream industries to take advantage of their allies. It is possible to realize the redistribution of industrial profits by having an equal and open mindset to optimizing the industrial chain.
2. Organizational cognitive iteration
I used to say that early stage investments are all about people, but investments in the mid and later stages are not. In fact, this is not true. In the mid and later stage investments, it is also important to look at people. For example, in Taihe’s internal evaluations, there are usually only 2-3 projects in a field that have advanced into the C round. The amount of funds and business volume have not been widened. We would like to have a team with little anxiety and benign redundancy. With pressure to perform and compete, there is still room to think about innovation and management, and to incubate new businesses outside of internal business innovation. Such a team has room for continued growth. On the other hand, if the team is struggling with the existing business and having conflicts, the internal organizational system may have bigger problems.
From our data, the team with benign redundancy typically receives twice the amount of term sheets. The “one-voice team” (an organization led by a single voice), received an average of four term sheets, because the decision-making efficiency was high enough and the execution is usually the most efficient, so the data was not bad. But we prefer “wolf-like teams.” Such teams may see many opposing voices and different ideas for the business, but the organization allows for the existence of activeness and has the opportunity to bear bigger challenges. Investors prefer teams like this.
More and more teams pay attention to the development mechanisms. Even in the initial stage, these mechanisms are relatively rough, such as front-end sales commissions, but as the business develops, they need to be gradually optimized. We once worked with a company that incurred a loss of RMB 10 million in a single month. It started to make a profit in the third month. By the end of the year, it had a profit of over RMB 100 million. We found that the team had a very clear set of mechanisms, with its own knowledge community, brand community, and interest community. Based on each community, it was able to give the front-end product manager enough innovation, vitality and support. This is the value of having proper and supportive organizational mechanisms.
Another new trend, from Taihe Venture Capital’s Q1 data, is that nearly 40% of the projects are big corporate splits or incubations from in-house innovation. On the one hand, the company has the vitality of continuous innovation. On the other hand, there may be newer ways to motivate teams, such as equity redistribution. The best way is to split the financing, and the incentive component may be greater than the capital operation component.
3. Capital Cognition Iteration
In the past, entrepreneurs generally thought that financing was an auction, and that the rounds were not related to each other. More and more, entrepreneurs now recognize that financing is an important part of their business strategy.
First, professional division of labor is becoming more and more important. For example, we are very happy to see that the probability of using Financial Advisors in the mid and later stages of financing is getting higher. From the perspective of the company’s organizational structure, 60% of AI projects we have served in the past have specialized financing leaders, and their qualifications and titles are good. Most of them were recruited from Hong Kong investment banks. On one hand, it shows that Hong Kong investment banks are under great pressure. On the other hand, it shows that startup companies, especially early-stage entrepreneurs, clearly recognize the important strategic value of capital and will seriously look for so-called financing partners.
Second, financing is normalized. When you feel that the market is tight, you should make a financing arrangement as soon as possible. Some founders think that they don’t need the money now, but in the long-run, they always need funds for three or ten years. The best way is to get as much as possible to help you develop your own funds and ensure a certain amount of financial redundancy. In the past six months, of the companies Taihe serves, over 50% raised a plus round, and the frequency of financing continued to accelerate.
Third, actively embrace the war. In the past six months, of the projects that Taihe completed, 85% were a “war” for industrial capital, where Tencent accounted for nearly half of the total funding. In previous wars, receivers of early capital are completely different now. The layout of the war is more and more advanced. The most typical one is Tencent, including Toutiao, which is very positive.
Financial investors are very anxious. Except for money, there seems to be nothing that compares to war. Everyone thinks back then, it was about handing over the plate between you and I, and now it’s a conflict of smashing each other’s bowls. In fact, it is not the case. It is a healthy competition for financial investors. From an entrepreneurial perspective, we call on everyone to actively embrace good industries and strategic investors.
First, they can bring a perspective from a different industry. Entrepreneurs may be a small player in a single breakthrough in the industry chain, but the entire industry chain is very complicated and lengthy. It would be very valuable if you had a broader perspective or gained valuable experience from a large industrial group that had experienced multiple cycles. Secondly, investors like BATJ are still in a flat state of mind. Especially Tencent, whom we don’t think is a pure strategic investor. Funding support and brand endorsement are even more important. In some highly competitive areas, entrepreneurs will also turn Tencent’s investment into an important financing strategy.
4. Policy Cognitive Iteration
Since 2017, the so-called policy risks have become important in the capital market. But the policy itself has no risks, rather, non-compliance is the risk. There were a lot of new projects in the market in 2010-2013. Could you say that they were compliant at the time? It is a new species and there is no new policy to bind it. Now such a disordered development window no longer exists.
First, we must pay attention to the trends and policies that occur in the core of our industry. From the results, 2017 policies were sensitive to three relatively large directions, involving human life, ideological content, and systemic risky financial actions. Projects in these areas saw many investors rescind their offers, due to concerns about whether the start-ups can be compliant with policy, or fact that the policy is unclear, or that the policy is risky. Even if financing was obtained, the safety of the project itself is not enough. If you are limited by the “policy ceiling,” you must first find ways to open up other markets. Secondly, consider how to refine operations in the existing market, improve efficiency, and draw your own profits. Of course, policy can also be good. For example, the logistics and manufacturing sectors have recently had a series of tax reduction policies. It seems that there are only 1-2 points of influence, but the impact on the profit margin in the entire industry is likely to be very large.
Second, do not blindly pursue hot spots. For example, recent unicorns are actually just concepts and results, not a hot spot. The industry hotspots that people usually understand are brought about by the rise of a certain industry and a new technology, rather than a hot topic. Why do I say that unicorns are poisonous? Because I feel this is very similar to the situation in 2015. At that time, the capital market was also very hot. At the end of 2014, a VC partner asked us, if, because everyone is spending so much money in mobile internet, whether there would be a bubble? We worked hard to close all our projects that year before Chinese New Year. However, after March 2015, a war front was expected, and a large number of RMB funds became active, and a demolition brigade was established. De-VIE to pursue an A-share listing became a hot spot in the industry, but till today, I still feel the pain of the lessons learnt, as over 90% of the de-VIE projects did not end up listing on the A share. This year, there was another wave of de-VIE, but did everyone fully think about their strength and ability to achieve a listing on the A-shares? The key is that the unicorn is the result, not the cause, and is the natural result of your own business value. If you don’t appear on the list of the first unicorns to return to China, don’t think too much, don’t join in the fun, do your own business, and focus. This is the most crucial. Respect common sense; prices revolve around value fluctuations; do a good job; and create value as your fundamental basis.
In summary, the cycle always exists, and the market may become less optimistic in the coming half year or the next three quarters. How should we deal with it? We have experienced several cycles in the industry ourselves. Looking at the economic cycle is like witnessing periods in history; you’ll get more peaceful as you see and experience more. The market is actually not as good as it seems when it is doing well, and the market is really not as terrible when it is bad. No matter how the external environment changes, the only thing we can do is try to control ourselves. As the NBA often says, “GO BIG OR GO HOME,” you have the ability to continue iterating and have the ability to adapt to the challenges that this era has brought you. You can be powerful. If you don’t have this ability, then sorry, you go home.
Thank you all!
