Editor's note: China's venture capital and private equity industry have undergone huge shifts over the past few years, thanks to a sea change in the global and domestic socio-economic climate.
As Chinese businesses struggle to adapt to the new normal, marked by more stringent regulatory oversight against overseas listings, a Covid-battered economy, dwindling household consumption, and stronger headwinds as startups move up the value chain, so will their financial patrons.
How are VC/PE investors faring in these turbulent times? What are the challenges they deem the most intractable and what are their solutions? Conversely, which are the emerging areas of opportunities that can be turned into the next money-spinner with their Midas touch? More generally, how do they expect China's entrepreneurial scene to evolve in the next couple of years? And most importantly, after having their finger on the pulse of the country's innovations, are they still China bulls or have turned perhaps into China bears?
These are defining questions to which no one has the exact answer. But we at EqualOcean believe that one can at least get a glimpse into the future of the Chinese economy by looking at how VC/PE investors are planning and making their moves.
With this in mind, we start a new series called "China VC Interview," in which our analysts will sit down with frontline industry practitioners to hear their opinions about China's VC/PE industry.
The following is the second in this series, conducted after interviewing Ray Hu, founder and managing partner at Blue Lake Capital(Chinese:蓝湖资本).
About 「Blue Lake Capital」 and Ray Hu
Blue Lake Capital is a next-generation, research-driven venture capital firm, founded by Mr. Ray Hu in 2014, which focuses on big market opportunities primarily on cloud software with a strong portfolio of investments including Meicai, Momenta, JST, Leyan Technologies, Zhenyun Technology, Cloud Helios, Moka, Thinking Data, Zaihui, Asinking, etc.
Ray Hu has 15 years of experience in venture capital investing. Before founding Blue Lake Capital, Ray worked at GGV Capital and the Boston Consulting Group. Ray holds a bachelor’s and master’s degree in economics from Fudan University and an MBA Degree from the Kellogg School of Management of Northwestern University.
Part Ⅰ Retrospect| Locating relevant variables and knowable questions
EqualOcean：What are the different types of venture capital firms?
Ray Hu：Relatively speaking, some firms tend to source their deals extensively while Blue Lake Capital focuses on two lanes: intelligent manufacture and SaaS. Of course, extensive sourcing is a precondition for finding quality deals. The purpose of doing research is to raise the efficiency and accuracy of investment decision-making after quality deals were found through early-stage sourcing and to be more targeted when sourcing deals.
My team was able to build a set of methodologies through research that promises lesser time and lesser decision-making in the future. After all, our investments — the startup companies — are high-risk assets. Oftentimes, their products are yet to be formed, the competition landscape unclear, and many variables awaiting in line. We research so we can locate the relevant variables to investment ROI and rule out the irrelevant ones. After that, we still need to distinguish between the knowable and the unknowable within the relevant range. Focusing on the relevant and knowable parts could bring about a small lift in investment success rate in one deal. That way, our fund as a whole could embrace a giant leap in return over time.
EqualOcean：Are you satisfied with the work of these eight years since Blue Lake Capital was founded in 2014?
Ray Hu：I’d give it a pass, but not without regrets. We’re not depressed for missing deals worth hundreds of billions of dollars, but we feel sorry for locking down on some deals in later rounds rather than earlier when their valuations were lower, which means more return for us. For example, we had a chance in a SaaS startup during their angel plus fundraising. But we ‘thought’ that the founding team had no sales team management experience which could leave them vulnerable. At the round following angel plus, when the team had proved their ability to manage the sales team, we then worried that their future expansion might hit a rock. This has given our team a lesson: base our decisions on the knowable and not waste time on the unknowable.
The success probability and achievement ceiling of a startup lie heavily on its founding team. But as investors, we can hardly reach a reliable judgment of the founder’s capacity based solely on several hours of communication and that would be meddling with the unknowable. Since then, we’ve made a turn towards objective and knowable questions, such as business progress, client contracts, price level, client conversion rate, and efficiency per capita. Venture capital firms need to look for universal patterns that could quantify a startup’s levels and risks.
EqualOcean：In the two sectors you’re experienced, intelligent manufacturing and SaaS, are founders’ backgrounds relevant to what they later do?
Ray Hu：Not so much as for academic degrees. But of course, more founders of intelligent manufacturing startups are of science and engineering background and have experience in relevant industries. It would be rare for a total stranger to come into this industry. Most SaaS founders also come from within the industry. For example, the CEO of JST was once CTO of a shoe company with the experience of ERP development and the founder of Thinking Data worked previously as a developer at Tencent Interactive Entertainment Group. They were aware of certain needs underlying the industry, and how to design products accordingly, hence successful companies.
EqualOcean：In hindsight, are there commonalities among successful founders?
Ray Hu：Of course. First, successful founders are good learners. They will find themselves in an emerging industry in China with a perplexing marketplace and few predecessors to learn from. Besides, SaaS founders mainly worked as PMs or programmers before and lacked experience in managing a functional organization. Things such as managing a sales team, issuing performance indexes, remaining independent, recruiting partners, and constantly adjusting to the external environment could be challenging.
Another important quality would be to get ahold of the Pareto Principle — the law of the vital few. It’s both tricky and essential for founders to recognize with accuracy the fundamental issues of the given moment right in the given business line. The first half-year after getting financing would be a dangerous period for many startups when they tend to proceed too aggressively. The familiar financial condition for most SaaS startups in China would be in deficit. To ration limited resources while losing money and expanding quickly could be complicated. Different companies face different situations such as whether to expand territories or to expand product lines and how. In the meantime, a lot of opinions coming from investors and from within the team are interfering with the founder constantly.
Part Ⅱ Status quo| Discerning certainties among uncertainties
EqualOcean： Is the plummet of major SaaS indexes in the US stock market a hit on your confidence?
Ray Hu： I wouldn’t worry about the stock market too much because I am optimistic about the fundamentals of the SaaS industry on solid grounds. When we look into some holistic indicators, we would see a fast growing market. The companies in our portfolio have acquired a lot more business leads this year than those of two to three years ago with more and more potential clients showing up with a clear budget and project. Based on companies’ communication with clients, we have the confidence to say that the market maturity has lifted prominently. Two to three years ago, clients would raise concerns about data security which hardly anyone would mention nowadays. What the buyers frequently bring about is whether the software could meet their operation standards and allow for flexible deployment suiting their organizational features. No longer is SaaS deemed mere “paperless tools”, but also a booster of elevated core competitiveness. Lots of industries do appear to move forward towards what the Chinese government calls for — digital transformation.
Here let’s raise an example of a contract management SaaS company we’ve invested in. In the past, we assumed contract management as helping companies to draft, approve and ratify contracts. Much more than that, lots of companies have procured the system to improve operational efficiency. Salespersons used to bring back a contract from clients to their direct leaders and district managers along with financial and legal departments within. Several weeks have passed before a contract could be finalized. Not to mention there might be hundreds of clients for a company and thousands of contracts involved. Now, using SaaS, the average contract signing period could be reduced to two to three days. That’s a huge lift of efficiency and motivation for salespersons to lock clients. We now see more SaaS applications have been approved by clients as of their value to businesses and have become a must to companies. That’s why I wouldn’t be too worried about stock performances since the SaaS business models are getting more recognition.
EqualOcean： How does the market view SaaS nowadays?
Ray Hu： When I started to talk about SaaS when raising funds in 2016, 90% of limited partners were not optimistic on it. Now, most of them do. With some SaaS companies going publicly listed and the frenzies about consumer internet cooling down, most importantly all general partners believing in the future of SaaS, limited partners are more open to this business model.
The same situation has befallen publicly listed SaaS companies over the past few years. Stock prices went high at first, then dropped. This implied that the market held expectations toward SaaS companies. Investors voted with money when companies with quality benchmarks went public, then vetoed when they were disappointed by bad performances. The currently listed SaaS companies derive their revenues mainly from customization, but the majority of their incomes go to building SaaS businesses. So they’re in transition. We do need eight to ten IPOs of high-quality and fast-growing SaaS companies to boost market confidence. Based on my evaluation, there are currently over 20 SaaS companies with Annual Recurring Revenue or ARR over CNY 100 million. It takes them two to three years to grow to the size qualified for IPO — which is USD 100 million of ARR at least.
EqualOcean： What would be your suggestion for fundraising SaaS companies?
Ray Hu： The financing environment may not be very friendly to SaaS companies this year. At the end of the last year, the valuation of SaaS companies in the US stock market was at its peak, most of which reached a dozen to twenty times Price-to-sales(PS). Now that number has dropped more than half. SaaS companies with a growth rate over 50% are valued eight to ten times PS, yet those with less than 50% are valued only six to seven times PS. This means for SaaS companies seeking financing this year that revenues need to be doubled than that of the previous year only to get a valuation equal to the previous year’s. For many entrepreneurs and former investors, mentality needs to be modified and the market status quo needs to be recognized. For worse, the fund is not guaranteed even if revenues double and valuation is equalized. Many VC investors are so overwhelmed by the turbulence in the stock market that they haven’t had the time to rebuild a sound evaluation pattern. We’re all in the process of adjustment.
I would recommend SaaS startups to hold a steady expanding pace, be prudent on cash flow planning, and resume financing the next year unless they were willing to bear the extended fundraising duration and harsher valuation and terms. We are hoping that long-term economic policies could be more explicit after the 20th CPC National Congress. We’ll see if it would be possible for some companies to seek IPO in the US stock markets. The HKSE is at a relatively low spirit for an IPO now. We’ll wait and see what happens next. We expect some good news to boost the market.
Part Ⅲ Prospect| Reacting promptly with prudent optimism
EqualOcean： Do you believe that Chinese SaaS companies could win global markets?
Ray Hu： Mostly I do. Firstly, there are a bunch of Indian companies with ARR of USD 30 to 50 million that live in Western markets. So SaaS companies from non-Western countries can open Western markets. Chinese SaaS companies usually start in domestic markets. The adaptability to global markets varies with product types. But it is reassuring that one SaaS startup in our portfolio that develops reimbursement systems has successfully won several Japanese key accounts despite all the obstacles, such as gaps in finance and taxation administration, approval procedures, FMIS, and HRMIS — that would be Financial Management Information System and Human Resources Management Information System.
Since startups themselves are in the process of probing, it would be hard for me to make assertions. But we can deduce from experiences that expansion would not be too quick for SaaS companies serving key accounts since they need time to adapt to the complicated operation procedures of global markets. While things could be different for SaaS companies who provide tools for small and medium-size companies in emerging industries, such as e-commerce and games, tools are often more applicable in a universal sense and they could bring about quantitative outcomes which help speed up clients’ decision-making process.
EqualOcean： What would be the challenges and opportunities of business service SaaS companies when going global?
Ray Hu： Building local teams would be the most challenging part, much more than mere recruitment. For example, SaaS companies targeting key accounts need at least pre-sales, delivery, and customer success departments to work together. In China, companies may win over a client with a broad tender and make modifications throughout the delivery process. But in Japan, they may need to submit a 300-page pre-sales proposal that wholly displays every interface of the software to the client. Once the proposal is agreed upon, there will be no modification commands from the clients. The whole team needs to cooperate functionally, including the local teams abroad and domestic supports. Besides, conditions in every market vary from each other. It may take six to nine months on average to recruit one employee in Japan!
There are not as many challenges at the technical level as in the product sense. Again take Japan as an example. Japanese companies hold zero tolerance for interface and language imperfections. They emphasize data security and compliance. The clouding environment is different there. So we’re talking about a lot of localization to be done.
Challenges aside, Chinese companies still stand a chance with better services. The western SaaS giants are somewhat slow speaking of their response time to Japanese clients’ needs. After all, it’s just a regional need of a regional market to them. But Chinese companies can be quick to respond when it comes to meeting clients’ demands. Besides, just like to China, Japan is also a foreign market to the west. So we’re equal in terms of localization.
EqualOcean： Do you think that this round of the Covid-19 epidemic would hurt entrepreneurs’ morale? How about the influence on your following investment allocations?
Ray Hu： Their morale appears to be higher than I thought. Since June 1(the day the city-wide quarantine was called off), I had been going around about the companies in our portfolio. Founders are generally in positive spirits based on the fact that over 90% of sales leads acquired before quarantine are still in pipeline. Market needs are not erased, maybe a little postponed. There would not be many changes to my investment allocations. CNY funds would be divided pretty much evenly between intelligent manufacturing and SaaS. USD funds would flow mainly to SaaS. In all, the SaaS industry would take up around 60% of the fund and intelligent manufacturing about 30%. The remaining 10% is for consumer Internet.
EqualOcean： While the economic growth has slowed down, what new Chinese narrative would you bring about to global investors?
Ray Hu： I would speak frankly to investors. The current environment may seem discouraging, but the future is bright. Economic policies could be more explicit after the 20th National Congress and the customs administration could be more liberal at the end of this year. In terms of asset allocations, it would be impossible for global investors to ignore an economy with such size and growth rate as China. Their perception of China needs adaptation: it is no longer the wasteland as ten to fifteen years before. The environment for investment has changed. Every VC firms, and every investor, need to have this question constantly in mind: how to better design their investment portfolios.
The science and technology innovation system(STAR) is still full of fast-growing opportunities. Big firms like Sequoia Capital, Hillhouse Capital, and GGV Capital tend to source from broader ranges and distribute their resources in sectors from consumer technology, and industrial technology, to even more advanced ones. For more compact organizations like ours, we focus on two fields so that the personnel and funds assigned to each field still have an edge in competition with big firms.
All in all, we hold a prudently optimistic attitude toward the economic trend. But this is not drawn from anything. We would keep a close eye on the companies in our portfolio as of their performance in the following two quarters. Being a venture capital investor is just like being an entrepreneur, “you gotta stay alert and react promptly to the outside world, and all the time.”
EqualOcean would release the ‘Exclusive Interview Series on 100 Global Brands’ in July 2022. By selecting the 100 most representative global brands originating from China and interviewing their principals, EqualOcean intends to deliver industry know-how and boost the global journey of Chinese enterprises. You’re welcome to scan the QR code below and get in direct contact with EqualOcean if you’re interested in the aforementioned topic.