XVC 2018 Annual Letter
To the investors of XVC:
It has been one year since the initial closing of our first USD fund and two years since the initial closing of our first RMB fund. Overall, 2018 was a difficult year for most investors around the world; however, it was an exciting year for XVC. We grew the organization, built relationships with quality investors, and partnered with extraordinary entrepreneurs.
So, how are the funds performing? Honestly, it is too early to tell. Our first RMB fund and USD fund have marked an astonishing gross IRR of 106.17% and 538.14%,[1]respectively. However, this is mainly because the "average duration" is short, not because we had an enormous absolute gain, so we expect it to get "back" to normal over time. Also, the IRR of the USD fund is exaggerated due to the delaying of cash outflows—it takes at least three months for a domestic company to set up a proper structure to receive capital from overseas.
What makes us more excited is the healthy growth of the companies. Below is a chart showing the combined revenue/GMV of the portfolio companies. As you can see, it has grown by almost 5x over the last 12 months.
We are excited because this growth is strong and healthy.
First, the companies are in extremely large markets and the drivers of the growth are mostly scalable and durable. Thus, we can expect them to grow for a long time.
One of our core strategies is to focus on "very big ideas." We have invested in a marketplace for auto parts, a few online education services, a fresh-food e-commerce platform, a fashion e-commerce platform, etc, most of which are $10-billion+ opportunities in $100-billion+ markets. Below is a chart that shows our estimates of the sizes of the opportunities (we have replaced logos with letters due to confidentiality obligations, but you can find real names in our quarterly/annual reports).
Second, the growth is subsidy-free, meaning that the orders are generating a positive contribution margin—the marginal revenues are greater than the marginal costs. I know you are tired (or even sick) of subsidies, particularly those who have exposure to some of the bike-sharing companies. Now, you can set your mind at ease.
Third, the growths can build lasting competitive advantages, and this is much more important than being "subsidy-free." In fact, I would vote for subsidizing if doing so can gain competitive advantages faster. The problem of the bike-sharing companies was not that they subsidize—the real problem was that subsidizing did not help build competitive advantages, at least not ones that last.
Below are a few types of competitive advantages our portfolio companies are building:
1） Network effects (marketplace for auto parts)
2） Economy of scale (fresh-food e-commerce)
3） Monopolization of key data that can be used to improve user experience (adaptive learning SaaS, big-data driven apparel retailer)
4） Self-reinforcing brands (online education)
Another thing we are happy about is that we have been able to get meaningful ownership of these companies. On average, we own 20%+ of the core bets immediately after our investments. Below is a chart showing our ownership (cross-fund) of the companies post our rounds.
We were able to achieve meaningful ownership because we have chosen to invest at an early stage. Typically, we can get a 20%+ ownership of a company if we manage to lead its series A. Going forward, we will continue to put our focus on Series A.
However, our bar for "good companies" is extremely high, and it is not easy to always catch them in Series A. Fortunately, we were able to raise a slightly bigger fund than we had initially planned, so we can still fire a Series B bullet if we miss a good one in Series A.
Company K is such an example. We liked the thesis and looked at the company twice in its Seed round and A round in 2017, but we could not build enough conviction to invest. When we revisited the company in June 2018, it had already received an offer from one of its existing investors to lead an internal round. Once we finally saw the proofs of product-market fit and good execution, we completed our due diligence over a weekend and offered the company a term sheet. We ended up co-leading its Series B at $100 million post-money valuation with the existing investor and owning only 6% of the company. Nevertheless, we are still happy about the investment.
So, overall, we are satisfied with the portfolio.
However, there are still things we must improve. While we keep reminding ourselves to be independent thinking, it is difficult. Occasionally, we still let market sentiment and our own emotions sneak into the decision-making process.
In one case, the company we were looking at received another term sheet and pushed us to make a decision before dawn. We finished our due diligence and management interviews at 4 a.m. and signed a term sheet in the morning. After a nap, we immediately felt uncomfortable about it. We still think the company has a chance to become great; however, we let our FOMO get in the way, and we put too much weight on some low-confidence information and too little weight on some high-confidence information.
Since then, we have upgraded our process. Now, before making any investment decisions, we perform some extra paperwork that takes at most five minutes to finish. This paperwork serves as a checklist that reminds us to review the information quality we have and to think about what is important. We believe too much paperwork will make smart people dumb, and we have tried our best to reduce paperwork. However, we are fine as long as the paperwork is not intended to let some busy boss make decisions remotely but designed to help one think clearer.
Regarding other concerns, some of you have asked me how I feel about the macro-environment. This is a difficult question. Fund raisings and exits are both slowing down. Stock markets are down. Automobile sales were down 16% in the first 11 months. Mobile phone sales were down 9% in the first three quarters. Furthermore, some powerful people started a trade war.
It seems we have entered a downturn. Will we be in a downturn forever? Probably not. The economy has been growing at a compound rate for centuries, and the two fundamental drivers of the growth are 1) the never-satisfied aspect of human nature and 2) ever-improving productivity. Neither of these drivers has changed. Therefore, this is simply a momentary downturn that will eventually lead to an upturn.
And even if the downturn lasts a long time, among all the GPs you have invested with, XVC is probably the least worried about the economy. In the chart below, we are in the upper-right corner: extremely long-term and extremely alpha-driven, the farthest away from the "disaster area."
Nevertheless, downturns can hurt companies, as it becomes more difficult to raise funds and sales will be significantly slower in some sectors.
To prepare, we performed a sensitivity test on our portfolio. We categorized the companies by two dimensions: 1) profitability and 2) how long can they live if they keep burning at their current rate without any new funding. Among the 13 running companies, two are profitable, six are growing at loss but can breakeven at any time, three are generating revenue but still far from breakeven, and the other two are pre-revenue.
We also looked at the cyclicality of the companies. Most of the companies are counter-cyclical—six education companies, one low-cost retailer, one entertainment company and one auto-part marketplace (in downturns, people tend to buy fewer new cars and stick with old cars that need parts).
After the sensitivity test, we felt much more confident. We will closely monitor the companies that might have trouble.
Essentially, our job is to look for "great companies," and "great companies" are friends of time. In an upturn, great companies win because they can raise more money than competitors and grow faster to stay ahead of the game, enabling them to raise even more money; in a downturn, great companies win because they offer better services and products at lower cost and take market share with good capital efficiency.
Lastly, I want to let you know that, although we work tirelessly to avoid mistakes in decision making, we often remind ourselves that we should not make a "high success rate" our top priority.
In a typical VC portfolio, you will see 25 to 30 companies, but the top one or two successes will generate 90%+ of the total return, and the scale of those top successes will define how good the fund is. We have decided to build a more concentrated portfolio than typical VC funds; however, to win the game, we still need to catch at least a "truly great one."
We made eight core bets in 2018 and six core bets in 2017. Although most of them are trending well now, there are great uncertainties down the road. Looking back in 10 years, we might find the "truly great one" among these 14 companies, or we might find it among our investments in the next few years. In any case, it will take us a long time to see which one will eventually shine.
This is part of the beauty of the VC business—you must live in the future. The massive uncertainty and the extremely long feedback cycle work against human nature and drive most people crazy, thus leaving a significant market unexploited.
But we were born crazy—we are entrepreneurs who happen to be venture capitalists. We feel blessed to have this job and truly believe it is the best one to have. Without your support, we would not be able to do the job we love and would not have the courage to do it so differently. So, once again, I would like to thank you for supporting XVC. We look forward to a long-term and rewarding partnership.
Best wishes,
Boyu, on behalf of the XVC team
[1] The IRR calculation uses remittance dates for cash outflows and assumes we liquidated the portfolio on 12/31/2018 at its latest market value.
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