To the Investors of XVC:
It has been three years since the initial close of our first RMB fund and two years since the initial close of our first USD fund. By December 31, 2019, we had deployed a total of 152.5 million USD, and the gross IRRof the portfolio was 59.9%. Although IRR is probably the best measure with which to benchmark funds, we try to ignore it in the short term and focus on the intrinsic value of the portfolio and long-term competitiveness of our firm. So, in this letter, I will try to share some thoughts and observations we had on these.
The year 2019 has been a very slow year for the VC industry in China. The total amount raised by the VC funds dropped by around 50% from the previous year. Fundraising has also been difficult for entrepreneurs—the total amount invested by the VC industry also dropped 50% from the previous year.
Moreover, the changes in the international political and economic environment are so large and drastic that we can feel and see their impact in our daily lives. We live in a turbulent time. I asked myself a question: How would we define this year if we looked back in 20 or 30 years from now?
My answer is—it’s probably just another normal year.
Thanks to the support from a group of quality LPs with a long-term mindset, we have been able to raise our second USD fund—268 million USD in XVC USD II and 61 million USD in Super Select Fund II. And, despite the unfavorable environment, a few portfolio companies have raised a total of 259 million in follow-on rounds—6.3x of the funds we have initially invested in them.
The companies have kept growing fast, too. Below is a chart showing the combined revenue/GMV of the portfolio companies.
As you can see, the combined revenue and GMV of our portfolio companies grew another ~4x in 2019, on top of the ~4x growth in 2018.
Although the VC industry is slow, XVC is well funded and we have been actively looking for opportunities. However, only four companies passed our threshold to join the portfolio in 2019, and they are on average more expensive than our past investments.
You might wonder what happened. We asked ourselves the same questions. Are we affected by market sentiment? Are there great opportunities that we missed? Or is it possible that there are no longer big opportunities because this is the end of “a golden era”?
We couldn’t answer these questions. The VC business is cyclical, but it’s driven by very different considerations and not synchronized with the cycle of the macro economy.
Below is a chart that shows a top US venture firm’s investment activity and exit events over the last 24 years.
They led 283 investments and recorded 75 exit events in the 24- year period. The aggregate market value of the companies at the time of the exit events was around 200 billion USD. But as you can see in the chart on the right, four big exits contributed to a vast majority of the total value. The second one occurred 14 years after the first. As shown in the left-hand chart, their number of investments made in each year can vary from 40% to 200% of the average. I checked out the same data of a few other leading VCs in the US and China. They all showed a similar pattern.
The chart tells us a fact we already know—that VC returns are mostly driven by a few outliers, and they are very hard to predict in the short term. So, my answer to those questions is to think in the long term and be patient.
Patience is the most-needed skill in our business. We at XVC spend most of our time working on these three things below, and each of them requires us to be very patient:
1) work very hard to find the next big thing,
2) invest in it in the early stages to secure meaningful ownership, and
3) help it succeed.
Let’s take a moment to review the path of a very patient company—Walmart. It only had 32 stores when it went public in 1970, 25 years after Sam Walton opened the first store. Almost all were in Arkansas. Nine years later, when Walmart had 229 stores, they were still in Arkansas and its surrounds (see chart below).
Here’s what Sam Walton said about his strategy in the early years:
I have to admit that in those days we did not have anywhere near the emphasis on quality that we have today. What we were obsessed with was keeping our prices below everybody else’s.
In those days, Kmart wasn’t going to towns below 50,000, and even Gibson’s wouldn’t go to towns much smaller than 10,000 or 12,000. We knew our formula was working even in towns smaller than 5,000 people, and there were plenty of those towns out there for us to expand into.
Maybe it was an accident, but that strategy wouldn’t have worked at all if we hadn’t come up with a method for implementing it. That method was to saturate a market area by spreading out, then filling in.… In the Springfield, Missouri, area, for example, we had forty stores within 100 miles. When Kmart finally came in there with three stores, they had a rough time going up against our kind of strength.
As Sam’s words show, Walmart was not the first mover, but it was on a different learning curve, and that learning curve was longer and steeper than the one its rival incumbents were on, so it eventually became good enough to offer something better than what the incumbents can offer to their mainstream customers.
Longer, steeper “second curves” are very rare (the incumbents usually win) and are very hard to predict (they are usually recognized only after the challengers have won). This is because the incumbents usually start by serving a niche, underserved market.
You can observe the same pattern in our portfolio companies. Most of them are initially targeting small, underserved markets. However, we are betting that they can move upstream and extend their business as they grow along a very long and steep “second curve.” We try to identify “second curves” using a few patterns: 1) platforms that benefit from network effects, 2) applications that can generate or monopolize data, as well as use the data to improve their user experience, 3) platforms, products, or services that benefit from strong economy of scale, and 4) self-reinforcing brands.
Let me give you a couple of examples.
One of our new bets, Company Y, offers a mobile video match-making and dating service for people seeking serious relationships.
Online match-making services like Baihe.com and Jiayuan.com have been around for a long time, and they have served their customers well with professional service and a good level of privacy protection. Online dating apps are already very big, too—Momo and Tantan (acquired by Momo) have over 100 million monthly active users.
In Company Y’s app, most users are less-educated people in low-tier cities, and they are served by part-time, amateur (but real) match-makers for a very small price (starting from 30 cents USD). And by default, the app offers a unique dating experience—a three-person video chat livestreamed to the public.
The service is rough and most of the video chats end within a few minutes with no follow-ups. But the users like it. They were underserved. They like the seriousness, genuineness, and ice-breaking service offered by the matchmaker, and they like the fact that they can chat with a sizeable quantity of people within a limited time, facilitated by convenience at their fingertips.
And the company is growing along a lengthy and steep learning curve. When we invested in the company three quarters ago, only 40% of the video chats happened between people in the same province. As it grows in scale, it’s much easier for one user to be matched with another with a similar profile—age, education level, and looks—who must also be online at the same time. Moreover, as the app grows in scale, it will be able to find ever better matches for users with algorithms and insights powered by more data. In the eight months after we invested, the company grew 5x in scale and doubled its user retention.
Another bet we made this year was very unusual. The company is an online grocery company in the US. It started by serving a small niche market—Chinese people in Silicon Valley, and then tried to extend the business to more geographies and more ethnic groups.
We have studied many fresh food/grocery businesses across different markets (China, Korea, India, UK, US, etc.), both online and offline ones. This company has one of the highest long-term retention numbers and share of wallet.
What made us more excited was that we have seen evidence showing that as its customer density increases, its service quality keeps increasing and costs keep dropping. From this observation, we imagined a “second learning curve.” We saw a possibility, although very, very small, that when the company builds its customer density to a certain level, its cost of delivering a product from the supplier to the consumer will be lower than an efficiently run supermarket chain—in our vision, it’s a threshold that might unfold an extremely large upside. At that point, the company will be able to offer lower prices, more selections, and greater convenience than supermarkets. As a retailer, you need to be better at one of those three things to survive. But if you are structurally advantaged to be better on all three aspects than your competitors, you will kill them.
We feel excited about these investments, although we know that only very few of them will eventually “get there.” On the one hand, we try to maintain our passion and optimism when we search for opportunities, so that we will be able to spot that “diamond in the rough.” On the other hand, we have to keep reminding ourselves that these companies are very fragile, and we need to keep our eyes wide open to see the risks.
Company R, one of my favorite portfolio companies, which raised almost 100 million USD in four rounds within one year, made a series of fatal mistakes that led to a cash crunch in November 2019, and turned into hibernation mode. This case urged us to review our portfolio development practice.
For the most part, I would doubt that venture capitalists can make real positive changes to their portfolio companies, aside from the money they provide. We are talking about the companies founded by top entrepreneurs who are extremely smart, hard-working, and self-confident. They are on the ground and they know their customers, competitors, and employees well. They should know their business better than the venture capitalists; otherwise, the venture capitalists shouldn’t back them.
So, in theory, when a company’s founder and its investor think differently on something, the founder has a higher chance of being right—let’s say the founder’s chance is 70%. What happens in the 30% of the cases when the investor is right? The founder wouldn’t listen to the investor.
So, in reality, besides helping the founders on fundraising and a few key hires, we just try to be a sounding board when they seek one.
Now, we believe that’s not enough. We have come to realize a few things:
Founders are usually good at product and marketing, but very few of them are good at financial planning. In some businesses, finance is a crucial part of strategy, so it’s important that the CEO always perform a financial forecast before making any important decision. One big mistake can destroy a fast-growing company’s financial health very, very quickly.
Founders usually learn to build good organizations after, not before, becoming a founder. Many efficient organizations, such as Meituan, were very inefficient and chaotic in their early days.
Founders know their business better than us, but they have to make decisions in very stressful environments. In addition, although founders are closer to customers, sometimes being the “boss” prevents them from getting at the truth.
With these gradually acquired insights in mind, we are developing a few post-investment services.
For a few portfolio companies, we are coaching the CEOs to build a financial forecast, and until they become good enough at it, we will do it for them temporarily. We call this service “Outsourced CFO.”
For a few other portfolio companies, we are coaching the CEOs to become a better interviewer to hire the right people. To prepare to do this well, we have hired consultants to train ourselves in the past two years. Additionally, we are working with senior executives and consultants to develop an organizational diagnostic program to help portfolio companies assess their organizational efficiency.
We are strengthening our fact-finding and research capacity to try to offer important information to CEOs before they know it. We don’t want to make decisions for the CEOs, and we still encourage the CEOs to be independent in their thinking, but we’d like to be a more proactive sounding board than before.
These are all challenging endeavors. At the end of the day, most of the efforts may be futile, because only a small number of companies will “make it.” And the ones we spend the most time helping may not be among them.
Most people wouldn’t invest in or spend their time to help a company if they knew that its chance to “make it” was very small, because the uncertainty and the extremely long feedback cycle work against human nature. But we enjoy working with the uncertainty and have enough patience to deal with the long feedback cycle. We view ourselves as entrepreneurs who happen to be venture capitalists. We love entrepreneurs, and we keep trying to improve ourselves to be better prepared to help them. So, once again, I would like to thank you for supporting XVC and letting us have this blessed job. We look forward to a long-term and rewarding partnership.
Boyu, on behalf of the XVC team
 The Internal Rate of Return (IRR) calculation uses remittance dates for cash outflows, and it assumes we liquidated the remaining portfolio on 12/31/2019 at its latest market value. We wrote off some companies in hibernation mode, and the final number has factored in the write-offs.
 Gross merchandise value (GMV) is the total value of merchandise sold over a given period of time through a customer-to-customer exchange site.