Survival and Evolution
CAI Lei, founding partner of JD Capital, incumbent chairman of JD Capital. This is an excerpt of the speech CAI delivered at the half-year conference in July 2013, with revision.
Where is JD Capital’s future? I have been thinking about it and reading and studying. I came across the sentence below when reading Zhuangzi.
“Two fish stranded in a drying pool were trying to moisten each other with their saliva. Would it not be better for them to roam the ocean and forget about each other?”
Let’s first look at its literal meaning. When the land dried up, two fish blow air and spit into each other’s mouth to survive, which is a touching scene. But such living status is abnormal and helpless for fish. The ideal living condition of fish is still water after all. They belong to rivers, lakes and the ocean. Only by living in these places can they find back their sense of comfort and happiness, forget about each other, and that period when they lived on each other’s saliva.
Perhaps “moistening each other with their saliva” seems a moving scene, but “roaming the ocean and forgetting about each other” implies a wiser choice. This is the old wisdom passed on to us from our ancestors. I think this must have inspired your pondering.
Combining the current conditions of JD Capital, you may have deeper understanding of this sentence. JD did and is doing one thing persistently – pre-IPO equity investment, or pre-IPO. How much have we done? We have been doing it in large-scale with standardized procedures and human wave tactics, and we even made it a PE factory. Everyone present here has participated in it.
Pre-IPO is Chinese-style PE business. Now how is it going on? A vivid metaphor is that there is less meat and many bones left in the soup. Or a formal statement goes in this way: there is less profitable business while the business left is tough. This means the tide of pre-IPO has been fading away with us left just like the fish left on the beach “blowing air and spitting into each other’s mouth to survive.”
So how to solve the problem? Zhuangzi has told us, “We had better go back to the ocean and forget about each other.” If we are a fish, to look for the ocean that belongs to JD is fundamental to addressing the problem.
The nature of PE
Where is the ocean? It is necessary to carry out some theoretical or academic discussions. First of all, essentially, PE is about capital.
After tens of thousands of years of development, capital has come into two forms. One of them is industry, corresponding to real economy. The other is financial capital, corresponding to virtual economy. As industry capital developed to certain degree and social division of labor became more refined, part of the capital no longer entered into the original industry. Instead, it started making money by lending, which led to the advent of financial capital. Industry capital and financial capital constitute the two major forms of capital.
Industry capital has two features. Firstly, it is stable and long lasting since each input of industrial enterprises’ investment capital brings profit on a long term basis. Secondly, Industry capital takes the initiative. When the capital is invested, it needs to take the initiative in making such decisions as to whether to invest in fixed asset or working capital, whether to purchase equipment or hire staff, and the proportion and size of these arrangements.
Financial capital is different from industry capital.The first feature of financial capital is liquidity. The investment of financial capital is aimed at cashing out. For example, both the debenture capital granted to businesses by banks and the equity capital of individual investors invested in listed companies emphasize liquidity and aim to cash out. The second feature is passiveness. Financial capital investment normally does not influence the specific decision-making and arrangement of the enterprises.
The differences between industry capital and financial capital are relative. Besides, there is of course a transition form with features of both industry and financial capital. This is PE. In fact, this is how PE came into being. Starting from the 1950s and 1960s in the US, PE then spread through leveraged buyout in the 1960s and 1970s. PE capital is an amphibious capital with both financial and industry features. It meets the need of the social division of labor and is an inevitable product of capital development.
In the past several years, the capital utilized in the pre-IPO business of JD Capital has such prominent financial features as time-phases, liquidity, and passiveness in management. But at the same time, it also has some industry features since our investment period has been longer. Originally, it lasted only 2 to 3 years while now it lasts 3 to 5 years, and even 5 to 8 years. Additionally, it takes the initiative to some degree. For example, we participate in some important operation decision-making activities such as how the enterprises are going to enter into the capital market and matters concerning their outbound investment and M&As.
The world of capital
The PE capital, or the “fish” is about to swim back into the ocean, so let’s look at the so-called ocean.
Based on the degree of industry attributes and financial attributes of capital, we can have a general picture of the capital world. It’s not hard to recognize that pre-IPO is still at a stage with relatively less capital and industry attributes. As a result, as competitions become more intense, the tide fades away faster with the beach appearing immediately, which is an inevitable result.
There are many areas in the world of capital. From the perspective of industry, there is both capital invested in the shares of industrial companies and participating in their operations and capital that leads to controlling shareholding in industrial companies and that comprehensively engages in enterprise operations. The capital with the highest degree of industry attributes is that involved in industry investment.
From the perspective of finance, there are mutual funds, or so-called public funds. Capital in this category has more financial attributes and less industry attributes, for example, bank lending capital, mezzanine investment, quantitative investment, hedge funds, etc. Yet, hedge funds are very proactive.
There is an area in which capital has both obvious industry and financial attributes, which is leveraged buyout (LBO) developed by the KKR and The Blackstone Group back in 1980s and 1990s. LBO requires not only deep engagement in the industry, but also proficiency in making use of financial instruments and tools, which is really a business for real experts.
This is the capital world. Currently, we are doing pre-IPO business in this world, which is indeed at the low end. PE business with pre-IPO as the major mode was a product of the special economic environment in China in the past years. It is only a temporary phenomenon rather than the normal state. It is for sure that soon we’ll not be able to make money out of it.
PE capital that can achieve long-term success should have two distinctive features, namely, prominent financial and industry attributes. This is quite critical for us to figure out the future path of PE institutions and lay out JD’s future development, upgrade and evolution path.
The law of evolution
Given that JD’s pre-IPO capital needs to be upgraded or evolve, we still need to study the basic law of evolution itself. Speaking of evolution, Darwin and his work The Origin of Species, in which he proposed the core point of the theory of evolution, must be mentioned. Yan Fu translated The Origin of Species into Tianyanlun in Chinese in the late Qing Dynasty and summed up his basic idea that is the fundamental law of evolution – survival of the fittest in natural selection.
The so-called “survival of the fittest” is the result of competitions within and among species. If any organism wants to survive, it needs to strive for external natural resources, which gives rise to competitions. The competition for survival is rather fierce, be it among individuals of the same species, or between the upstream and downstream of the food chain, or between seemingly irrelevant species. Organism with stronger competitive edge owns more external resources and lives better. Even if it gets old and dies, the competitive edge can still be passed on to the future generations by genes, which is the inheritance of species.
However, “survival of the fittest” only addresses one part of the problem. If there is only competition for survival among species, then only the strongest one will remain and there will no longer be so many species in the world. It would even become impossible for human beings to emerge and exist, let alone evolution. So there should be another law.
The other law is “natural selection.” While species evolve, the nature is also changing. Even the strongest creature at certain period can be too weak to stand the changes in natural environment. For instance, dinosaurs once won out over other species and dominated the planet a hundred million years ago, but they failed to stand the test of nature and died out long ago.
Nevertheless, creatures have an ability to respond to the changes of the external environment, which is mutation. During the survival and inheritance process, gene mutations happen to creatures. The mutations might be either to the advantage or to the disadvantage of the creature. This is when natural selection works. The species that have become more physically adapted to the natural environment after gene mutations will survive. Otherwise, they will be eliminated. In this way what species go through is not simple duplication. Instead, they evolved and upgraded so that a diversified and lively planet was created.
Now let’s go back to the economic circle where such species as businesses live. The same law applies here. On the one hand, businesses rely on their competitive edges to survive the competitions within the industry and industrial chain. But it is far from enough to solely rely on the static competitive edges. From the perspective of long-term development, it is more important for businesses to have the ability to adapt to the changing environment and have the mutant genes, on the other hand.
The short-term survival of a species is dependent on its competitive edges while in the long run, it needs to go through gene mutations to upgrade and evolve. This is a highly critical, profound, and even philosophical conclusion.
In contrast to other species, the advent of human as a species has realized a more significant upgrade since human beings can change the genes in themselves on their own to adapt to the environment while other species can only rely on natural selection.
Now I’m going to move on to how JD Capital has evolved. The basic framework of my analysis includes all of our investment businesses, both current and future ones. For instance: How is the competition condition? What competitive factors are needed? Do we have any opportunity?
To begin with, let’s reflect on the current pre-IPO business. There are many competitors – banks, securities companies, industrial companies, governmental institutions, and private and individual competitors. The market is highly diversified. And the majority are small and medium sized institutions. Because this business does not have too many financial and industry attributes, which means the competition threshold is not high, many competitors have come in, the competitions remain intense and high ROI does not last long.
What are the competitive factors of pre-IPO business? There are several important stages: seeking capital, developing projects, evaluating projects, entering into transactions, and the final exit. There are some competitive factors in almost every stage. Objectively speaking, we can be confident enough to say that we are not inferior to our competitors in every aspect and we have done the best in pre-IPO business.
The volume of pre-IPO business is directly related to the number of enterprises that can get listed each year. The estimated investment size of tens of millions yuan annually is indeed at a low point, which calls for our further reflection as to whether we are too pessimistic. Human being is an emotional animal. So is an institution. There will probably be some opportunities in the future, but not our major ones.
I have talked about our direction of evolution. If we are stranded on the shoal, we can choose to go ashore to the mountains, which means to develop vertically towards industry capital or to go deep in the water, which refers to evolve horizontally towards financial capital.
The first is an industry capital-oriented development, following which we’ll have to engage in specific industries and compete directly with industry capital. There are different competitors in different specific industry area, but what JD Capital and JD’s people have are still the financial genes. It is hard for us to achieve gene mutation in this regard since we are not equipped with the industry genes.
The second path is a financial capital-oriented evolution. We can do bank, securities and trust business. However, the first handicap is the license since it is strictly controlled in China. Moreover, we are faced with the problem of limited equity capital, but gene mutation can be realized in this regard. There are many competitors who are also very competent in the financial sector. Yet, at the same time, there are many business opportunities here. The biggest one is the liberalization of interest rate, which has already got started.
The third one is evolving towards stronger financial and industry attributes, which is standardized PE industrial M&A. Our competitors will be large-scale industry capital since they are doing M&A, but often within their own industry rather than cross-industry. Our competitors in a real sense will be first-class PE institutions from both home and abroad, with whom we will frequently compete, including international ones like The Blackstone Group, KKR, The Carlyle Group, and TPG and domestic ones such as Fosun Capital, Hony Capital, CDH Fund, and CITIC. Participating in such competition makes gene mutations more necessary. The biggest opportunity lies in industrial reorganization and ownership reform which will lead to huge market capacity.
We need to get out of the current capital shoal as soon as possible. Otherwise, we will become a small dinosaur who is extremely vulnerable in the face of environmental changes. JD is going to upgrade and evolve either towards the industry capital to become the “king of the mountain,” or towards the financial capital to become the flood dragon deep in the ocean. This is the future path of JD.
Initially I came up with several different themes for today’s summary. One was “creative destruction,” the core idea of Joseph Alois Schumpeter, which is about the economic cycle and entrepreneurship. Another one was “sublation” at philosophical level by Kant and Hegel. It says that when old things die out, new things need to inherit some on the one hand, and discard some on the other hand. This applies to us well. Another theme I considered was “nirvana of phoenix,” which indicates rebirth.
But after careful thinking, I decided to choose this one – survival and evolution, which accords with our current conditions better because it concentrates on business as a living entity. The most important thing for a living entity is to survive. And how? Through evolution. Constant evolution is a normal living state.
What does evolution mean? It could be a destiny. If we choose to make investment and lead a business, we cannot stop evolving. Evolution is painful and even brutal. We might have to abandon what we take pride in and even take leave to colleagues with whom we used to work with, but this is a must in evolution and this is our choice. Only by continuing to evolve can JD materialize its dream in investment. This is the choice we are going to make with no hesitation.