[Review of 2016 Annual Meeting of JD Capital Fund] Cai Lei: The Future is Coming -- Third Season of
Speaker: Cai Lei (Founding partner and chairman of JD Capital)
This article is an excerpt of the keynote speech delivered at the 2016 Annual Meeting Conference of JD Capital Fund on May 26, 2016.
Hello everyone! I’m pleased to share with you my thoughts at this annual meeting. Many things can happen over a year, but people always tend to attach more attention to what is happening around them while undervaluing those really matter. And since our theme is “The Future is Coming”, today I want to focus on things that are of great significance.
Ⅰ. Gravitational Waves
The first important thing is the discovery of gravitational wave.
On February 11, 2016, LIGO, a US-based scientific exploration organization, released a report saying that it had discovered the gravitational waves originating from a pair of merging black holes one billion light years away from earth. The discovery shocked the whole world.
I like reading sci-fi novels including Galactic Empire and The Three Body Problem. The detection of gravitational waves is such a big event that excites all sci-fi fans. So what are gravitational waves at all? How important they are?
It is widely known that Newton formulated the universal law of gravitation and developed classical mechanics. He thought that gravitation among objects existed universally and could reach one another instantly irrespective of the distance in between. However, Einstein changed how people understood universal gravitation with his theory of relativity. In this theory, he interpreted gravitation as the change of the curvature of space-time caused by mass of objects. Meanwhile, Einstein predicted that gravitation could exist in the form of gravitational waves travelling at the speed of light.
Let’s make an analogy between gravitational wave and electromagnetic wave. There are different forms of electromagnetic waves, including radio waves and light waves. Human cannot live without electromagnetic wave now, for the signals of our cell phones and TVs are both transmitted by it. Just imagine: what will the world look like if people no longer use cell phones nor watch TV.
The similarity between gravitational waves and electromagnetic waves is that both of them travel at the speed of light. What’s different is that the latter can be shielded. For instance, once a meeting room is equipped with shielding devices, the phone calls made within the room would end in failure. In contrast, gravitational waves can travel without any intermediary and there is no attenuation during its transmission.
From my point of view, all kinds of intelligent lives including human beings are babies of the universe. Human beings have not reached any place farther than the moon; so, we are only newborns for the mother universe. The discovery of electromagnetic waves helps these babies struggle to open their eyes, look around and feel the existence of the external world. And the observation of gravitational waves signifies that babies can hear the voice or see the affectionate eyes of their mother. The information about universe formation is traveling towards us.
Already detected, the gravitational waves are now left for exploration, understanding and employing to unveil mysteries of the universe and better interprete the law of it.
Therefore, a future with better understanding of the universe is approaching.
The great progress made by AlphaGo is also worthy of attention. AlphaGo, nicknamed “阿法狗” in China, is an artificial intelligence product developed by Google. It is capable of highly complicated self-learning.
In March this year, AlphaGo played against Lee Sedol, the former world champion of Go, in a five-game match. In fact, AI system vs. human player is not new. Twenty years ago, Deep Blue, a chess-playing computer developed by IBM, defeated Garry Kasparov, the Russian world champion. However, the Go has uncountable number of moves; and the number can even reach several hundredth power of ten, exceeding the total number of atoms in the whole universe. Therefore, Go is far more complicated than chess. It is recognized as symbol of the greatest human wisdom and was almost unconquerable for traditional AI in the past.
However, AlphaGo defeated Lee with 3:1. When AlphaGo pinned the most excellent human Go player, made him anxious or even self-doubting, and forced him to resign, it seemed like the plot in The Matrix and implicated that the future of battles between human beings and robots is around the corner. Then what will the rapid development of AlphaGo and AI bring to us?
Human society has gone through many critical revolutions over the past several ten thousand years. The earliest ancestor of human beings felt quite at ease when they went out from the African savannahs to fish, hunt, and pick for food and in the primitive natural environment. However, such a pre-historical society can hardly advance and expand.
Several thousand years ago in the ancient Mesopotamia, human beings domesticated some plants and animals in nature after long-time learning, which indicated the advent of agriculture and animal husbandry. After that, human beings gradually learned to settle, form groups, set up villages, and build cities, and eventually states came into being. Relying on natural resources and environment, mankind could grow crops and harvest twice a year, which addressed the problem of survival. That was the agricultural revolution.
After that, a new revolution happened several hundred years ago -- the industrial revolution, about which we all know well. In Europe, steam engine was invented. People learned to use various mechanical devices and made high-power machines that could sail to all the continents across the world within a short period of time. The industrial revolution also greatly impacted the agricultural society, which was vividly reflected in the modern history of China.
The next revolution that has exerted profound influence on human society took place several decades ago, namely the US-led information revolution with information and Internet technology at its core. The information revolution has further accelerated mankind’s pace in changing the world where we can know everything happened around the world without stepping out of our home. And it is still ongoing.
I think the next important revolution will be the intelligence revolution. Different from natural selection, human beings will create a brand-new species as intellectual as man. This species is capable of self-learning and self-management and has neither sense of fatigue and hunger nor human emotions and sensory pleasures. This is machine life, a kind of life more advanced than protein-based life.
From the agricultural, industrial,, and information revolution to intelligence revolution, human beings are constantly developing and evolving. The agricultural revolution solved the problem of food shortage; the industrial revolution labor force shortage, and the information revolution information shortage. After the intelligence revolution, almost all the problems currently facing human society can be addressed.
However, every coin has two sides. The agricultural revolution made mankind more reliant on land, the industrial revolution turned people to the slavery of machines and the information revolution gave rise to Internet addiction and social alienation. When the era of intelligence revolution comes, mankind could probably become the slavery and plaything of machine with the human brain, the wisdom center and the pride of human beings, being replaced, just as shown in the films.
We look forward to while also fear the AI. This is the shock that comes along with AlphaGo.
Of course, in my opinion, we don’t need to be over pessimistic about the intelligence revolution. After all, the artificial intelligence cannot completely take the place of human intelligence within a short term. Human’s brain still has large room for development. For quite a long time in the future, it will be more likely to see the mutual reinforcement and common development of human intelligence and artificial intelligence.
Based on such interpretations, we can deepen our understanding towards “life”, in particular, the intellectual creatures unique to earth. As I said before, life is created by the universe. The universe had witnessed numerous birth-to-death processes, only that none of them was recorded due to the lack of intellectual creatures. Eventually, the substances in the universe evolved into the galaxies, the Milky Way, the sun, and the earth, followed by the advent of the inorganic life, organic life, intellectual life and human life, and possibly even machine life and more advanced life in the future.
Life is what the universe has created to record, confront, and save itself. This could be the meaning of lifes.
A future of life is coming.
It seems that gravitational waves and artificial intelligence bear no direct relationships to our daily lives. Let’s talk about some important things that are relevant.
It is “Economy”.
Economy is about governing a country, prospering a society and bringing its people a better life. As one of the most significant activities in human society, it reflects the process of creating and distributing wealth. The essential problem economy is supposed to solve is how to allocate various resources more effectively in this process.
Economic problems facing individuals are mainly about how to allocate his/her resources, time and energy. However, groups consisting of two or more people and society as a whole have to solve more comprehensive problems. Only through sorting out economic problems can we have a better understanding of the basic law of human society development.
There are two fundamental elements influencing economic activities and promoting social development, namely the demand of people and the supply of people. Unfortunately, these two elements are not stable at all.
Let’s talk about demand first. It is the primary motivation for social development. Will a man be satisfied with a ten square meter house or a one hundred one? Does he like Chinese food or Western food? With regard to these problems, there are no laws to follow. Then, supply. The demand is satisfied with supply. Things will go wrong if demand cannot be satisfied; but supply is also unstable. It is quiet common for supply to exceed demand and vice versa.
Both of the two elements are uncertain, so how can we ensure long-term stability of economy? As far as I’m concerned, this is a goal cannot be achieved. The primary cause lies in the fact that economic problems derive from human’s limited ability to think rationally. Since information asymmetry of demand, supply and between the two is very common, and human beings are emotional creatures, it is hard for man to make absolutely rational decisions. There is non-rationality in groups, as well as among individuals. Group non-rationality can cause even more serious results. Human beings have profound lessons in this aspect. The tension between demand and supply caused by human beings’ non-rationality always exists. Neither market economy nor planned economy can solve these problems thoroughly, and periodic fluctuation is the normal state.
Based on what mentioned above, we can interpret the hot words of China’s economy “new normal” and “the supply side” better. Now China’s economy has entered the new normal stage. Officially, this means “three phases superimposed”, which means that China has to deal simultaneously with the slowdown of economic growth, making difficult structural adjustments, and absorbing the effects of previous economic stimulus policies. In my view, the deep-seated problem of China’s economy is “three cycles superimposed”, namely the long cycle, the middle cycle and the short cycle.
Firstly, there is an economic term named Kondratieff Cycle. Lasting for 50 or 60 years, it is a long cycle that comes into being as a result of deep industrial and technological revolutions. Nowadays, the global economy are facing post-war long-cycle adjustment. The driving force of economic growth brought by technological revolutions such as electronization and informatization is coming to an end, and the new technological revolution has not occurred yet. To break out of the present cycle, we probably need space technology, artificial intelligence and other forms of industrial revolution.
Secondly, there is another term called Kuznets Cycle, a middle cycle reflecting the condition mid-term economic factors. In the past more than 30 years, China’s economy growth, driven by demographic dividend, opening-up policies and government investment, has reached a periodical peak. Now, it needs cycle adjustment.
Last, I’ll talk about the short cycle, also called the business cycle. The effects of previous economic stimulus measures since 2008, such as monetary and fiscal policies, need to be absorbed.
Therefore, the new normal state of China’s economy is caused by a combination of long, middle and short cycle factors. The high-speed growth is essentially accidental and non-normal. Long and middle cycles are formed by factors on the supply side, such as technology update and labor efficiency. Measures taken on the demand side can only change the cycle period and its influence degree, but not cycles themselves. This is why we must rely on innovations, thorough revolutions on the supply side and improvement of resource allocation to break out of the new normal stage.
It seems that the economic cycles will exist for a long time. Only when the limited rationality of human beings is changed completely, can the future of new economic model, or the future of new society model come soon.
Then, let’s talk about finance. We are in a time of finance -- how do we understand it?
In my opinion, the essence of finance is credit. It is based on credit that people deposit their money in the bank and that companies take out loans from the bank. Companies issue shares through the capital market, trying to make the shareholders believe in the value of those shares before seeing the profits -- this is also based on credit. And it is on the same basis that JD Capital seeks investment from its limited partners and that currency works as the basic financial instrument. These are all fundamental financial forms.
Credit means the promise of achieving something. To put it extremely, it can be seen as running businesses without capital. In theory, finance is to allocate resources among economic entities across time. Because of its capacity of allocating resources based on credit, finance plays a more and more important role in modern economic society and even becomes the core of economy.
We have mentioned that there are natural economic cycles on which finance has its influences. Finance can affect the demand. For instance, during economic depression, the central bank can issue more currency, and commercial banks can provide loans to people to increase their consumption of cars and houses. Finance is also able to affect the supply. If a company has a good opportunity but no capital, it can seek help from banks or investment institutions. The significance of finance lies in the fact that it changes the operating pace of economy.
Financial activities are conducted on the basis of commercial operations and the normalization of such activities is called financial products. Companies providing financial products are financial institutions. The premises for issuing and transferring financial products are financial market. Organizations set up for finance and financial products, institutions and market supervision are called financial supervision departments. Together, they form into the financial system.
Essentially, as the core of the financial system, financial institutions are all credit intermediaries. It is based on credit that they conduct financing and investment. In general, there are two key evaluation points in financial institution assessment: first, the capital side, also called the financing side; second, the asset side, also called the investment side. We need to assess the quality and risk of the two sides in the aspect of credit.
A well-operated financial system reduces information asymmetry between the demand side and the supply side within an economy, thus helping to improve resource allocation efficiency. However, a badly operated financial system intensifies information asymmetry. If the system loses efficacy, it would induce financial crisis or even economic crisis. Therefore, finance should be put under supervision. Of course, the supervision must conform to the law of finance development.
There are many financial hotspots in China, such as Internet finance and finance technology. Time is limited; we won’t talk about them today. However, a phenomenon worth noticing is that a great number of big Internet and industrial enterprises are now engaging in financial businesses. Nevertheless, it is still uncertain whether they can do it well or not. We cannot deny that some industrial enterprises, especially some Internet ones, have great capacity to provide financial assets. Nonetheless, the biggest difference between financial institutions and industrial enterprises is that the former can act as credit intermediaries, They have to give priority to “controlling risks” rather than “making money”, which means their major task is to achieve stability and continuity. Entrepreneurs, on the contrary, need to innovate continuously and hold the principle of “making money taking priority over controlling risk”. If an industrial enterprise brings its operating style into the financial institutions, it is likely that the risk of industrial system will be transmitted into the financial system quickly. It will be a great challenge for the financial supervision departments.
The future of various forms of “new finance” is coming, and common sense is needed to get a better understanding of finance.
Ⅴ Private Equity
JD Capital mainly engaged in private equity. PE development in China is 30 years behind that in the US. Though lagging behind, China’s PE industry has experienced three phases.
The first is the growth investment phase, from 2000 to 2008. PE was introduced to China in around 2000. Before the global financial crisis in 2008, China’s economy grew rapidly, and all sectors was flourishing. At that time, China’s economy was growing at a double-digit rate. The annual growth rates of some industries could reach 20%, that of some enterprises even reaching 30%-50%. Money was the only requirement to do well in PE, for all the enterprises were making profits and expanding. The profit model was “gaining four, even more, out of one”. The main players in China’s PE market were foreign institutions as well as some foreign-funded institutions. They invested in such enterprises as Mengniu Ltd, Co., Shuanghui Group, Yurun Group and Belle Holdings which all turned to be a great success. We can say that it was a time of “picking up money” -- bend over, you could get money.
The second is the growing Pre-IPO investment phase. China’s economy entered the adjustment stage after the global financial crisis in 2008. However, because of the opening of the Chinext, China’s PE market came to the second phase. Since the economy grew slowly, the players not only needed to master skills of growth investment, but to understand China’s capital market more deeply and combine growth market with China’s capital market. This is the Pre-IPO phase. JD Capital developed and grew in this phase. The performance of invested unlisted growing enterprises would develop by double in 3-5 years and redouble after listing because of the liquidity premium valuation. This is our classic “2x2” model, which helps us to “gain four out of one”. The key skill of players in this phase was to understand capital market as well as the development law of growing enterprises. It was a time of “fighting for money”. Compared with the time of “picking up money”, it required for more professional knowledge and abilities.
However, this phase was ended as we entered the new normal. The economy grows more slowly, and the number of quickly-developing industries and enterprises is reducing. It becomes difficult for a company to be listed on the A-share market. Though the company will get enormous return after listing, the listing cycle is pretty long and there is great uncertainty in this process. If a company wants to do well in equity investment, it has to find the third growing factor -- merger and acquisition. Through M&A, we can realize the reorganization of resources of different industries and enterprises, give play to the synergistic effect, and achieve new growth of the companies. This is the third phase of China’s PE development -- merger investment phase.
The investment model of merger investment phase is “1.5×1.5×1.5”. The first 1.5 means that we can still invest in growing industries, but not pursue high growth. The acceptable annual growth rate is between 5% and 10%, meaning that profits will increase by 50% in several years. The second 1.5 means that we need to make full use of the premium of the primary and secondary markets of China’s capital market, and help targeted companies realize a 1.5-time premium through direct listing or indirect listing. The third 1.5 means that we can improve the company’s efficiency, give play to the synergistic effect and bring extra growth to increase the profit to 1.5 times. Multiply the three 1.5 together, we can get an increase of three or four. This is the third season of China’s PE development -- the merger season. Compared with the times of “picking up money” and “fighting for money”, this phase could be called the time of “making money”.
In the times of “picking up money” and “fighting for money”, it was easy to gain profits, but it was also easy to lose some. In the time of “making money”, the external environment is more difficult and the professional requirements are more strict, but it is a much bigger arena and will last longer. It is a time specially designed for competent PE institutions that are ready to achieve something. It requires that PE evolves from simple finance capital to industrial capital. There are higher standards and bigger market in this era, but less players. In fact, it is the golden age for China’s PE development. In this era, China may create several global PE giants.
In the time of merger, what should PE do? We have set up two models for merger. Since merger means improving the concentration ratio of industries, the number of companies will decrease and leading companies will emerge. Therefore, merger must be related to leading companies. Our first merger investment model is “Leading Company Model A”, which focuses on the existing leading companies in different industries. As merger is a very complicated process, only through taking the existing leading companies as the leading factor and providing capital to serve them can we conduct merger successfully.
The second merger investment model is “Leading Company Model B”, which means we create leading companies on our own initiative. Up to now, there are many sectors in China that have no leading companies, such as health care, education, tourism, public utilities, and urban services. Taking heath care as an example, there are many separate hospitals in China, but no real large-scale health care chains. In the future, China will give birth to a number of large regional even national health care chains. While gaining enormous profits, these chains will also provide customers with quality medical services to achieve social benefit. We need a great amount of capital to conduct this model and excellent entrepreneurs to run the chains. Since most sectors involved in “Leading Company Model B” are related to urbanization and family life, we also call it the “Population Model”.
Be it “Leading Company Model” or “Population Model”, providing capital to serve entrepreneurs or employing entrepreneurs to serve capital, they are all about the combination of entrepreneurs and capital. A company must have its own competitive edge, and a company developed through merger also need this to achieve its value. A company’s competitive edge, (in products, technologies, franchise and customers) depends on the creativity and execution of entrepreneurs. Only excellent entrepreneurs are good at utilizing capital, finding cheap and abundant capital for the company’s development, and promoting merger and integration.
In my opinion, merger investment is the future of China’s PE.
VI. JD Capital
Last year, JD has achieved some substantial results. By the withdrawal from some invested companies, we brought benefits to many investors and have won some honors. I always feel humbled in spite of such returns, for what we have done is far from sufficient for meeting social requirements and there is still much room for improvement. But indeed, I believe there are few agencies in China like JD Capital whose hundreds of employees are all thinking about innovating and constantly creating returns for investors.
How to understand the investment model of JD Capital? Over the past year, JD Capital grew from a PE investment agency into a listed company (600053.SH). Why did we go public?
As an asset management agency, JD Capital mainly deals in capital management for its customers. Back in the time of share-participation investment or growth investment, tens of million or one hundred million yuan would be invested for each project. It was reasonable to manage tens of billion yuan in a decade. However, in this M&A era, we often need to invest one billion, several billion or even ten billion for merely one project. Besides, there are greater requirement for investment efficiency. All these mean that, customer funds will be barely enough and we need much more self-owned capital to support investment needs.
Expanding self-owned capital does not contradict with managing customer capital. Self-owned capital, mainly included in the funds under our management as LP investments and is on the same front with all investors. In order to grow, to upgrade business scale, and to create better and more stable returns for our investors, JD Capital has to grow from an asset management agency into one that deals in both asset management and investment, realize a sound combination of “self-owned capital + customer capital.” This is what are planning and doing in terms of capital using.
With regards to assets, JD Capital used to focus on Pre-IPO shareholding. However, since 2013, we have gradually developed a business mode with PE as the principal part and VC and real estate as two supporting investment areas. JD’s real estate investment is not targeted at property development projects; real estate is a kind of financial product. The three investment areas develop independently but with the same purpose of bringing substantial benefits to investors and shareholders. The core of JD’s PE investment lies in M&A.
In addition, what is JD Group? The parent company and controlling shareholder of JD Capital, JD Group is a large-scale investment corporation listed on the National Equities Exchange and Quotations (NEEQ). In addition to JD Capital which mainly engages in PE businesses, the Group has other subsidiary companies managing public funds, or dealing in securities, etc., and has just finished approval procedures for the acquisition of Hong Kong Ageas Insurance. All these institutions are to provide capital sources for JD Group’s investments. The competitiveness and value of the Group lies mainly in its investments and assets, and is manifested in the investments made and returns realized by the Group as a whole and its subsidiaries individually.
What kind of values will JD create for society? I believe the essential value of an enterprise is in providing products which could be classified into four levels.
The first level is products in the general sense, regardless of quality. For instance, medicines with no effect or even harmful are also products. Those on the second level are products meeting quality standards — they could perform their functions and generally meet customers’ needs. Products on these two levels don’t have much competitiveness and are prone to being discarded by the market.
Products on the third level are innovative or high-quality ones. Some of such products are developed on the basis of new concepts; some are innovative and some are highly cost-effective, all of which boast competitive advantages. Those on the fourth level are great products that bring changes to human life. For instance, iPhone and Tencent’s Wechat have changed the life style and habits of millions of people and so could be praised as great products.
A great enterprise certainly has great products. The greatness of an enterprise depends not on its shareholders, not on its customers, not on the words of its founders or managers, but on its products. The level of its products determines the level of the enterprise.
JD Capital aims to become such a great enterprise. Our products are asset management and investments, the purposes of which lie in bringing continued and stable returns to shareholders and investors. To realize these purposes, we have to invest in companies that offer society with excellent, innovative or even great products. We hope to become such an investment institution, so as to provide capital and services to entrepreneurs with the vision of building great enterprises. The realization of this goal will bring more great enterprises to the world and a better society for mankind.
This is the ideal of JD. It is a future we are creating.
VII. The Future is Coming
Universe, life, economy, finance, PE, JD…
From the macro perspective of the universe or life, JD Capital, as a financial investment agency, is so small, and its business too menial to mention against the backdrop of the cosmos. But from another perspective, we are also indispensable. The universe is composed of atoms, molecules, matter and species; each individual has its significance.
How shall we grasp the rules of the universe? The universe is measured with time. Only with a good understanding of time could we really perceive the existence and changes of ourselves and the world. Future is time to come and the past is time already gone. And the point separating the past and the future is now. Drinking a cup of tea and living a lifetime are all descriptions of time and also descriptions of the state of oneself and the world. Time is also the direction of universe evolution, i.e., of the increase of entropy, and therefore has perpetual significance.
In his theory of relativity, Einstein points out that the speed of light is the highest velocity in universe. If there were to be a technology to surpass the speed of light, it would mean that we can go back on time. But what’s the meaning of going back?
The value of life lies in the unpredictability of its future — there will be surprises both terrifying and pleasant. Such unpredictability is the essence of life and the ultimate goal of life is to challenge the unpredictable future. If life remains the same every day, what’s the meaning of it even if we can live forever?
Is there really no speed faster than light? Well, actually there is. It takes eight minutes for sunlight to reach earth but takes only an instance for us to think about the sun. It takes tens of billions of years before light can reach the edge of the universe from its center, but only an instance for us to imagine what it might be like beyond the universe.
The boundless curiosity and imagination of mankind has a speed faster than light and a power stronger than gravitational waves. This is the power of life, the most valuable thing in the world.
Most individuals, institutions, groups and even society as a whole, however, are passively accepting what fate has chosen for them rather than creating the future on their own. The way I see it, what we should do is to charge into the future, to challenge what it has in store for us and to let our imagination and creativity guide us in the exploration into the unpredictable and the unknown.
The future is to be created. It is in the hands of each and every life. The courageous and creative should face the future head on and create their only future.
More speeches on JD Capital’s Fund Annual Meeting 2016 are to be released. Thank you for your attention.