Exclusive Interview with JD Capital: A Trinity System for Risk Control and Management
Risk and profit have always been the themes of investment practices. Open data shows that since its startup in 2007, JD Capital has managed a number of RMB funds and USD funds, with paid-in capital of nearly RMB 30 billion and almost 300 enterprises as its investees. By June 30, 2016, 97 invested projects have been listed on the main board or on the NEEQ, and 52 projects have realized complete withdrawal, reaching a compound IRR of 29%.
How should large investment institutions exercise risk control? What are the origins and characteristics of their risk control systems? How to put different stages into effect? Dang Yaning, Vice President of JD Capital and Leader of its Risk Control System, gave us an introduction.
Q: JD Capital has made remarkable achievements. Are they directly related to risk control?
ROI is closely related to risk control, but it is more than that. In general, risk control in investment is a systematic job intimately related to project development before investment, risk control during investment, and management after investment. Hence, it requires that we combine the three elements of investment, control, and management. Besides, there is a prerequisite for risk control in JD Capital: to grasp systematic investment opportunities.
Q: Could you please further elaborate on the trinity structure of “investment, control, and management”?
The overall risk control in JD Capital can be seen as a model of reversed pyramid.
Title: Establish Independent Teams for Due Diligence and Exercise Overall Risk Control
Layer 1: Project development / Develop 20,000+ enterprises
Layer 2: Two rounds of appraisal + investment decision-making / Conduct due diligence in 3,000+ enterprises
Layer 3: Accomplishment of investment / Invest in 280 enterprises
At the bottom layer of the “reversed pyramid” is the project development system, which guarantees the source of outstanding projects through maximum contact. Only about 15% of enterprises we reach enter the stage of on-scene due diligence and appraisal, i.e. the middle layer. The top layer refers to only 1.4% of enterprises, which passes our investment decision-making process and receives our investment. Following this, these enterprises shall continue to grow with support from the teams of post-investment management.
Consequently, JD Capital forms its trinity system of risk control, including project development before investment, risk control during investment, and management after investment.
Q: How to understand JD Capital’s idea that “the best risk control is to grasp systematic opportunities”?
We perceive that in the present China with a large economic size and rapidly changing market environment, different systematic opportunities will emerge at different macroscopic stages, and the greatest risk comes from misjudging or even missing these opportunities. In this sense, we always believe that seizing systematic opportunities is the best kind of risk control. A review of PE’s development in China reminds us of the different features demonstrated by systematic opportunities at different stages.
The first stage for China’s PE is growth investment, from its introduction into China in 2000 to the outbreak of the global financial crisis in 2008. In such a golden era of high-speed economic growth in China, PE firms just have to find promising enterprises, make investment, and become their shareholders before directly benefiting from its growth and passively receiving high profits. JD Capital has caught the last train of this “money-picking” era when everyone can make a profit.
PE 2.0 refers to the stage of listing investment. Following the outbreak of the global financial crisis in 2008, major adjustments took place in China’s economy. While high growth, the fundamental motive in the PE 1.0 era, faced a direct shock, this era witnessed a tide of mass listing of private enterprises in China, namely the commencement of securitization. At such a moment, some wise PE firms emerged. The strategy of profit-making in this era is to find proposed listing enterprises with growth potential, or the so-called Pre-IPO investment. JD Capital is a typical one that has risen amid this round of systematic opportunities.
PE 3.0 is known as the stage of M&A investment. Since 2014, China’s economy has entered the new normal. Despite a few fast-growing sectors and enterprises such as internet enterprises, the economy featuring traditional manufacturing and service industries face profound structural adjustments, and there is no longer basis for large-scale growth investment. Although listing still brings about considerable profit, there are only very few non-listed targets available for investment. In addition, the long period of withdrawal by way of listing renders it difficult for mass listing investment to continue.
In this period, to continue with PE investment and receive relatively high returns, it is necessary to find a third growth factor – M&A. It can be applied to reorganize industrial and corporate resources, give play to the synergy between integrators and those being integrated, and realize additional growth.
JD Capital has always been dedicated to distinguishing these three stages, and recognizing and seizing investment opportunities in them. It is vitally important, both for enterprises and for investors, to follow the trend and seize the opportunities. To welcome the new era, JD Capital, in the PE sector, has enhanced its investment strategies with M&A investment as its core. Focusing on leading enterprises and industrial M&A integration, we put forward the “Bellwether Plan,” hoping that JD Capital will become a strategic shareholder in leading enterprises in different segments as an institutional investor. Within three to five years, it plans to help quality enterprises in these segments to grow into absolute industrial bellwethers with market value of tens or even hundreds of billion by means of M&A integration.
Q: To be specific, what are the major aspects covered by JD Capital in its selection of investment projects?
We often analyze and judge an enterprise from three levels, namely the superficial level (finance), the middle level (business), and the basic level (team).
If an enterprise is compared to a tree, then financial data is equivalent to the branches and leaves at the surface, business and products are the trunk in the middle, and the team and corporate governance are the root at the bottom. Therefore, the financial data of an enterprise, as a result of business procedures, is only superficial, and it is rooted in the corporate structures of governance and team.
These three levels are not mutually separated; instead, it is important to conduct cross checks in due diligence. Our risk control has always adhered to the organic unity of such three-layer analysis: we seek financial performance in business analysis, trace back business motives in financial data, and assess the future of the team and enterprise in the organic unity of business and finance.
Q: Let’s discuss these three levels respectively. What kind of basic structures (teams) can be selected by JD Capital?
JD Capital normally divides corporate governance into several modes. Moon surrounded by a myriad of stars: This refers to a team formed by a major shareholder plus several small ones, with a mechanism for restraint and supervision by the latter. This is a sound governance structure. Management team: Some capable large shareholders form a team and start business together. Single superpower: Typical private enterprises have only one major shareholder, while others can be ignored. Egalitarianism: This mainly exists in state-owned reorganized enterprises, where shareholding is extremely dispersed. When selecting potential investees, JD Capital prefers those with the first two kinds of governance structures, or to transform ineligible ones into one of these two kinds.
In terms of corporate teams, JD Capital particularly values the “entrepreneurship” of entrepreneurs. The willingness of an excellent entrepreneur to do business goes far beyond earning itself, and the passion for his endeavor and pursuit of success outweigh profit making. Besides entrepreneurship, an entrepreneur also has to be equipped with wisdom and diligence. It is observed that given a longer period, diligent business starters will always be able to beat those who are not.
Q: How does JD Capital analyze the middle level (business) to reduce risks?
JD Capital usually conducts analysis of the company’s business from both external and internal perspectives.
External business analysis is relatively macroscopic, and usually includes the environment and cyclical fluctuation of the sector. JD Capital pays more attention to enterprises with higher growth in industries. Cyclical fluctuations take place at both the demand and supply sides. While fluctuations at the demand side directly lead to changes in the market volume, those at the supply side affect the profit margin of enterprises.
Internal business analysis focuses on competitions. The core of internal analysis for an enterprise lies in the judgement of whether it has competitive advantages. Above all, it is necessary to study the overall background of competition the enterprise is facing, know its market share in the segment, and find out what the other competitors are. Meanwhile, the enterprise’s competitive advantages vis-à-vis its rivals should be explored to work out its development potential.
Q: How to control superficial (financial) risks then?
Research shows that 80% of failures in the PE sector can be attributed to the financial fraud of investment projects, and only about 20% stem from accidental factors such as market environment changes. In this aspect, JD Capital boasts a complete set of anti-fraud system.
First is the financial warning system. Having compiled the “33 criteria for judging fraud,” we take precautions if an enterprise is found to meet a certain number of these criteria during our due diligence. With our abundant practices, we have now added about 20 criteria to the existing ones.
Next is the regular examination system. Firstly, an estimate of the enterprise’s statement should be made based on common senses and its business behaviors, and the reasons for the difference between the estimated and actual financial statements should be analyzed by inspecting original documents and cross-checking the balance sheet, income statement, and cash flow statement. Secondly, business interviews should be matched with financial data. JD Capital has a minimum requirement of the number of external interviews with clients, suppliers, rivals, and industrial experts. When necessary, even the downstream customers of our clients will be reached. Thirdly, information obtained from internal and external interviews should be compared and analyzed against the financial data of the industry and enterprise to allow quantitative reasoning.
The last is the recalibration system. The result of regular examination should stand against reversed deliberation, e.g. whether it follows the business and industrial rules, whether it matches the profits brought by the competitive advantages, and whether it can be proved from the enterprise’s industrial status and its upstream and downstream customers. Within JD Capital, there is a formula called Newton’s law in investment: excessive return = competitive advantage. Generally speaking, unexpected and sustained high return with no competitive advantage falls into the following conditions: either that such return is supported by of-the-book assets or unpaid assets, or that the data is inflated. This has been proved by a number of fraud cases in the market and many projects in JD Capital’s due diligence.
Q: How was JD Capital’s risk control team set up?
The biggest feature of JD Capital’s risk control team is its self-establishment. We usually don’t outsource our due diligence work so as to ensure its high efficiency and quality. The well-managed labor division in the team also gives full rein to its proficiency in finance and business.
Most of the members come from PwC, DTT, KPMG, EY, or well-known accounting firms in China, and have over four years of relevant experience. Of every 100 companies we communicate with, we usually conduct due diligence for ten of them and eventually decide to invest in one of them. In this process, our risk control team has accumulated enormous practical experience, and the extensive training in the previous due diligence has cultivated the team members’ ability to undertake tasks independently. Additionally, for further development, the team regularly reviews invested projects to update experience and methodology constantly.
Our risk control system has zero tolerance for immoral behavior, and has established a strict rewards and punishment system and a monitoring mechanism. The calculation of the salaries and rewards is independent from the final decision on the investment of the project. Instead, it depends on the quality of due diligence and financial prediction. There are also negative incentives for substandard performance. Such mechanism enables the risk control system to show an impartial picture of the projects.
Q: What are the specific risk control tasks in practice? And how are they accomplished?
Risk control runs through the entire project, from project approval, due diligence, and review, to investment decision, investment, and post-investment stage.
Project approval refers to the decision on exercising on-site due diligence according to pre-research reports. Due diligence is usually conducted from two aspects of business and finance, covering key point identification, internal and external interviews, due diligence report preparation, and other tasks.
After the due diligence report is completed, there are two rounds of review. In the first review, an in-depth discussion is held to analyze the project value and relevant risks across the board, and based on the discussion results, decide whether further due diligence is necessary. If it is necessary, the project team will carry out another round of on-site due diligence based on the key points identified in the first review, and revise the due diligence report, only after which can the project launch the second review. The review this time makes quantitative analysis on the project value and relevant risks, discusses investment structure and key investment terms, and submits the plan to the investment decision-making committee, who reviews the entire project, and makes decision after discussion. At the stage of investment, professional legal personnel carefully go through all investment terms. After the investment, the risk control team regularly reviews the invested projects and then puts forward reasonable suggestions for corporate development.
Q: What are the exact objects of risk control in due diligence?
To put it specifically, there are three objects: authentic financial condition, reliable profit prediction, and configuration of financial regulations and listing scheme.
Authentic financial condition means that we filter exaggerated statistics in the financial statement to reveal the actual condition of the company and endeavor to eliminate information asymmetry, so as to pave the way for business analysis, value judgment, and investment valuation.
In terms of reliability of profit prediction, we combine the law of industry development and the competition situation to analyze and quantify the corporate growth path based on various scenarios and aspects, thus achieving quantitatively and qualitatively accurate prediction.
In terms of the configuration of financial regulations and listing scheme, we, proceeding from cost efficiency, take listing requirements into account to regulate the improper financial issues in the actual operation. Meanwhile, we provide all-round assistance for the listing of companies.
Q: The second object you mention, reliable profit prediction, is not an easy task. How does your risk control team fulfill this goal?
The rise of every enterprise implies the sign of the times. The high fatality rate in the early stage and the decline in the long run are usually inevitable. The only way to extend the life span of a company is constant innovation. PE firms usually invest in a relatively mature company in a relatively stable industry, and therefore there are rules to follow in analysis, judgment making, and risk control.
To yield reliable profit prediction for PE investment, the key is to identify the propeller and the sustainability of corporate development. This is the most challenging task for risk control. Companies in a mature stage grow on the basis of either crowding out or sharing, and outstanding enterprises make use of both of them. One of the results is the constant expansion of their market share.
The development of reliable profit prediction should holistically consider and quantify the industry space, business growth rate, periodical fluctuation, corporate competitive edge, return on investment, incremental capital, and other aspects. The prediction should also take into account the operation capability of the team based on previous data.
Q: How to ensure the fulfillment of the above-mentioned objects?
We ensure that mainly through due diligence and project reviews conducted by the project team. As I said, there is a key step and two rounds of project reviews involved in the risk control system. In practice, there can be more than two rounds, involving any information related to the projects.
The review committee consists of members with rich investment experience and high professionalism, and industry experts when necessary. All of those who are interested are welcome to participate in the discussion and provide comprehensive and correct information for decision making.
The contents for review cover a wide array of aspects, such as industry, enterprise, finance, business, investment valuation, investment plan, and post-investment value-added services. The reviews mainly concentrate on the project itself and the judgments of the project team. The multi-aspect due diligence and reviews, as well as the additional due diligence and reviews afterwards are the guarantee for the achievement of our goal.
Q: You mentioned that the risk control system is made of three parts: investment, control, and management. What are the contents of post-investment management? And how to prevent post-investment risks?
The traditional version 1.0 of the post-investment management of JD Capital mainly comprises of value-added services, day-to-day management, agreement implementation, and exit management. We deploy post-investment management specialists for each invested company. The specialists provide value-added services and constantly enhance corporate value from the perspectives of industry integration, business enhancement, team improvement, and financial services. The day-to-day management and agreement implementation are our fulfillment of responsibilities as a shareholder in line with the requirements of the day-to-day corporate operation and development, and with those stipulated by the investment agreement. We also assign operation management teams to companies for in-depth operation participation as a dominant stockholder. For exit management, we adopt IPO listing and NEEQ listing as the main measures, and make flexible use of such means as M&A, back-door listings and back-buy. In order to implement the “Bellwether Plan” across the board, the post-investment management of JD Capital has also upgraded from version 1.0 to version 2.0. The fully upgraded version 2.0 proposed by JD Capital provides all-round services focusing on external financing and M&A investment.
There are three key points in terms of post-investment risk prevention. First, avoid blunders in the corporate development direction and planning, and ensure correct decision on long-term corporate development goals. Second, provide professional suggestion and assistance for the implementation of internal management, M&A, financing, and so on. Third, step up the connection of companies and the capital market, so they can grow rapidly with the capital support from the market.