How to Ensure a High ROI
2013-02-17
WU Gang, founding partner of JD Capital and Chairman of Tongchuangjiuding Management Co., Ltd. (JD Group). This is an excerpt of the speech WU delivered at JD Capital’s annual conference of 2012 in February 2013.
Industry-wide excess return on investment does not exist anymore.
As an equity investment management institution, the only reason why we are here is that we want high returns, or returns higher than the average return on invested capital (ROIC) in society.
As we all know, ROI=ROIC=Average social return on capital (SROI) + Industry excess return on investment + Enterprise excess return on investment. ROI consists of several parts. One of them is average SROI, which refers to the average level of return of all investors in society, or the average return of ordinary enterprises. In fact, people on the street can get long-term returns on investment at an average rate of 10% just by investing or buying stocks at random without consulting professionals or working too hard. As an institution specialized in investment, we must strive for ROI higher than that.
How to ensure high ROI?
Whether the PE industry is able to get higher ROIC than other industries is determined by the short-term supply-demand relationship. Before 2010, the whole industry fell short of demand. Because many businesses were in need of funds while there were merely a few real PE institutions at that time, demand exceeded supply in the whole industry, which gave rise to excess return on invested capital. People in this industry could make a lot of money even if they were not professional enough. JD Capital enjoyed high returns before 2010 not only because we had done a good job, but also due to sound industry fundamentals. Some said that: “Pigs can fly as long as the wind is strong enough.” To some extent, JD Capital was like a pig in strong wind before 2010. However, the PE market has changed since 2010. High returns on investment attracted huge fund inflow, leading to oversupply in this industry. As a result, excess returns faded away.
Some proposed to continue looking for investment that is able to yield excess ROI, for example M&A, but such exploration could only bring about high ROI in the short run rather than long-term sustainable excess ROI. We must fully understand that it is unrealistic for any industry to maintain long-term excess ROI. If an enterprise wants to stay above the average social ROI level, it has to strengthen its competitive edge to outperform its competitors of the same industry and get a ROIC higher than the industry average, which means to get enterprise excess ROI.
Analysis Framework of Competitive Edge in the PE Industry
Enterprise excess ROI equals the competitive edge of an enterprise, which is the core analysis framework of an enterprise from the perspective of investment and is regarded as Newton’s laws of motion in the area of investment. If we are to get excess ROI from the projects we’ve invested, we need to sharpen our competitive edge.
Now, let me elaborate on the analysis framework of the competitive edge. To begin with, we need to set a target for excess ROI, which is twice the industry average. It is predicted that all of the PE institutions, be it professional or not, can get a 10% ROI on average (Average social ROI).
What does 10% mean? It means that 1 can grow up to 1.6 within five years. The compound interest is 1.6 which is the fifth power of 1.1 and can be converted to a simple interest rate of 12%. This is my estimation of the average long-term compound rate of return, which means that the industry excess ROI is 0. Average annual compound rate of return of professional PE institutions is predicted to be 15%, which means 1 can be turned into 2 within five years with an annual simple interest rate at 20%. What about us? Our target for the annual compound rate of return is 30%, which means to turn 1 to 4 within 5 years with an annual simple interest rate as high as 60%. That is to say, each RMB 100 we invest needs to yield RMB 60 as simple interest annually.
This is not an easy target. If JD Capital is to outperform the average level of the whole industry and the average ROI of other professional PE institutions, we need to give full play to our competitive edges, which lie in five parts, namely project sources, brand, risk control, investment judgment and design of investment plans, and post-investment management.
Competitive edge ONE: project sources
First of all, let’s look at the industry average. I made a simulation. Generally speaking, ordinary PE institutions may invest 6 out of 12 reliable projects. Suppose the normal earnings multiple of these six projects are 2.2, 2, 1.8, 1.6, 1.4, and 1.2 respectively. Then the average earnings multiple is 1.7, which means five years later each RMB 1 will be turned into 1.7. This is the industry average.
Yet, we need to ensure that our reliable projects-to-invested projects-ratio doubles the industry average. That is to say, we only invest in the top 3 of all the 12 reliable projects. By doing so, the average earnings multiple is 3. While the industry turns 1 to 1.7 within 5 years, we can turn 1 to 2. Moreover, from the perspective of investment, the ROI multiple will be increased by 15%. You may think this is no big deal, but if converted to simple interest, the total simple interest will be 40% higher. Simply put, maintaining a higher rate of return than the industry average requires us to develop one time more projects than others for the same number of projects invested. This is what we are doing now. Our threshold was particularly high in 2012 when we investigated over 500 projects, selected 200 in the first round and finally invested in only 40. The base pool of project development should be huge and the final investment decision should be carefully made.
Competitive edge TWO: brand
Here, “brand” refers to the brand value of JD Capital regarded important by potential enterprises to be invested. We need to build up specific value-added points of our brand that attract enterprises that are to be invested. Preferably our brand value shall make enterprises willing to choose JD even for half the PE value than to be invested by our competitors. In this way, our investment input can be 10% lower than the industry average.
We have some advantages in terms of brand, for example: we are at the top of this industry, we can help enterprises get listed and we are able to bring value-added services to them. These advantages will be maintained and expanded in the future. As the focus of our potential clients is constantly changing, we need to adjust our brand essentials with it.
How much value can a good brand bring to us? Let’s do the math. Since investment prices are 10% lower, all return multiples will be 10% higher, raising the simple interest rate to around 27%. This is the power of brand.
Competitive edge THREE: risk control
Risk control here only means financial investigation. The overall situation of the industry can be put into two sentences. First, “serious financial frauds exist.” I think projects with serious fraud account for 10%. Second, “minor financial frauds prevail.” It is estimated that 20% of the projects have inflated profit figures used in valuations. These are objective estimations.
JD Capital has set up strict risk management system and financial investigation system based on past experience, which have constituted our competitive edge. Our goal in 2013 is to wipe out serious frauds. Our requirement for the risk management system is to complete all the work related to eradicating serious fraud. It is hard to completely stop minor frauds, but the proportion should be no bigger than 10%. If 10% of the projects in the industry are affected by serious financial fraud while none of our projects are and 20% of the projects in the industry have minor financial fraud while only 10% of ours do, we can enjoy a 10% higher return multiple, which is a 27% simple interest rate.
Competitive edge FOUR: investment decision-making and design of transaction plan
In the whole industry, on average, the rate of significant failure in the investigation and judgment of such factors as business value, growth potential, risks and exit channels is 20%. It is inevitable to make mistakes. And the rate of significant failure in the design of transaction plans stands at 10%.
It is required that we contain the rate of significant failure in the investigation and judgment of business value, growth potential, risks and exit channels within 10%, improve the pertinence of the design of transaction plans, and keep its rate of significant failure around 0%. The design of transaction plans is where our specialty lies. Moreover, we have been accumulating experience for six years in regard to investment decision-making. We have more than 200 investment cases and a stable core team. And we have drawn lessons from failures and explored constantly. These efforts have blessed us with the ability to make better investment decisions than the industry average.
Competitive edge FIVE: post-investment management
Post-investment management includes deciding the development path and pace of enterprises, promoting IPO, implementing compensations of earnings forecast and buy-backs, and assisting in M&As. We have four requirements for post-investment management.
First, to ensure that there is no serious mistakes in the development path and pace of enterprises. In the past, some enterprises we invested in did not perform well and impacted us negatively. If we can properly handle the long-term development path of enterprises, our returns can be 5% higher than the industry average.
Second, to ensure that we apply for IPO one year earlier than the industry average. In this regard, we have done a good job this year. We should set target and time table for and take control of each project. In addition, we should help businesses properly manage their market value. For example, we can assist enterprises that have got listed in communicating with fund researchers and in sending out more industry research reports and favorable news, which is likely to raise our earnings by 5%.
Third, to ensure 100% of earning compensations and buy-backs are strictly carried out. Compensations of most PE institutions are poorly implemented, notably with non-implementation, delayed or sub-standard implementation. Our goal is to implement 100%. We achieved 60-70% in 2012. In 2013, we are going to try all we can to carry out the VAM, which can increase our earnings by 5%.
Fourth, to assist, on average, each business in finishing one merger or acquisition with a value equaling 10% of its profit. Since the earnings of M&A is about 10 times and those of IPOs are 20 times, we can earn the difference, meaning a 5% increase of ROI.
Based on the above analysis, we can be convinced that, first of all, maintaining high ROI is possible. Once we put in place what it takes to acquire high ROI in the competition, we are bound to make it. Second, getting high ROI is no easy job. Only by being equipped with prominent, comprehensive and solid competitive edges like the above five can we realize high ROI. Any shortage of those five aspects will make the situation harder. For instance, if we do post-investment management only in a perfunctory manner, “1 turned into 4” will be reduced to “1 turned into 3.2” and the ROI will drop shortly.
Based on the above points, I want to propose a new earnings model, which is the new “2×2=4” model. The old “2×2=4” model referred to that the businesses we invested in saw both their profits and P/E ratio double in 5 years, turning 1 into 4. Yet, this model was common in the PE industry before 2010 when ROI was commonly high.
In contrast, the new “2×2=4”model represents that the industry average turns 1 to 2 (2=2×80%×2×60%), which means the return falls short of the original “2×2.” The first reason is that it is impossible to double in 5 years. Instead, a business can only turn 1 into 1.6, so the performance falls 20% short of the ideal one. The second reason is that the success rate of the IPO cannot remain 100%. In fact, I think it would only stand at 50%. So plus the buy-backs, the total is 60%. Such calculations show that mediocre institutions in this industry can only turn 1 to 2, which means 2×80%×2×60%.
If institutions with competitive edges want to double their returns, or to turn 1 to 4, they need to multiply 2, the industry average, by 2. Then the formula would be “2×1.15×1.1×1.1×1.2×1.2,” which equals 4. The new “2×2=4”model only applies to institutions with strong competitive edges when industry-wide earnings have returned to the rational level.
Key points in realizing competitive edges
1. Choose the right reference institution.
How to estimate the overall situation of the industry? We need to be specific and avoid abstraction. First of all, we need to get to know the industry average. I have tentatively selected three institutions whose average can generally represent the industry average. We need to do better than them in every aspect.
Second, we’d better know about the top institutions in this industry, which are our benchmark institutions. Each department in our investment team should get to know which one is the best in the same area. Study the benchmark institutions and figure out the gap. We need to catch up with them and even exceed them in each niche field and aspect to build up our competitive edges.
Competition means to compare with others, so we must be clear about whom we are going to compare with. Therefore, we need to pick out an average institution and a top one in this industry to compare with them in every aspect.
2. Formation of competitive edges calls for extra efforts.
There is no free lunch. If we are to get competitive edges, we need to make extra efforts. A ROI several times higher than the industry average requires more than twice the average efforts made in this industry. Diminishing marginal ROI means realizing 10% return needs 100% hard work. And realizing 20% return probably needs 300% hard work rather than 200%. This has set higher requirements for us.
In detail, how to make efforts? First, our team should outperform the industry average and the above-mentioned three institutions. And it needs to be far better than them. Second, the working intensity of our team should be higher than the industry average. Third, we need to put in a bit more people than the industry average since some work requires more people to yield high returns. Fourth, the management such as organization and coordination of our team should be better than the industry average. Only by getting these things done can we build up our competitive edges in a real sense and guarantee extra returns.
3. Formation of competitive edges requires participation by everyone.
Building up competitive edges is a systemic project, which cannot be finished by a single department. Instead, it requires systemic and concerted efforts. Our competitive edges come from all aspects, so the realization of them needs everyone’s effort.
If we put extra efforts in it, we are bound to get competitive edges, high ROI, and, at last, success. We are in full control of our destiny. As long as we get the above things done, high ROI and success will be the natural result. Thank you!