A Letter from a VC to Its LPs

By Jiaxiang Shi

Edited by Jing Liu

At the start of the new year, a lengthy PDF began circulating in investor WeChat groups. Titled "2023 Chinese Annual Letter," it was XVC's customary year-end letter to its LPs. Based on Anyong Waves' limited awareness, this may have been the most widely circulated edition in recent years.

The opening followed its usual format, presenting the year's returns: as of October 31, 2023, XVC's total invested cost was RMB 3.6694 billion, with a book value of RMB 6.7802 billion and a gross IRR of 27.66%. Year-over-year, total invested cost had increased by nearly RMB 400 million, while book value had risen by nearly RMB 100 million.

Founder Boyu Hu candidly noted that the gross IRR had declined from the previous year-end, attributing this to the challenging external environment. "This year, most of our portfolio companies did not raise new funding rounds, so their valuations remained largely flat compared to last year." He had said the same thing the year before. This meant that most of XVC's portfolio companies had gone two consecutive years without a new funding round.

XVC is a microcosm of China's golden age of venture capital. Born in the second half of 2016, it raised nearly $200 million for its debut fund right out of the gate. Hu once explained that the name XVC was chosen to evoke the independent variable "X" — the fund would think for itself.

While communication skills have always been a plus for VCs, some are clearly more gifted than others. Compared to descriptions that are either too grandiose or too granular, Hu's writing consistently resonates more deeply. Beyond his superior command of language and abstraction, what may matter more is his willingness to lay bare an investor's thought process. In an era where projects and trends move at breakneck speed, this requires a willingness to risk being proven wrong.

XVC has indeed been "proven wrong": in an industry where many don't consider research important, or even necessary, Hu has consistently emphasized "research-driven" investing. Yet his once-dominant focus on studying the what led to a bitter lesson with Dailuobo. The irony is hard to miss. Though perhaps more importantly, in an industry where keeping quiet about your wins is the norm, those who speak up inevitably face harsher scrutiny.

This year marks XVC's eighth anniversary. For a VC firm, this is the age when substance must be separated from pretense. Placed alongside dollar-denominated funds founded in the same period, XVC's performance may not seem dazzling — but there don't appear to be any obviously better candidates either. At least for now, no dollar institution founded in 2016 seems to have clearly outpaced its peers in either investing or fundraising.

This confirms an adage: investing is about timing; running a fund is about vintage.

In his annual letter, Hu highlighted four companies: Ba Wang Cha Ji, Yup, Yuanding, and Laifen, with Ba Wang Cha Ji and Laifen's annualized gross revenue both exceeding $300 million. Hu has called investing "a game of hunting whales" — one wonders if these qualify as whales in his eyes.

The following is our edited compilation of key content from the 2023 annual letter, with some material drawn from previous years' letters:

Investing in a Founder Who "Couldn't Read Before 18"

The most eye-catching case in this year's letter is Ba Wang Cha Ji. It also represents Hu's most complete articulation to date of this comeback brand, revealing several previously unknown stories. One key detail concerns the company's founder, Junjie Zhang.

Hu recounts that during his first conversation with Zhang, the founder told him he had never attended school. Hu's initial assumption was that he meant no university education; he later discovered it meant "no formal education whatsoever" — Zhang had been homeless between ages 10 and 17, so he couldn't read before turning 18. This was so profound that when he later wrote on whiteboards for them, some characters were still rendered in pinyin.

Even in the down-to-earth restaurant industry, a founder with such a background standing out in the 21st century remains legendary.

But whether such a founder was investable was a real question for any VC.

So Hu explained that in subsequent conversations, they "kept pressing for more." They found that Zhang was an exceptionally fast self-learner, having consumed numerous audiobooks. His understanding of business models and managerial insight surpassed most CEOs Hu knew.

XVC spent an entire day speaking with Zhang's core team, learning how he observed people, what he did to attract and motivate them, and what organizational mistakes he had made in the past. The firm ultimately agreed that Zhang was confident, intelligent, and humble, with high emotional intelligence. One telling signal: at Ba Wang Cha Ji's earliest stage, he had successfully recruited several core executives from Hey Tea, including one of Hey Tea's co-founders.

There was a further twist. Initially, the company had three founders: Zhang as founder and chairman, plus two other partners serving as CEO and executive, whose combined stake exceeded Zhang's. They effectively ran the company, but their vision diverged sharply from Zhang's, whose approach was clearly more long-term oriented.

After due diligence, XVC concluded Zhang was better suited to be CEO. They spent an entire evening interviewing Zhang, then spoke one by one with the new executives he planned to bring in. They promptly convened a simplified "investment committee" on-site, deciding to help the founder buy out the other two partners' shares entirely and replace the existing management team.

From the team's first meeting with Zhang to completing research and issuing a term sheet, the entire process took just seven days. This investment surpassed their commitment to Weee!, becoming the largest check XVC had ever written.

A Potential Homerun

At a sharing session last March, Hu had projected that by this March, Ba Wang Cha Ji's total store sales would reach roughly RMB 10 billion, with profits around RMB 1 billion. "After that, achieving RMB 20-30 billion in sales is something to look forward to." He specifically noted that XVC was a first-round investor, holding close to 20% ownership, "so a single IPO from this company could return roughly twice all the money we've ever invested."

Over the past two and a half years, Ba Wang Cha Ji executed a "super single product" strategy, focusing entirely on fresh milk tea with original tea leaves, whittling fruit tea down to only "lemon" and "coconut" — products without seasonality and extremely easy to standardize. The result: per-store sales nearly quadrupled, while the top five SKUs now account for nearly 70% of revenue.

This accumulated momentum led to explosive growth in 2023. According to the year-end letter, Ba Wang Cha Ji's per-store cup sales are now triple Starbucks', with monthly per-store revenue double. A strategy of stable, rapid, automated production combined with fast franchise expansion has allowed Ba Wang Cha Ji to capture profits that Chayan Yuese left on the table.

Last July, Bloomberg cited sources reporting that at least six Chinese tea chains were exploring overseas IPOs. Ba Wang Cha Ji was said to be working with Bank of America and Citi on a potential US listing; the following day, the company responded that it currently had no definite IPO plans.

Earlier this year, Mixue and Guming filed their first applications with the Hong Kong Stock Exchange, and with Nayuki's precedent as the "first new tea IPO," this at least suggests Ba Wang Cha Ji could become XVC's first IPO.

Hu probably never imagined that Ba Wang Cha Ji would become one of XVC's signature investments — an upside surprise. After all, before Hey Tea became an investor favorite, offline consumer businesses weren't considered to have enough upside potential.

"Scarce Characteristics"

This year, XVC's annual letter was titled Focus on Finding "Scarce Characteristics." In Hu's definition, scarce characteristics comprise three elements: PMF (Product-Market Fit) driven by long-term structural change, the founder, and self-reinforcing learning curves with limited anti-scale gravity.

Despite this year's terrible market environment, XVC's portfolio companies still performed strongly. In the first three quarters, combined gross revenue from 37 core portfolio projects grew approximately 60% year-over-year. For full-year 2023, this figure is projected to reach roughly $4 billion. In other words, these projects average over $100 million in annual revenue each.

In Hu's view, this owes to XVC's focus on "scarce characteristics," because "scarce characteristics" don't depend on cycles. So even though the vast majority of portfolio companies faced negative macro impacts, their overall operations remained solid.

In fact, scarce characteristics describe not only the "next Tencent" they seek, but also Hu himself and XVC.

Around XVC's founding, Hu was notably expressive, even openly acknowledging that his fund product registration had failed material review four consecutive times. He excels at attributing outcomes and forming methodologies. Even in an industry as rapidly changing as venture capital, his genuine adherence to research led to him being tagged as the VC circle's "thinker."

One investor assessed that Hu truly practices theoretical results, that thinking for him isn't merely a hobby, "but a way of life, integrated into his worldview." He's also been teased as "someone who builds models for everything."

He doesn't believe in "collective wisdom," so XVC abandoned collective decision-making. Meetings at XVC are for information sharing, not investment committees. Final calls are made by whoever has the highest-quality information.

Research-driven model-building is also XVC's keyword. Even for something as seemingly random as people, XVC attempts rational attribution.

For instance, the people-focused investment decision in the Ba Wang Cha Ji case may partly trace back to the shock of Dailuobo's failure — an exclusive angel investment that XVC doubled down on at Series A, which grew so rapidly and collapsed so quickly within months. For someone accustomed to understanding the world through models, this was viscerally painful.

After Dailuobo, Hu realized that the mobile internet era's reliance on network effects, where one or two major battles could determine victory, had stretched into "five-year wars with countless, varied smaller battles in between." When first-mover advantage could no longer be quickly established, human decision-making and organizational capability became the keys to winning.

When XVC completed its new dollar fund raise two years ago, Hu shared with Anyong Waves: recognizing the paramount importance of founders' decision-making and organizational capabilities, XVC made a major adjustment — amplifying the weight of "people" in investment decisions.

But people are complex, and investment decision cycles are short, making comprehensive understanding nearly impossible. So XVC built a minimalist model for outstanding founders, evaluating just two things: whether they make correct decisions well, and whether they build efficient organizations well — even disregarding educational credentials.

When evaluating a company, they now spend over half their time observing the person, then using various proxy variables to assess whether they meet this standard. Entrepreneurs who rely solely on intuition fall outside XVC's range.

Over the past seven years, as XVC's portfolio has grown, Hu's annual letters have expanded from roughly 1,000 characters to over 10,000. Someone recently compiled all of XVC's annual letters across the years, and the evolution reveals Hu and XVC's transformation.

Initially, he simply shared investment methodologies (such as applying stock-picking approaches to VC) and analyzed other projects. But starting in 2019, external changes entered his year-end letters. The following year, COVID-19 and US-China tensions became backdrop themes. The emphasis, however, fell on recognizing "structural changes that will impact economic behavior more than COVID-19 and US-China tensions."

By 2021, as portfolio projects gained prominence, the letters devoted substantial space to case analysis. Cases are clearly more persuasive than theory, though the landing point remained methodology. From methodology as starting point, through meticulous analysis of external information, to cases as foundation, and back to methodology itself.

XVC's team hasn't changed much, nor has its philosophy. It remains, as at its founding, stubbornly attempting to dissect investing through models. Hu still resembles an engineering student, much as he described himself in his blog: "...that disheveled nineteen-year-old boy, as if he never left, still sitting in the corner of the school computer lab, writing code all night long, tap-tap-tapping at the keyboard."

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Additionally, we will be hosting an "Unserious" Gala this Friday evening. Details below.

Image source | IC Photo

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