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Prospect Avenue Capital’s Liao Ming on investing in startups from secondary market perspective

Written by KrASIA Writers Published on     10 mins read

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Hailed as the primary market investor who knows the most about the capital market , despite its relative obscurity in China, PAC stands out globally with its unique capital market-driven thesis.

Cloopen Group Holding Limited, a leading Chinese cloud-based communications solution provider, made its public debut on NYSE in early February in what was the first Chinese SaaS IPO in a US bourse.

Its investor lineup includes the likes of some of the biggest names in the country’s venture capital industry, such as Sequoia China and TrustBridge Partners, in addition to Prospect Avenue Capital (PAC), which is relatively lesser-known in the market.

Founded only three years ago, PAC’s portfolio companies are still in the single digits and spans a wide range of sectors, including online brokerage, cloud communications, technology-enabled trucking platforms, and e-sports. It doesn’t seem to focus on one single area or any specific investment trend.

PAC’s founding partner, Liao Ming, noted that the firm’s primary investment philosophy is capital market-driven. Because IPOs of Chinese firms are spread throughout various TMT sub-sectors. PAC, which follows the aforementioned methodology, will not focus on just one area. According to Liao, all nine of his mid-to-late stage investees have extremely straightforward IPO paths. Several of its other investees will go public in the US this year, in addition to Cloopen.

Prior to founding PAC, Liao worked at Morgan Stanley and Carlyle Group and was the chief representative of UBS Beijing branch.

In contrast to its relative obscurity in its home market, PAC is well-known among global Limited Partners. It’s been chosen three times by global financial data service Preqin to co-author reports introducing China’s primary market to global investors. The latest is the “2021 Preqin Global Private Equity & Venture Capital Report,” the most in-depth annual review on the global primary market, which was released in February.

In this interview, local tech news outlet IPO Zaozhidao sat down with Liao to hear more about his firm’s philosophy and practice.

 

Global capital market’s view on enterprise software companies

IPO Zaozhidao (Q): Chinese investors have been waiting for a local Twilio, then came Cloopen. What made PAC a key investor in the company?

Liao Ming (A): We believe that “the secondary market hinges on the primary market, and the capital flow starts from where it ends.” We did a lot of capital market homework after contacting Cloopen. We tried to understand the US market’s recognition of SaaS, how to valuate the sector, and the specific financial indicators behind the valuation. We got to see SaaS companies’ increasing valuation on the market through fund managers and analyzed their business models and financial metrics.

We also commissioned Citi to arrange for the company to perform non-deal roadshows on the west coast of the US after we completed the investment. As a result, several heavyweight long-term investors expressed their interest in taking part in the upcoming financing rounds or pre-IPO rounds.

Q: Is the post-IPO performance consistent with your earlier judgment?

A: It was. One hour into Cloopen’s IPO roadshow, institutional coverage grew to ten times and peaked at 70 times, the highest for a China concept stock as far as I know.

Q: Cloud communications companies such as Twilio, Zendesk, and RingCentral have all seen 15x to 25x growth since their IPOs. What are their growth drivers?

A: Four perspectives to look at it. First, on a macro level, there is abundant capital on the market that’s propelling the valuation of quality companies from various sectors, and SaaS is one of them. Second, industry level, SaaS companies’ business models are gradually being recognized by the market. Third, these companies managed to grow rapidly despite their size, echoing market expectations on them. Finally, the pandemic has been beneficial to all software companies, resulting in high valuations.

Q: How should private equity or venture capital evaluate a SaaS company?

A: We began looking at the B2B service and enterprise software sector in 2019 and noticed a trend at the time: in the US markets, these companies’ P/S (price-to-sales) multiples were seven at the time. However, because of Chinese SaaS companies’ relatively small size—many of their growth plateaued after they reached RMB 200 million (USD 31 million) in sales—chances for them to get listed in the States is slim.

Our view is that when looking at B2B companies, we should first look at the top line and then at metric breakdowns, looking for a customer retention rate of 85%, 65% for gross margin, and 50% growth. Then the market will give a fair valuation.

Q: Are Chinese SaaS companies’ gross margins, on average, slightly lower?

A: It is an issue. We knew that gross margin would be a hurdle for Cloopen’s IPO. However, given that it may be China’s first SaaS stock, the scarcity in the market can compensate for the disadvantages. In addition, Cloopen maintained good growth after reaching a certain revenue scale. These are the two main reasons why we made a swift investment choice to lead an investment in it.

SaaS firms in the US usually offer a single product that’s subscription-based. In contrast, SaaS companies in China typically provide multiple products and charge by projects, which is a significant distinction that concerns the capital market.

During our investor education process, fund managers realized that even Chinese SaaS companies charge by projects, the contract period is usually three to five years. And chances for them to get replaced after the contract ends are very slim. So they equate project-based revenue with subscription-based revenue.

Q: Will Cloopen’s exuberant post-IPO performance improve the valuation of SaaS startups?

A: Whether a valuation is high or low, investors have their own judgments. I believe the DPI (Distributions to Paid in Capital) multiple carries more weight than a single project’s valuation. As long as your fund has good DPIs and returns, LPs will follow up for your next fundraising. Eventually, a fund’s overall performance will justify all your investments, regardless of whether their valuations are high or low.

Capital markets-driven thesis leads to higher IPO success

Q: Will PAC accelerate its investment pace this year?

A: We’ve been in business for four years, and our investment pace has remained consistent. This year, we’ll invest a little more. We’ve been mentioned more by media because the projects we’ve invested in have been reported on. Additionally, after a few of Preqin’s reports were released, international media also took notice.

Q: Based on PAC’s portfolio, it seems that it is not focusing on any specific sector. Why is that?

A: Our thesis is capital market-driven, and China Concepts Stocks spread across various TMT sectors, which means that if we hinge primary market investment on capital market (performance), then we can’t focus on any specific area.

Q: Anything to share on your single investment?

A: We favor companies with business plans recognized by the capital market, those with solid performance, valued under USD 1 billion or 500 million. We believe those will go public successfully.

We help firms plan their IPO and provide knowledge about and access to capital markets. Our judgment and investment thesis get checked out if they successfully list on stock markets.

Q: Why the USD 1 billion benchmark?

A: The capital market will have better faith in a billion-dollar or multi-billion company going public, so investing in them might not reflect our investment judgments. Investing in them will certainly help with a fund’s industry recognition, but LPs don’t choose their GPs because they are a household name. We don’t invest in IPO-able companies just for market recognition.

Q: Has PAC missed out on investees in the last two years because of this benchmark?

A: Yes, but this was an intentional decision. We gave up on some high valuation companies. But of course, we hope our second fund can broaden its coverage based on the thesis checked out by our first fund.

Q: So you also don’t invest in pre-IPO (deals)

A: We had the opportunity to speak with a number of USD-denominated LPs after the release of the Preqin report, and they didn’t like the idea of their GPs making money through pre-IPO deals because the networking resources (that lead to these deals) are not sustainable. They reiterated that they are seeking a viable and long-term investment strategy.

Q: Despite that, PAC appears to have a high success rate (in terms of IPOs), with Tiger Securities, Cloopen, and another portfolio company reportedly going public in the US soon.

A: I can’t discuss particular projects, but the nine mid-to-late stage projects we’ve invested in so far, in addition to Tiger and Cloopen, all have clear IPO plans. Our fund’s IPO success rate and DPI will be great.

How to decide between raising from primary market and going public

Q: Back to the basics, how do you choose an investee?

A: When we first meet with a company, we discuss its positioning in the capital market if it goes public, how to position it for the highest possible valuation, what the comparables are, their valuation range, etc. Then we plan every step along its way to an IPO by extrapolating what should be done in the months and quarters leading to its filing and listing.

Once our investment is in, we will follow through with a plan to guide a company towards its eventual listing.

Q: Will founders understand how it works?

A: After hearing us out, they will.

Startups usually do not know their pace for an IPO. They believe they have to reach multi-billion-dollar valuations before that could happen, resulting in round after round of time-consuming and arduous financing in the primary market.

But as long as their business concepts are recognized and their valuations hit more or less USD 1.5 billion, an IPO should be on the way.

Not all financing is the same. For example, if you raise through an IPO, hundreds of millions of dollars will be raised in just one morning, totally the opposite of raising through the primary market. After our explanation, companies come to realize that. They want us to be on their cap table and start their IPO process based on their business developments.

Q: Wu Tianhua’s Tiger Securities is your first IPO. Wu later mentioned in public speaking slots that he wasn’t keen on an IPO at that time.

A: I am grateful to Wu for the free publicity. Tiger was our first project, and I told him that the company was ready for a market debut the first time we met. He wasn’t so convinced at the time, so I invited the China heads from eight investment banks to meet with Wu—one of the banks flew their bankers to Beijing to meet Wu twice. All banks thought highly of Tiger and suggested an immediate IPO, believing it would be well received in the market. That’s when Wu was convinced. I felt that he was convinced by the time he met the third bank.

Q: My previous conception is that it’s not commonplace to raise another round immediately after a market debut, but that’s not the case for PAC portfolio.

A: After their initial public offerings, some of our portfolio companies will look to raise another round.

I’ll specifically ask the investment banks to locate crossover funds, such as pension funds and long-only funds with significant secondary market clout, and invite them to participate in the pre-IPO round, where they can price the listing price, and, at the same time, place orders during the public offering. Given their KOL status in the capital markets, their participation guarantees the success of an offering.

These crossover funds, which have hundreds of billions of dollars under management, are investment banks’ clients. If you get the banks involved in pre-IPO deals, they won’t charge you for these deals since underwriting fees will cover the cost. For startup companies, the banks will find you a quality investor and ensure a successful debut.

Q: Is this some sort of post-investment service? In that regard, what makes PAC stand out?

A: Based on our market knowledge and resources, we will flesh out IPO plans (for our investees), including capital market access, such as access to investment banks, among other agencies such as law firms. Companies only need to focus on their businesses.

Take one of our ongoing cases, for instance. The first time we met with this company was in December 2020. We mapped out what needed to be done during the time leading up to its US listing by June 2022. With our support, its management could focus on its business to deliver a solid performance. The company is currently progressing well. It expects to launch its US IPO in the second half of the year, followed by a round of crossover fund-led pre-IPO funding.

Q: Is it necessary to keep in close touch with investment banks?

A: As long as we have quality, solid, IPO-able projects, they will approach us for deals. The fact is, they want to underwrite our projects and are willing to share capital market information with us. And this type of communication and exchange is two-way.

To put it another way, we communicate with secondary market participants, including banks, on a daily basis about deals and market information. This helps us expand our market knowledge and improve our services’ quality. We also communicate with fund managers on both the east and west coasts very closely.

Q: Are these companies not covered by investment banks?

A: Investment banks don’t look at early-stage projects. They prefer to look at IPO-ready companies. As a result, some companies are not on investment banks’ radar, even if they are ready for an IPO.

Our job is to spot these businesses two years before the investment banks do. We assess the firm’s quality and ability for an IPO before investing in them, and then after our investments, we help the company get listed faster.

Q: So, would you say your investment thesis and post-investment service are now on the right track?

A: There is still room to improve. I don’t want to boast. But I believe that we are unique in our thesis and practice. At least that’s what I heard from Preqin and the companies we worked with.

Q: Some media wrote that your organization is the “primary market investor who knows the most about the secondary market.”

A: I would like to thank the media again for recognizing us. LPs would expect exits and IPOs from their GPs. So as a fund, understanding the secondary market is an essential skill.

Similarly, for companies who have already completed their Series B, it is more important for them to understand the capital market before charting out a development path so they can get listed faster and reach a higher valuation.

This is a win-win situation for all parties, including corporations, GPs, and LPs.

 

This piece first appeared in IPO Zaozhidao, and was written by Stone Jin.

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