A Conversation with Ray Hu from Blue Lake Capital: Standing on the Other Side of the Table

What are the hottest arenas for VC firms this year? Most investors would agree—it’s new consumption and enterprise service.

However, enterprise service is not nearly as accessible as internet products are for most people. You don’t often hear sexy, insane growth stories. However, as the internet traffic dividend dwindles to a trickle, business warfare starts to break out from behind the scenes — among companies that are quietly serving their big-name corporate clients.

In the enterprise service sector, SaaS attracts the largest amount of capital and is considered the most likely to disrupt the software market. It is estimated that China has about 20 SaaS companies with over 100 million RMB of ARR (annual recurring revenue, a key indicator that measures the size of a SaaS company). Blue Lake Capital is a champion of SaaS and has placed a substantial bet on the arena.  According to the company, they have invested in 6 of the 20 biggest SaaS companies of the past 4 years.

In July 2021, I had the chance to meet up with Managing Partner Ray Hu, Chen Haohui and Wei Haitao, partners of Blue Lake, and hear what they had to say about SaaS. Blue Lake Capital was founded by Ray Hu in 2014. He is an investor of Momenta, Meicai, Qunar, and Grab. Starting from 2016, Blue Lake Capital gradually shifted its focus area to SaaS, with investment in Moka, Zhenyun Technology, JST(Jushuitan), among other SaaS companies. The insights into the SaaS business they gained over the past five years are more than hard-earned experience than investment methodologies.

Blue Lake Capital was founded at a time when the big VC firms got even bigger in China. That made it impossible to stay a competitive and comprehensive boutique fund. Placing big bets on highly selected companies and becoming part of a value chain has become a way forward for some small and medium-size funds.

Ray Hu characterized this domain-specific strategy as “standing on the other side of the table”.

01 “There’s a devil in every irregularity” 

Tencent News: When did the idea of “standing on the other side of the table” come to you?

Ray Hu: When I made my worst misjudgment with Moka. The founder said in angel round that he wanted to do ATS (applicant tracking software). I told him: stay away from ATS. I’m telling you, I’ve looked into it and there’s simply no market for it in China. We talked again in Series A round, and I still decided it was a no-go for me because however, I looked at it, the ATS market was just not big enough to make sense. But then in Series B+, we just couldn’t let the Moka slip away again, so we jumped on the bandwagon.

Tencent News: What did you learn from this case?

Ray Hu: Don’t give too much thought about the ceiling. Knowing the unit price and scale of the customer base should suffice. If both are five-digit, we would take the plunge; if one is five-digit and another is 6-digit, chances are it’s quite a good project. 

Basically, it’s about zooming in on matters most in any given stage: in Series A round, see whether the product is standardized; in Series B round, see whether the sales are scalable.

Tencent News: What methodologies have you accumulated for investing in Series A and B rounds of SaaS companies?

Ray Hu: What exactly is an investor looking for in a deal? One, real product with value. Two, margin of safety. Three, compound interest. In the SaaS business, these three things can be translated as: Is there customer value? It is complicated enough, with barriers to entry? Retention/renewal rate?

What’s really good about this arena is there are many success stories, especially in the US. You can look at the growth trajectories of these companies from year one to year ten. By year ten, a company would typically be listed already. The revenue they generate each year, the number of customers they have and the amount of money they burn – all these numbers are readily available. Our job is to identify metrics that are quantifiable so we don’t spend much time on those when doing due diligence, but instead focus on the outliers. Evaluating a deal is about sniffing out irregularities.

Tencent News: What do you mean by irregularities?

Ray Hu: For example, three salespeople generating 20 million RMB of sales.

Tencent News: Isn’t that great?

Ray Hu: It might be. It could also be a red flag for many of the problems you didn’t see. As the Chinese saying goes: there’s a devil in every irregularity.

What could the devil be? No competitors, robust customer demand, short sales conversion cycles, contract signed after one or two visits – all these are irregularities.

Tencent News: Isn’t that supposed to be great? What can be the problem?

Ray Hu: 3 salespeople for 20 million RMB. That’s 6+million RMB per person. That means these are big contracts. Chances are this company is not working on SaaS products but contract deliverables.

Tencent News: Such companies may have a hard time scaling up in the future.

Ray Hu: And the sales pipeline can be problematic. 3 big contracts worth of 20 million. Where can you get 3 more next year? You simply have no idea. I’d rather the 20 million come from 100 small contracts, and next year I can look at signing up 150 to 200 small customers and growing at a steady pace. That’s the certainty I’m looking for.

Tencent News: Any other irregularities?

Ray Hu: Along the lines of sales, say, if a company tells you the cost of sales is only 15%. That just can’t be for a startup in its first few years. We need to dig up as many reasons as possible when doing due diligence because the window is small. 

Tencent News: How do we identify irregularities?

Ray Hu: You would have to go the opposite direction by knowing what’s normal or regular. If we have a feel for the business, we would know what’s normal and not get obsessed with it; we would also know what issues are problematic, but not too important. You have to take the bull by the horns and figure it out.

Tencent News: President of Zhenyun Technology Yao Yiming said that if a SaaS company (in China at least) has a high enough ARR rate and retention rate, you can invest with your eyes shut.

Ray Hu: Yes, you can invest blindfolded if those metrics look great. But most companies are not that good, especially in the early stage. They are not around long enough to have a track record, much less a renewal rate.

Tencent News: Two of the four partners of Blue Lake Capital are pure investors, and two are operator-investors. Do you pay attention to different things?

Ray Hu: A pure investor would usually look at the product interface and talk to a few customers, which might be a setup or a bait. You may go one step further and talk to experts and competitors. But even if you find inconsistencies you might not be able to interpret it. An operator investor, however, would hit the nail on the head.

The pure investor would have to know what your hammer looks like and try to find the right nails. Back in the day, there were many opportunities but not nearly enough money. If you showed up in the market with enough money and tried your luck here and there, you could always nail something. Now with fewer opportunities around, if you go hunt for nails with your hammer in your hand, you’re more likely to hit the nail on the head.

Tencent News: What is your hammer? 

Ray Hu: That would be our knowledge of how SaaS software should be done.

A SaaS company is supported by three pillars – products, sales, and service. The last two are just as important.

02 “The first 12 months post fundraising are the most dangerous.”

Tencent News: What are the implications of SaaS companies’ rising popularity over the past two years?

Ray Hu: It’s a mixed picture. The good news is it’s easier to raise capital for your portfolio. The bad news is the post fundraising 12 months is the most dangerous period for any company as it tends to make lots of mistakes.

Second, there is a lot more competition – VC firms that used to steer clear of SaaS are coming in; Before you had a deal for 30 million dollars, but now you don’t even get a chance to talk to the founder without putting 50 million on the table; In the past, you had 3 weeks for due diligence, but now you have to whip out a term sheet in three days. The “involution” (cutthroat competition) is incredible. But this is expected – just a matter of sooner or later. You should be worried if you don’t see competition in the industry you want to invest in. 

Tencent News: Why is that 12 months the most dangerous? Is it because of euphoria?

Ray Hu: You do get a boost but end up making more mistakes when it comes down to business.

Let’s see what could possibly happen. During the fundraising process, the founder tends to paint a nicer picture and tells investors that the company can bring in at least 30 million next year while it’s more like 20 million. Now, they have to make it happen, say, by having 50 salespeople after fundraising instead of working with just 15. That’s how SaaS companies dig themselves into a hole.

What happens then, with the 50 salespeople out there hunting for new orders? A salesperson may come to his boss and say, this product is usually sold for 200,000RMB, but this big client/sucker/friend I know would sign an 800,000RMB order. But he has a handful of other requests. Yes or no? 

Tencent News: No. 

Ray Hu: You wouldn’t say no. If you do, the order is gone, so is the salesperson. The order may go straight to your competitor.

You’d just have to sign it. And you’d soon realize that the salesperson has made a way bigger promise to the customer than he was telling you. You’d realize you can’t deliver, and you would have to get more R&D people on board to deliver. Say you have five orders like that and the entire R&D team is burying itself in work trying to deliver, the company would be ground to a halt. Scheduled upgrades are left behind.

Tencent News: What would be the right way to go?

Ray Hu: Do not rush to hire more salespeople.

You need to sign more orders but don’t rush to hire more salespeople. They are shortsighted. The right way to approach it is to follow the original trajectory and do not set a growth target too high. There’s a pattern in this business. A typical SaaS company can grow 50%-100% each year in the early years, but something is wrong if it suddenly hits 200%.

There’s no such thing as a free lunch. A company can grow crazy fast, but not without a hefty price.

03 “Do not put human nature to test.”

Tencent News: Moka CEO Li Guoxing said that organizational capability is more important to a SaaS company than having a heroic CEO.

Ray Hu: The SaaS business is one long value chain that requires the concerted effort of everyone. It is an arena without secrets. The trick is to be able to gather a group of people to do it out of pure faith while being paid a lowball salary. 

Tencent News: From your vantage point, what are the typical traps for SaaS startups?

Ray Hu: Sales and delivery are always the two biggest traps out there.

You will not only need good salespeople to drive sales, but you also need willing customers. The salesperson may peddle really hard and rattle off a list of product features. But even if some of the features are unique, 1) it’s not a done deal because that feature might not be what the customer wants, and 2) even if it is, a competitor can catch up within 2 or 3 months.

Tencent News: What should you do then?

Ray Hu: There are many ways around it. For example, developing a new feature. It can be one that customers really need and see great value, or it can be one that looks fancy for driving sales, but that’s not necessarily useful for customers. We need to have both and use them alternately. Every responsible investor would keep revisiting these issues with the founder until they get it right. 

Tencent News: What are the fail-safe tips you have?

Ray Hu: The founder of a company we invested used to be in the tech business. One of our partners with operational background asked him about the company’s revenue breakdown by region. He said 50% came from Northeast, 30% from Southeast and 20% from the East. Most investors would just let it lie, but our partner immediately knew the numbers were off – all management software companies get 50% of their sales from the East.

If you build a new sales team in the East region, but the salespeople keep picking the low-hanging fruits. Would you let them? You want to go beyond the tech industry, but how do you tackle the barriers down the road – brand new use cases you don’t have experience with? Greater investment into R&D? Longer conversion cycle for your salespeople? Lower ARPA in other sectors compared to the deep-pocket tech industry? Would you be willing to solve more complicated issues for less? It’d be even more agonizing for the salespeople. If I were the sales lead, I’d think – would this impact my performance and commission? Who should I send to fight the toughest battles? What’s in it for him? All these are typical managerial issues.

There’s a simple solution for this. Let’s say this company is trying to boost its sales in the East. Step 1, send your main sales force to the East to seize the tech industry. If you don’t get it in the bag, your competitors will.

Step 2, cast your net wider to cover more sectors, but not with the entire sales force. Send scouts instead. These are people that will take one for the team. But don’t send your top salespeople. You don’t want to lose them in the fight and impact the team. Send people with mediocre performance.

But then the scouts can’t explore at random, going for the medical industry today and FMCG tomorrow. For example, a salesperson in Guangzhou is assigned to cover FMCG companies. Beyond that the supervisor would have to grant him the approval and go with him. His commission can a bit higher just so his real income does not suffer. If he manages to sign on new customers, he may actually make as much as when he covers tech firms. That’s how a company gets people on board. Take it slow, see whether a certain sector generate more revenue than cost incurred. If the cost is greater, then move on to the next. That’s how you get a hang of the sales dynamic in each sector, at a small cost. 

There are many detail issues it’s quite fun. Just tackle them one at a time.

Tencent News: How about delivery?

Ray Hu: A typical delivery issue is – should I say yes to customers’ weird demands? If so, for how much? How much is too low and not doable? Do I do it on my own or hire more people for it?

You may say yes because this feature may be useful to future customers. Then you’d need to involve R&D personnel in customization. Should these people follow the lead of the delivery team or R&D team?

Tencent News: The delivery team.

Ray Hu: Wrong. They should follow the R&D team. After all this customized product will be integrated to the product mix. There are many similar issues like this where choices would have to be made.

Tencent News: Of all customers with weird demands, what type of customer can I say yes to?

Ray Hu: It’s complicated. You’re asking because it’s a judgment call. That’s usually because you don’t have enough customers to tell whether it is a universal demand. Companies would say yes in most occasions because they want to get the order.

Firstly, You need to figure out how to lower the cost as much as can. Second, whether the customization team follows the R&D or delivery team. This is crucial.

Tencent News: Having homogeneous products would only set a company up for an endless price war. So how does one build a differentiated product?

Ray Hu: Moka is highly responsive to customer demands. It has a Net Promoter Score of 8 while the industry average is -20. How did Moka pull that off?

Moka runs a “group for grumbling users”. Everyone from CEO to frontline salespeople and customer service are there. Anyone who receives customer complaints shares a screenshot of the complaint for follow-ups and troubleshooting. If it’s a common issue, it will be put on the agenda for the next meeting, and addressed with a timetable and a lead person. 

I don’t think other companies have a group chat like this.

Tencent News: Wouldn’t that make the CEO overwhelmed?

Ray Hu: All discussions would happen among a much smaller group of people. Say, if a salesperson shares a product complaint in the executive group chat, the product manager would go: why did you blast it to the group? You could’ve just sent it to me. Companies with that kind of corporate culture can’t possibly be product-driven. Every company can make the change their customers wish to see, but most would take longer. 

Tencent News: They are trying to keep the CEO in the dark. 

Ray Hu: We all try to look good and capable. Such is human nature. So don’t put human nature to test.  

Tencent News: With all this insight into the business and what’s going on in their minds, how does that help with your investment decision?

Ray Hu: Operator investors tend to subscribe to the Eastern philosophy, which is more about human nature, while pure investors lean toward Western philosophy, which is more logical and categorical.

Investing is an art, not something that can be solved with just equations and numbers.

04 “Herd Behavior in Venture Capital”

Tencent News: Where does the SaaS market stands in terms of development stages? What is the macro-environment that sets the stage for SaaS explosive growth over the past 2 years?

Ray Hu: It is in the early stage of explosive growth. My understanding of the macro environment is different from that of operators. As a pure investor, I would say it happens against the backdrop of raising labor cost, widespread availability of IT equipment and mobile devices, and the readiness of cloud infrastructure. Operators would attribute the rapid growth to VC’s involvement. After all, building a software product can cost 300 ~ 500 million RMB. Apart from VCs, who else has the wherewithal to do it?

Tencent News: So why did VCs enter the fray?

Ray Hu: there is the herd mentality among VCs. They wouldn’t have joined the race without these few success stories.

Tencent News: Why can’t we see a salesforce of China? How do you look at future trends? 

Ray Hu: We will, in the next 3-5 years.

Most SaaS companies in the US follow the same playbook. Value creation typically happens after IPO, and the market cap would at least double after IPO.

A growing market cap correlates with stronger performance, higher valuation, and M&A, which is an important factor. Being the first public company in a sector means it has money to acquire latecomers. Salesforce, Adobe and Workday all expanded via acquisition funded by the capital market. The salesforce is key to a SaaS company. That’s how you generate additional sales. SAP and Oracles have been known for their shopping sprees. In China, SaaS companies have not yet taken advantage of the capital market, but they will, sooner or later. 

Tencent News: When do you think SaaS companies in China will be ready for the capital market?

Ray Hu: Within 2-3 years. A company can scale up very quickly if it has a solid main business and a smart acquisition approach.

Most B2B companies will live, but they may find it difficult to scale up. If a company grows to become huge, the capital market will give it a high premium. Why? Because we all know that it’s a highly unlikely event. We pay more for scarcity.

In China, I think 10 billion is just a starting point. It’s possible for a company to grow to a 30-50 billion enterprise.

Tencent News: What is the worse fear of a B2B company?

Ray Hu: B2B companies can’t grow fast, which is a good thing, because your competitors can’t either. So if you’re lagging behind, you can catch up real quick. You can afford to make mistakes.

Top B2B companies are investors’ darlings. They have money to burn. The flip side is the cash flow can easily go in the wrong direction. That’s why managing cash flow properly is important. It’s not unusual for a company to stay in the red for the first 3-5 years. But you’ll need enough money to keep up with the bleeding.

Tencent News: Tech giants such as Alibaba, Tencent, Baidu, Tictok have all burst onto the B2B scene. How does that impact startups?

Ray Hu: No impact at all. Granted, they have more traffic, but that has nothing to do with you. Second, even a tech giant will have to stay in the game for years to see any result. The best and brightest always go where they can deliver the best performance. Third, customers don’t always opt for big brands. 

Tencent News: With so many SaaS companies in your portfolio, have you created a profile for successful SaaS founders?

Ray Hu: CEOs always care more about customer satisfaction than anything else. This is a business built on repeated purchases, which is an enabler of long-term profitability and a positive growth cycle. A kick-ass SaaS company keeps their customers happy, and the rest of the problems take care of themselves.

Tencent News: I don’t think you’re betting on the founder. As one of your partners Wei Haitao said, “you can’t bet on the founder based on your own preferences.”

Ray Hu: No, we definitely bet on the founder. Regardless of how much we know about a business, 70% of its success depends on the founder. But there are uncertainties. Will a kid make it to an Ivy League school? You never know.

“Not based on one’s preferences” means acknowledging what the founder manages to achieve in a given industry environment. Try putting the entrepreneur and the deeds in perspective instead of being way too biased.

Tencent News: Any profile that you think is no good?

Ray Hu: Those that dither won’t make the cut. A good founder has just the right amount of salesmanship. Smooth talk is important, but he can’t get carried away. He should be aware that he is smooth talking, in a way that the investor picks up without calling him bluff.

Tencent News: As a fund with a focus on SaaS, how do you feel if you fail to invest in the top players? 

Ray Hu: How I feel doesn’t matter. It’d be a failure.

Tencent News: How do you just keep winning, and make sure that you always get to invest in top SaaS companies?

Ray Hu: first of all, we have a bit more common sense and a feel about the business than most people. Second, we continue to create value for entrepreneurs, for example, by offering sales enablement module, etc. Blue Lake is like an SaaS for our founders.

We can’t be sure, of course. We can only work harder each day. As we say in Blue Lake, keep showing up at your customers’ doors – that’s how you get business. And we also say that there are only two seasons in a year – a busy season if you work hard, and a slow season if you don’t.

Grab a drink, keep these words in mind, and keep at it. Go home, get some sleep, and go to work again the next day. (chuckle) 

05 “VCs are for lazy folks. At least they can get home for dinner.”

Tencent News: You had worked in BCG for 4 years, and GGV for 7 years. Why did you decide to quit and become an investor?

Ray Hu: A consulting project lasts for about 8-10 weeks. 3-4 weeks down the road you know what you are about to write. The rest of the time is spent on writing it up, double checking the format, footnotes, numbers and punctuation, tweaking the wording to get rid of the edge, and fiddling with the color palette. If you look to spend 20 years in consulting, 15 of those years will be all about tweaking formats and wording. That’s kind of boring.

So I was thinking, can I do it the other way around? As a consultant, I put together slides to share my insights with clients. I charged them on a per person per day basis. I couldn’t make more than my hourly rate, which can’t get beyond a certain range. Investing, however, is about using a financial leverage to magnify the return on my insights. 

Tencent News: What was your focus area for investment in GGV?

Ray Hu: GGV didn’t assign specific sectors. There were 10 of us and we invested mostly in internet companies and enterprise service companies. We didn’t invest in gaming, though.

I was new to investing. I couldn’t read the three financial statements, and I didn’t know how internet traffic worked. GGV was nice for a rookie like me. I didn’t know anyone there when I joined, and I didn’t make any meaningful contribution in the first 18 months but I didn’t have to stress over it. Those days are gone. Now you can’t possibly show up at GGV clueless about investing. There are more than enough smart and capable people in this business.

Tencent News: Among the companies you invested in GGV, Qunar, 21Vianet and Grab, which is the most interesting?

Ray Hu: Every deal has interesting stories to tell. Qunar opened a door for me. When I heard Zhuang Chenchao’s thinking behind the founding of Qunar, I got inspiration about how to spot investment opportunities in an ocean of companies. He co-founded Shawei.com, a sports website after graduating from college. I asked him why. He said Sina was the hottest portal in 2000 it was impossible to beat. So he picked the hottest channel.

He thought about doing news, and if he did, whatever he created would probably be as big as Toutiao (news site Jinri Toutiao). But he decided that doing news was risky and entertainment news was no fun. Sports is not bad and sports advertisers were rich. So he decided to do a sports portal.

Before he founded Qunar, Baidu and Google were the hottest companies, and finance contributed the lion’s share of revenue for Google. So he founded rong360, a financial search platform. The second biggest advertisers were travel agencies so he switched to OTA and founded Qunar.

Tencent News: Why did you leave GGV in 2014 and founded Blue Lake Capital?

Ray Hu: I was tired of working for others. I could run a financial model and calculate how much I would make in the next 10-15 years. It was a depressing exercise. Not that the numbers weren’t great, just predictable.

Tencent News: Have you seen a seismic shift in the VC industry since 2014?

Ray Hu: The total amount of capital it the hands of top VCs is 2 orders of magnitude (100 times) larger than that of the second-tier VCs. Sequoia, Hillhouse and Tencent each have a pocket so deep it’s bottomless. This was unimaginable back then.

Tencent News: How did you manage to slowly switch Blue Lake’s investment focus to the SaaS vertical?

Ray Hu: In 2016, we saw a shift in the macro environment and sectoral landscape. Money was increasingly concentrating in the hands of top VCs. So they grew bigger in size. When capital is no longer scarce, brand recognition becomes more important. That rules out the possibility of staying as a competitive and comprehensive boutique fund. If you run a small fund and you want to be competitive, you must specialize.   

Tencent News: Why didn’t you run a big fund? 

Ray Hu: Even big funds start small.

The VC cultures in China and the US are different. Many LPs told me that LPs in the US would usually ask a GP: what is your specialty? And your ROI? But the first question for a Chinese GP is: how big is your fund?

Tencent News: How do small and medium funds like yours survive in an increasingly concentrating VC market?

Ray Hu: We live by diving deeper into a vertical to achieve a network effect. I heard investors quote a famous Chinese saying “the water may be boundless, but I’d take the one ladle I need”. I thought they meant to caution against investing in too many companies. Later I realized it wasn’t a matter of quantity. As long as you’re investing in companies of the same type, same vertical, or of similar nature, you’ve got it all under control. 

Tencent News: Large VCs and PEs are putting heavier bets on B2B businesses. How do you get ahead and get deals? Your parnter Chen Haohui said, there was a time where he spent 6 months trying to get a deal, but he still lost it even with 5kg of Chinese liquor down the throat.

Ray Hu: Branding has indeed given them great momentum. Let’s say if you are not the first to meet the founder, you have to be at least the 10th, or you have to set up a meeting in the same week, or do your dd three days ahead of top VCs. And salesmanship is important. We need to lay out what we can offer – our understanding of the business, how the company can snowball and how we can keep learning and providing input. This isn’t just inputting resources. I just disdain the practice of putting together a Wechat group and providing post-deal services from there.

Tencent News: Any advice you have for B2B investors?

Ray Hu: Most investors like me have a pretty steep learning curve. So I’d say spend more time with businesspeople. Old birds like us are not likely to grow wiser hanging around pure investors like we did in the past decade.

Tencent News: Do investors born in the 60s, 70s, 80s, and 90s have different investment styles? 

Ray Hu: Generally speaking, the older the investor, the more conservative he is.  If you’re born in the 60s and still in the game, you must really love investing. Most post-90s investors are in it for the money. Post-70s is a mixture of both. They haven’t made big bucks, but the love is still there.

Tencent News: Any difference between Beijing VCs and Shanghai VCs?

Ray Hu: People in Beijing VCs tend to hang out more with those of the same work level. Young folks tend to hang out, have a meal, get some kebabs, and gossip. Those in Shanghai keep to themselves instead of having big gatherings.

Tencent News: How will China’s VC landscape change in the next few years?

Ray Hu: It’s hard to tell. The handful of VC firms at the top will get bigger, so does the tail, because money is abundant.

Tencent News: How would you describe the standing of Hillhouse, Sequoia and Tencent in the investment community today?

Ray Hu: They are the Wudang Mountain and Shaolin Monastery (two establishments that churned out Kungfu masters), while we are honing our “Dugu Nine Sword Moves” (the invincible killer sword moves in a well-known Kungfu fiction).