Hillhouse's Zhang Lei - Be a Friend of Time Part 4
- By Grahamites
"We are entrepreneurs who also happen to be investors."
- Zhang Lei
In 2002, Zhang Lei received his MBA and M.A. in International Relations from Yale. He then worked for Emerging Market Management and the New York Stock Exchange.
At Emerging Market Management, he was an investment analyst covering South Africa, Southeast Asia and China. He traveled frequently to South Africa to research mine resources. At the New York Stock Exchange, he was the chief representative to China and established the NYSE's Hong Kong and Beijing offices.
Hillhouse Capital
2005 was an eventful year for China's internet industry. In March, Pony Ma acquired Foxmail and recruited Allen Zhang, the man who later created the mega-popular social app WeChat. In May, Microsoft's (NASDAQ:MSFT) MSN entered the Chinese market. In July, Google (NASDAQ:GOOG) (NASDAQ:GOOGL) announced its entry into the Chinese market as well. In August, Baidu (NASDAQ:BIDU) IPO'ed in the U.S. Also in August, Yahoo acquired 40% of Alibaba (NYSE:BABA).
2005 was also a special year for China's venture capital industry. Some visionary U.S venture capital funds started operations in China with a fully localized domestic team. Zhang Lei sense enormous opportunities. On June 1, 2005, Zhang founded Hillhouse Capital with a few partners, named after an avenue on Yale's campus. According to Zhang, the founding partners were all learning machines. They all love reading and are great at practicing what they learn from reading. They are all intellectually curious and honest. When debating each other, they only focus on what the truth is.
Pitching China to foreign investors
From the beginning, Hillhouse set out to raise capital from overseas investors and targeted U.S. endowments and foundations. It was not an easy pitch because even though China's economy was growing very fast, it was still much less developed then many foreign markets, and U.S. investors' impression of China had not kept up with China's pace of economic development. But that didn't deter Zhang Lei and his team. They made a convincing case for investing in China.
Most important of all, China was going through multiple reforms and transitions. The economy was transitioning from a planned economy to a market economy. Industrialization and urbanization were taking place rapidly. The society was transitioning from an agriculture-based one to an industrial society. On top of that, information technology and the technology revolution were widely and rapidly adopted by the society. In other words, a lollapalooza effect was taking place in China, which was turbocharging the economy. Investors need to get on board urgently.
Investment from Yale Endowment
Most investors didn't buy the story, at least not right away, except for Yale's endowment. In July 2005, a month after Zhang Lei founded Hillhouse Capital, Yale's endowment team, led by David Swenson, flew all the way to China and visited Hillhouse's team. They grilled Hillhouse's team about their investment strategy, research methodology, fee structure and operation structures. When Hillhouse's team couldn't answer a question, they acknowledged that they didn't know and took notes. After a rigorous due diligence process, Yale decided to invest $20 million and later added another $10 million. As of April 2020, Hillhouse has made a whopping $2.4 billion profit on this initial $30 million investment from Yale.
Big bet on Tencent
Hillhouse's most famous investment is its investment in Tencent (HKSE:00700). Tencent IPO'ed in Hong Kong in 2004. While gaming is Tencent's most important business today, in 2005, Tencent was still a telecommunication company. Its main product was an instant messenger called QQ. In the high end instant messenger market, Microsoft's MSN was dominating. QQ was dominating the lower end market. Hillhouse wanted to understand some important questions. What's the essential utility of communication software? Is it creating new ways of communication? Or is it improving efficiency of communication? Is it recreational? How sticky is it? Is there a network effect?
Obviously today the answers to the above questions seem obvious, but in 2005, it wasn't very clear. So Hillhouse's team did their trademark grassroots research. They went to lower tier cities in China and conducted market research. One of the important findings was that almost everyone's business card included their QQ account number, including government officials. It was clear that QQ was creating enormous intangible value for its users. Insights like this convinced Zhang Lei and his team that Tencent should be a big investment for Hillhouse.
Hillhouse almost went all in on Tencent with the initial capital. When Hillhouse invested in Tencent, Tencent's market cap was less than $2 billion. Today it's more than $500 billion. Zhang Lei admitted that luck did play a role in Hillhouse's Tencent investment, but he also emphasized the deep research Hillhouse conducted prior to making the investment decision.
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This article first appeared on GuruFocus.
