Lemon and Lemonade
In 1970, a 30-year-old first-year assistant professor at UC Berkeley published a paper in The Quarterly Journal of Finance under the title “The Market for ‘Lemons’.” That same assistant professor, by the name of George Akerlof, later married the future chairwoman of the Federal Reserve, Jenet Yellen, and became a Nobel prize-winning economist.
‘Lemons’ refer to second-hand used cars that have lower quality, in contrast to those with higher quality, which Akerlof called ‘Peaches.’ In this seminal paper, Akerlof modelled the used car market to study a very important economic theory — information asymmetry.
Akerlof found that in a market where the sellers are better informed about the quality of the product than buyers, sellers possessing higher quality products will eventually leave the market, as the market price is lower than the fair price for their product. Thus, the market will be left with only lower-quality products, and eventually, the buyers will also decide to leave the market. Such is the case for the second-hand car market.
Not everyone can make lemonade
Forty years later, brave entrepreneurs took up the same market and problem and attempted to turn ‘lemons’ into lemonade. Unfortunately, only some succeeded.
Whether in Europe or in China, the used car market is huge.
In Europe, the total GMV of used car transactions added up to € 429 billion, with 32 million cars sold in 2021. In China, a total GMV of ¥ 1060 billion (€ 135 billion), with 16 million cars sold in 2022.
These numbers can make any VC salivate. And it did for Chinese investors. Since 2015, Chinese investors have invested a total of € 6.35 billion (that’s 50 billion Chinese Yuan!) in the used cars marketplaces start-ups such as Uxin, Guazi and Renrenche with big name investors on the cap table such as Tencent, Alibaba, Softbank and Hillhouse Capital (an early backer of Tencent, JD.com, Uber, Airbnb).
The investment thesis is a simple and solid one.
In 2016, the Chinese used car market was due to have a strong supply. In China, the number of cars has increased from 70 million in 2009 to 172 million in 2015 in only six years, implying potentially over 100 million cars would be entering the used car market in the following years. On average, Chinese car owners are expected to sell their cars within six years of usage. Therefore, around 16 million used cars are expected to enter the market every year starting in 2016.
Furthermore, the huge market has also attracted numerous fragmented dealers, a must-have feature for any functioning marketplace. According to data from 2022, China has over 600,000 second-hand used car dealerships, with more than half of them starting operation in only 1–5 years.
With a strong supply and fragmented dealers, the market is ready for disruption; it’s an ice-filled-mint-infused mason jar ready for lemon juice. One could easily imagine a large marketplace serving as a centralised trading platform that connects the buyers and sellers — an eBay for second-hand cars. But even with all the capital and connections these investors can provide, they didn’t succeed in squeezing any drop of lemon juice into their mason jar.
Uxin Ltd, founded in 2011, is a B2C marketplace for second-hand used car trading platforms. The Beijing-based company’s early- backers include Tiger Global, Warburg Pincus, Hillhouse, Tencent Investment and DCM Venture. Following the successful Nasdaq IPO in 2018, it made a total net loss of over ¥10 billion from 2016 to 2022, and its stock price has dropped from its IPO price of $9 to the current price of $1.7. Its other two major competitors, Guazi and Renrenche, were both reported in 2019 to be struggling to generate operating cash flow. The marketplace business model, which created numerous great companies in the last two decades, seems to struggle in the used car sector.
The struggle might not come as a surprise to their users.
The used car marketplace platforms in China have faced challenges with transparency and credibility. There have been reports of sellers occasionally engaging in practices like price-fixing, adjusting odometers, and other tactics to enhance the appearance and value of their vehicles. For example, some sellers might preserve the original tires or protect the car’s interior to give the impression of a newer vehicle at the point of sale. These are problems that buyers hope the platform has addressed.
A Recipe for Lemonade
Trust — something in life that you can only lose once. George Akerlof based his research on a fundamental economic assumption: people respond to incentives. A key insight from his research is that the right incentive in place can solve the market for the lemon problem I mentioned in the beginning.
“When life gives you lemons, make lemonade,” a phrase exemplified by the Prague online-based used car retailer Carvago.
Carvago uses the right incentive system to build consumer trust. Let’s dig deeper.
Carvago pools inventory information from its trusted dealers. When the customer chooses a car on their website, Carvago carries out a comprehensive car inspection report at a price of €79. If the report comes back positive, the customers will be given the green light to order the car. Then Carvago will purchase the car from the dealership and sell it to the customer.
Then comes the brilliant part. In addition to just sourcing and inspecting cars for customers, Carvago goes one step further to give customers warranties to cover future maintenance and repairs. This shifts the risk of buying a lemon to Carvago, incentivizing Carvago to perform careful due diligence, thereby earning the buyer’s trust.
Carvago solves the problem from the demand side. Let’s see an example that solves the problem from the supply side.
Founded in 2011, the German-based company Auto 1 is another interesting example. Auto 1 operates a unique C2B business model showcasing a unique value proposition in the used car market. The company purchases used cars from individual sellers, after passing a transparent and fair valuation process, reselling the cars to dealerships. Unlike other platforms, Auto 1 focuses on servicing individual car sellers, allowing sellers to sell their cars at a fairer price and much faster. Avoiding many sellers’ fear of the long and tedious selling process and of being ripped off by car dealers. Auto 1 can expect to create a strong moat through a network effect, where dealers will find it more and more difficult to bypass Auto 1 and source cars from individual sellers. Thus, dealers will opt to conveniently source cars from Auto 1, albeit at a higher price.
Key Lessons and Prediction
From this analysis, we drew two key lessons.
Firstly, the importance of product-market fit.
When analyzing the growth of the used car market in both Europe and China, it becomes evident that the traditional marketplace business model may not be the best fit. One distinct characteristic that sets used cars apart from many consumer goods is the infrequent purchase cycle and large order size. Most buyers are in the market for used cars only once every few years. This frequency affects two primary aspects. Firstly, while marketplace models often tout convenience as a prime advantage, this aspect doesn’t hold as much weight for sporadic purchases such as used cars. Secondly, due to the large order size, elements like pre-transaction quality assurance and post-transaction services, including warranty, repair, and insurance, have become crucial in this sector.
Secondly, the importance of product-capital fit.
Venture capitalists are naturally drawn to the used car sector, primarily due to its vast market size. Another allure is the myriad of unresolved challenges in this domain, representing ripe opportunities for innovative solutions. However, there’s a significant concern that shadows investments in this sector: the immense inventory. As businesses in this realm expand, the inventory scales up, consuming substantial capital.
Finding the Right Business Model
For the market to truly thrive and attract consistent investment, the right business model is essential. One that not only addresses either pre-transaction or post-transaction challenges but also minimizes inventory risks. A model that successfully establishes trust with both sellers and buyers, specifically by addressing these pain points, has the potential to revolutionize the market.
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