We started 2015 with enthusiasm for the Chinese consumer, A-shares generating 53% annualized returns, and healthy private equity performance. This year begins with severe pessimism about China’s economic transition, public markets all sharply lower, and private equity returns in question. One friend complained that his clients were demanding to know why anyone even still focuses on China, adding bluntly “why are you wasting your time?” So feeling a bit on the back foot, battered but not bruised, we are going to stick our necks out and predict that the long arc of our investment horizon bends toward private equity outperformance generally, and upside for our strategy specifically.
China’s economic transition will remain on track
Investor pessimism is overdone. The slowing rate of growth and concerns over misallocation of capital in a tightly controlled economy overlook a magnitude of upbeat data that show China’s economic transition remains well underway. While the headline rate of growth and industrial production in China has fallen by half over the past decade, the economy grew nearly five-fold, a reminder of the law of big numbers and the fallacy of obsessing over whether GDP is 5% or 8%. Private consumption has risen from 32% of GDP growth last decade to 41% in the past five years, and will hit nearly 50% for the remainder of the decade, already overtaking heavy industry in terms of contribution.
Where we predict a few surprises in 2016
Despite the volatility, our team feels that China’s fundamentals today are not that different from where we began last year. China never fails to surprise though, and here are some areas where we would stick our neck out and make some predictions for the coming year:
Positive: Better demographics and many billions of RMB of new consumption will result from the scrapping of the one-child policy and reform of the household registration, or hukou, system. More than 70% of families with one child now want to have another, so expect demand for bigger houses, better education and a new wave of internal migration. Hukou reform will drive further urbanization and millions being brought under the social security safety net, resulting in a redirection of income toward consumer spending.
Positive: The size of the upper-middle class, by McKinsey’s definition, will stay on track to half of all households by 2022, up from 12% in 2012, and surprises will come from the non-linear growth of consumption. Expect certain sectors to sharply outpace overall income growth as households cross from one income threshold, i.e. middle class, into another, i.e. upper middle class.
Positive: The weaker RMB and lower equity valuations will result in domestic opportunities looking more attractive by the second half of the year, resulting in higher demand for local acquisitions and benefitting the businesses we control.
Negative: Expect richly-valued listed companies to continue to drop, led by A-Shares, while H-Shares, especially in the consumer sector, hold their own. For the past few years, overvalued stocks got richer, and cheaper H-shares got cheaper. This will finally reverse.
PE in China is changing
Signs that Chinese private equity is migrating toward developed market models are clear. Capital deployed in buyout transactions has jumped from US$5.4b in 2014 to $16.7b in 2015, while investment in growth capital deals fell to US$22b from $24b, the first decline since 2012. We believe this is partly due to economic challenges, succession and lifestyle issues, and also the limited attractiveness of minority investing, especially pre-IPO stakes. However, most buyouts remain heavily predicated upon multiple arbitrage – such as take privates in the US with the intention to relist domestically. The competition for these transactions has been extremely fierce, prices paid have been rising, and relisting comparables falling. The number of transactions predicated on control and operational improvements remains very limited, and this is where we will continue to specialize.
These changes highlight the growing opportunity for our Lunar Way
These three pillars of our investment strategy will grow stronger in 2016. First, our experience buying and building platforms in the mobile, baby, kids, beverage and snack foods sectors have taught us that focus works, and will continue to provide us an edge in sourcing, diligencing and managing investments. Secondly, the greatest value, certainty and risk-adjusted returns we have generated historically have resulted from the transparency, daily involvement, improved governance and lower risk of adverse selection that comes with control. Thirdly, our track record of effecting the necessary transition from founder-led to professionally run management, in Yeehoo, Linktone, Yonghong, Yaotaitai, Joysun and many other businesses, is becoming increasingly valuable.
We foresee our addressable opportunity set growing in 2016, influenced by three factors. First is the economic slowdown, which is taxing founder-led management and creating the need for a fresh approach. Second is succession, a growing problem whereby 82% of China’s aging private entrepreneurs lack a successor. Thirdly is the desire for better quality of life amongst entrepreneurs nearing retirement, a marked departure from the “all work, no play” culture of the past three decades. In aggregate, we estimate that at least $20 billion of consumer businesses will turn over in 2016, with that number rising to $35 billion per annum by 2025. These themes are all evident in the current pipeline we are pursuing in snack foods, women’s apparel, baby products and other target sectors.
A clear roadmap for deploying capital
We will deploy capital to buy and build privately held, mid-market consumer companies that remain the sweet spot for Chinese private equity, but will strive to build greater scale. We will accomplish this by leveraging our experience successfully building platforms, such as Linktone, Little Star and Yunnan Forestry, to aggregate a number mid-market acquisitions similar in scale to Yeehoo and Yonghong, smaller spinouts like Peekaboo and SmartPay, and synergistic bolt-ons like Soho Baby and Pinco Pallino. This will allow us to benefit from our middle market focus, operational value add, and entrepreneurialism, while building the scale necessary to maximize operating efficiency and routes for exit. Expect us to build platforms in sauces, seasonings, women’s apparel and others, while continuing to invest in snack foods, baby, kids and agriculture.
We have the vision and roadmap to build about six platforms over the coming investment period, comprised of a number of acquisitions, spin-outs and bolt-ons, financed initially by LCP-IV, and expanded through co-investment capital and increasingly available domestic financing. We are furthest along in building out our snack food platform, Castle Snack, which recently acquired a majority controlling stake in Yaotaitai for its brand, distribution, potential for e-commerce, and opportunity to attract younger, more affluent consumers concerned with health and lifestyle. As with previous acquisitions, our first goal will be to transition Yaotaitai from founder-led to professional management. We are simultaneously working on a pipeline of additional acquisitions – most notably, one of Shanghai’s most famous snack food brands, and another with established leadership in the Beijing market.