In a recent interview with EMPEA, Derek Sulger discussed the private equity landscape in the context of China’s recent volatility, and the prospects and challenges for Chinese consumer-related businesses.
How would you assess the current state of the private equity landscape in China, specifically in the context of recent volatility on the Mainland stock exchanges?
China’s economy is in better shape than the Western press would lead you to believe. The consumer goods and services sectors in particular are bright spots in the market. This is apparent in the continued strong growth of retail sales, performance of domestic consumer companies that are taking market share from multinational corporations (MNCs) and the earnings reports of businesses overseas like Uniqlo and Apple. However, the economy is bifurcated. While the transition toward domestic consumption is well underway, traditional industries and some aspects of the banking system are in the midst of a managed bumpy landing. This is better for the overall economy in the long-term as it will lead to tougher reforms, but will also give rise to more volatility.
This environment has been positive for Lunar Capital since there is a large pipeline of privately-held consumer businesses that can benefit from a control-oriented, operationally intensive strategy, to professionalize management, establish new growth initiatives and renew their focus on margins and profitability. One major driver is succession – a recent study by Peking and Oxford University showed that owners of these types of businesses are overwhelmingly between 55 and 75 years old, and 82% lack a successor. We expect succession challenges to feature in many coming Chinese private equity transactions.
A further result of recent volatility has been a noticeable increase in mergers and acquisitions. Interestingly, the surge in activity has been most notable amongst domestic Chinese firms, as they become more acquisitive in the current environment. An increasing number of domestic firms are seeking to procure higher quality, professionally-run corporate assets, and MNCs are also acquiring professional, rather than founder-led, businesses.
Going forward, the current pace of consumption will remain on solid footing. One concern has been that the fall in equity prices will dampen spending, but this is unlikely. Chinese consumers are relatively insulated from stock market swings; Xu Sitao, Chief China Economist at Deloitte Beijing, estimates that equities represent only 7% of Chinese households’ wealth, with families’ savings more exposed to real estate, which has stabilized or increased in value recently. While recent public markets volatility may affect the timing of exits, our outlook for China overall remains cautiously optimistic.  
What sectors are represented in Lunar Capital’s current portfolio, and which ones do you view as most attractive for investment in China over the next two to three years and why?
We focus on control investments in the consumer sector, in such areas as apparel, snack foods and beverages. We take a long-term view on the sectors we chose and look for characteristics such as established brand presence; strong margins and pricing power; room for distribution expansion; potential for product innovation and improvement; and ability to drive consolidation in a fragmented sector. Chinese companies will continue to do well given their brand, presence and taste – according to Bain’s report, Winning Over Shoppers in China’s “New Normal”, over 85% of retail sales growth from 2013 to 2014 has gone to domestic companies and away from foreign multinationals. Much of our investment strategy is driven around acquiring and developing mass market premium brands that are familiar to, and resonate with, increasingly sophisticated Chinese consumers who are willing to pay more for better quality.  
Our strategy is to remain focused on our target sectors, and apply consistent execution to deliver the professionalized management, revenue growth and improved profitability. We benefit from having a portfolio of businesses facing similar challenges, which makes the processes and solutions we implement more easily repeatable.
Lunar Capital has recently completed several investments in the children’s apparel sector. What are the unique opportunities for this space in China, and why should investors be interested in this sector?
Luxury apparel brands have seen little impact from recent market volatility on the public markets, and the same has been true for mass market premium segments, such as baby and maternal products. Sales remain on an upward trend. According to AT Kearney’s Sector Mapping Report, China’s baby goods sector has grown approximately 20% since 2005 and is expected to reach RMB120 billion in 2015. This sector offers compelling investment opportunities due to a number of trends:
The liberalization of the one-child policy is driving the size of the addressable market. China’s recent move to allow families to have more children will increase the number of babies being born. According to James Liang, a Peking University economics professor, China is predicted to see two to three million more babies being born each year in addition to the annual 15 million births, compared to 4.3 million babies born annually in the United States.
On-going urbanization and rising wages are driving consumers to buy higher quality, more expensive mass-market premium brands and products. Parents in China, like elsewhere, are notoriously insensitive to price increases for baby products that are safer, higher quality or differentiated. Furthermore, the number of discerning parent consumers is rapidly increasing in China due to continued migration from rural areas to urban centers; better consumer infrastructure to buy products in stores and online and higher wages.
Parents and grandparents are more willing to spend money on their children and grandchildren than they were in past generations. The older generations in China have extremely high savings rates, but have been tight-fisted consumers. This is less evident in the baby and kids-related sectors. The rise of spending is not just apparent amongst parents, but also amongst grandparents and great-grandparents due to smaller family sizes and deeper involvement of relatives in family life.
The sector is highly fragmented. The baby wear market is highly fragmented, and China has a low relative rate of consumption versus its Asian neighbors, signaling room for significant growth. The luxury kidswear market is also attractive due to the rapid growth of Chinese luxury goods consumption, which represents about a third of the overall global market according to Bain’s Worldwide Luxury Goods Report.
Better consumer infrastructure is accelerating new channels for company growth. E-commerce is the most notable new channel for consumers, as is the surge in shopping malls, hypermarkets and other points of sale. Competition amongst online platforms for market share has heated up dramatically. For example, one of our portfolio companies in the baby wear industry is on track to generate more than RMB100 million from e-commerce channels in 2015, up from nearly nothing three years ago. Moreover, these are channels that many first-generation founders have difficulty tapping into given how fast these innovations have occurred, and this is where private equity can deliver value.
What role can private equity play in adding value to children’s apparel companies in China and helping them grow?
The most well-regarded, most valuable brands and businesses in Chinese children’s apparel are all roughly 20 to 30 years old, and are led by first-generation founders. These businesses often have a real edge in terms of taste, brand, reputation, product and distribution, but are facing challenges in adapting to the new realities of Chinese consumption: e-commerce, margin pressure and slower growth. This is where operationally-involved private equity fund managers can add tremendous value, but often only are able to do so with the control necessary to be highly involved with these businesses. For example, in addition to driving our baby-wear brands to category leadership online, we have appointed senior management with multinational retailing expertise, upgraded products and packaging and invested in enterprise resource planning systems to better manage inventories and cash flow. This is the low-hanging fruit that makes investing in these businesses really exciting.
What do you view as the main challenges—both on the macro and micro level—for your target sectors in China over the next five years?  
The main challenges are in maintaining strong margins and managing rising wage and input costs. On the micro level, the primary challenges are the mounting succession and management challenges within first-generation-led private enterprises. Consolidation in fragmented sectors will also be a theme that creates both challenges for smaller companies and opportunities for those better managed and capitalized.
Chinese consumers are also becoming increasingly sophisticated, and their behavior is changing. It is very important to have management that deeply understands these trends and is able to capitalize on opportunities quickly. Chinese consumers will keep buying familiar Chinese brands, but they will demand more in terms of branding, innovation, quality and other intangibles. Furthermore, brands will need to tap new types of distribution, such as e-commerce, and connect with younger consumers, most of whom have significantly different shopping habits compared to past generations. As the consumer landscape in China modernizes and retailing infrastructure grows, there remain enormous opportunities for the continued emergence of Chinese mass-market premium brands with strong products, branding, marketing and innovation.