Driven by rising disposable incomes and lower confidence in food safety, Chinese consumers are willing to pay a premium for quality. PE firms have identified the opportunity, but taking it can be difficult.

Fifteen years ago, Charles Shao left his career as a technology investor in the US and returned to China to set up a milk supply business. The mantra to which Huaxia Dairy aspires might as well be “small is beautiful.” While others in the industry sought to build scale, this firm has grown to a manageable 12,000 head of cattle, prioritizing quality and safety over volume. The entire production process, from animal feed inputs to raw milk output, can be traced.

Olympus Capital Asia came on board two years ago, paying $30 million for a significant minority stake. A second round of funding worth $50 million, also led by Olympus was completed last year. At same time, Huaxia appointed a CEO to assume responsibility for day-to-day operations, freeing up Shao to combine his dairy and technology expertise and take the next step in the traceability drive.

Huaxia sells most of its milk to large food processors in China but the company has also branched out and created its own brand, Wondermilk. Shao's goal is for a customer to walk into a supermarket, scan a code on the Wondermilk packaging with his iPhone and retrieve information as to how it go there.

“We want to take a domestic product and show people the various steps it has been through back to the batch of milk,” says Peter Cimmet, executive director at Olympus. “Our research suggests consumers would pay a premium for this added level of security. There isn't much demand for it elsewhere because there aren't the same kinds of food safety concerns you have in China.”

Rich and wary

Huaxia represents a high-end niche in China's food industry but traceability is the foundation of PE investment theses ranging from pork processing to beverage brands, as well as all manner of ancillary service providers that help get goods to market. A series of safety scandals have created a crisis of confidence in China's consumers, even as disposable incomes grow and the appetite for consumption increases. They want quality and they are willing to pay for it.

“If you look at growth in the sector it has been in double digits in the last seveal years, driven by increasing disposable incomes and the upgrade in consumer behavior,” says Alex Zhang, a partner at Hosen Capital, which is currently raising its second agriculture-focused fund in partnership with New Hope Group. “The statistic we look at is animal protein consumption per capita. It is increasing steadily and pushing up consumption of beef, pork, chicken and dairy.”

According to the UN Food & Agriculture Organization, China's per capita daily calorie availability relative to that of the Organization for Economic Cooperation and Development average increased from 66% in 1978 to 89% in 2008; protein intake jumped from 53% to 90%. Per capita pork consumption is expected to be nearly 4 kilograms between now and 2022; poultry will jump by 2 kg, and beef and veal and whole milk powder by 0.4 kg and 0.3 kg.

The opportunities for PE in terms of creating value exist all along the supply chain. However, success hinges on asserting control over several steps further upstream from the entry point, so that products reach the required standards.

Break down the investment numbers of agriculture and food and beverage – or upstream versus mid- and downstream – and a clear pattern emerges. Private equity activity began to gather pace in 2006, reaching just below $800 million, and it has only fallen below this threshold in one year since then, but it was and remains a downstream-led phenomenon. Meat and dairy processing and food and beverage brands are the most prolific sub-segments. Investments in agricultural production, especially when forestry is stripped out, have been much smaller.

“At first glance, local farmers appear uneducated and you think, ‘If they can do it so can I.' But when you study the business deep down you realize why most financial investors shouldn't get into this business. So many things can go wrong,” says Julian Wolhardt, China regional leader at KKR. “We went through all the risk factors – weather, disease, changing government regulations – and everything you think won't happen will happen. It's an amazingly difficult business to get right.”

After the crisis

KKR and CDH Investments were responsible for one of the highest-profile investments in upstream agriculture when they committed an initial $202 million for a 45% stake in China Modern Dairy. The deal was conceived in 2007 but executed one year later, not long after a spate of tainted milk products cost the lives of six infants and hospitalized hundreds more. The problems originated from faults in the fragmented supply chain through which Chinese dairy processors sourced their milk.

KKR's China team had previously invested in one of these processors – China Mengniu Dairy – seven years earlier while part of Morgan Stanley Private Equity Asia, also alongside CDH. For this new venture they approached Jiuqiang Deng, a farm equipment supplier who invested in Mengniu in the early days and ended up vice chairman of the milking business.

At the time, he had 20,000 cows and two farms; the PE firms proposed transforming the business into an institutional farming operation with a watertight supply chain.

As Wolhardt notes, trust was a key factor on both sides: for KKR and CDH conducting due diligence in an industry that was notoriously difficult to track given the proliferation of cash payments and related-party transactions; and for Deng, being asked to help break the mold in China's dairy industry.

Modern Dairy now has 185,000 cows, with plans to add another 65,000 over the next two years. Before KKR and CDH made the investment they had shaken hands with Mengniu on a deal that would see the processor take 70-100% of Modern Dairy's milk output. This guaranteed the firm a customer and ultimately provided the investors with a partial exit. Modern Dairy went public in 2010 but KKR and CDH sold the bulk of their holdings to Mengniu earlier this year.

The move is described by some in the industry as an example of vertical integration: Mengniu wants to have greater control over its milk supply, although it has stopped short of a full acquisition.

Comparisons are inevitably drawn with another sizeable piece of M&A as Shuanghui International, China's leading meat processor, bid $7.1 billion including debt for US-based Smithfield Foods last month. Shuanghui, which counts CDH, Goldman Sachs, New Horizon and Temasek Holdings among its backers, was already on an upstream consolidation drive in accordance with government policy.

If the Smithfield acquisition goes through, it will own a company that has already been through the vertical integration process and can trace disease all the way back to the sperm used to impregnate a particular sow.

“This opportunity is about improving efficiency, quality and food safety,” says Stuart Schonberger, managing director at CDH. “Shuanghui is the market leader in China, but they still have a lot to learn. Smithfield's innovations in production and processing will help improve all areas of Shuanghui's operations.”

The traceability in Smithfield's supply chain echoes that of Modern Dairy: cattle imported from Australia are impregnated with semen sourced from the US to maximize milk yield per head; dedicated teams work with the farmers who produce cattle feed to ensure standards are met; and the cows' living conditions and routine are managed to optimize output. The current objective is to track the nutritional content of milk all the way back to the individual cow.

Issues of scale

What remains a challenge is striking a balance between quality and scale. Modern Dairy tests every single batch of milk it produces – it is estimated the milk is subject to three times the amount of testing typically carried out in the West – and even installs GPS in trucks so it can check deliveries are not interfered with en route to the customer.

Putting in place these checks and balances requires substantial investment, but past experience suggests that the larger a supply chain becomes in China, the greater the strain. Shuanghui slaughtered approximately 10 million pigs in 2011 but became embroiled in a safety scandal when it emerged that pigs sourced from a third-party supplier – representing a tiny piece of the company's sourcing network – had eaten feed containing unsafe levels of Clenbuterol.

Shuanghui cleared the tainted stock from supermarket shelves, closed down the offending plants and passed a subsequent government inspection. It then invested in technology and now products now go through 18 quality checks before heading to market. It could also be argued that the weaknesses exposed by the scandal ultimately contributed to the Smithfield bid.

However, not everyone is in a position to take such aggressive steps, which means investment options for private equity are limited. “Anybody in the livestock business needs access to large amounts of capital,” says Chong Min Lee, co-founder and managing partner at agriculture-focused PE firm CMIA. “As long as they can position themselves with a big private equity fund or another financial backer they have a good chance. But smaller players will struggle.”

CMIA and Hosen – currently raising funds of $150 million apiece – therefore look more broadly in terms of upstream agriculture exposure. Farm equipment features and inputs such as vaccines, nutrients, seeds, fertilizer and pesticides feature strongly, leveraging the shift to industrialized farming and the need to generate greater productivity from raw materials.

Both firms have also ventured into the fruit and vegetable cultivation. This area is subject to the same industrialization forces but remains a challenging area for investors, given concerns about securing land use rights and, by extension, the ability to build up scale. There have been numerous cases of fraud and every industry participant has war stories to share of investment targets dismissed because six farmers claimed to own the same piece of land.

With China's urban population exceeding the rural population for the first time in 2011, Hosen's Zhang argues that an inflection point has been reached. The government is not bound as tightly as it once was by social and political issues because there is now a desire among rural communities to consolidate farming operations, and this should free up policies regarding the transfer of land use rights.

The theory is that local authorities tasked with signing off on most industrial farming arrangements – a common approach is for the farming company to obtain long-term leases on the land in exchange for capital investment and employing local people to work the fields – will become more open to land consolidation.

CMIA found this to be the case when it relocated portfolio company Lvya Mushroom's principal production base from Fujian province to Jiangsu. It won permission to cover 600 mu (40 hectares) in cement and then build cultivation rooms on top. “We had to explain how the industrialized farming would be beneficial,” says Lee. “They liked the size of the investment and the large production base, thinking the area could become a hub for the mushroom industry.”

CMIA opted to invest in mushroom cultivation because of the capacity for consolidation and the introduction of technology. The vegetable has traditionally been grown in mud huts and it saw the potential for larger-scale industrial facilities equipped with temperature and humidity controls. Much like dairy and livestock, by creating a higher quality mushroom in a controlled environment, Lvya should be able to command higher margins than in other vegetable groups where entry barriers are lower.

Quality and safety also underpinned an earlier CMIA investment in vegetable producer China Minzhong. The PE firm first backed Minzhong in 2004 and it effectively became a private equity buyout four years later when Olympus entered with Government of Singapore Investment Corporation. The company was one of few vegetable growers in China that was able to export processed vegetables to multinationals and it went public in Singapore in 2010.

With corporate farms only accounting for 3-4% of the country's vegetable output, there is huge capacity for more deals along these lines. But challenge is distribution. Lvya is unable to sell direct to supermarkets because it doesn't have sufficient scale; even Minzhong, with nearly four times as much land, relies on intermediaries to get processed produce onto the shelves.

CMIA is trying to address this by finding brands with established distribution networks extending into supermarkets so it can create a large, integrated platform that deals with a range of products. Hosen and Olympus are also looking further downstream at opportunities in logistics and distribution, although more at niches such as cold chain solutions and high-end foods.

The challenges on the distribution side, however, are more fundamental and they affect any company seeking a premium for quality produce.

“The main reason for investing downstream is to distribute your product and convince people that it's safe and good quality,” says Derek Sulger, managing partner at Lunar Capital, which has made upstream and downstream consumer-focused investments. “We have looked at businesses like this and it's a challenge – there are people claiming all sorts of green credentials and you go down to where they are located, ask the locals if it is really happening, and they laugh their asses off.”

Race to the bottom

What this implies is, regardless of a company's credentials, wholesalers and distributors have yet to shake the habit of gravitating towards the lowest cost option. As one industry participant puts it, if you took three companies – A, B and C – all operating in the same product category but A invests in quality while B and C cut corners in order to sell at lower prices, A would struggle.

It is not impossible to create a sustainable company A – provided it can also be the lowest cost producer.

“A challenge with China today is that quality is not always recognized and paid for,” says KKR's Wolhardt. “You have to be good and have the lowest costs because the price differential between top and bottom isn't that great. On average, cows in China produce 3.5 tons of milk per year; our cows produce 8.2 tons. If our cows were producing 3.5 tons then the cost structure wouldn't work compared to the local farmers who don't have the same infrastructure as us.”

This may seem like a damning indictment of the consumer safety philosophy but it is really symptomatic of an industry – and an economy – in transition. There is demand for quality products and a willingness to pay for them but it isn't present at all levels. Private equity success on the upstream side has fallen into two broad areas: targeting particular niches or needs and backing companies that can achieve scale. Both remain valid approaches.

It is the larger players, though, that will dictate the next step in the evolution of China's food and agriculture sector as the push for vertical integration – and with it control of supply chains – gathers pace. In the dairy industry alone, large farms account for 8-10% of the market compared to 55% in the US. Shifting this even by a few percentage points will take years.

“People will pay a premium for high quality products, that is only going to get stronger and we are interested in riding the wave,” says Olympus' Cimmet. “Maybe in 20 years people won't have to worry about safety issues and just buy produce in the market, but it's a long wait.”

SIDEBAR: Entry points – Upstream and downstream

The larger the number of middle men in between you and your customer, the more your profit margins will be eroded. One way of addressing this issue is to invest further downstream.

“Everybody knows that long-term the brands are most valuable, but when can you buy them at the right price? When I think back to private equity in 2005-2006, it wasn't clear the brands had pricing power and there was a lot of competition,” says Derek Sulger, managing partner at Lunar Capital. “As much as we liked that last mile, in beverages if you wanted to buy the brand the price was extraordinarily high but if you wanted to buy the ingredients makers it was extraordinarily low.”

In early 2010, Lunar participated in an investment in Beihai Perfuming Garden Juice, a fruit juice ingredients manufacturer. Fast forward to the present and the PE firm has completed two control deals for consumer brands in the space of 12 months: walnut beverage brand Sichuan Zhiqiang and beef jerky specialist GuizhouYonghong. It is Sulger's view that, with valuations down and consumers finally willing pay up for quality brands, now is a good time to invest.

The agenda is very much integrate and stabilize, trial new product lines, and establish a position in new market segments, but food safety features prominently in the stabilization phase. Equipment is upgraded, processes are improved and supply chain weaknesses removed – all with a view to achieving international product quality accreditation.

With several large Chinese food processors and brand owners looking at vertical integration, why not secure supply chains by buying up the suppliers? Sichuan Zhiqiang sources its walnuts from farmers in western China via a handful of specialist wholesalers. Lunar has so far resisted entering the upstream space, describing it as “shockingly different.”

China Modern Dairy, a portfolio company of KKR and CDH Investments, actually bought 100,000 mu (6,666 hectares) of land on which to grow its own animal feed. This was part of a wider, ongoing effort to ensure that the company's cows – and therefore the milk they produce – were receiving the best nutrition.

“Given how fast we are growing, we would need more than 1 million mu to feed to most of our cattle and it's not practical,” says Julian Wolhardt, China regional leader at KKR. “From this year, we are going to give more economic benefits to farmers and putting them on longer-term contracts. We now have a track record so the farmers are confident we are here to stay.” The farmers will still be subject to close oversight.

“An integrated supply chain means all componnets are well connected and coordinated, but one company doesn't necessarily own all the pieces,” adds Alex Zhang, a partner at agriculture-focused GP Hosen Capital. “A restaurant shouldn't go all the way up to own hog farms and hog farms shouldn't produce their own animal vaccines. There are different business models and operating logic.”