China’s retail format is evolving as Chinese consumers grow wealthier and savvier. To generate sustainable growth going forward, businesses need to upgrade their retail platforms.

Generally speaking, in developed markets where GDP per capita reaches USD 8,000, new retail formats, such as supermarkets, shopping malls and hypermarkets tend to become more attractive to consumers. China has now reached this inflection point. In 2011, GDP per capita for first tier cities, such as Shanghai, Beijing and Guangzhou, exceeded USD 10,000; and in 2013 year-to-date, the number of shopping malls grew to 3,500, 10% greater than 2012.

Chinese consumers’ buying behavior is gradually shifting from the traditional department stores to a more standard supermarkets, hypermarkets, convenience stores, shopping malls and other new formats. However, as the retail industry struggles with concerns over high capital expenditure and low profitability, reliance on traditional retailing channels is limiting growth. Rising costs also exacerbated the reluctance of retailers to invest in new formats. China’s Chain Store & Franchise Association reported that China’s top 100 retail companies experienced increase in rent, labor, and utilities costs of 21%, 20.5% and 16% respectively last year. Further, we believe that since the most well run retailers are generally private enterprises, the lack of developed capital markets to allow for receivables finance, working capital loans, and other tools to facilitate smarter investment are limited. These are all areas where private equity can play a critical role.

In contrast to the generic retailing strategy of the past, cost and scale have now become critical to growth and survival. Businesses need to conduct detailed planning of channel development and expansion to remain competitive in the face of increasing competition from large multi-national retailers, such as Carrefour, Walmart, and Westfield. Stand-alone stores and low-end mom and pop shops face the risk of being eliminated as a result of rising costs and limited bargaining power with suppliers. Moreover, the standalone-shop experience is in stark contrast with the evolving Chinese consumer desire to shop, dine and seek out entertainment in one central locale.

As retail formats grow more competitive, Chinese consumers have also become more demanding. Consumers are no longer satisfied by the crowded display of various brands, and the poor shopping experience offered by traditional retail format. Instead they have developed a clear preference for stores with cutting edge products, merchandising and service. This shift in market dynamics poses as a challenge to most retailers as these new platforms demand a higher entry barrier and stronger brand recognition.

Indeed, the transition from traditional to new retail formats remains challenging. But we see this market evolution as an opportunity to unlock value for our portfolio companies and investors. One of our portfolio companies, Yeehoo, has historically focused on department stores. But in the past year not only have we enhanced the development of Yeehoo’s store presence in shopping malls by leveraging the company’s brand recognition, we have also helped the company launch its online site to capture the growth of China’s growing online spending and to facilitate the company’s transition toward China’s new retail formats. To attract the attention of affluent parents, we are currently in the process of revamping Yeehoo’s store display and merchandising.

For Yonghong, a Lunar portfolio company focused on snack foods, the company’s brand value was often overshadowed by weak channel expansion and old-style packaging. Lunar is currently spearheading packaging upgrade of the company’s products to cater to the appeal of young consumers in supermarkets. At the same time we focus on improving the Yonghong sales channels and building brand value, to give consumers a more modern, more perfect shopping experience.

We are convinced that China’s retail formats will continue to evolve and increase demand overall, and that this new market dynamic is more favorable to our investments since it will reward smart choices and intelligent use of investment capital and resources. We are also fortunate that our portfolio consists mainly of branded products with high consumer recognition. We will continue to add value by leveraging our operational expertise for our companies’ to transition toward higher value chain retail venue, and we will maintain focused in proactively seeking good companies with defensible franchises and well-regarded branded products.