China's retail sector flourishes
Allan Liu is Managing Partner of Pacific Alliance Equity Partners. He has observed the development of China’s retail sector over the last 20 years. Lui is now putting that experience to good use, as China’s economic development places more emphasis on domestic consumption. Though China has been impacted by the global recession, especially for exports, the domestic sector is still quite resilient. Although Liu says he does not believe the double digit private equity multiples seen in 2006 and 2007 are sustainable, he sees value in this approach to investing in China retail: “The business model we have operated since 2006 has been focused on creating value by improvements in operating efficiency or by consolidation in particular consumer categories, and typically with five year investment horizons.
“Looking at the market over the last five years, we have seen a lot of high valuations placed on ordinary companies. That has changed, with the Chinese and Greater China stock markets down 50% or more, although there has been a rebound recently. If you have built an inventory of expensive investments, you might be stuck, so that limits your options, but if you are going out to find new investments now, it’s easier to tell the good from the bad. In the bull market, even a mediocre company was achieving 30% growth. Now, if a company can outgrow the market, it is easy to filter those good companies.”
The Government has realised that longer term sustainable model must shift to a domestic demand driven, because it could take years for export markets to recover. ” consumption will not help the recovery, but consolidation will create a lot of value,” says Liu. His value approach is based on creating a team of experienced business managers: “Value creation is an active philosophy, where we bring our operational capabilities to bear on a business.”
Full year performance for 2008 was single digit negative, but Pacific Alliance is optimistic for better performance in 2009. Liu says, “Consumer confidence is the lowest it has been for years, but retail sales figures have been up on a year ago. Savings rates are 50% in China, so this is not a liquidity issue. People are not over-leveraged. It’s a confidence issue; manufacturers are holding on to their cash - nobody’s buying a new house, because they think prices will drop further. We expect the difficulties to continue in the second quarter, but in the second half of the year, the stimulus measures will start to pay off. I am quite confident the consumer market will rebound later this year.”
An example of the type of company that has played well in the Pacific Alliance portfolio is Goodbaby. The firm specializes in children’s products; prams, strollers, bassinets. They have a 70% market share, 40% of which is in the US and 20% in Europe. They are very innovative, says Lui, with a strong R&D capability and centres in New York, Tokyo, Shanghai and Australia. They own over 4000 patents. When Pacific Alliance bought control of Goodbaby in 2006, 75% of its growth came from exports. The turnaround for the company is happening at a time of increasing affluence in China and a steadily increasing population. Lui says, “We believe that China’s domestic market is where the greatest future growth lies. The population produces 20 million babies a year. The market for strollers is growing by 15% a year, bike products are popular and currently the market for baby seats in cars is non-existent, so the potential is huge as increasing numbers buy cars and car seat regulation is imposed.” With streamlined manufacturing, outsourced in China, the business is much less prone to price shifts. All this helped it become a much more locally focused business.
Pacific Alliance’s investing institutions include funds of funds, family offices and pension funds. Lui says, “we get a lot of European and US private capital. Our approach is especially attractive for investors who are interested in China’s growth. And it’s a much better way to invest in China than through the A shares or QFII route.
The valuation gap is one key reason why Lui believes his approach is best. He says, “We are investing in companies at 10x PE at a time when the market is 40x. That’s why we don’t experience a huge dent in our NAV.”
Growth will be much more modest in the next 10 years, he says. “So you need to work harder to find companies who can deliver the improvements in efficiency. There are now far fewer low-hanging fruit. Private equity needs to go through a major change to adapt to these conditions. Other managers who bought at high prices now have to work through that - protecting their rights while being marginalized by local management and contract tie-ups. The only thing they can do is work to get the company back on the right track. We all recognize that China is behind in corporate governance. It’s much better to put your money with managers who are very hands-on. The due diligence process becomes the real challenge. As an investor, looking for talent, getting people who know about managing companies, suddenly there’s a limited supply.”
But he says the market is much more amenable to private equity than in previous years. “In the last few years, companies had easy sources of capital and didn’t need to give up any of their upside, when they could go the banks. Now those sources have dried up, private equity is suddenly attractive.”