Slower, but smarter(2)

Retail has been one of the sectors most obviously affected by the slowdown in China. 

Although revenue and profit have both doubled in three years, according to Thomson Reuters figures, it has become increasingly difficult to maintain margin growth. UBS found that 45 percent of Chinese retailers surveyed fell more than 5 percent short of expected earnings in the first half 2012. And all of the large retail chains have revised growth plans to focus on profitability, according to William Shen, head of Greater China at Headland Capital Partners.

Shen says that retailers can no longer rely solely on China’s growth story. “It used to be that you open a store, and people would come – that’s no longer going to work,” he says.

But the slowdown hasn’t been bad news for everyone. The average Chinese person now actually has more disposable income, and wants more than just the bare necessities, explains Jie Gong, Morgan Stanley Alternative Investment Partners executive director. As such, certain subsectors of retail – like accessories, for example – have grown faster than those servicing basic needs.

An easy way to divide China’s $90 billion retail sector, according to Lunar Capital founding partner Derek Sulger, is by price range: high-end luxury, mid-market, and low-end generic goods. Slowing GDP growth is stifling both luxury and low-end sectors, since people are becoming more price-conscious and more suspicious of unbranded goods.

However, China’s mid-market sector is growing by an average of about 18 percent, Sulger says. “The middle market is seen as high-quality goods, but within reach of the middle class.” Some of Lunar Capital’s mid-market investments have seen growth of more than 40 percent, he adds.

“Our challenge now is to convince our companies to stop worrying about growing so fast, and start growing smarter,” Sulger says. 

Slowing growth has brought inefficiencies to the fore, explains Headland’s Shen. Given rising labour and rent costs, operational changes based on a long-term sales strategy become vital.

Hao Capital partner Elaine Wong believes private equity firms will also have to be more “creative” with business models. Changing furniture retailer Ju Tai Long to a directly-owned model from a franchise, for example, helped Hao grow the business from RMB 20 million (€2.5 million; $3.2 million) in sales to RMB 1 billion in just five years.

“Even the best companies have much room for improvement,” adds Gong. “Once they hit a certain scale, the founders see where the bottlenecks are, and most often know that they cannot solve the problems alone.”

Retailers are especially looking for private equity investors with extensive knowledge of the sector or experience solving specific problems, Gong says. So the sector will not be open to any private equity firm – only those with strong links to the industry, she believes.

Nonetheless, both Shen and Wong insist they would still make another retail investment in China. Shen forecasts double-digit growth for the retail sector overall for the next few years, an opportunity few markets in the world can rival. 

“The key,” he says, “is to find those companies that can outgrow the overall market growth.”