Expert commentary: Eaton Partners

In headline terms the China story seems straightforward enough: a tale of slowing growth and a shift from an export-driven to a consumption-led economy. But this does little to help private equity investors seeking to understand the underlying trends driving change, nor where the investable or executable market opportunities lie. All that really becomes clear is the realisation that investing across China as a proxy for growth is unlikely to be a winning formula.

Instead, we are witnessing an unprecedented move towards specialisation. This tendency towards focus and differentiation is less a function of the fast-changing private equity landscape than a by-product of a top-down economy where new regulatory frameworks and socio-demographic differences have created market segmentation and supply-demand imbalances.

The good news is that the economy has reached a clear turning point. Fixed asset investment has slowed and a batch of key industrial indicators covering everything from manufacturing and export levels through to shipping volumes and industrial consumption have fallen back. But consumer and services indicators such as retail sales, air travel and leisure spend have all experienced significant double-digit growth. As a result, almost two-thirds of China’s GDP in 2016 was driven by domestic consumption.

Moreover, even in the face of slower growth, China’s economy is expected to produce nominal private consumption of $6.5 trillion by 2020, according to BCG. This would make it larger than the combined markets of India and Japan with projected growth equal to a market roughly 1.3 times the size of Germany or the UK.

While China’s millennials make up slightly less than a third of the total population, their impact on the economy is second to none. This consumer cohort of more than 400 million is larger than the entire US population. Moreover, millennials are entering their prime consumption years. Indeed, Goldman Sachs research suggests that the aggregate income of millennials in China is expected to more than double to $5.2 trillion by 2024.

Fashion conscious, unafraid of debt and accustomed to rapid change, they are among the world’s fastest adopters of new technology. And as the most educated consumer segment who are more likely to have siblings than their predecessors, they are taking the entire family unit with them.

Private equity has taken notice. Bain & Company estimates that the amount of money deployed into technology driven venture investments in the past two years is more than five times the levels invested from 2011-2014. This contrasts with traditional consumer products companies, where growth rates have declined over the past five years with multinationals losing market share to local companies.

But while China may have leapfrogged the rest of the developed world in front-end consumer technology platforms and mobile applications, the supporting infrastructure has yet to catch up. Demand for higher quality products and the shift to convenience and premium brands require overhauling the supply chain and upgrading production and logistics networks.

While the main physical and e-commerce infrastructure is largely built, China still relies on a highly fragmented set of domestic suppliers and increasingly expensive manual workers. There is significant upside potential in supply side solutions that improve productivity.

The hunger for IP deals is an indication of the crossroads in the Chinese economy, where capital productivity has fallen significantly in the past five years and Chinese companies are operating on thinner margins than their international peers.

The implication for private equity is profound. Traditional covenant light, minority growth investing as a momentum play or capital markets arbitrage is not enough to outperform. Operational know-how has to become imbedded and institutionalised in the private equity tool kit as a way to mitigate competition and help generate real value.

Our view is that the best returns will come from investing in new exchange platforms and consolidators in the value chain that leverage tech infrastructure rather than necessarily build it. We would also extend this to disrupters in the supply side of semi-regulated and still antiquated areas of social infrastructures such as education.

Healthcare in China is another important component of the consumption story. The wealthiest segment of China’s population – those born in the 1960s – will begin to enter their golden years in the next decade. Wallet share will shift to health and wellness.

The dietary and lifestyle changes of the past decade bring with it parallels to disease and risk factors in the West. The top-selling global medicines are vastly underpenetrated in China. That won’t last. Today’s consumers are well informed. They have the money and means to demand better. Private medical insurance is also beginning to take hold. As a result, we expect over 70 percent of the top 200 Chinese healthcare companies to be replaced in the next 10 years.

Much as we witnessed the emergence of homegrown internet giants in China, new national healthcare champions will emerge to address a demographic need and a social and political trend towards supporting domestic companies.

In addition, although this will take longer, we would also expect digital healthcare infrastructure and technology to present a scalable opportunity for China to upgrade the level of its care and services. This, though, is highly dependent on the ability to import or replicate diagnostic and non-invasive medical technologies at cost-efficient prices, which is possible due both to scale and the protectionist approach of the relevant regulatory bodies.

Not unrelated is the topic of succession. To date, most buyout activity in China has been large cap and intercontinental in nature. But looking further ahead, the consumption trends appear to suggest a stronger role for mid-market buyouts in this transitory phase.

The first generation of Chinese post-reform entrepreneurs and business owners is coming of age and will need to consider passing the baton. But a combination of the youth of its economy, cultural norms and local management style has prevented China from building out the depth of professional executives we see in developed economies.

This presents a real opportunity for private equity to add value and institutionalise best practices and new operating technologies. The wealthy second generation, or “fuerdai”, have new aspirations and as the rich get richer and income disparities grow, change is inevitable. The resultant industry shakeout and subsequent consolidation is going to create winners and losers.

Competition and the burden of owning a business is further amplified by the rise of debt and the resulting pressure on balance sheets. Since just prior to the global financial crisis, total borrowing as a percentage of GDP had almost doubled, driven primarily by non-financial corporate debt. Without productivity and margin improvements, this will force the hand of certain owners to seek out private equity partners.

We anticipate that for most this will create more a bankable risk return opportunity than the pursuit of paper discounts on non-performing debt from the foreclosure on real estate assets. Buyouts could also provide fertile ground across broader Asia. At a time when global macro uncertainty and protectionist rhetoric in the West abounds, expect Chinese companies to strengthen ties in the region with other Asian counterparties.

Chris Lerner is the head of Asia for Eaton Partners based in China where he started his career over 20 years ago. He has completed over $15 billion in private markets and investment banking transactions.

This story is sponsored by Eaton Partners and appeared in the PEI China Special 2017 published in Private Equity International in May 2017.