The below article is from The Economist 1843 on Lunar’s Edu-tainment Platform.

FIAMMETTA ROCCO | FEBRUARY/MARCH 2018

PHOTOGRAPHS  KANGKAN

IMAGINING A NEW CHINA

All along the length of the attic at the top of the Ullens Centre for Contemporary Art (UCCA) in Beijing runs a long corridor that opens on to a series of small rooms. Not many of the visitors who flock to the UCCA’s main exhibition spaces downstairs, dressed in chunky trainers and taking selfies, ever make it up here. But the people who do are art lovers all the same. Just a different sort.

Bright sunshine floods in through the small windows set high up in the walls. A square table fills the room, its legs cut low enough for children to sit comfortably around it. There are eight of them, all aged under seven, and their heads are bowed in a dark circle of concentration.

Having run around outside collecting leaves, sticks and tree bark, the children are trying to make something of the different textures. They focus on the feel of the objects and how they change as you run your fingers around their contours. Unusually for China, the teacher offers little in the way of instruction. Instead, the children are encouraged to be curious, to use the raw materials they have collected and to talk among themselves about what they’re doing. They are learning creativity.

What these children absorb here may change their lives for ever.

What is taught will certainly transform the UCCA.

Founded in late 2007 in the city’s 798 arts district by Guy Ullens, a rich Belgian art collector and patron who made his money out of Weight Watchers and sold a collection of Turner watercolours to get the project off the ground, UCCA is Beijing’s top contemporary art space. Its ​ exhibitions bring in 1m visitors a year.

By 2016, Ullens was 80 and thinking of selling. One potential purchaser was Chen Dongsheng, a prominent party man who is married to Mao’s grand-daughter and who, in 1996, founded a big insurance company that also plays around the edges of the art world. But Ullens, who was concerned about his legacy as an art lover and philanthropist, was persuaded that another group of investors would care more about the UCCA’s future as a not-for-profit.

Jerry Mao, a 35-year-old Shanghai entrepreneur, and his business partner Derek Sulger, a British-American financier who used to work for Goldman Sachs, set up a private equity firm, Lunar Capital, focusing on children’s clothing, babywear and healthy snacks and condiments – all investments aimed at prosperous Chinese parents who are willing to do almost anything to help their children get ahead. Contemporary art doesn’t look like an obvious fit for Lunar – until it is seen through Sulger’s and Mao’s eyes.

They believe that an unmet appetite for contemporary art, and especially for artistic education, creates a business opportunity. “The Chinese are very hungry for better and better education experiences,” says Sulger. The UCCA, they believe, is the only institution in the Chinese contemporary-art world that comes anywhere close to being a consumer brand.

Key to this is Philip Tinari, the UCCAs 38-year-old American director. A Fulbright scholar at Peking University who moved to China just as the underground art movement of the 1980s and 1990s was becoming mainstream, Tinari found himself translating the catalogue for the 2002 Guangzho Triennial. He never looked back. Today, Tinari is one of those rare people in the art world who can speak knowledgeably to Chinese artists about what they’re working on and also make sense of the art world to people who know nothing about it.

Under its new ownership, the UCCA will be divided into a not-for-profit organisation and a commercial one. The first will continue to put on major exhibitions. One to look forward to this year is a retrospective of Xu Bing, a printmaker, calligrapher and installation artist who has taught many of the coming generation of Chinese artists. Xu, whose work came under government scrutiny after the Tiananmen Square massacre, was one of the key artists featured in “Ink Art”, at the Metropolitan Museum of Art in 2014, but he has never had a retrospective in China.

On the commercial side, UCCA will have a retail arm (a “concept store that sells artsy things,” Tinari calls it) and develop special projects, such as one-off pop-up art events for property developers who want to use culture to give their shopping malls a bit of class. The biggest opportunity, though, may well be in education.

Chinese schools place heavy emphasis on memorising, not least because mastering Mandarin is so hard; it takes children six years to learn the 3,000-or-so characters you need to read a newspaper. In other subjects, such as history and geography, rote learning is also the norm. Not only does the government consider analysis and critical thinking dangerous qualities for Chinese children to develop, but the system is also heavily skewered towards exams. The competition to get into the best middle and high schools is fierce. Teenagers are made to cram for years for the gaokao, the competitive university entrance exam, which tests Chinese, maths and English, leaving little time in the curriculum for exploring other ways of learning.

There are growing complaints – especially from entrepreneurs – that China’s education system encourages emulation rather than innovation. Jack Ma, the founder of Alibaba, China’s largest e-commerce company, has voiced such concerns. “If we are not innovative…if we are not creative enough it will be very difficult to survive in this century.” As the economy matures, manufacturing shrinks and services expand, these worries will grow.

Some parents who have reached the same conclusions as Ma are searching for ways out of the gaokao rut. Hundreds of mainstream schools now offer an international curriculum; Waldorf schools, inspired by the philosophy of Rudolf Steiner, are increasingly popular. It is the appetite for such alternatives that has created an opportunity for UCCA.

In the heyday of communism, Chinese parents who wanted their children to learn about art took them to Youth Palaces – Soviet-style community centres that promoted technical excellence by focusing on realist drawing, painting and sculpture. Even now, art teaching remains very traditional. “What we’re doing,” says Tinari, “is quite different. “It’s about using art to spark or inspire children by promoting a creative mindset, a creative mode of inquiry.” UCCA describes its curriculum as “promoting self-discovery and self-growth through art as a medium, allowing every child to experience the environments where they grow up, and to reflect on who they are as well as what path they will take within these environments.” Children explore the seasons, through courses “on the beauty of yellow in nature”, for example, or on sound art using birdsong.

Most of the learning in the UCCA’s classes is being done by the children on their own – which, to some parents, can seem both confusing and unstructured. But despite such misgivings, the approach seems to be catching on. Parents report that their children are more talkative and more curious.

A year after the UCCA started its weekend art lessons and workshops, nearly 400 children are signed up every term. Sessions cost 245-380 yuan ($38-58) per hour, and parents have to pay 21,000 yuan upfront. Crucially for the UCCA’s cashflow, education is already bringing in nearly $1m a year.

The next big challenge is to try to expand the model beyond the UCCA’s own premises. Whether this means starting new schools of its own or developing textbooks and art materials remains to be seen. But the UCCA folk sense they’re onto something important. “As people become more affluent,” says Sulger, “they want to do things to promote creativity, something that might just help their kids become the next Steve Jobs.”

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The most important event of the first quarter for our team was the Chinese New Year Spring Festival. The year of the Rooster symbolizes fidelity and punctuality, with its early morning crowing perceived as a call to action – urging us to roll up our sleeves and get to work. The holiday also rings in the busy season for us, with new deals commencing in earnest, annual budgeting finalized, and strategic planning meetings.

Macro discussions at this time last year centered on debt in the system, fiscal stimulus, and money flowing offshore. This year the focus remains on debt, asset price inflation, retail sales gains, and the stabilization of the RMB as capital outflows slow. Debt as ever remains the X-factor that weighs on valuations, perceptions and the risk premium many associate with China. The observers we trust the most believe this is not a systemic concern, but for every two in that camp, there is a Cassandra with the opposing view. What all should agree on is that the effects of last year’s stimulus measures are indisputably material. Retail sales running at double-digit gains continue to mirror the underlying trends we see in our portfolio companies, and in the pipeline businesses we are targeting. Chinese New Year sales reached RMB 840bn, up 11.4% year-over-year, with tourism up similarly to 100bn from 90bn last year. Overall, China’s long-term growth trajectory remains on track, namely:
(i) transitioning China from an export and investment-led growth model to one empowered by the domestic consumer, (ii) promoting global trade and commerce through initiatives such as One Belt One Road, and (iii) further liberalization of the capital markets. The recent announcement that the US will soon restart beef imports to China, which were initially halted in 2003, will provide an attractive alternative for Castle Snack’s to source more competitive pricing for raw beef for its beef jerky.

Capital controls have limited our ability to distribute investment gains, but money staying onshore has created demand for investment, including a surge in the number of domestic IPOs. Bloomberg reported that outbound takeovers by Chinese companies buying offshore assets are down 67% this year due to capital controls, the biggest drop since the financial crisis. Regulators continue to place obstacles in the way for getting funds offshore, which has helped the RMB stabilize to a far greater degree than anticipated. It has also made for very high breakup fees, something, to reassure, we very much have in place with exits we are working on.

Our industry is evolving as well. There is a notable uptick in demand for private equity from domestic entrepreneurs and founder/managers, which we believe will continue to serve China’s capital markets and our strategy well. Venture still attracts the most mindshare, and probably the most capital as well. However, in the more mature private equity strategies, we believe control continues to stand out as offering the best risk-reward, and we remain an early mover. Skillset and focus is winning out versus the pure capital, relationship-driven approach, and younger team members and management are at a distinct advantage as opportunities and structures evolve very quickly, especially onshore.

We are seeing a few key reoccurring themes and trends which continue to drive our investment strategy. Firstly, we remain focused on building scale through platforms and believe that rollup strategies work. Secondly, we will keep fighting for control. The more control we have, the better the outcome will be and the easier we find it to make improvements and scale our businesses. Thirdly, move quickly. China is the world’s most dynamic economy, and everything moves faster. Changing management, rationalizing product lines, or implementing change is better done fast and swift. Lastly, be mindful of leaving cash on the table. We were early to exit an investment we held in Hangzhou Kings at well above cost due to concerns over our status as a foreign shareholder. We chose to exit rather than propose creative structures to our LPs that could, perhaps, have retained our involvement despite layering on structuring risk. Hangzhou Kings went public domestically this quarter, and after trading at near its limit nearly every day since, the current valuation of the company would have implied more than 12x our invested cost. As we plan for future exits, we will work to educate our investing partners on where we may be able to take prudent risk to capture upside in situations where often structures require more work to understand.

That leads to the greatest challenges we face in our portfolio: modernizing thinking, continuing to execute, and accelerating the pace of all that we do. China today is about the new taking over from the old, modern outpacing traditional, China’s youth consuming much differently than their parents, and young managers moving faster and more creatively than their 45-year-old-plus peers. We believe that our ability to quickly modernize, whether in Castle Snack’s manufacturing operations, Yao Taitai’s products and packaging, or Yeehoo’s distribution, is truly where we can move the needle for our partners.

This Chinese New Year, we celebrate the 15th anniversary of China’s accession to the World Trade Organization. GDP per capita now exceeds US$8,500, up from US$1,200 in 2001, and the World Bank classifies China as a middle-high income society. Morgan Stanley believes China will achieve high-income status by 2027, yet China only ranks as the 75th richest nation per capita on earth. There is still a long way to go.

Highlights from our businesses
The strength of the Chinese consumer delivered for our companies this year, dwarfing any drag from the more sluggish aspects of the broader economy. Our businesses continued to grow revenue, with profits rising and the following notable accomplishments:

– Yeehoo ranked as China’s top babywear brand, tripled its November 11 Single’s Day e-commerce revenue, and attracted numerous suitors
– Castle Snacks completed two further acquisitions and reached domestic-IPO scale
– Lao Heng He quadrupled e-commerce sales growth, and doubled its traditional channel sales, two of our most important KPIs

Exits and distributions
We had success translating momentum into exits and generated distributions from several of our businesses during the year, which in total should return limited partners a substantial amount of capital. In most cases, comparable valuations for our businesses rose considerably, which will drive further uplifts in valuation. While we generally do not underwrite based on multiple arbitrage, we believe it presents us with tremendous optionality for additional upside.

Capital committed to new investments
We committed more than $100 million to new investments during the year. We were most aggressive in buying snack food companies, with the acquisition of Yao TaiTai, Orchard Farmer, and LifeFun. We also closed our investment in Honworld.

While this represents a growing amount of investment for us, it is still small compared to the size of the opportunity we are addressing. Far too small in fact. In critiquing our own performance, we believe that we have left too many opportunities sitting on the table, where we could have leveraged our platforms and driven growth at reasonable valuations. In babywear, for example, there were several large acquisitions we should have made, where investment and execution risk could have been mitigated by leveraging our market leadership. We missed similar opportunities in snack foods. We will work to better present these investments to our investing partners in the future, and ensure that we do not miss chances like these again.

Pipeline and investment focus
You will hear more from us about baby- and kids-related businesses, snack foods and condiments. Our team has strong conviction that our foothold in these sectors is an enormous opportunity to put more capital to work and deliver investment gains. We have about a half-dozen new platform concepts under serious consideration in areas like early education. We believe that we can leverage the large base of VIP customers we have built up through our Little Star Brands platform and provide Chinese families with more professionally run, higher quality educational services to compliment the clothing and supplies that our brands provide. We look forward to discussing similar ideas in travel, cosmetics, and other sectors with you soon.

Risk factors
We begin the year with more of the same concerns over a potential credit bubble, the weakening RMB, and the increasing the risk of some form of trade war. Domestic politics will also be a factor as the quinquennial process of making leadership appointments, including Xi Jinping’s likely successor, will occur.

Goldman recently postulated that a hard landing is likely over the coming three years. Morgan Stanley takes a different and very bullish view on China, believing that a shock will be avoided and a focus on domestic consumption and services will lead to high-income status by 2027. So, Goldman fears a crisis, Morgan Stanley urges focus on the long term positives, and, at Davos last year, George Soros said he was no longer expecting a hard landing, but already “observing it”! From what we see in our businesses, we believe that a series of soft landings occurred in 2008-09, 2012-13, and 2016. Together, these may be the speedbumps that slow growth, lower valuations, accelerate restructuring, and prevent the economy going off the rails. For now, we concur with Morgan Stanley (“[they are] able to navigate [it]”).

As for our investment strategy, we believe that for so long as China remains underdeveloped, with a high savings rate, reasonable asset prices, and a growing middle class of aspirational consumers, the opportunity to buy good consumer-focused businesses with the potential for growth at reasonable prices is compelling. We remain convinced that putting capital to work and mitigating risk through our operational efforts, disciplined focus, and ability to leverage control is a wiser course of action versus remaining underinvested.

Potential surprises
Readers of our year-end letter (and of Nostradamus’ works) want predictions. Below is a recap of how our forecasts from last year fared, and the trends we believe remain in place based on the feedback we receive from our businesses, management teams and dealmakers:

Last year we forecasted that the impact of one-child reform would kick in. And it has. CLSA recently reported that China’s birth rate recovered to 12.95% in 2016, the highest since 2001. Expect the birth rate recovery to continue near term with 18-20 million new-borns in 2017-2020 – a “mini baby boom” that will drive consumption. We also predicted liberalization of the Hukou System would fuel further urbanization and internal migration, which was premature but remains low-hanging fruit to drive future consumption, and we believe it will occur soon.

We believed that the upper middle class would surprise and deliver non-linear growth rates of premium consumption in areas such as healthy food, overseas travel, education, healthcare and higher quality apparel. This trend continues. Each of China’s online shoppers will spend US $473 on foreign goods this year, up from $446 in 2015. Luxury brands like LVMH, are reporting “better momentum after a tough 2015” as are Re?my Cointreau and Kweichow Moutai. “Re-shoring” of luxury is accelerating as China cuts duties on luxury goods imported through official channels, and cracks down on “daigou” (overseas personal shoppers unofficially bringing back grey-market goods). This dovetails with our channel checks that show better sales domestically, but weakness in places that cater to daigou, like Hong Kong.

We were correct in foreseeing that the weaker RMB and lower equity valuations would fuel M&A. The demand to acquire good companies we control is positively impacting our portfolio, although the weaker currency has led to outflows for China-focused fund managers, and macroeconomic concerns for investors globally. We expect the currency will continue to experience a managed decline, and that it is the volatility, not the absolute level, of the RMB that most concerns policy makers. The market will grudgingly conclude that China has the growth, reserves, policy tools and force of will to bring the RMB in line with fundamentals while avoiding overshooting to the downside.

We also called the narrowing of the valuation gap between domestically listed A-Shares and Hong Kong-listed H-Shares, especially in the consumer sector, although our belief that this would be fueled by a rebound in the valuations of H-Share consumer stocks, which traded sideways, was a bit off. For the coming year, we anticipate that the stock-connect, which provides domestic Chinese investors access to reasonably-valued Hong Kong listed companies and, indirectly, foreign currency exposure, will become too tempting to resist and offer reasonably priced yield, versus the very expensive growth on offer elsewhere.

We overstated the risk that businesses and startups in China “losing more to sell more” would rattle investor confidence. Enough unicorns were minted to prove us wrong. Going into the New Year, we still see an overabundance of capital searching for a home, especially in early-stage venture-land. Growth is overvalued, but expect nonsensical start-up valuations and the general dodginess in industries like peer-to-peer lending to persist for a while longer. Domestic equity valuations will also remain high. While the local markets are imperfect, the trend toward higher quality listings, better regulations, greater institutional participation and more overseas involvement combined with China’s extremely high domestic savings rate will keep valuations robust.

Priorities
Finally, we would like to recap our priorities for 2017:

First, we will continue making distributions and complete further closings for the exits we commenced in 2016. We believe we can do this while ensuring that these companies continue to grow.

Second, we aim to sell down our last two remaining investments in LCP-II, our vintage 2008 fund. To this end, we are off to a good start in 2017.

Third, we will optimize our remaining investments in LCP-III to achieve higher valuations, generate distributions and achieve industry-leading returns.

Fourth, we are taking advantage of the platforms we currently own to invest more capital, with a target of exceeding the $100 million we committed last year into further snack foods, sauces and baby/kids-related businesses and one new platform.

Fifth, we continue to build Lunar’s franchise and reputation.

From LPs looking for realizations from GPs as well as paper gains, to the factors contributing to more buyout opportunities in China, industry participants give their perspectives on the year to come:
BRIAN LIM, PARTNER AT PANTHEON, ON THE LP PERSPECTIVE:
Sentiment has been more subdued on Asia. You will see some fundraising noise that comes through from the timing of some large funds coming to the market, so maybe the figure to focus on is the average over two or three years. But even allowing for that, fundraising is probably down.
There is also a theme of consolidation of GP relationships by many LPs. This has benefited some of the larger funds that are able to raise more money, but some smaller managers are feeling the negative impact of that consolidation. You will see continue to see some oversubscribed funds in the mid-market space, but by and large, the days when you would be able to command a strong fundraise as a new face on the block or as a re-up without much in terms of realizations are past. LPs are more demanding in what they are looking for. Your DPI [distributions to paid-in] matters; your ability to justify your fund size over and above what you raised last time matters.
Regarding China specifically, there are some issues at the political and economic level, but there remains a fair amount of optimism. As long as managers are able to command capital this is quite a good investing environment – there is less competition and more time to conduct due diligence.
I also see some optimism in India, despite the recent demonetization efforts. Fewer firms are able to raise capital, particularly if you strip out VC, but pockets of capital have been raised locally. There is increased realism as to what it is practical to expect of foreign institutional investors, so if managers can rely on local investors to get going that is a sensible strategy.
Australia and Korea will hopefully both continue to be steady, and Japan continues to defy expectations and perform well despite a difficult backdrop in terms of macroeconomics and demographics. This could well be Japan's year in terms of private equity fundraising, because a number of firms are coming to market at the same time.
RICHARD FOLSOM, CO-FOUNDER OF ADVANTAGE PARTNERS, ON JAPAN:
The pace of deployment has continued on an upward trend, especially in the small to mid-market deal space, and we see signs of that continuing to be robust going into 2017. The pipeline will continue to be driven largely by founder-owner succession deals and some corporate spin-offs.
One thing we see going forward is that succession deals will be coming not only from ageing founder-owners but also those from in their late-30s to mid-40s as they realize the merits of working with private equity firms based on word of mouth and what they're seeing in the market. That's a change in perception that has accelerated over the last year or so and will be driving deals in the future.
Corporate divestments are a bit more cyclical in nature and I think we're at a point in the cycle now where Japanese companies are feeling more pressure to divest and focus on shareholder value. Additive to that, improvements in corporate governance initiated over the past year that make it easier for private equity to participate in larger deals are beginning to take effect with these companies.
We are seeing appetite and opportunity to sell to Japanese strategics in 2017 and foreign companies will begin to take on a role as buyers as well. There are different angles to achieve double-digit growth in Japan, so private equity will focus more on creating value with differentiated products, bolt-on acquisitions and helping companies go overseas.
WONPYO CHOI, PARTNER AT BAIN & COMPANY, ON KOREA:
From next year, it will be a much more challenging environment for private equity in Korea, even for deals over $1 billion, because the spectrum of competition is going global and even the smaller funds will be able to source additional money from LPs through co-investment. LPs, who have witnessed a number of high-return mid- to large-cap deals in Korea, are pushing the global funds to build up their teams in the country and secure more deals.
For the next 3-6 months, the current political instability may have a negative impact on private equity markets because it's not just about politics – it relates to concerns that Korean conglomerates may be accused [of improper conduct], which could delay the important decisions such as portfolio adjustment or M&As.
However, I still think deal flow will be strong for the next 18-24 months because there will be activity in the distress market. There will also be a lot of secondary deals because many PE portfolio companies are mature.
In addition, there are still a number of mid-cap companies that need support for globalization on top of growth capital. PE funds will continue to have a preference for consumer and retail despite the potential macro headwinds, but there are some contrarian views that they could actually be more active in industrial sectors due to cheaper prices. More investors could turn companies in those sectors around with creative deal structures, drive consolidations, or shoot for an industry cycle play.
The issue will be exits because domestic strategic investors are quite selective regarding local deals and pursue cross-border opportunities more actively. We have also never seen any IPOs for majority-owned PE portfolio companies and we've had some political impasses between China and Korea making it hard for Chinese strategics to do deals in Korea. Unless we resolve the political issues with China and the stock exchange allows companies majority owned by PE to go public, it is likely exit activity will face challenges in 2017.
DAVID PIERCE, HEAD OF ASIA AT HQ CAPITAL, ON EVOLVING LP ATTITUDES:
The thing that has struck me most in the last year or two has been the mood swing of many international investors. Those of us within the region continue to believe that Asia represents a very interesting place to invest private equity capital, if done intelligently, but globally the mood seems to have swung broadly against the region as an investment destination. The perhaps excessive enthusiasm of a few years ago has gone away and been replaced by excessive pessimism.
Of course, this can actually create some interesting opportunities, because reduced capital inflows can also reduced competition for deals, potentially making entry valuations more attractive. But the pessimism makes it very challenging for GPs to raise money, especially those still trying to prove themselves.
For the last year or so now, managers seeing fundraising success are those that have proven an ability to get money back to their investors. An attractive TVPI [total value to paid in] alone is not sufficient. Investors want to see distributions, an area in which Asian funds have lagged peers in Europe and North America. So we've seen some of the bigger Asian GPs do really well with fundraising, because they tended to invest more in the buyout space where they can control the timing of exits, or in larger deals where they could get listings on exchanges or do some other form of recapitalization and get money back.
On the other hand, for many GPs managing smaller funds, while the portfolios may look good, fundraising has been very challenging because of the inability to show that they can actually realize returns. I think that's likely to continue to be the case in 2017.
Another development worth noting is the growth of the secondary market in Asia. Many of the funds that were raised in the mid to late 2000s are coming to the end of their lives, and they need to find solutions to their exit problems. So the secondary market is increasingly a way to get liquidity for investors or, in some cases, give new life to a GP by recapitalizing a fund or using other techniques to permit pursuit of a promising investment course.
CAMERON BLANKS, MANAGING DIRECTOR AT PACIFIC EQUITY PARTNERS, ON AUSTRALIA:
The Australian private equity market is very stable with a consistent set of competitors, and the economy is heading into its 27th year of continual growth. We therefore don't really see a lot of change happening over the next 12-24 months in terms of dynamics or conditions.
There's a A$2.1 trillion ($1.57 trillion) pool of capital in the Australian superannuation space that continues to grow at a faster pace than the economy, so there's no doubt that investors at a macro level will be seeking to invest that. But I don't think it's going to lead to an oversupply of capital in the local market because a lot of it will be invested offshore. The superannuation funds also invest lower percentages of their funds into PE compared to global benchmarks, and I don't see that changing in the near term either.
One theme that is coming out in Australia, however, is exports of services, which has now overtaken exports of iron ore. We expect that trend to continue, especially in the education sector, which is set to grow off Asian demand. Australia is now said to be exporting more education services than the UK or Canada. New Zealand will have a similar services dynamic with probably more of a focus on food businesses and agriculture.
There has also been a good appetite in the Australian market for services-related businesses to go public. We've seen a strong IPO pipeline since late 2013, but it has tightened up recently so it will be interesting to see how that goes in the first quarter next year. That will depend on what happens in the US and economies around the world in terms of investor appetite.
KARTHIK REDDY, MANAGING PARTNER AT BLUME VENTURES, ON INDIA VC:
One trendline is about definitely watching the leading start-ups – the Flipkarts and Olas of the world. In 2014, 2015, and to some extent in 2016, they were also the forerunners for M&A and aggregation and consolidation in this space, and if they're not strong aggregators, then what happens is M&A dies down a bit. And so it's not only the companies themselves to watch out for, but also the lead indicators on M&A activity and late stage investors coming into India. A lot of people have money invested into those companies that they cannot afford to lose. It may swing momentum away at late stage if that happens.
The contrarian trend to that is there's a lot of early stage capital with resident managers in India, whether that's Accel Partners, Nexus Venture Partners or even early-stage funds and angels, but it's far more tentative when it comes to what gets backed. The good news is that models that are more robust, that have more traction, are getting recognized and funded. India-centric or unique-to-India models got a bit of a rough ride from investors in my view, but that is changing dramatically in favor of those companies. Some sectors that we like or we've bet on already are going to get a huge uptick in the next 12 months: healthcare, financial services, education, small business technology, small business enablers, B2B enterprise and software-as-a-service (SAAS).
A lot has yet to be seen in terms of what impact demonetization has on the overall economy. I don't think it's all positive. It's going to hit discretionary spending, and it's going to slow down the economy for the first six months of the year. The full impact will roll out early in the first half of next year. And compounded with that is all the policy uncertainty. I think the government does realize that they have made mistakes in the short term, and to fix that they'll have to throw a whole lot at one layer or the other. So whether it's to facilitate trade, or to boost consumer spending, some of that is going to happen.
If start-ups are able to survive through the next year, my belief is that the end behavior, whether that's in six months or five years, should benefit new age start-ups, because a lot of the frictionless transactional activity, whether it's goods or services, is bound to move online. And anything that piggybacks the mobile internet economy is likely to benefit, if they've executed it well. So apart from payment start-ups and financial services, once you've taken a lot of cash and pushed it through the formal banking system, consumers become savvy enough to operate their cash flows digitally, and the digital service offering suddenly becomes far more viable.
DMITRY LEVIT, FOUNDER & GENERAL PARTNER AT DMP, ON SOUTHEAST ASIA VC:
Some business environment factors in Southeast Asia, such as internet connectivity, are quick to change, while others take longer. One important missing element of a healthy digital ecosystem is a stock exchange capable of providing liquidity for technology companies. Before this becomes a reality, an entire generation of equity analysts, traders and investors will have to be educated. Other important factors such as a culture of risk-taking, access to a deep pool of technical talent and availability of experienced mentors are noticeably changing, but likely have further to go.
In terms of investment sectors, although VC enthusiasm for Southeast Asia's e-commerce market – Indonesia's in particular – has subsided somewhat following an intense period of interest, an interesting group of businesses has emerged in its wake. These are the back-end infrastructure systems necessary to support e-commerce operations, such as last-mile logistics, advertising and affiliate technologies, and digital payments.
Certain industries succumb to the hype generated by the global tech ecosystem. In my opinion, financial technology is one area where the current buzz exceeds substance. While there is much talk of disrupting banks and insurers, I find that start-ups whose initial role is to support, rather than replace, financial institutions' processes are more successful in establishing a beachhead from which to advance. Separate from the buzzy fintech space is digital payments, which has been developing nicely in the past couple of years, and where I think we will see some consolidation.
Overseas investors, who deploy the majority of capital into Southeast Asia's tech companies, will continue to have a major influence over events in 2017. For example, we are seeing a resurgence of interest from mainland Chinese investors in certain markets – Indonesia and Singapore feature most prominently, but increasingly also Thailand and Vietnam. This may be why, after almost a decade out in the cold, the amount of buzz around Vietnam's tech ecosystem has risen again.
MARCIA ELLIS, PARTNER AT MORRISON & FOERSTER, ON CHINA:
Over the last year, PE funds that I represent have become very interested in working with Chinese corporates to do outbound investments. And with the recent curb on outbound investment (not formally announced but widely reported), there is certainly doubt at least for the first half of 2017 as to what is going to happen with that flow of investment money offshore.
Some of the funds that I represent are actually seeing this as a potential opportunity for them: Because they have offshore cash available, they can provide a bridge for Chinese companies that are trying to do investments but can't get their cash out. If you figure that eventually the tap is going to be opened again and cash will be able to leave China, then if you are an offshore fund you can make money off of financing those offshore investments in the interim. Many of my fund clients are also focusing on the China NPL [non-performing loan] market, acquiring portfolios of loans and investing in companies that work with Chinese NPLs.
I think that a lot of people are finding other sorts of exits besides IPOs. There are always secondary sales to other funds. There are also a lot of people looking to consolidate businesses in certain sectors like education and healthcare, and often you can just sell your asset to somebody else who is consolidating. We've assisted a number of PE sellers in sales to strategics. In the past, maybe people would have held out and tried to do an IPO, but now they're saying, ‘Let's go ahead and sell this to a strategic.” Often the multiples are actually quite high. People are rethinking IPOs, which are really expensive to complete, assuming you are able to complete them. Indeed, when you look at the returns and factor in the cost and the time it takes to do an IPO – plus the time it will take the fund to sell its shares post IPO – sometimes an IPO is just not the optimal exit.
On the fundraising side, we still see LPs very willing to commit to China-focused funds. I think you're going to have a period with people pausing to sort out between the types of China-focused funds they will invest in and the types of funds they won't. The Chinese economy is slowing, so you can't just invest in a fund if its only strategy is to bet on growth. You need confidence that the people at the fund have real ideas and can figure out an investment strategy that really works.
DEREK SULGER, PARTNER AT LUNAR CAPITAL, ON CHINA BUYOUT STRATEGIES:
Domestic consumption will continue to steadily rise – it started out weak in 2016 but ended the year very strong. You'll see that reflected in funds like ours that focus on what people eat, drink and wear. When I think of consumer I think of the mass market premium brands – it's the products and services that people are buying. I really think we will see the most success in that area, which means that strategies oriented around the consumer, mass market, and tangible qualities will continue to see good growth.
We feel very strongly that what we're doing will remain a sweet spot in terms of attractive entry valuations, less competition, and most importantly, the greatest opportunity to add value. You're still going to see enormous opportunity, especially in areas like consumer, to buy established businesses with a strong pedigree and a strong track record, and bring them into the modern age. If you're a younger entrepreneur, and you're at an early stage of running and building your business, you may not see much value-add from private equity. You also may not want to sell your business, and if you need to raise money, you might solicit PE investors but probably as little as possible. So these opportunities are difficult for growth capital to invest in, and those founders are probably not likely to do something even with a buyout firm.
But if you look from a big-picture perspective, there are approximately 12 million mid-size companies in China. And the average age of the established mid-market companies is older, as they were typically started in the 1980s and 1990s, and are now approaching 20 or 30 years of operational and brand history. A lot of those businesses are run by people who are thinking about what's next for their company, beyond their own lifespan, and certainly beyond their tenure as CEO and founder. To the extent there will be competition, it's going to come from domestic Chinese companies rather than from other private equity firms, but they'll focus a little more on the larger and slightly more mature end of the sector.
Increased competition is narrowing the upside in minority growth transactions. This is not necessarily driven by other private equity firms, because there hasn't been that much capital raised, but from from increasingly-developed, deeper, more robust capital markets that are better positioned now to provide meaningful financing. A well-run company looking to raise money, can now get it at very reasonable prices. You don't have to give an arm and a leg to a growth capital fund like you had to five or ten years ago. That investment approach will be challenged, and I don't see the trend reversing any time soon.
 

As we enter the year-end holiday season, the world’s two largest economies will generate tremendous levels of shopping both online and offline, bringing the sheer scale of China’s consumer growth into sharper focus.

Double 11 – The online Chinese consumer is as healthy as ever
Sales during November’s “Double 11” promotion reached 120.7bn yuan, or US$18bn, up 32% YoY. Chinese shoppers were enticed to build their shopping carts early, and in return were promised discounts and lightning-fast delivery. The first Double 11 order on TMall was received 13 minutes after the purchase was processed online.
In the USA, an impressive US $3.34bn was sold during Black Friday, with Cyber Monday generating US$3.45bn in sales. Together they total less than 40% of what Double 11 achieved in a single day. Again – less than 40%. Moreover, 80% of Chinese purchases were made via mobile phones, compared to approximately 32% for US consumers.
We believe these numbers will continue to rise, even from such a staggeringly large base. China and the United States are both consumer societies and we are seeing Chinese express individually, spend savings and seek out a better life through shopping. China also has room to grow by tapping into less urbanized and rural customers. During our recent AGM, Alibaba executives discussed their plans to bring an additional 500 million rural Chinese online through mobile phones, regional drop-centers and better logistics.

Lunar brands performed in all categories
Our Yeehoo babywear was the clear market leader. Yeehoo staffed more than 1,150 workers across three 8-hour shifts to ensure that orders were fulfilled and customer satisfaction remained high. Our snack food businesses, Yonghong and Yao Taitai, also showed strong growth, showing that strong traditional brands can tap online channels for new growth.

The uplift from e-commerce and the strengthening economy overall should make for a strong year end. The middle class continues to rise, consumption grows, policies are favorable and a weakening RMB probably is having a stimulative effect.

We look forward to updating you in more detail at year-end.
 

During our most recent Annual General Meeting, Lunar Capital Partner Robin Song led a group of investors to meet with the Chinese Association of Small-Medium Sized Enterprises (CASME) in Beijing to learn how public and private financing is helping small-medium sized enterprises move up the value chain to become listed enterprises on China’s domestic stock exchanges. SMEs in China possess local products and services, innovation and new technologies, but require investment capital to monetize their competitive advantages, modernize management, gain capital markets expertise and – perhaps most importantly – deliver a solution to succession issues. More than 11 million of these enterprises lie within Lunar’s target revenue and EV scale.

As China’s moves towards a “new normal”, it is evident that the capital markets and investment industry will also need to continue to evolve in parallel. Over years of engaging with local entrepreneurs and domestic financing channels, we have observed firsthand that needs are shifting – entrepreneurs are now eager to source capital from those capable of “driving the vehicle” and are reluctant to take on “pure speculative investors” who simply want to go along for the ride. Similarly, domestic investors are taking a much more professional and stringent approach towards allocating capital and are no longer chasing “miracles”. Local authorities have noted these trends, and understand that more robust capital structures will help relieve economic pressures on businesses and their communities.

From the visits with CASME and discussions with regulators, it is clear that this form of economic development can be divided into two overlapping “triangles”. The first encompasses industry, the market and resources. The type of industry is driven by the characteristics of a specific region, its marketplaces, and its native resources. The second triangle is made up of the enterprise or business, its city and the relevant government agencies. Business is the central theme of the second triangle, the city its carrier, and government supports and facilitates commerce. These two triangles can be summarized in a simple statement – “Government should follow market-oriented principles, leveraging the city to organize and mobilize resources, to cultivate leading enterprises in a specific region to develop comparative advantages”. Professional investment management firms or financial institutions can accelerate the development of these SMEs, through the combination of industry acumen and finance prowess.

In modern China, all levels of government are faced with the challenge of ensuring that their local SMEs’ balance sheets are strong, or well financed. Weaker enterprises should be left to fail or simply fade-out, with minimal intervention from the government, which should focus on supporting enterprises with the potential to create products and services demanded by consumers. These enterprises can in turn create jobs and generate stronger tax proceeds in the future. Additionally, government should no longer solely allocate capital to SOEs, but rather promote state-owned and private capital investing in privately run businesses with potential to become domestic champions. Government and policy should encourage state-owned capital to invest in private enterprises through investment fund vehicles such as fund of funds, to help develop these enterprises and to introduce operational best practices. Government can act as a leader in establishing links between urban and industrial development, and strengthen tax incentives and subsidies for private business and investors. Tax relief programs for professional investment managers (such as private equity firms like Lunar Capital) can encourage private investments and stimulate economic activity at China’s current stage of development.

Robin Song, Partner, Lunar Capital

China’s rising consumer middle class, driven by urbanization and rising per capita consumption levels will drive global growth and analysts estimate that the effect could be greater than that of the post-war baby boomers of the west. China’s working class, aged 15-59, is expected to swell by an additional 100 million people in the next 15 years and will bring domestic consumption from $2.5 trillion to 6.7 trillion, according to McKinsey research. These consumers are increasingly optimistic about their upward mobility compared to their western peers and are consuming for lifestyle and premium experiences.

These themes will continue to play well for Chinese consumption in the near and long-term.  We are also seeing positive momentum drivers in babywear and kidswear, as we enter a “third baby boom” in China. Fertility rates are expected to remain high, average childbearing age remains between 25 and 30, and China’s one-child policy has effectively dissolved following the government’s 5th National Plenum. Couples are now evaluating having – and paying for – a second child and in the next few years, the number of additional newborn babies is expected to range from 1.5 to 4 million per year. This will have a profound impact on China’s economy, by boosting consumption and also gradually improving demographic disparities. More newborns supported by increasingly wealthy mothers and fathers will mean strong sales opportunities for our leading babywear and kidswear brands, Yeehoo, Peekaboo and I Pinco Pallino.

The rising demand potential from China’s increasingly large number of newborns has attracted foreign brands, such as Disney, which have established market share across clothing, toys, books, and educational supplies. Domestic brands are simultaneously strengthening their own product offerings, acquiring knowledge and capabilities to provide key products for the growing children’s marketplace, such as strollers and car seats. The space has also drawn attention from capital market participants, with investment capital targeting the full value chain, from tech investors investing in online maternal and infant retailers, to media investors focusing on animated children’s films.

Children’s wear is a central and investable theme and along with toys, diapers, and food, account for nearly 50% of the total children’s consumer goods industry, which according to the China Research Center for Children’s Industry is expected to grow at a CAGR of 15%. Children’s wear specifically is expected to nearly double from RMB 116 bullion in 2013 to approximately RMB 200 billion in 2018.

Brands must focus on design, quality and safety to attract consumers and capture these rising trends. Consumers in China prioritize functionality, brand recognition and safety of products over pricing and are willing to pay a premium for safe and reliable products. Additionally, companies must provide convenient online and offline distribution channels for parents looking to shower their kids with products and clothing. For brands like Yeehoo and I Pinco Pallino, that can execute on high product quality and strong distribution channels, China’s new wave of children represents a massive and sustainable growth opportunity for years to come.

As China addresses the sustainability of high growth rates and economic rebalancing away from export-and manufacturing-led growth, outlook for domestic consumers continues to grow increasingly positive as disposable incomes rise and unemployment remains low. China’s middle class, now more than 200 million, can afford basic necessities and are pursuing premium products and a well-balanced lifestyle with an emphasis on health, family, and “socializing” the shopping experience.

Consumption to improve quality of life

McKinsey’s consumer sentiment survey recently noted that 55% of Chinese believe their income will grow significantly over the next 5 years, compared with less optimistic views from American and British consumers, at 32% and 30% respectively. These expectations lead to greater pressure on the Chinese working class to purchase expensive real estate, maintain higher-paying jobs, and start families.

A survey conducted by Tsinghua University revealed pressures are mounting – 88% of respondents consider themselves “generally fatigued” and 53% are not satisfied with their physical and mental health. Furthermore, more than 60% of civil and white-collar workers said pressure was largely driven by the requirement of buying a home and paying a mortgage.

As a result, the middle class is becoming more attentive to health and wellness, driving a renewed focus on premium products and services, nutrition and balanced diets. Western fast food, which historically experienced strong growth in China, is on the decline as more consumers become aware of the negative health consequences and obesity issues. Consumption of carbonated drinks is also down markedly, while more people are drinking fresh fruit juices.

Government policies are further promoting the awareness of health related issues and in 2011, China’s 12th Five-Year Development Plan formally highlighted the nutrition and health food industry. Mintel, a market research firm, expects sales of vitamins and dietary supplements to reach USD 5.3 billion by 2017, more than double the level from a decade ago. This transition is creating opportunities for brands to address more health-conscious consumers. Within our portfolio, Yao TaiTai and Yonghong are launching healthier concept products to capture the rising demand.

Shopping as quality family time

While China is the world’s largest e-commerce marketplace, with a US$600 billion market compared to around US$ 350 billion in the U.S., the consumer experience is still driven by the brick-and-mortar experience. Many consumers prefer shopping offline, but the gap is narrowing as consumers enjoy the convenience of online shopping. The concept of “Retailtainment”, in which consumers socialize around the shopping experience, is becoming increasingly important in China. Two-thirds of consumers say that eating out and shopping is one of the best ways to enjoy their time with family. Property developers are analyzing the use of creative space in shopping malls to offer destination-style experiences with one-stop shopping, dining and entertainment experiences to address the needs of an entire family.

Consumer brand loyalty growing as rewards kick in

Chinese consumers are more attentive to loyalty rewards and the benefits of VIP-shopper memberships. This is fueling the trend that consumers typically stick with one or two specific brands in each category and are less likely to switch to brands outside their “core list”. This helps to address long-standing concerns in China around brand loyalty. However, it also results in increased marketing and promotional costs to achieve customer conversion, especially in entrenched industries like apparel.

Within Lunar’s portfolio, Little Star Brands Group was an early adopter of brand loyalty programs and now boasts a sizable VIP-shopper database allowing products to be directly marketed to a consumer base that is actively engaging with promotional content. Our brands are also able to creatively work to selectively cross-sell product offerings, which we anticipate will result in a number of interesting strategic partnerships in the near future. 

In conclusion, do not sell the Chinese consumer short! The opportunity for operational improvements, the changing customer behavior we are observing, and the continued drive for a better quality of life in China will mean phenomenal opportunity for our consumer businesses in the years ahead.