As the economy slows and midtier brands lose favor with consumers who are switching to premium brands and to shopping online, China's retail sector is changing.
The result is that private-equity firms that once bet on sky-high consumer growth are now buying into restructuring situations or into companies that cater to more-sophisticated tastes.
“Going from a founder focused on growth to a team focused on modern management techniques is a hard curve for Chinese companies,” said André Loesekrug-Pietri, chairman of private-equity firm A Capital, which has invested in the sector. “Retail is not only about branding and fast growth but about efficient inventory management and logistics.”
For the private-equity firms that buy into retailers, the mission has to go beyond helping them open more stores, says Weiwen Han, a Shanghai-based consultant at Bain & Co. “Pure growth capital has hit a wall.”
Retailers in China are battling a number of challenges. The economy is slowing but wages continue to rise, affecting costs. Meanwhile, competition is growing, not just from foreign brands, but also from online shopping channels. Hardest hit, say analysts, are those brands that haven't built up nationally by expanding into second- and third-tier cities—developed provincial capitals and prefecture or country-level city capitals—where consumer demand is still strong.
“Their products aren't cheap enough, or they don't have a premium brand that appeals to Chinese consumers,” said AlixPartners Asia head C.V. Ramachandran.
Two firms that have been hurt by China's changing consumer landscape are TPG Inc.-backed sportswear-maker Li Ning Co. and Bain Capital-backed retailer Gome Electrical Appliances Holding Ltd.
Both are trading near multiyear lows after posting losses in 2012 and are restructuring. Li Ning is focused on cleaning up its inventory and Gome on boosting its online presence.
TPG has seen shares in Li Ning fall 29.2% since it bought convertible bonds of the sportswear company in January 2012. The private-equity firm is leading the charge behind a three-year restructuring plan begun last July to help the firm reduce its inventory as well as introduce new products more quickly. Li Ning said in March that its bottom line should improve this year, although the first half is likely to “remain challenging.”
China's sportswear industry has been weathering not just competition from foreign brands like Nike, but a shift in tastes.
“The Chinese are differentiating between wearing athletic versus casual wear day-to-day,” said William Shen, Hong Kong-based partner at private-equity firm Headland Capital Partners Ltd.
Gome, in which Bain Capital bought $233 million worth of convertible bonds in June 2009, said in December it plans to integrate its e-commerce platforms, in an attempt to catch up with online competitors such as retail site 360Buy.com. Since Bain Capital converted its bonds to equity in September 2010, Gome shares have fallen almost 30%. Bain Capital declined to comment.
Even once-hot companies such as women's shoe retailers Daphne International Holdings Ltd. and Belle International Holdings Ltd. are down more than 30% this year. However, the private-equity firms have done well from those investments. Daphne shares are more than 90% higher than where they were when TPG bought in in May 2009. TPG has yet to exit. Belle investor Morgan Stanley bought in before the shoe retailer went public in 2007 and exited that year. Morgan Stanley declined to comment.
To be sure, no one is writing off China's retail sector, with retail sales still growing at 12.8% year over year in April. As a percentage of total private-equity investments in China, retail investments fell to 1.5% last year from 3.8% in 2011, according to data from Bain & Co. This year, they have climbed to 3.6% of total private-equity investments.
But private-equity investors that focus on expanding the company rather than restructuring will need to be picky. Kidswear has been one choice among business models that cater to more-sophisticated tastes.
Shanghai-based private-equity firm Lunar Capital Management invested $100 million for a controlling stake in babywear brand Yeehoo Group Ltd. in January 2012. Yeehoo sales rose more than 40% last year, a person familiar with the matter said.
Another example is Warburg Pincus LLC's $55 million investment in China Kidswant Investment Holdings Co., which not only sells children's clothes, but also offers ballet, photography and exercise classes in its stores. Warburg declined to comment on sales growth at Kidswant.
Supermarket chain Yonghui Superstore Co. has tried to distinguish itself by focusing on fresh food, at a time when Chinese consumers are searching for high-quality food. Its shares are up 8.1% this year, outperforming the benchmark Shanghai index.
“Today, you have to be a great operator to grow a network of stores, focusing on unique products or services, category management and customer loyalty,” said Headland Capital's Mr. Shen. Headland bought into Yonghui in 2007, and has since cut its stake to 16.5% from 24%.