Future of Alternatives 2025: Success in China Will Require a Robust and Consistent Strategy

PREQIN SPECIAL REPORT:

THE FUTURE OF ALTERNATIVES 2025

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China’s consumer retail industry is booming, but investment success will depend on a rational, capital-market-driven investment strategy

China’s private equity & venture capital (PEVC) industry is getting increasingly competitive, with capital surging into the country’s vast consumer market. In this environment, simply investing in this fast-growing market will no longer guarantee the future success of fund managers. Going forward, GPs investing in Chinese consumer companies will need a robust valuation and disciplined capital-market-oriented investment strategy to profitably monetize their portfolios by 2025.

These two factors should be especially top of mind for PEVC investors right now. The consumer retail sector in China has been an unusual hotbed for private market investment activity this year. In the face of further deteriorating geopolitical relations with the West, domestic household spending is seen as a primary driver of China’s future growth. Investors have responded quickly, snapping up stakes in consumer companies expected to benefit from more inwardly oriented economic policies.

Investor appetite has pushed valuations skyward. In the public market, China’s largest bottled water maker, Nongfu Spring, experienced a very warm welcome for its Hong Kong IPO. Its book was covered dozens of times and ‘mega-long funds’ were clamoring for a piece of the offering. Most impressive was the company’s IPO valuation of 35x price-to-earnings (P/E) of 2021 projected net income – it traded at more than 50x P/E ratio for its 2020 earnings post-IPO. Consumer retail companies are typically valued at 20-25x, a measure of the optimism surrounding these companies. 

Valuation Methodology Matters

Public appetite for the sector has been spectacular, but it is encouraging a worrying new trend in private market valuation methods. Unlike Silicon Valley-based VCs, which rarely make investments in the consumer retail industry, China-based PEVC fund managers expect investments in consumer retail start-ups to achieve impressive levels of return – just like that of popular internet and technology companies. To achieve this, domestic GPs encourage heavy subsidizing of customer acquisition and revenue growth regardless of profitability on the road to a quick exit via IPO. However, this approach is unsustainable, as seen with recently delisted Xiamen-headquartered Luckin Coffee, which pursued this strategy before its accounting fraud was exposed by China’s Ministry of Finance earlier this year.

Consumer retail business models are completely different from technology ones. Successful investment tactics applied in technology start-ups do not translate seamlessly to consumer retail, despite both industries valuing large customer bases and gross merchandise value (GMV). Indeed, brand perception and long-term profitability are the core drivers of success in consumer retail companies. These factors depend on years of providing quality products, services, and consistent marketing, all of which cannot be realized over a short period of time. 

Lacking profitable cash flows, PEVC fund managers backing consumer retail start-ups have increasingly come to rely on price-to-sales (P/S) ratios. This practice is now seen across traditional food & beverage businesses, cosmetic products, and newly minted retail brands, leading to a growing number of investments at highly inflated valuations. As demonstrated by historical data, most of these deals have a very low chance of ever being exited successfully in the future. Indeed, some retailers with more than $1bn in revenues are still deep in losses – with profitability far out of reach.

With IPOs in the US and Hong Kong likely to remain the primary method for PEVC funds exiting Chinese companies for the foreseeable future, investors need to remember that public capital markets have always valued the consumer retail industry on a P/E basis. To set up for a profitable exit, investment strategies in the private market must consistently adopt the valuation methods applied by the public market. This disciplined approach is especially important for funds jumping into the consumer retail deal mania this year, as their portfolios plan for fast-approaching exit timelines over the next few years. 

LPs Expect Disciplined Investment Strategies

While institutional investors and start-ups have traditionally valued, and will continue to expect, both capital and resource contributions from their GPs, they are increasingly demanding a more disciplined and consistent investment strategy. Moreover, LPs are becoming ever more vigilant of   possible turns in liquidity conditions and the business cycle, motivating institutional investors to look beyond brand names to find fund managers that are methodical and sustainable. 

There is no shortage of fund managers in China’s PEVC industry, which boasts almost 10x as many firms as the US. Spoiled for choice, international LPs have become more selective, searching for local teams with tested strategies that can be repeatedly applied to many investment opportunities. This sustainable strategy has become even more crucial and necessary for LPs than analyzing each specific investment made by a particular fund. Faced with the current boom in consumer retail and subsequently inflated valuations in the sector, LPs investing in China should continually monitor GPs to ensure adherence to a disciplined investment approach. 

Spoilt for choice with investment opportunities, today’s GPs will need to articulate a disciplined and consistent capital-market-oriented strategy for every investment to both LPs and company founders. There must be a clear roadmap to future success to remain competitive in China’s rapidly expanding PEVC market.