The Global Economic Impact of Private Equity Report 2008 - World ...

y an aggressive franchise strategy, the company’s thinmanagement ranks resulted in very weak oversight of thefranchisees. The problems were aggravated when mediareports began to appear claiming substandard quality andservice in certain Little Sheep franchise stores, inevitablydamaging the brand.At the end of 2002, Zhang faced a critical decision: shouldthe company curtail growth and scale back the franchisesuntil his management team could be strengthened, eventhough this would result in the immediate loss of substantialfranchise fees? Moreover, he would risk alienating a growingroster of franchise applicants who were waiting to capitalizeon the brand and open Little Sheep restaurants. Resistingthe temptation to maximize short‐term profit, Zhang decidedto temporarily halt the awarding of new franchises in thefollowing year. In addition, he initiated efforts to more closelymonitor the performance of the existing franchises, anddesignated one of his long‐time lieutenants, Zhang Zhan Hai,to be in charge of the task.3i’s Investment in Little SheepManagement’s goalGradually, Zhang’s decision to scale back the expansionbegan to pay off. In 2004 the company strengthened itsmanagement ranks significantly by hiring as senior vicepresident of finance, industry veteran Lu Wenbing, formervice president of Meng Niu (Mongolian Cow), a well‐knownInner Mongolia‐based dairy company. Lu brought muchneeded financial discipline and internal control to thecompany and by 2005 Little Sheep’s performance hadclearly rebounded as the company collected a number ofprestigious regional and national business awards, includingthe Little Sheep brand being ranked 95th by the WorldBrand Lab among “The 500 Most Valuable Chinese Brands”.According to Ministry of Commerce statistics, the companyhad the second largest market share among China’srestaurants chains, behind only the fast‐food giant KFC.(See Exhibit 2 for a major‐events time line in Little Sheep’scorporate history up the 3i investment and Exhibit 3 for thecompany’s footprint in China at the end of 2005, just beforethe 3i investment.)Notwithstanding this renewed success, Zhang recognizedthat sustaining the company’s growth would require not onlyfinancial resources but, more importantly, additional industryexpertise. Like many Chinese entrepreneurs, Zhang cameto believe that the ultimate validation for Little Sheep’ssuccess would be a public listing, preferably on an overseasexchange. 4 This would give the company a diversified sourceof capital as well as brand recognition, and subject it tomarket discipline. His preference for an overseas listingwas rooted in his concern about the lax listing standardson the domestic Chinese exchanges; he preferred insteadan international certification. But to prepare for an IPO, hebelieved that the company needed to attract not onlyadditional capital, but a partner with the capability to providemuch needed industry knowledge and expertise. “Whatwe lacked were high-level professionals from the food andbeverage industry who could help take Little Sheep to thenext, higher level... We needed a partner that could helpus prepare for an IPO outside China”, explained Zhang.Origin of the dealLittle Sheep’s extraordinary growth and brand namerecognition attracted many willing investors, includingsuch prestigious investment banks as Morgan Stanleyand Goldman Sachs. At 3i, Little Sheep was spotted byan associate director, Daizong Wang, a Wharton MBA whohad recently joined the group after a four‐year stint withGoldman Sachs in Hong Kong. As 3i’s investment strategyin Asia was becoming more sector-focused, Wang wasassigned to study the food and beverage sector, whichhad been growing at a rate twice as fast as China’s GDPfor over 15 years. As the Chinese economy began to shifttowards more consumption‐led growth, Wang believed thatconsumer‐related sectors such as restaurants would offertremendous upside. (See Exhibit 4 for some growthstatistics of the Chinese restaurant sector.)Wang also noticed that even though the sector wasexperiencing rapid growth, prior to 2005 there had beenno private equity investments due to the lack of scale in typicalrestaurant businesses. Unfazed, he began to analyse themarket share rankings of restaurant chains in China to screenfor investment targets. Little Sheep ranked second, occupying6.2% of the entire restaurant and catering market, behindKFC. 5 Intrigued by Little Sheep’s ability to achieve scale unlikemost other restaurants, Wang realized that the key was thesimplicity of Little Sheep’s business model: “The Chineserestaurant business is fragmented because it is difficult tostandardize. In most restaurants the largest cost componentis the chef, but it is difficult to achieve consistency. Little Sheepis different because customers cook their own food in the hotpot, which eliminates the need for a chef. This do‐it‐yourselfstyle of dining and the ease of standardization made thisbusiness capable of scale.” In fact, these characteristicsmade hot pot restaurants a significant sub‐sector of thetotal restaurant industry, accounting for more than 20% ofall consumer spending on restaurants, with Little Sheep theclear market leader with one third of total hot pot revenue.(See Exhibit 5 for statistics on the hot pot sub‐sector.) Basedon this analysis, Daizong Wang concluded, “From the verybeginning, I wanted to invest in this business.”His next step, in August 2005, was to cold call Little Sheep’ssenior vice president of finance, Lu Wen Bing. After makinghis pitch to Lu, whom Wang found “surprisingly open-minded[about private equity]”, he was invited to a formal meetingin Baotou, Little Sheep’s headquarters. Reflecting on theinitial exchange, Wang said: “At a time when few in Chinaunderstood the difference between private equity and4At the time, the Chinese A‐share market was also closed for new public listings.5According to Euromonitor, Little Sheep has a higher, 9.9% market share among China’s full‐service restaurant chains, excluding fast food.The Global Economic Impact of Private Equity Report 2008 Case studies: 3i Group plc and Little Sheep 133