When the Carlyle Group (CG), Citic Ltd. (0267.HK), and Citic Capital Holdings agreed to buy, operate and manage McDonald’s Corp.’s (NYSE:MCD) massive China and Hong Kong restaurant network in 2017, they held out big hopes for ramping up the Golden Arches’ presence in one of the world’s fastest-growing consumer markets.
Now, that partnership is showing signs of cooling, following reports last week that Carlyle and the two Citic entities were looking to sell down their stakes in McDonald’s largest franchisee outside the U.S. The step isn’t completely unexpected in the current climate, but still marks a sharp departure from the early great expectations expressed by both sides.
The partnership represented one of Carlyle’s biggest deals in China when it was first announced, demonstrating the U.S. private equity giant’s “confidence in the strength of the Chinese consumer,” Carlyle managing director X.D. Yang said at the time. McDonald’s dished out an equally big serving of hype. CEO Steve Easterbrook, the company’s CEO at the time, pointed out that China would soon become the company’s largest market outside of the U.S., and would now have a super-sized Sino-U.S. franchisee as its main partner in the market.
But five years later the market hasn’t been quite as hot as expected, chilled by three years of tough Covid restrictions. Those troubling times have caused a partnership that once seemed rock-solid to show signs of cracks, which were evident in last week’s reports that Carlyle and Citic Capital were seeking a partial exit.
The move may look like an unravelling alliance on the surface. But it more likely reflects the difficulty China-focused dollar funds are facing exiting their investment in the current sluggish IPO market, as well as difficulties created by heightened geopolitical tensions. China’s sluggish economy isn’t helping either.
Carlyle and Trustar Capital, Citic Capital’s private equity affiliate, are setting up a new vehicle to execute their planned partial exit, Bloomberg News reported. Singapore’s GIC Pte and Abu Dhabi’s Mubadala Investment sovereign wealth fund were approached about becoming potential new investors, the report said.
McDonald’s China told Reuters that the partnership’s shareholding structure will not change. Carlyle currently owns 28% of the McDonald’s restaurant business in China and Hong Kong, while Trustar owns 42%. Citic Ltd. owns 10%, and McDonald’s owns the remaining 20%.
Rolling over assets into a new investment entity – typically called a continuation fund – has become a popular way for existing investors to cash out some or all of their holdings as global IPO markets cool. Global private equity secondaries – transactions where an investor sells an interest in an existing private equity investment to new investors – totaled $102 billion in 2022, the second-highest value on record, according to consultancy Zerone.
Exit strategy
Carlyle made its 2017 investment in McDonald’s China from its Carlyle Asia Partners IV fund, a $3.9 billion fund that closed its fundraising in 2014. Citic Capital’s investment came from a fund that began investing in 2017. That means both the Carlyle and Citic funds are now facing rising pressure to cash out of their investments and return the profits to the funds’ contributors, also called limited partners.
China-focused dollar funds are also now facing new challenges due to Sino-U.S. tensions, as well as from Ukraine’s conflict with Russia, which China counts as a partner. Those factors have led many western funds that might normally be interested in a deal like the one being offered by Carlyle and Citic to increasingly shun such China investments.
Carlyle and Trustar are reportedly seeking to raise $4 billion in their latest deal, which would value the entire McDonald’s China restaurant business at up to $10 billion, including debt, according to the Bloomberg report. That would mark a huge increase from the $2 billion the business was valued at when the strategic partnership was formed in 2017.
That surge likely reflects heavy investment in McDonald’s China business – including debt financing – after the partnership launched its “Vision 2022” plan shortly after the landmark deal. That blueprint set a target of 4,500 McDonald’s restaurants in China by the end 2022, nearly double the 2,500 when the partnership was signed. McDonald’s currently has 5,400 stores in China.
While the partnership didn’t slow its rate of new store openings during the pandemic, strict Covid restrictions hit McDonald’s profitability in the country. McDonald’s doesn’t disclose performance of businesses where it holds a minority stake. But it revealed in its 2022 annual report that earnings from China dropped as a result of Covid restrictions.
Citic Ltd. disclosed in 2020 that McDonald’s China provided more than 60,000 free meals to frontline medical workers at the height of the pandemic, and the chain also provided delivery meal service for 1,500 hospitals.
The fresh capital raising also reflects the need for ammunition in McDonalds’ brutal battle with Yum China (YUMC; 9987.HK), China’s largest fast food company, which operates the KFC and Pizza Hut brands in China. KFC is by far China’s biggest fast-food chain with 4.9% of the market, or nearly double the 2.7% for McDonald’s, according to consultancy Horizon Insights.
Yum China owned 12,947 restaurants across China at the end of last year, including 9,094 KFCs, with plans to add up to 1,300 new stores this year. The company is targeting 20,000 stores in the country over the medium term. By comparison, McDonald’s is aiming to roughly double its current store count in China to around 10,000 as a “future milestone.”
Yum China’s status as a dual-listed company in both New York and Hong Kong also gives it an edge over McDonald’s China operations by making fundraising easier as it ramps up its expansion in China’s smaller cities. Yum China’s backers include the likes of global money managers Invesco and BlackRock, which are both stakeholders in the company.
A more immediate threat for both McDonald’s and Yum China is China’s flagging economic recovery. Indicators involving consumption, investment and exports have all pointed to a gloomy picture in recent months. At the same time, the unemployment rate for youth – typically some of the biggest fast food customers – is now around 20% and may worsen.
“I have often stressed that the true indicator of economic growth is the increase in jobs and payroll, as they are fundamental to domestic consumption,” Citic Capital Chairman Zhang Yichen warned in a letter to shareholders in 2020. “When they are severely impacted, future consumption and growth will slow down significantly.”
Disclosure: None.
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