Portfolio: YPX and China casual dining

Yum Brands, the behemoth behind restaurant chains such as KFC and Pizza Hut, has more than 6,200 outlets in China; McDonald's has over 2,000. Yet these two groups' combined share of the Chinese quick service restaurant market is 7.7%. The 18 companies that make up the top 20 together account for a further 4.3% last year, according to Euromonitor International.

As many as 500 million Chinese are expected to join the country's nascent middle class over the next decade. Rising disposable incomes are already driving people to seek out a better quality dining experience - they continue to prioritize affordability, but they are willing to pay a small premium for food safety, consistency and a pleasant restaurant environment.

Four years ago, Chris Tay, a Singaporean tech entrepreneur turned casual dining expert, didn't think this consumer demand was being met. Put simply, the growth of China's economy had outpaced the development of its food industry. "Restaurant chains at that time were dominated by fast-food options like KFC and McDonald's as well as higher-end players such as Xiao Nan Guo," Tay says. "There was an empty space in between, and casual dining fell into that gap."

Hans Tung, now a partner at GGV Capital but then with Qiming Venture Partners, adds to the picture of fragmentation but also offers a hint of the payoff for investors capable of guiding a business from start-up to scale.

Like many developing markets, China is dominated by small, family-run and often inefficient restaurant businesses that nevertheless manage to scrape fringe profits in an under-regulated industry. "There were five listed dining chains in China and three had been bought out by other players," Tung observes. "In the US there are 50-plus and Japan has 16."

Concept to reality

This was the context for the creation of YPX Cayman, which operates the mainland China franchise of Taiwan-based casual dining chain Cloud 9. Last month the company received $25 million in Series D funding led by Maybank Private Equity, with participation from existing backers LionRock Capital and Ignition Capital, as well as several individual investors. YPX is now looking to introduce other restaurant franchises, capitalizing on the traction it has gained with China's growing yet still underserved casual diners.

Tung recently became a personal investor in YPX but in 2010 he was at Qiming, examining the potential for a tech-style start-up in the restaurant space. Tay was a logical partner in this endeavor. He had run IT systems for the group that licensed Dairy Queen and Yoshinoya in China, headed up Taiwan food conglomerate Tingyi Holdings' China casual dining business, and launched dairy company Yili Group's ice cream parlor chain.

"Chris has worked for a Hong Kong family, a Taiwan family and a state-owned enterprise, restructuring portfolios and taking them to the next level," says Tung. "He has a scientific, data-driven approach to the fast casual restaurant business."

With the concept and the CEO in place, it took six months to identify Cloud 9 - which has 67 stores in Taiwan - as the franchise of choice. YPX's formative days were challenging. One of the earliest outlets, located next to a railroad in Shanghai, closed down because foot traffic didn't translate into sales: people rushed by in a hurry and didn't want to spend a lot on food. Another two restaurants struggled after opening in 2011 when inflation was at its peak. YPX also once changed the Cloud 9 menu three times in the space of 15 months.

Teething troubles were unsurprising given the company was trying to bed down a concept that had yet to fully establish itself in China. Brand loyalty must be earned over time. "The most difficult thing is to convince people," says Tung. "If a restaurant chain wants to achieve scale, it takes 10 years, and maybe 13-15 years to go public. Even if there is enough capital, you need the patience, you need to build consumers' trust."

Efficiency was also critical to YPX creating a sustainable and scalable business model. Cloud 9 uses three suppliers for all its products; it develops ideas for dishes, devises recipes, and relies on these third-party providers to handle the rest. "We look at ourselves more as a brand operator and as a service provider, not as a manufacturer," Tay stresses.

The restaurant chain addressed the risk of becoming overly dependent on certain chefs by preparing complicated dishes in central kitchens. The cooking facilities in each restaurant are used for the preparation of simple dishes and re-heating, all in adherence with a standard operating procedure. This approach is intended to ensure consistency of taste and allow YPX to focus on expansion relatively unencumbered by the staff turnaround and process orientation issues that plague many restaurant businesses.

"YPX is using a very efficient IT led model of development. All of its stores are very standardized and not chef-dependent. From day one, it has been a very scalable business," says Daniel Tseung, managing director at LionRock.

The company has grown rapidly. From just one restaurant in 2010, Cloud 9's network has increased to more than 40 outlets stores covering Shanghai, Beijing, Tianjin, Hangzhou, Nanjing, Changzhou and Hefei. Sales revenue exceeded RMB100 million in 2013, with more than 3 million customers passing through the doors.

After Qiming put in an initial $5 million to get the business started, a Series B round worth $15 million came in 2011, led by Taiwan's Hotung International. Qiming re-upped, Mitsui Global Capital entered, and several high net worth individuals (HNWIs) made contributions. A further $6.5 million came through a combination of investors exercising warrants and debt financing. LionRock led an $11.5 million Series C round in November 2012, with Qiming and Ignition also participating.

YPX's HNWI backers include the likes of Koh Boon Hwee, former chairman of DBS Bank and Singapore Airlines, and Peter Tan, former Greater China president of McDonald's and ex-Asia Pacific CEO of Burger King.

Network expansion

Of the $25 million raised last month, three quarters will be spent on expanding both YPX's network of directly-owned stores and its franchising system. It is expected that 25-30 new stores will be opened under the Cloud 9 brand next year. The overall target is 225 Cloud 9 outlets in China, comprising 100 franchise stores and 125 directly-owned stores.

YPX has only become a franchisor this year and the most frequently asked question was what would happen to its brand image. These concerns are rooted in the mixed fortunes of franchising in China due to poor monitoring, a mismatch in values between franchisors and franchisees, and unethical practices by franchisors who emphasized short-term gains over long-term brand sustainability.

"I worry about it every day," Tay says. "My strategy for establishing a proper franchise is not to have too many franchisees, but rather have a few operators opening up more stores. I select quality franchisees that have not only financial backing but also relevant management experience in food and beverage industry." By having a small number of franchisees with multiple locations, it is easier for YPX to maintain the brand's reputation.

There will also be further investment into the IT infrastructure that supports the company's franchising system. The objective is to collect and calibrate consumer data in order to identify areas in which efficiency can be improved. For example, YPX will be able to plan purchases of ingredients more accurately, speedily modify menus based on customer preferences, and shorten ordering and payment processes in the restaurants without compromising on the dining experience.

"The biggest challenge is not expansion - 25-30 stores is quite achievable," Tay adds. "The biggest challenge facing any brand in China is manpower." As such, providing the right training program is fundamental to the drive for greater efficiency. The bottleneck occurs at the operational level, with companies typically struggling to persuade the abundance of managers in big cities like Shanghai and Beijing to take up frontline roles elsewhere. YPX's non chef-dependent model is intended to minimize the impact in this area.

For any restaurant chain, the recent food safety scandal that saw McDonald's overhaul its oversight procedures after a supplier was accused of intentionally selling expired meat is a reminder of the supply chain vulnerabilities that can crop up in China. Indeed, offering consumers certainty in terms of sourcing procedures and product quality is a key driver of industry consolidation.

Investors in YPX are actually quite positive on the issue. Yasu Sakoh, chief representative in Beijing for Mitsui Global Capital, points out that, even as the company expands - receiving more products from a wider variety of suppliers - food safety is not a concern provided there is sufficient focus on monitoring and educating suppliers.

Koh, the former DBS chairman who now chairs property developer Far East Orchard and was among YPX's first investors, adds: "I am not worried about YPX's brand image. In any emerging market, every now and then something like this will happen. What YPX constantly emphasizes is the importance of food safety and food handling processes in our company, and I know that Chris has a lot of training programs in this area."

Competitive edge

While these efforts are integral to building consumer confidence and a credible brand image, there are now more rivals looking to do the same within the casual dining space, from Western food chains to local players. YPX responds to the challenges presented by the two groups in different ways.

In the face of competition from Western chains, the emphasis is on making the business relevant and staying up to speed on market needs. Koh stresses that beyond the realm of McDonald's and KFC there remains strong demand for Asian fast food cuisine. As for local competitors, YPX believes its differentiating factor is a focus on marketing, brand management and improving service quality.

"We have our own genre, those in the 18-25 age range who want to eat out but don't want to spend more than MYR40 per person," Tay says. "The menu is not that limited and changes every year." The company's investors assist in this area by supporting the implementation of international standard systems and processes.

In addition to recruiting and retaining talented staff, Keong Pneh Tee, CEO of Maybank Private Equity, sees YPX's major challenge as securing good locations. This means building strong relationship with mall landlords is especially important.

However, Tan, the ex-McDonald's and Burger King executive, believes the youth and freshness of the Cloud 9 brand represents a comparative advantage - it potentially helps draw a broader demographic of customers to the mall.

Buoyed by the steady growth of Cloud 9, YPX is adding two new China franchises to its portfolio over the coming year, an American casual dining brand and a Japanese casual dining brand. "Now the competition has intensified and there are people have more choice, scaling up is not as easy as before, so we have new brands coming in," Tay explains.

In expanding its portfolio in order to increase market share, YPX is following the Yum Brands model of operating multiple brands. There are plans to enlarge the company's store footprint to include western China regions, focusing on cities such as Chengdu in Sichuan province and Kunming in Yunnan. Given the size of the untapped market within China there are no immediate plans to go overseas. Tay says it is also too early to consider exit options, although he wouldn't be surprised if the situation changed after 2017.

"Aside from an IPO, I would not discount the possibility of another private equity firm coming in and buying us out," he observes.

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• Topics
• Venture
• Consumer
• Greater China
• Venture
• China
• Consumer
• Qiming Venture Partners
• Maybank
• Lion Rock Capital