Photographer: Daniel Acker/Bloomberg

Bad Burgers Are Gold to KKR as China Scandals Yield Opportunity

  • KKR is biggest private equity investor in China food sector
  • Modern Dairy investment yielded a return of 300% for KKR

China’s continual food safety scares haven’t spoiled the appetite of Julian Wolhardt, one of KKR & Co.’s top executives in the country. In fact, they’ve been good for deals.

He spent more than two years trying to persuade the chairman of China’s largest chicken breeder and processor, Fujian Sunner Development Co., to accept an investment from KKR, arguing that private-equity backing could help the company take market share. Fu Guangming kept saying no, even after the outbreaks of avian flu in 2013 and early 2014 hurt the poultry industry.

Julian Wolhardt

Source: KKR & Co.

Then, in July last year, Wolhardt got a break. News broke that the Chinese supplier to McDonald’s Corp. and Yum! Brands Inc.’s KFC had been repackaging old meat as new. Amid the outcry that followed, Wolhardt redoubled his efforts. Fu relented. The next month, KKR agreed to buy a $400 million stake in publicly traded Sunner, its biggest investment in China’s food sector.

More than any other buyout firm, KKR has wagered that China’s recurring food-safety scandals can yield windfalls for an investor willing to shoulder the risk. The New York-based firm has spent about $1 billion on five food-related investments in the world’s second largest economy since 2008, spanning everything from milk to fish feed.

Opportune Time

The aftermath of a food scandal is an opportune time to buy, according to Wolhardt: Owners are more willing to sell and rival companies are often battered by the event.

“If you’re a company, when a market incident happens, you want to work with an investor like us to really take advantage of the market downturn,” Wolhardt, 42, said in an interview last month.

China’s food safety hasn’t kept pace with an economic expansion that’s lifted hundreds of millions of people out of poverty since free-market reforms began in 1978, fueling demand for everything from poultry to milk and beef. Scandals ranging from babies poisoned by tainted milk powder to dead pigs found floating in a river serve to regularly remind consumers that the produce they eat might not be safe.

Dairy History

Three of the food deals KKR has struck in China track a similar pattern: They were made amid a food scare and followed by an overhaul of supply-chain procedures, along with expansion plans designed to take advantage of competitors’ weakened positions.

"Everyone knows food safety," said David Liu, 45, KKR’s co-head of private equity in Asia. "There’s interest in the sector, but I don’t think people have done as many deals as we have and made the kind of returns we have."

Before joining KKR in 2006, Liu and Wolhardt worked together at Morgan Stanley’s private equity arm. There, they led a $26 million acquisition of Inner Mongolia Mengniu Dairy Co. in 2002 -- the first foreign private-equity investment in China’s dairy industry.

KKR sealed its first food deal in China in September 2008, a $150 million investment in China Modern Dairy Holdings Ltd. At about the same time, one of China’s biggest-ever food scandals was breaking. Milk and infant formula containing the chemical melamine killed six babies and sickened an estimated 300,000 more. Parents flocked to Hong Kong in search of safe milk powder.

Farm Expansion

As the scandal engulfed some competitors, KKR moved to boost production. Modern Dairy accelerated expansion of farms, increasing its number of dairy cows by almost eight times to 180,000 in the five years after KKR bought its stake. KKR executives spent 16 months working with Modern Dairy management on everything from improving the feed mix for cows to cutting electricity and water usage, according to Liu.

"The crisis is actually a catalyst, because without the incident, people will never bother to tell good milk versus bad milk," Liu said. "When you had the melamine crisis happen, the biggest benefit to us is people are willing to pay a premium for quality milk."

Modern Dairy went public in 2010 and in 2013, KKR sold most of its stake to China Mengniu Dairy Co. -- earning the firm a roughly 300 percent return on its investment. Another dairy investment, Asia Dairy Holdings, has yielded a 250 percent return in about two years. Sunner shares are trading 71 percent higher than the price KKR bought at.

KKR’s first foray into China’s pork industry followed another food fiasco. In March 2013, more than 10,000 dead pigs were found in Shanghai’s Huangpu river, prompting the local government to increase food-safety checks. Three months later, KKR announced a $150 million investment in a meat-processing unit of Cofco Group.

Risky Business

To control disease, KKR reviewed the key vaccines Cofco was using and put newly added hog farms close to slaughtering facilities to enable tracing of every pig’s origin. It set out to increase the number of pigs born, raised, and sold to market by one single sow to about 50 percent above China’s average.

Huge gaps in the government’s enforcement and inspection capabilities make investing in China’s food sector a risky business, according to Paul O’Brien, an analyst at Hangzhou-based ChemLinked Food, an industry researcher.

“Last year’s meat scandal proved that no investment, regardless of the financial stakes or reputation of the stakeholders involved, is insulated from the threat of scandal," he said.

Success in China’s food industry requires more than investing savvy, according to Wolhardt. When KKR invested in Modern Dairy, he lived at one of its farms during the entire due-diligence period to learn the ropes quickly. Two years before KKR even bought into Sunner, he was discussing with Chairman Fu how to make its chicken feed more digestible. Wolhardt regularly attends the annual World Dairy Expo in Wisconsin, a five-day event showcasing the newest technologies available to the industry.

Then there’s the power of experimenting. Wolhardt said he discovered that jabbing cows with vaccine shots while they’re standing still and milking will stress them and hurt production. Testing the pH value of cow manure and checking whether it contains corn kernels can reveal whether the animals are digesting well. And while reading up, his team came across studies that suggested playing classical music will improve milk yields.

"So we started playing music in our milking parlor to really focus on creating a stress-free environment,” he said. Yields rose, and Wolhardt learned another lesson: “Some cows prefer Mozart.”

Before it's here, it's on the Bloomberg Terminal.