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Crisis or Opportunity?

What China's 3rd Child Policy

Means for Consumer Investors

L Catterton Consumer Insights

October 2021

1

Introduction

On May 31st, 2021, the Chinese government released its latest population policy, lifting the number of

children allowed per family from two to three. The explicit gesture towards birth encouragement was

unsurprising, considering the staggering 10% annual drop in China’s birth rate since 20171. What sent

a shock wave across the system, instead, was the sweeping education reform which quickly ensued. In

July, the government banned new K12 after-school tutoring businesses from opening, required the

existing ones to convert into non-profit organizations, prohibited their public listings and imposed

restrictions on foreign capital raising. Combined with the ongoing crackdown on the technology sector,

this news triggered a $1.5 trillion sell-off of Chinese stocks on global exchanges2.

Though seemingly unrelated, the third child policy, the education reform, as well as a string of auxiliary

regulatory changes targeted at inflated property prices, white-collar working hours and more stem from

the same goal – to alleviate the growing financial burden on Chinese families, so they can supply the

population base necessary to drive China’s next phase of economic growth. But are these sweeping

reforms enough to reverse China’s falling birth rate? How will families, consumer businesses and the

market react in the medium-to-long term? Ultimately, who will be the winners, and who will be the

losers?

In this piece, we take a deep dive into China’s demographic challenge by analyzing its root causes, the

potential impact of remedial policies, and the implications for investors in the consumer market.

Figure 1: Timeline of birth-related policies in China

1 National Bureau of Statistics 2 https://www.bloomberg.com/news/videos/2021-07-28/why-china-s-stock-market-is-selling-off-video

2021May 11

2021May 31

2021Jul 22

2021Jul 5

…

20162011

The 7th census

showed

newborns

dropped 18% to

12mm

All parents

allowed to have

a 3rd child

School-district

zoning restricted

in select cities

Unprecedented

crackdown on

K12 tutoring

All parents

allowed to have

a 2nd child

Parents without

siblings allowed

to have a 2nd

child

2nd Child Policy 3rd Child Policy and Related Regulations

1982

Parents only

allowed to have

1 child

…

1-Child Policy

2

Figure 2: Stock performances of China’s leading tutoring companies

Where did the babies go?

A quick glance at the numbers and one understands why the Chinese government has been alarmed into

action. The number of new births has plunged from 18 million in 2016 to 12 million in 2020. The current

fertility rate3 of 1.6 children per woman falls far short of the replacement rate of 2.1, spelling a future with a

shrinking population, and more problematically, a downsized workforce for the world’s most populous nation.

The culprits for the contraction in China are many. The rising cost of urban family life, the infamous

“996” work schedule (whereby employees work from 9 AM to 9 PM, six days a week) normalized by

startups and tech giants, as well as the proclivity for extended singlehood and courtship amongst the

country’s millennials and Gen Z have all conspired to delay, if not discourage, procreation. Adults in

China today seem simply too financially strained, too busy and too self-focused to have babies.

The intense level of competition in China’s education system has only exacerbated the situation. For

decades, after-school tutoring has exerted financial and mental stress on academically-motivated

parents and students. Worried about being out-competed, driven families cram their children’s already-

full schedules with supplementary classes, spending up to $43,500 per year on after-school tutoring for

a better chance of being accepted by a top academic institution4.

3 An estimate of the number of babies a woman would have over her lifetime; https://www.nytimes.com/2020/01/16/business/china-birth-rate-

2019.html 4 https://www.scmp.com/news/china/society/article/2176377/chinese-parents-spend-us43500-year-after-school-classes-their

-100%

-80%

-60%

-40%

-20%

0%

20%

Jun-21-2021 Jun-28-2021 Jul-05-2021 Jul-12-2021 Jul-19-2021 Jul-26-2021

TAL Education (NYSE:TAL) New Oriental Education (NYSE:EDU) Gaotu Techedu (NYSE:GOTU)Normalized as of Jun-21-2021

60-75% market value lost over three trading

sessions for large Chinese education stocks

3

Unsurprisingly, the government has unleashed a bout of regulatory changes aimed at addressing each

of these pressure points, with education being the first and main target. The recent reform effectively

put an end to after-school academic tutoring programs, but it remains to be seen what activities will fill

the gap. Meanwhile, a host of supplementary policies, such as the removal of select urban school

zones that previously drove real estate price inflation5, a new law that deems it illegal to require

employees to work 72 hours a week (as was the case with “996” schedules)6, and the tax deductions

afforded to parents with three children7 have collectively signaled the government’s resolve to make

raising children less daunting and more appealing to its citizens.

However, these multi-pronged, strictly-enforced policies may not be enough to reverse the trend of

declining births. According to a forecast by the Boston Consulting Group, while there will be a

slowdown in the pace of decline following the new policies, the number of newborns will still drop by

3-5% year-on-year from 2021 to 2025. Experts concur on this range, suggesting that the new measures

will at best mitigate the drop by 0.5-0.6 million babies per annum8, and impact mainly lower-tier cities.

Similar to tackling climate change and income inequality, resolving a demographic crisis will take a

long-term, consistent, and comprehensive set of political and social changes. One would be naïve to

expect the issue to disappear overnight.

Figure 3: Number of newborns in China, 2010-2025 (million babies)

5 https://www.scmp.com/business/china-business/article/3141444/houses-beijings-top-school-district-lose-allure-young 6 https://www.protocol.com/china/china-996-overtime-era-ended 7 https://www.china-briefing.com/news/china-releases-supporting-measures-for-three-child-policy/ 8 https://mp.weixin.qq.com/s/r6KEnbGqiw1L5e5jEJ17YQ

20

14

20

13

20

15

20

25

E

20

10

20

11

20

16

20

17

20

12

20

18

20

19

20

20

1616 16 16 17 17

1817

1515

12

9

-5%

Number of newborns in China, 2010-2025, (million babies)

Source: National Bureau of Statistics, expert interview, LCA analysis

4

Given this outlook, how should investors view deal opportunities in the Chinese market, especially in

the maternity and children (M&C) space? Where might investible opportunities lie, underneath the

shrinking headline numbers? As consumer-focused, insights-driven investors, we have backed

numerous distinctive M&C businesses in our 32-year history, including the Honest Company, Zarbee’s

and Plum Organics. Informed by our experience investing across economic cycles and demographic

shifts, we believe that challenges also breed opportunities. In the next section, we review key consumer

segments and business models that could serve as growth engines in the space, particularly in relation

to post-90s moms, parents in third- to fifth-tier cities, and outbound opportunities.

Opportunity #1: Post-90s (九零后) moms

Post-90s moms represent around 60% of China’s new mom population today. Compared to their

predecessors, they are more sophisticated in evaluating product formulations, efficacies and designs,

and are more focused on their own wellbeing when pregnant and when raising children. As such,

premiumization tendencies among such consumers and the penetration headroom of new product

categories in this group represent pockets of growth even amid declining birth rates.

Figure 4: The post-90s generation has become the major mom cohort

Indeed, brands catering to these self-caring, high-spending moms have emerged. For example,

premium maternity personal care brand Evereden promotes a five-step baby skincare ritual – including

body and hair wash, massage oil, body lotion, face lotion, and bottom balm products – all made with

100% organic ingredients. Another of the brand’s top-sellers is its Golden Belly Serum, which uses the

same botanical active ingredients that can be found in luxury facial serums to prevent stretch marks.

Care for their own wellbeing

Ingredient & function savvy

Design & IP savvy

>80% of post-90s moms “care more about their own physical health and appearance” in 2021 than in previous years

90% of post-90s moms want “more specific functionalities that suit my baby”

72% of post-90s moms “prefer unique designs in baby products to make my baby stand out and shine”

Age composition of moms

62%

53%

2018 2019

57%

2020

Post-90sPre-85 85-90

Characteristics of post-90s moms

Source: Babytree (N=3,564) Source: iResearch (N=2,500)

5

With premium product quality at price points 2-5 times higher than peers’, Evereden has created and

occupied a white space in the market, which did not have a sizable audience until this generation of

new moms showed up.

Figure 5: Evereden caters to new moms looking for premium products

It is worth noting that a key caveat in pursuing this premiumization thesis is the size of the total

addressable market, which may be limited by the relatively high price point and the niche nature of the

relevant product categories. Therefore, to win with this strategy, premium brands must be equipped

with superior capabilities in brand-building and storytelling, in addition to product development. For

those in search of a more sizable slice of the pie, the mass market presents an alternative opportunity,

which we turn to next.

Opportunity #2: Parents in third- to fifth-tier cities

As stressful lifestyles pervade the metropolises, tier 3-5 cities are expected to contribute over 80% of

China’s newborns in the foreseeable future9. Consumers in this market exhibit drastically different

shopping preferences than their peers in tier 1-2 cities. They tend to be more price-sensitive, less

focused on technical functionalities, and most importantly, they purchase from much more fragmented

and localized channels. In these lower-tier cities, M&C stores represent the largest sales channel (43%

market share vs. 28% in higher-tier cities). Within this channel, 78% are single-store businesses and

only 2% belong to chains with over 10 stores.

9 https://mp.weixin.qq.com/s/GPeC9wg3YwcS07DecEpzmg

6

Figure 6: Channel structure in higher- vs. lower-tier cities

Given the channel fragmentation, brands looking for success in lower-tier cities need to be able to

penetrate a vast network of dispersed points of sale. Besides building this capability in-house, brands

can also rely on ecosystem enablers to break into hyperlocal neighborhoods. Hipac is one such an

enabler, helping over 8,000 brands get on the shelves of more than 220,000 M&C stores10 across the

nation. Leveraging local market insights, the company also helps brands incubate customized SKUs to

appeal to customers. For example, in 2019, Hipac collaborated with Pampers to launch a “Gold

Pampers” product, which offers enhanced absorption features to address parents’ habit of changing

diapers only once every night in lower-tier cities11.

Figure 7: Hipac’s tailor-made product for Pampers featuring enhanced absorption features

10 From company website 11 https://mp.weixin.qq.com/s/t11kteuEvebu3U7RY-jmag

>10 stores 6-10 stores 2-5 stores

19%

1 store

2%

78%

1%

Size of M&C stores in China’s lower-tier cities

Source: Hipac 2020 survey

48%

30%

28%

43%

24% 27%

Higher-tier cities Lower-tier cities

Ecommerce

M&C stores

Other offline

100%

Source: Kantar Worldpanel

Channel split of M&C category by retail sales in 2020

7

Opportunity #3: Outbound brands

Yet another emerging strategy is to go overseas. The so-called “outbound brands” leverage China’s

hyper-efficient supply chain networks to ship direct-to-consumer (DTC) products at a fraction of the

costs of international competitors and delivery at a much faster speed. Leading players in this space

include Shein, Patpat, and Hibobi, all of which have developed childrenswear lines. Shein, already a

formidable global fast fashion player on track to reach $15 billion in annual sales, focuses its kids’ line,

which is simply a downsized version of its women’s products. Patpat has become the largest pure-play

childrenswear outbound brand, reaching $200 million in global sales in 2020 and raising more than

$660 million from Softbank Vision Fund, General Atlantic, and Sequoia China in previous rounds.

Hibobi is a relatively new entrant that differentiates itself by focusing on the Middle East, but it also

aspires to expand into more emerging markets and product categories in the future. Even though

Patpat and Hibobi are each less than 1/20 of Shein’s size today, given the immensity of the $150 billion

global childrenswear market12 and rising ecommerce penetration across the board, we believe a

winner-takes-all scenario is unlikely and that more insurgents can reach scale.

An increasingly salient challenge to this strategy, however, is the heightened ESG risks associated with

the fast fashion business model. Some businesses are already facing consumer backlashes and

regulatory scrutiny related to labor practices and supply chain opacity, so brands will have to balance

productivity with social responsibility more thoughtfully going forward to sustain their growth and

consumer appeal.

Figure 8: Patpat and Hibobi websites

12 Euromonitor

8

Looking beyond the maternity and children market …

While the M&C market is the most directly impacted by China’s demographic shift and regulatory

changes, these developments hold broad implications for the entire consumer market. Secondary

effects spill into sectors including education, pet, and consumer health, just to name a few. As after-

school academic tutoring becomes restricted, lessons in non-academic disciplines such as the arts and

sports are likely to gain traction. As urban adults stay single for longer, they increasingly turn to pets for

emotional companionship. One can therefore expect an acceleration in the humanization of pets and

the premiumization of pet products. Finally, as China’s population distribution tilts towards seniors,

chronic disease management and elderly care will likely see an increase in demand, and so will the

broader “silver hair economy”.

Amidst structural shifts in the economy and the accompanying regulatory changes, players in China’s

consumer market continue to adapt, evolve, and self-disrupt. As insights-driven, consumer-first

investors, we at L Catterton remain laser-focused on how the market behaves alongside the changing

landscape. As always, we look forward to being the partner of choice to distinctive entrepreneurs as

they navigate the changing waters to build world-class brands.

9

About L Catterton

With $30 billion of equity capital across its fund strategies and 17 offices around the world, L Catterton is the largest global consumer-

focused private equity firm. L Catterton's team of nearly 200 investment and operating professionals partners with management teams

around the world to implement strategic plans to foster growth, leveraging deep category insight, operational excellence, and a broad

partnership network. Since 1989, the firm has made over 250 investments in leading consumer brands. For more information about

L Catterton, please visit www.lcatterton.com.

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