Little Sheep: Deal of the year as featured in The Deal magazine

British farmers have long complained that they can’t make a living from sheep. But when U.K.private equity shop 3i Group plc and its Miami coinvestor, Prax Capital Management Co., brought Little Sheep Group Ltd. to market in Hong Kong, profitability was not an issue.

Thanks to a successful initial public offering in June, the investors stand to reap 3.5 times their money on the Mongolian hot pot restaurant chain in realized and unrealized gains. Both still hold just over half their original stakes in Little Sheep.

3i identified Little Sheep as China’s No. 3 restaurant business (after McDonald’s Corp. and Yum! Brands Inc.’s Kentucky Fried Chicken) and the market leader among domestic brands. It pumped $20 million as growth capital, with a further $5 million from Prax, beefed up the management team and persuaded founder Zhang Gang to improve the business before attempting further growth. The company shuttered about 200 errant or badly performing franchises and set up a new operational headquarters in Shanghai, though it retains its home in Baotou, Inner Mongolia. By then, Little Sheep was ready for a stock exchange listing.

“That’s our style of investment,” says Anna Cheung, a partner based in 3i’s office in Hong Kong. “We’re not an investor who puts in some capital and says, ‘See you later. When can I get my money?’ We choose each of our investments on where 3i can leverage our experience, expertise and, in a particular sector, our network.”

Zhang, a former steelworker turned cell-phone entrepreneur and hobby cook, opened his first restaurant in 1999. He refined the local hot pot delicacy of sliced lamb and vegetables dipped in a soup base containing more than 60 spices and herbs. By 2005 he boasted more than 500 franchises.

China’s lack of trademark protection encouraged the founder to quickly build market share before someone else stole his brand. But he neglected to register his trademark until about the time of 3i’s investment in June 2006.

When 3i’s Wang Daizong called him and offered to invest, Zhang was ready for a new financial partner. He talked to Goldman, Sachs & Co., Morgan Stanley and other potential investors, but he was finally persuaded by 3i’s pitch. Wang and Cheung flew in former Burger King International CEO Nish Kankiwala, who had worked on Burger King’s expansion into China. 3i also introduced Yuka Yeung, the chief executive of the KFC master franchisee in Hong Kong, who, after a year as an adviser, eventually left KFC and became chief operating officer of Little Sheep. Wang himself later left 3i to join Little Sheep as CFO.

With characteristic attention to detail, 3i also brought in consultant Roland Berger Strategy Consultants GmbH to examine the burgeoning Chinese market and propose improvements.

When it came to the IPO (with financial advice from Rothschild and with Merrill Lynch & Co. and Deutsche Bank AG acting as joint lead managers, bookrunners, coordinators and sponsors), 3i and Prax were ready to dip into Zhang’s kettle themselves.

The proceeds from new shares the company raised totaled about HK$462 million ($59 million). With the shares priced at HK$3.18, the market capitalization was about HK$3 billion. 3i and Prax, which reduced their holdings from 20.5% and 5.06% of the company, respectively, to 11.32% and 2.83%, received about HK$172 million and HK$43 million after fees and expenses.

They can hope for up to HK$45 million and HK$11 million more, respectively, from the overallotment option. If the greenshoe is not taken up, the shares 3i still owns in the company will be valued at HK$370 million, while Prax’s remaining stake is HK$92.5 million. Both investors are locked in for six months.

The Little Fat Sheep, as the chain is called in Chinese, has been shorn of its valuable wool, but there is still meat on the animal for future dining pleasure.