China’s education sector crackdown hurts foreign investors

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China’s sweeping $100 billion private education reform will wipe out foreign investors from much of the sector and threaten to wipe out billions of dollars in investment from groups like BlackRock, Baillie Gifford, Tencent, Sequoia and SoftBank’s Vision Fund.

The regulations will ban companies studying curriculum subjects from making profits, raising capital or listing on stock exchanges around the world, and will prevent them from accepting foreign investment.

The move could fundamentally damage a sector that has thrived in recent years, leading to massive valuations for the three largest listed US groups, TAL Education, New Oriental Education and Gaotu Tecedu.

The changes are part of the Chinese Communist Party’s campaign to make childrearing and education affordable and to combat a looming population decline that threatens the country’s economic future.

This tightening is also a sign of China’s growing desire to restrict foreign investment in its companies. Chinese regulators are reviewing rules for groups seeking initial public offerings in the United States after ordering a security review of passenger-delivery app Didi Chuxing just days after its $4.4 billion listing in New York last month.

Chinese authorities announced the measures targeting education companies over the weekend, sending shares in listed groups lower on Monday and ending months of regulatory uncertainty.

Shares of New Oriental Education have fallen 60 percent in New York since Friday, when a leaked note indicated that Beijing plans to clamp down on the sector, and fell 37 percent on Monday in Hong Kong. The market value of TAL Education listed in New York collapsed from $59 billion in February to less than $4 billion. Gaotu Techedu, formerly known as GSX, has shrunk from $38 billion in market value in January to $900 million.

Analysts at Goldman Sachs predict that the size of the tutoring market in China will collapse by 76 percent, to $24 billion.

Selling has spread outside the education technology sector. Shares in Chinese delivery platform Meituan fell 13.8 percent in its worst one-day performance ever as Beijing announced new regulations for the food delivery sector.

“It is unclear what level of restructuring companies will have to undergo with the new regime, which, in our view, makes these shares virtually uninvestable,” JPMorgan said.

This regulatory move will have a broader impact on the economy. The for-profit teaching sector employs hundreds of thousands of teachers and staff. Investment in online learning has been ramping up during the coronavirus pandemic, and the industry is an important advertiser for major internet companies including Baidu and Tencent.

Education companies such as Yuanfudao, Tencent-backed VIPKID and Gaotu have already begun small-scale layoffs in recent months. Staff said Monday they expect more to arrive.

The latest move could also increase risks for investors in entities with shifting interest, offshore vehicles that allow foreign investors to own Chinese companies listed abroad. New regulations prohibit for-profit education companies from using this structure.

“It’s as bad as it can be,” said the chief executive of a large private equity firm in Hong Kong that has an opening to Chinese edtech companies. “The sector will take three to six months to adjust, but then we will have to assess whether we are going to write off investments or write off some completely. Every private equity firm will have to make this necessary revaluation.”

Chinese authorities are seeking to lower the cost of raising children, which, along with relaxing family planning policies, aims to reverse slowing population growth © Reuters

Foreign investors such as BlackRock, which until November owned a 5 per cent stake in Hong Kong’s New Oriental, have found themselves barred from investing in Chinese education companies that cover school subjects.

However, they can still keep their stakes if the business moves into other areas of education. The rules target tutoring after school but do not cover adult education or technical and vocational training.

BlackRock is also the third largest shareholder in US-listed TAL, behind Baillie Gifford, a UK-based investor who has placed big bets on China’s tech sector. Bailie Gifford owns nearly 9 percent of TAL’s US shares after increasing its stake in March.

Meanwhile, investors including SoftBank’s Vision Fund, Tiger Global and Sequoia China, who have invested large sums in privately owned learning apps such as Zuoyebang and Yuanfudao, may not be able to cash out their investments by going public with the companies.

BlackRock, SoftBank, Tencent, Tiger Global, Baillie Gifford and Sequoia did not immediately respond to requests for comment.

TAL, New Oriental and Gaotu issued quick responses over the weekend to the regulations, pledging to stick to the Communist Party.

New Oriental said it would “fulfill its societal duties and serve the development of the nation”, although it added that there would be “material negative impacts” on its after-school educational work.

“What are we supposed to do? We can’t fight the Communist Party,” said one edtech executive.

Announcing the rules, China’s Ministry of Education said: “In recent years, a great deal of capital has been pumped into educational training . . . Advertisements are everywhere, bombing the whole community . . . It has destroyed the natural environment for education.”

By banning educational companies from using the ubiquitous VIE structure, which gives international capital access to restricted parts of the Chinese economy, the rules set an important precedent for investors. VIEs operate in a legal gray area and are not officially recognized by Chinese regulators. Analysts expect gambling investment firms in all sectors to face tougher regulations.

Gaotu, New Oriental, TAL Education, and several privately owned startups are using the VIE infrastructure to power parts of their businesses. The new rules warn that “those who are currently in violation will be cleaned up and corrected,” without going into details. The Chinese authorities have not set a clear timetable or procedures for foreign investors to exit their properties.

That left private equity and venture capital funds preparing for a blow in their ability to raise capital to invest in Chinese technology companies.

“For global investments in US dollars, the sentiment towards the technology sector in the short term is overwhelmingly negative,” said the head of private equity in Hong Kong.

However, “in the long run, sentiment can be reversed within days,” the person added, noting a shift in attitudes in favor of tech groups even after Ant Group canceled its $37 billion initial public offering last year.

Additional reporting by Hudson Lockett in Hong Kong

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