New rules for investing in China after Beijing’s after-school crackdown

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Chinese ride-sharing company Didi is offering cars to guests of the 2017 New Champions Annual Meeting (World Economic Forum’s Davos Summer Session) on June 27, 2017 in Dalian, Liaoning Province.

VCG | China Visual Group | Getty Images

BEIJING – As foreign investors reeling from Beijing’s regulatory crackdown, the rapid fallout in an industry like after-school tutoring may be a guide to what went wrong and where future opportunities lie in China.

Before China cracked down on tutoring schools this summer, big investment firms like SoftBank were pouring billions of dollars into Chinese education companies, many of which were listed on or in the process of being listed in the United States. be listed.

The strategy was to burn cash to fund exponential user growth, with hopes of profit going forward. To make the strategy work, investors were aiming for a “winner takes all” approach that they had used with other Chinese start-ups such as coffee chain Luckin Coffee and ride-sharing company Didi.

Didi has essentially paid Chinese consumers for cheap rides through his app, beating Uber to dominate around 90% of the mainland market, and raised more than $ 4 billion in an IPO in New York June 30.

But it soon became clear that the investment strategy might no longer work. Just days after Didi’s IPO, Chinese authorities ordered app stores to remove Didi’s app and began data security investigations, ending the company’s growth prospects. short-term business.

This came months after Beijing’s efforts to tackle the alleged monopoly practices of the country’s internet tech giants like Alibaba and Tencent.

At the end of July, the education sector was clearly Beijing’s next target.

Crackdown on after-school tutoring

In October 2020, online tutoring start-up Yuanfudao said it had raised a total of $ 2.2 billion from Tencent, Hillhouse Capital, Temasek and many other investors, for a valuation of $ 15.5 billion. .

Two months later, competitor Zuoyebang raised $ 1.6 billion from investors such as SoftBank’s Vision Fund 1, Sequoia China, Tiger Global and Alibaba.

“They were hoping to create another oligopoly like Didi” with market pricing power, said an investor and co-founder of one of the largest Chinese education companies listed in the United States, according to a CNBC translation of his interview in Mandarin. He requested anonymity due to the sensitivity of the matter.

However, the education sector already had several major players in the market, he said, and “it turned out that no company could really beat the other before the crackdown.”

Building a dominant leader in the after-school tutoring market was a lucrative prospect. The opportunity was huge given China’s population of 1.4 billion and a culture in which parents value the education of their children.

Early industry players like New Oriental got their start with physically leased locations and in-person classrooms. But the coronavirus pandemic in 2020 accelerated the shift in the online tutoring industry, and the money-searing struggles of the Chinese internet world were in full swing.

Advertising wars

Chinese after-school tutoring companies started spending heavily last year on advertising to attract new students.

U.S.-listed Gaotu spent more than 50 million yuan ($ 7.75 million) in a week last winter on ads on the Kuaishou short video platform, one person told CNBC close to the file.

“In China, Kuaishou is a smaller platform than [ByteDance’s] Douyin / TikTok, so the total spending on traffic of all K-12 education companies would be much more than that, “the source said in Mandarin, according to a CNBC translation.

Gaotu did not respond to a request for comment. In its results report for the first three months of the year, the company said that its sales and marketing expenses of 2.29 billion yuan were three times higher than a year ago.

Tal Education revealed that its spending in the same category jumped 172% from a year ago to 660.5 million yuan for the three months ended February 28.

Both companies posted a net loss in the quarter, as did another industry player, OneSmart International Education Group, which reported a 47% year-over-year increase in sales and marketing spending to $ 288.8 million. yuan.

OneSmart is listed in the United States in 2018 as part of an IPO underwritten by Morgan Stanley, Deutsche Bank and UBS. Later that year, the education company acquired Juren, one of the oldest companies in the tutoring industry in China.

But the new after-school regulations dealt a fatal blow to the 27-year-old company. About a month after the new rules were published, Juren collapsed, just a day before public schools opened on September 1.

OneSmart could be delisted from the New York Stock Exchange since its shares have remained below $ 1 since July.

Other Chinese stocks listed in the United States are also struggling. New Oriental did not report a net loss for the quarter ended Feb. 28, but revealed that it spent $ 156.1 million on sales and marketing during that period, 32% more than there was a year.

The surge in advertising spending to increase student enrollment came as investors crowded into the industry and increased competition drove up customer acquisition costs.

The landscape has changed considerably.

Ming Liao

founding partner, Prospect Avenue Capital

“Common prosperity” in China

The new policy marks Beijing’s latest effort to curb the sprawling growth of the education sector and its burden on parents – a concern for authorities trying to increase births in the face of an aging population and labor force. decreasing work.

Investors must recognize that tackling the demographic problem, slowing economic growth and tensions with the United States have become major concerns for the Chinese government, said Ming Liao, founding partner of Prospect Avenue Capital, based in Beijing, which manages $ 500 million in assets.

“The landscape has changed dramatically,” he said, noting that investors now have to consider national policies much more than just industry developments.

In addition to the crackdown on internet companies and out-of-school tutoring centers, authorities have ordered online video game companies to restrict children from playing three hours a week.

President Xi Jinping’s speeches emphasized that the goal is “common prosperity”, or moderate wealth for all, rather than some.

Education is just one of three so-called mountains that the Chinese authorities are grappling with. The other two are real estate and healthcare, all areas in which hundreds of millions of people across the country have complained of excessively high costs.

Over the past 20 years, corporate profits have gone largely to real estate developers and internet platform businesses, Liao said.

In light of new policy priorities, he said, it is important for investors to distinguish between internet-based businesses and those that develop more tangible types of technology like computer hardware, even though both types companies are loosely called “tech” companies in English.

Learn more about China from CNBC Pro

With the United States now ruled by President Joe Biden and determined to compete with China, Beijing is increasingly investing in an ambitious multi-year plan to develop its domestic technology from semiconductors to quantum computing.

The “Chinese market may still offer attractive returns on investment for global investors, and the challenge is to identify potential future winners as part of China’s rebalancing,” Bank of America Securities analysts wrote in a report by September 10.

They pointed to a shift over the past two decades in China’s biggest companies by market capitalization – from telecommunications to banks to internet stocks. In the future, they expect greater regulation of the Internet and real estate industries, “while sectors related to advanced manufacturing, technology and green energy will be encouraged.”

The bank has listed a few candidates for “future winners”.

  • Athletic wear: Anta
  • Health care: Wuxi Bio
  • Electric vehicles and EV battery: BYD
  • Lithium in new materials: Ganfeng
  • Renewable energy: Long Yuan
  • Technical material: flat glass

“Some industry sectors that we are not currently covering could also have promising opportunities,” analysts said.

The future of investing in China

For Chinese extracurricular tutoring companies that once attracted billions of dollars, they are now trying to survive by creating courses in non-academic fields like art or adult education. Those in the industry say it’s an uncertain path that has a market only a fraction of what companies previously operated in.

SoftBank is awaiting clarification on the regulatory front before resuming “active investment in China,” chief executive Masayoshi Son said in a call for results on Aug. 10.

“We have no doubts about China’s future potential… In a year or two with the new rules and new orders, I think things will be much clearer,” Son said, according to a FactSet transcript. .

Contacted by CNBC last week about its investment plans for China, Softbank explained how it has led investment rounds in recent weeks in Agile Robots, a Chinese-German industrial robotics company, and Ekuaibao. , a Beijing-based corporate reimbursement software company.

“Our commitment to China is unchanged. We continue to invest in this dynamic market and help entrepreneurs launch a wave of innovation,” SoftBank said in a statement.

But when it comes to betting on the education sector, some investors have decided to look elsewhere in Asia.

In June, Byju, a Bangalore-based online education company, became India’s most valuable startup after raising $ 350 million from UBS, Zoom founder Eric Yuan, Blackstone and ‘others. Byju is valued at $ 16.5 billion, according to CB Insights.


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