What are the regulatory developments?
On July 24, China released a new policy governing the After School Tutoring (AST) industry (the “Double Reduction” policy document). The purpose of this is to reduce the educational burden on children and parents, in the context of government concerns regarding the country’s slowing birth rate. The key points of the Double Reduction policy are as follows:
- AST must be “not-for-profit.”
- Foreign investors cannot invest in AST via the Variable Interest Entity (VIE) structure.
- AST institutions are not allowed to use capital markets for financing.
- Merger and Acquisition activity in the AST industry is prohibited.
- No new AST licenses can be approved, with preexisting AST (including online) needing to go through the approval process again.
- Subject-based AST classes (both online and offline) cannot be held on national holidays, weekends, and winter/summer holidays.
- Online AST class duration is set at a maximum of 30 minutes.
What are the implications of the Double Reduction policy?
The policy limits licensing and operating hours so AST companies will need to scale down their subject-based tutoring programs and pivot from traditional subjects toward enrichment topics, and from tutoring toward content or pre-recording. As not-for-profit entities, all profits and cashflows must be reinvested into the business and sponsors (shareholders) cannot lay claim to profits. Since foreign investors can no longer invest in AST via VIE, this will likely result in company de-listings.
What was our investment rationale in this space?
Our previous premise for investing in Chinese education companies was the exposure provided to a fast-growing tutoring industry with robust underlying demand, by companies with excellent operational capabilities and teaching quality, that were benefiting from industry consolidation. Despite growing regulatory scrutiny, our expectation was that the government wanted to regulate the growth of the AST industry instead of taking such extreme actions. As such, our sensitivity analysis of the regulatory impact had been focused on modeling a moderation in the growth and size of the AST industry due to supply-side restrictions such as a slowdown in the licensing process as well as restrictions on operating hours. We had also modeled in a higher probability of stricter supply-side restrictions on K-9 vs 10-12 restrictions based on the earlier State Council’s “Rules for the Law for Promoting Private Education” (covering private school providers) that was issued on May 14, 2021. Those rules differentiated the regulatory stance for K-9 (considered compulsory education and subject to stricter regulation) from 10-12 and higher education (non-compulsory and subject to more supportive regulation).
While we had modeled in potential risks on the operating side, we did not factor in the risk of the AST companies being designated as not-for-profit, or for foreign investors to be barred from investing.
However, our on-the-ground checks indicated that the demand side remains largely unchanged given continued competition to get into a good school with risk that a ban on tutoring will push parents into the grey market of unlicensed tutors or more expensive 1:1 options. The leading players have helped make tutoring services widely available to the middle class, have helped improve access to educational resources (especially in lower-tier/rural areas) via low-cost online tutoring resources, and have been active in national service (i.e. helping to shift students online during the peak of the COVID-19 period, providing technology platform support to education providers etc.). In addition, previous blanket bans in other North Asian countries have proven ineffective.
Despite the above considerations, the three key implications of the new policy make it evident to us that the current after-school tutoring business model is no longer viable, nor are the current listing structures. It is unclear how the businesses will restructure to satisfy key regulatory requirements (not- for-profit and no foreign investment), and necessary operational changes to the business model will likely take an extended period of time to resolve.
We doubt Chinese regulators have made these decisions in haste; rather, the country is socialist by constitution and thus elements of policy risk always exist. Government-led interventions are not unique to China, but the aims of “socialism with Chinese Characteristics” can have far-reaching impacts upon individual companies and sectors. The underlying thread that ties the intense regulatory activities across many industries lies in the party’s determination to develop China into a “modernized socialist economy” and achieve the “great revival of the Chinese nation.”
In particular, three developmental features seem to be key: 1) common prosperity, 2) green development and 3) independence in key technologies/industries. Past and future regulatory action need to be interpreted through these lenses. Furthermore, the role of private capital will be under greater scrutiny in order to ensure “orderly expansion” and to prevent risks to the economy.
The resolve of the Chinese government to change the status quo so dramatically has surprised the market. Furthermore, fair compensation, which would reasonably be expected for the actions taken, has not been forthcoming. Despite this, and the sharply increased regulatory scrutiny being applied to the internet sector, we continue to view government actions as a one-time reset of regulatory paramountcy, similar to previous cycles in China’s economic development. We do not foresee a broader application of the extreme policymaking applied to the education sector, but investor assessments of policy risk will undoubtedly rise as a consequence of these actions.
What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies; investments in emerging markets involve heightened risks related to the same factors. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks.
There is no assurance any estimate, forecast or projection will be realized.
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