This post is also available in: French, Italian
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.
Important Legal Information
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.
Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.
Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.
Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com – Franklin Distributors, LLC, member FINRA/SIPC, is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.