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New Guidelines for Investing in China: Classes from Beijing's Raid on Training

The Chinese ride-hailing company Didi is offering cars for the guests of the Annual Meeting of the New Champions 2017 (summer meeting of the World Economic Forum in Davos) on June 27, 2017 in Dalian, Liaoning Province in China.

VCG | Visual China Group | Getty Images

BEIJING – While Beijing's regulatory crackdown affects overseas investors, the quick ramifications in an industry like after-school tutoring can be an indication of what went wrong and where future opportunities lie in China.

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

The strategy was to burn money to fund exponential user growth, with hopes of future profits. In order for the strategy to work, the investors sought a "winner takes all" approach, which they had used with other Chinese start-ups such as the coffee chain Luckin Coffee and the driver service provider Didi.

Didi was essentially paying Chinese consumers for cheap rides through its app, beating Uber to dominate about 90% of the mainland market, and raising more than $ 4 billion in a New York IPO on June 30.

However, it soon became clear that the investment strategy may no longer work. Just days after Didi went public, Chinese authorities ordered app stores to remove Didi's app and initiated data security investigations, effectively stalling the company's growth prospects in the near future.

It came months after Beijing's efforts to combat alleged monopoly practices by the country's internet technology giants like Alibaba and Tencent.

At the end of July, education was clearly Beijing's next destination.

Action against tutoring after school

In October 2020, online tuning start-up Yuanfudao announced that it had raised a total of $ 2.2 billion from Tencent, Hillhouse Capital, Temasek and many other investors – at a valuation of $ 15.5 billion .

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

"They were hoping to create another oligopoly like Didi with market price power," said an investor and co-founder of one of the largest US-listed Chinese education companies, according to a CNBC translation of his interview in Mandarin. Because of the sensitivity of the matter, he asked for anonymity.

However, the education industry already has several large players in the market, he stressed, and "it turned out that before cracking down, no company could really beat the other."

It was a lucrative prospect to build a dominant leader in after-school tutoring. With China's 1.4 billion population and a culture where parents value their children's education, the opportunity was tremendous.

Early industry players like New Oriental started with physically rented locations and personal classrooms. But the 2020 coronavirus pandemic accelerated the online shift of the tutoring industry, and the struggles of the Chinese internet world were in full swing.

Advertising wars

Chinese tutoring companies started spending a lot on advertising last year to attract new students.

US-listed Gaotu spent more than 50 million yuan ($ 7.75 million) on ads on the Kuaishou short video platform in a week last winter, a person familiar with the matter told CNBC.

"In China, Kuaishou is a smaller platform than (ByteDances) Douyin / TikTok, so the total spend on traffic from all K to 12 education companies would be much higher," the source said, according to a CNBC translation in Mandarin.

Gaotu did not respond to a request for comment. In its earnings report for the first three months of the year, the company said that its selling and marketing expenses were 2.29 billion yuan, three times what it was a year ago.

Tal Education announced that its spending in the same category in the three months ended February 28 increased 172% year over year to 660.5 million yuan.

Both companies posted net losses for the quarter, as did another industry player, OneSmart International Education Group, which saw sales and marketing expenses increase 47% year over year to 288.8 million yuan.

OneSmart was listed in the US in 2018 as part of an initial public offering signed by Morgan Stanley, Deutsche Bank and UBS. Later that year, the education company acquired Juren, one of the oldest companies in China's tutoring industry.

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

OneSmart could be removed from the New York Stock Exchange as its shares have stayed below $ 1 since July.

Other US-listed Chinese stocks are also struggling. New Oriental didn't report a net loss for the quarter ended February 28, but did announce that it spent $ 156.1 million on sales and marketing during that time, 32% more than a year ago.

The surge in ad spend to boost student enrollment came as investors pushed into the industry and increased competition drove up the cost of customer acquisition.

The landscape has changed a lot.

Ming Liao

Founding Partner, Prospect Avenue Capital

“Common Prosperity” in China

The new policy marks Beijing's recent efforts to contain the sprawling growth of the education industry and the burden on parents – a concern of authorities trying to increase the birth rate in the face of a rapidly aging population and shrinking workforce.

Investors need to realize that addressing the population problem, slowing economic growth and tensions with the US have become the main concerns of the Chinese government, said Ming Liao, founding partner of Beijing-based Prospect Avenue Capital, which has a fortune of US $ 500 million. Dollars managed.

"The landscape has changed a lot," he said, noting that investors now need to consider far more than just industry developments.

In addition to raids against internet companies and tutoring centers, authorities have ordered online video game companies to limit children to three hours a week.

In speeches by President Xi Jinping, it was stressed that the goal is "shared prosperity" or moderate wealth for all, not for some.

Education is just one of the so-called three mountains that Chinese authorities are tackling. The other two are real estate and healthcare, all areas where hundreds of millions of people across the country complain of over-cost.

For the past 20 years, most of the company's profits have gone to developers and Internet platform-based companies, Liao said.

In light of new political priorities, it is important for investors to distinguish between Internet-based companies and those developing more specific types of technology such as hardware – even if both types of companies are loosely referred to as "tech" companies.

Read more about China from CNBC Pro

With the US now under President Joe Biden and looking to compete with China, Beijing is increasingly investing in an ambitious multi-year plan to build its domestic technology, which ranges from semiconductors to quantum computing.

"The Chinese market can still offer attractive investment returns to global investors, and the challenge is to identify the potential future winners amid China's realignment," Bank of America Securities analysts wrote in a September 10 report.

They pointed to a shift in China's largest companies by market capitalization over the past two decades – from telecommunications to banks to internet stocks. Going forward, they expect more regulation of the internet and real estate industries "while promoting advanced manufacturing, technology and green energy sectors".

The bank listed some contenders for "future winners".

Sportswear: AntaHealth care: Wuxi BioElectric vehicles and EV battery: BYDLithium in new materials: GanfengRenewable energies: Lange YuanTech hardware: flat glass

"Certain industrial sectors that we do not currently cover could also offer promising opportunities," said the analysts.

Future of investing in China

Chinese tutoring companies that once attracted billions of dollars are now trying to survive by setting up courses in non-academic fields such as arts or adult education. Industry insiders say it is an uncertain path that has a market only a fraction of what companies used to do.

SoftBank is waiting for clarity on the regulatory front before resuming "active investment in China," said its CEO Masayoshi Son in a conference call on August 10th.

"We have no doubts about China's future potential … In a year or two under the new rules and under the new orders, I think things will be a lot clearer," Son said, according to a FactSet transcript.

When Softbank was contacted by CNBC last week about its investment plans for China, Softbank pointed out how it has been running investment rounds at Agile Robots, a Sino-German industrial robotics company, and Ekuaibao, a Beijing-based reimbursement software company, over the past few weeks.

"Our commitment to China remains unchanged. We continue to invest in this dynamic market and help entrepreneurs drive a wave of innovation," SoftBank said in a statement.

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

In June, Bangalore-based online education company Byju became India's most valuable start-up 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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