Chinese regulation: Lessons from after-school tutoring

On 23 July 2021, Chinese regulators announced sweeping changes to China’s after-school tutoring (AST) industry, forcing AST companies to transform into nonprofit entities, banning foreign capital flows into the industry, and barring public stock listings for these firms. Following the announcement, the market capitalizations of China’s largest AST players plummeted to around 10% of their trailing 12-month highs.

But take a step back for a moment: Government regulation of Chinese industries is not new by any means. The AST policy move is consistent with the goals of China’s past regulatory actions and had even been foreshadowed through various channels during the first half of 2021.

Here’s a distillation of our China and emerging market (EM) equity specialists’ latest views on this turn of events — including why investors shouldn’t jump to any conclusions regarding potential implications for future regulation of Chinese internet companies.

Implications for Chinese internet companies

So what does China’s new approach to the AST industry tell us about its still-evolving approach to regulating its internet sector?

First, it underscores the benefits of investing alongside the interests and objectives of the Chinese government. We believe this “local perspective” mindset remains key to success in navigating Chinese markets. In late 2020, China conveyed its desire to contain disorderly expansion of capital and regulate monopolistic behavior in the internet sector. Importantly, however, China sought to balance these goals by articulating that its regulators would focus on the healthy development of the platform economy.

With the establishment of a centralized regulatory body, China has made strides to clean up the legacy gray areas around its internet companies. Regulatory changes impacting the internet sector to date have been more or less aimed at leveling the playing field. As promised, the government has cracked down on monopolistic tendencies, unwound acquisitions that should never have been allowed, halted anticompetitive behaviors, and improved data privacy and cybersecurity frameworks.

It’s also critical to consider the significant differences between China’s AST companies and its internet businesses. We see two primary factors that distinguish these industries from one another in the eyes of Chinese regulators:

• Value proposition vs externalities – Regulatory actions over time highlight the Chinese government’s emphasis on positive value added by a company to its users and stakeholders. In the case of AST, regulators believe the benefit of additional classes was not offsetting the social externalities created by the industry. Conversely, China’s internet platforms greatly increase efficiency and improve accessibility. E-commerce and marketplace businesses have value propositions that are clearly aligned with the platform economy. Social media, entertainment, and gaming platforms contribute as well.
• Strategic importance – For China to achieve its long-term goal of technological independence, it needs thriving internet companies that can serve as a foundation for the application, and perhaps development, of more fundamental research. Increasingly, internet companies are likely to conduct more hardware design/research, which relies on their free cash flow and the availability of talent. Hampering growth in the sector would threaten China’s entrepreneurial dynamism and disincentivize talent to join these firms.

So where will the internet stocks go from here? History suggests that their recent multiple compression may not be long-lived, particularly if China’s unfolding approach to internet regulation proves to be markedly different from the AST industry. The AST overhaul was hardly the first instance of China making major regulatory changes. In 2018, for example, the government imposed regulations on the pharmaceutical industry. Chinese pharma stocks struggled, but then rebounded sharply in 2019 as the drug companies adapted to the changes.

Implications for Chinese ADRs

Investors have also wondered how the new regulations could impact Chinese companies’ American depositary (ADR) listings. These listings leverage variable interest entities (VIEs), which are used by Chinese companies to raise international capital in sectors where foreign ownership is limited by the government. VIEs vary in structure and quality, but generally enable foreign investors to purchase economic interest through shell companies in other jurisdictions. The recent challenge to this model led many Chinese internet stocks that use VIEs to pull back as the market grapples with potential implications of the AST regulations for other sectors.

The Chinese government is likely to ratchet up pressure on companies to list domestically, either in Hong Kong (where the listing requirements are more stringent than for US ADRs) or as China A-shares. Our base case is a gradual shift toward more domestic listings, but we recognize the risk of a less orderly evolution as geopolitical tensions continue to rise. Investors should therefore focus on factors such as liquidity and fungibility for dual-listing companies when assessing the risk/return of Chinese ADRs. We anticipate VIEs will become less relevant as China’s businesses increasingly list domestically. Meanwhile, try to evaluate the merits of each VIE structure independently.