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School daze

27 July 2021 By Robyn Mak, Yawen Chen

Foreign investors in Chinese companies have some cramming to do. The prevalent so-called variable interest entities used to skirt overseas investment restrictions have long existed in a regulatory gray area, but Beijing’s latest ban on overseas funds in the tutoring business suggests things are becoming more black and white.

To sell stakes outside China, Alibaba and many others rely on convoluted structures to evade foreign investment rules in technology and other sensitive sectors. When U.S. fund managers buy shares in the e-commerce titan, for example, they own a piece of a Cayman Islands shell company. That in turn controls Alibaba’s Chinese operations through legal contracts, rather than equity ownership. It’s a clever workaround that has gained widespread acceptance from companies and investors: between 2016 and 2018, VIEs in New York added a whopping $1 trillion in equity value, per the U.S. National Bureau of Economic Research. They had reached some $2 trillion by March 2020.

Beijing has neither endorsed nor banned the practice, leaving VIEs in legal limbo. In 2009, then-U.S.-listed Chinese web portal Sina and advertising outfit Focus Media called off a $1.4 billion merger after the government spent 10 months reviewing the application because of the offshore structures. More recently, the country’s cybersecurity and securities regulators have been tasked to review and approve companies that want to tap overseas public markets.

The latest crackdown, on private education services, explicitly calls out VIEs, a rare high-level acknowledgement that they are used as loopholes. The new policy, circulated by the powerful State Council, bans foreign capital in the sector, including through M&A and contractual agreements. Ominously, it also demands “rectification” for those violating the rules.

The implications for the sector are significant. Shares in both TAL Education and New Oriental Education Technology have plummeted by at least 70%. Both probably will have to divest their after-school tutoring businesses to Chinese buyers. Smaller companies may be required to buy out their foreign shareholders and decamp from overseas exchanges.

Other industries will be taking notes. Beijing’s tougher oversight is hitting everything from food delivery to online payments. For companies and their foreign backers, that means a lot of difficult financial homework.


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