There is much to be done for foreign investors in Chinese companies. Variable interest entities, also known as variable interest entities, have been used to circumvent overseas investment restrictions for a long time. However, Beijing’s recent ban on foreign funds in tutoring suggests that things are getting more clear.
Alibaba and others use complex structures to avoid foreign investment regulations in technology and other sensitive areas. For example, U.S. fund managers can buy shares in an e-commerce giant and a portion of a Cayman Islands company shell. This, in turn, controls Alibaba’s Chinese operations via legal contracts and not equity ownership. Investors and companies have widely accepted this clever solution. According to the U.S. National Bureau of Economic Research, VIEs in New York have added $1 trillion in equity value between 2016 and 2018. They had reached $2 trillion by March 2020.
Beijing has not approved or banned this practice. VIEs are left in legal limbo. After spending 10 months reviewing the application, the U.S.-listed Chinese website Sina and the advertising company Focus Media stopped a $1.4 billion merger. In recent years, the cybersecurity and securities regulators of the country were tasked with reviewing and approving companies seeking to tap into overseas public markets.
VIEs are a rare high-level recognition that can be used as loopholes in the latest crackdown on private education services. The powerful State Council circulated the new policy. It bans foreign capital from the sector, as well as M&A and contractual arrangements. It also requires “rectification” of those who violate the rules, which is a worrying sign.
These are serious implications for the sector. Both TAL Education shares and New Oriental Education Technology shares have fallen by at least 70%. Both companies will likely have to sell their tutoring businesses after school to Chinese buyers. Other companies might be required to purchase their foreign shareholders and leave overseas exchanges.
Others industries will take note. Beijing has tighter oversight that affects everything, from online payments to food delivery. This means that both foreign investors and companies have to do a lot more financial homework.