The “golden age” of the Chinese education market is fast approaching. Four factors are driving the acceleration of the industry. First and foremost, Chinese government policies reveal its determination to fully support industrialization of the education market. Relevant development goals have been outlined for many segments of the market as evidenced in the 13th Five-Year Plan, which, for example, proposes to provide pre-school education in every community in the country by 2020 while encouraging private capital to invest in the education industry.
Besides government policy support, private capital has been flowing into the education industry. In 2015, total investment into the industry more than doubled from the previous year while the total M&A amount increased by 165%. With the number of IPOs growing by 76%, more capital inflow is expected in the future. Further, the education industry has attracted the attention of major players from other industries. Internet companies such as Baidu, Alibaba and Tencent (collectively referred to as BAT) have taken the initiative to invest into the education sector. Finally, an explosion of new technology has led to the innovation of online education which will continue to be a hot topic.
We estimate that China’s education market will reach RMB3 trillion by 2020, up from RMB1.6 trillion in 2015, with a compounded annual growth rate of 12.7%. In particular, the training education segment, which includes early childhood education, K12 tutoring and vocational training (both corporate and personal), will be the main driver of growth in the future. For early childhood education, thanks to the implementation of the new “Two-Child Policy” by the Chinese government, the market is set to take off with instant new demand. Similarly, the growing number of school-aged children will boost demand for K12 tutoring. In addition, the rising tide of further studies and international education will drive demand for K12 test tutoring and language training. For personal training, consumers are more willing to pay for training to improve their own competitiveness as their spending power rises (see figure 1).
Restrictions and roadblocks
The attractiveness of the Chinese education market has certainly caught the attention of foreign investors. But given that education in China as a whole is a highly sensitive sector closely correlated to ideology, the government has put some quite stringent regulations in place limiting foreign investment, particularly in the compulsory education segment. A summary of regulations on foreign investment into the Chinese education industry is illustrated. The only exception to the Sino-Foreign Joint Venture (JV) rules is that foreign entities are allowed to set up foreign wholly-owned international K12 schools for foreign children living in China (on page 11, see figure 2).
The National Development and Reform Commission (NDRC) under the State Council has prescribed several restrictions on China’s education industry. Its Catalogue of Industries for Guiding Foreign Investment (2015 Revised Edition) restricts foreign entities to investment in the non-compulsory education segment including pre-school, high school and tertiary education by way of JVs with Chinese counterparties. While foreign entities are permitted to hold majority ownership, the board of directors and key management positions must be held in majority by Chinese counterparties. Take tertiary education as an example: a growing number of China-foreign jointly-managed operations and China-foreign cooperative programs have been given the green light. Currently, 70% of tertiary educational institutions have established Sino-foreign joint programs (see figures 3 & 4).
For non-compulsory education segments, regulations are less restrictive. Foreign capital to investment in vocational education is encourged, including in English language, information technology (IT), sports and accounting. Foreign interests are prohibited from investment in ventures relating to military, police and political education.
How foreign investors choose to enter the Chinese education market invariably depends on the level of capital outlay and engagement. There are six potential entry models: self-owned schools, China-foreign cooperative education, franchise, institutional investment and M&A, online education, and education resources input (see figure 5).
Self-owned schools are entities in which site selection, design, construction and post-management are self-driven and operated by foreign investment. This is a capital intensive model with tangible assets output. Despite the high cost, benefits that accompany this model include sound international management, a professional education atmosphere and cutting-edge infrastructure. In general, self-owned schools are common for foreign international schools focusing on K12 education as well as some English language training institutions.
As of 2016, China has almost 600 international schools, of which 20% are international schools for foreigners. According to the Chinese government’s current Interim Provisions on the Establishment of Schools for Children of Foreign Nationals in China, only foreign children can be admitted to those schools, and foreign international schools are not permitted to create any branch facilities.
For English training institutions, more foreign-invested English training institutions are coming to China as a result of increased internationalization and demand for English language learning. Self-owned schools and self-management piqued the interest of some foreign-invested educational institutions which are in control of operations to guarantee the features and quality of these training institutions. Similarly, English language training institutions will continue to tap into the increasing number of students who make time to, and have the desire to, improve their English proficiency.
China-foreign cooperative education
China-foreign cooperative education can be classified into three categories: Chinese-foreign jointly-managed schools, Chinese-foreign jointly-managed departments and institutes, and Chinese-foreign cooperative programs. Chinese-foreign cooperative education is relatively mature in the higher education segment, penetrating all three categories. It is worth noting that the Chinese Ministry of Education has limited the number of new cooperative programs since 2013, allowing only top-tier universities to do so. It is believed that this new action aims at raising the bar to ensure quality of all the cooperative programs.
By comparison, the cooperative schools in vocational education are still in an early stage with little substantive communication and collaboration. Statistics show that among the 374 major cooperative vocational education programs in the first decade of the 21st century, only 12% have signed cooperation agreements.
Although Chinese-foreign cooperative education can effectively aggregate and share quality teaching resources of both countries, there exist certain integration and management risks with regard to differences in cultures and education philosophy. During the course of cooperation, digestion and integration of the education essence of both countries largely determines the quality of Chinese-foreign cooperative schools and their appeal to students.
Further, with more and more university students having access to international education information and a better command of the English language, they may now intend to go straight to the source to start their university studies overseas rather than choosing cooperative programs offered by Chinese universities. As a result, maintaining quality of the existing programs while attracting new students will be a major challenge for this model in the future.
This model mainly focuses on early childhood education and English language training. The model avoids significant capital outlay upfront while largely reducing costs for expansion. But the problem remains that foreign capital may not be able to maintain consistent standards across all franchises and branches, which may lead to deteriorating reputation. Currently, price competition among companies in the field of early childhood education and English Language training is fierce, and reputation is a key differentiator under this model. Thus, strict control over quality through an otherwise loose management system embedded in the franchise model will continue to be the biggest challenge for most foreign investment.
In addition, foreign characteristics and localized development are the key for a franchise to succeed. As globalization accelerates, more and more Chinese parents hope to instill in their children a sense of internationalized thinking and awareness. Compared to local educational institutions, foreign characteristics have big appeal. Additionally, franchised institutions also need localized development to speed up their expansion plans.
Institutional investment and M&A
In recent years, foreign investments have increased rapidly in both quantity and amount. Publicly, the number of foreign PE/VC-invested projects each year between 2011 and 2015 numbered 6, 1, 2, 8 and 5 respectively. The value of the single largest investment each year surged to US$100 million in 2015 from $20 million in 2014. In general, PE/VC investments are a relatively easy avenue for foreign capital to enter the Chinese education market. The caveat with this model is its high risk due to its low engagement level on the part of foreign investors with development of the invested educational enterprises and difficulties of control over the operation and management of such enterprises (See figure 6).
Given the current barriers to investment in China’s education industry, foreign investors often resort to “Variable Interest Entities” (VIE) structures which give offshore investors effective control over the onshore company through contractual agreements. The Chinese government does not forbid the VIE structure, which enables foreign investors to bypass most of the restrictions imposed by the government. For example, a domestic entity can invest in a domestic educational training company, while the foreign investor controls the domestic entity through a series of agreed arrangements rather than direct holding of the equity of the domestic entity.
China Maple Leaf Educational Systems Limited is a company that uses the VIE model. The group established Maple Leaf International School in Dalian in 1995 and now has 40 schools in cities across China. In 2007, Maple Leaf Education Systems registered in the Cayman Islands, and through contractual arrangements, took effective control of the schools instead of directly holding shares in the domestic operational entity. The group also set up a Hong Kong holding company controlling its affiliated Dalian Beipeng Educational Software Development Co., Ltd., which provides services for and receives payments from the domestic operational entity of Maple Leaf Education Systems, realizing the goal of transferring profits.
The VIE structure may seem complex on the surface, but it is actually quite effective and can reduce tax payments. If the holding company is registered in Hong Kong, a tax payment of no less than 5% can be exempted thanks to the tax reduction agreement between the Chinese and Hong Kong governments, known as CEPA (Closer Economic Partnership Arrangement) (see figure 7).
In the online education segment, content production, content sharing and related derivatives are the main development trends. The profit point of content production lies in original teaching content. For example, language training platforms attract consumers by creating unique teaching content. The profit point of content sharing, on the other hand, is the diversity and completeness of resources. For instance, course sharing platforms generate revenue by expanding their consumer base via integration and sharing of various teaching resources. As for related derivatives, the key to profitability is connecting online and offline channels.
For foreign investments, there are mainly two ways to enter the Chinese online education market.
The first is offering online courses through companies registered in China. Some companies prefer to establish related business in China to provide online education because it is convenient and easy to use, and there is a significant need to connect online and offline channels. This model can better promote online education websites.
The second way is providing online education directly via overseas companies. Some foreign online education websites can directly operate in China. It is a type of “asset-light” export which reduces operational costs, although it could be inferior in product promotion and can be subject to restrictions by the relevant Chinese Internet regulations.
The development of online education may be further fuelled by the new concept of “Internet+,” which has garnered the public support of China’s Premier Li Keqiang. There is huge potential in this new business model, and the rate of growth is expected to be high in the coming years. At the current stage, online education companies need to take action to identify a clear path to profitability. Many companies are now burning cash to buy market share. But in the end, only the most creative content provides will survive and many players have already been forced to drop out.
Export of education resources
Export of educational resources may include non-compulsory educational content and curriculum materials. This is yet another approach to entering the Chinese education market. But the fact is that very little genuine content has been introduced into the industry thus far and long-term profitability in this area is somewhat questionable. If high quality content can be introduced, this approach could be favored by customers who seek international exposure. An important factor to consider while adopting this approach is how to carefully plan localization work to ensure consistent quality across both languages.
In summary, the demand for high quality education and the willingness to spend continue to be high in China. The improved financial capability of Chinese consumers allows them to afford the higher price points of foreign education. Both Chinese parents and students are also willing to embrace foreign cultures and education as China becomes more internationalized. But the government has set up many hurdles to foreign involvement in the industry, particularly in the compulsory education sector. Thus, foreign investors will inevitably have difficulties navigating the market, and will need to be careful. Despite these hurdles, many entry models exist for foreign investors to choose from. The ultimate choice will depend on the level of capital input and engagement that a foreign investor seeks.
Roger Chung is the TMT manager at Deloitte Research. His areas of expertise include new media, telecom, cloud computing, big data, Internet, software and education.