China education investment: Competitive edge

Nord Anglia Education opened its first school in China 12 years ago. The British International School Shanghai had an initial capacity of 100 places. Fast forward to the present, the facility now has space for 1,800, having grown lock-step with the Pudong district in which it resides.

The company, which was taken private by Baring Private Equity Asia in 2008 and re-listed in the US last month, owns five schools in China. They are part of a network of 27 covering Asia, the Middle East, Europe and North America that teach the UK curriculum to more than 17,000 students. Three of the four other China-based establishments have more than doubled in capacity since acquisition. China accounted for 36% of Nord Anglia's pro forma revenue of $323.7 million for the year ended August 2013.

Speaking to AVCJ last year, Baring Asia CEO Jean Eric Salata identified three fundamentally attractive characteristics of education: customers tend to pay for courses up front; once students enroll they usually don't leave until graduation; and the industry is not easy to penetrate, with reputation, curricula and credentials essential in the top tier.

For Nord Anglia specifically, he might have added that success depends on identifying a market niche. Nearly all of the company's students in China are expatriates, leveraging an exclusive but growing constituency in the tier-one cities of Beijing, Shanghai and Guangzhou. It represents a capital-intensive yet niche play in a market in which a nationwide footprint is hard to develop.

"Education is much less scalable than a lot of PE and VC guys initially thought," says J.P. Gan, managing partner at Qiming Venture Partners. "The business has been cash rich but difficult to expand geographically. There hasn't been nearly as much consolidation as one might think."

Qiming invested in several classroom-based education businesses before turning its attention to online solutions and backing TutorGroup, an English-language tuition platform. The VC firm participated in a Series B round worth $100 million for TutorGroup earlier this year, led by Alibaba Group and Temasek Holdings. It was one of two transactions largely responsible for PE and VC investment in the education sector reaching $329.5 million so far this year, higher than any 12-month total since 2008.

The other was CVC Capital Partners' acquisition of a majority stake in EIC, which provides counseling services for students who want to go overseas, for a reported $200 million.

New channels

Three channels have traditionally been most popular among PE and VC investors in Chinese education: private schools along the lines of Nord Anglia, which caters to kindergarten through Year 12 (K12), test preparation and after school education services, and vocational training.

The business models within these silos are evolving, however. Few seek to emulate the likes of New Oriental Education, ChinaEdu Corp. and China Distance Education Holdings, all of which went public between 2006 and 2008 on the back of plans to create large, nationwide networks of language training and test preparation providers.

Their success gave birth to a host of similar investments, which saw deal flow jump from $39.4 million across nine transactions in 2006 to $251.6 million and 19 deals in 2007, followed by $337.4 million and 16 deals in 2008. Four from that vintage - Xueda Education Group, TAL Education Group, Global Education & Technology Group and Ambow Education - listed in the US in 2010, although Ambow is now the subject of a liquidation order.

New Oriental remains the largest private educational services provider in China, but Zhaoyu Zheng, a principal at ZhenFund, a seed vehicle set up by the co-founders of New Oriental in conjunction with Sequoia Capital, notes that the model is under stress. "In the past supply was equal to demand and competition wasn't that furious," Zheng says. "They continue to spend money acquiring customers, rent for centers and teacher salaries are increasing, but class sizes and profit per class are in decline."

New Oriental had 2.5 million student enrolments last year and a network of 57 schools, 669 learning centers and 32 bookstores across 50 cities, as well as 8.5 million registered online users. It begs the question, how big is too big, especially without the insulation of substantial barriers to entry.

Last October, Bain Capital completed the $140 million acquisition of a majority stake in RISE China, a provider of after-school English language programs for pre-kindergarten through K6. The company has 34 directly-owned schools in Beijing, Shanghai and Guangzhou and a further 126 schools run by franchisees.

Lihong Wang, a managing director at Bain, is bullish on the market opportunity - there are 26 million 3-12 year-olds in China's 100 largest cities and even if only a fraction can afford RISE's services it still makes for a strong demand base - but notes that local conditions vary.

"Recruiting students and delivering good results in Beijing may not be the same for schools in Shanghai," she says. "We've had better results in Beijing, but after 3-4 years we think we have cracked the code in Shanghai, and then we opened up in Guangzhou two years ago and it's ramping up. It is a big market but scalability is not automatic."

Expansion issues

Other obstacles are more practical in nature. Education is a cash generative business, with students paying for courses up front, but it is also capital intensive. Building out a network of schools requires investment in premises, staff and marketing before the first student walks in.

On the regulatory front, the Ministry of Education has bureaus in each province and city that is responsible for issuing licenses. Stephen Ip, education sector lead for transaction services at KPMG China recalls working with a client keen to enter the Qingdao market only to be told that the authorities were no longer issuing licenses for a particular kind of training operation. This can usually be addressed by purchasing a license from an existing local player, but this throws up its own set of challenges.

"A lot of the incumbents are small players with a handful of schools or learning centers. They are very entrepreneurial and it might be difficult for an investor to buy one operator in Qingdao, another in Dalian and a third in Jinan," Ip says. "Every city has its own competitive dynamic. It's not that you can't get scale, it just takes a time."

He notes that many investors simply target larger companies with 100 or more centers, either directly owned or franchised out, because they don't want to start from scratch. But do prospective targets make for appetizing business partners?

The existing principal is often the individual who holds the license and it can be difficult to replace them with management that can simultaneously handle the academic, operational and compliance burden that comes with scaling up a business.

There are plenty of anecdotes about schools with poor accounting, which complicates due diligence. Given companies may offer a variety of different programs at different price points and with different class sizes, investors want to tie revenues to the relevant programs in order to build up a picture of where the money is coming from.

Hidden liabilities are routinely cited as a potential pitfall. Teachers' employment contracts must be scrutinized to ensure that the correct social security payments are being made. Many education companies also claim they are charitable organizations and therefore not liable for tax. The reality can be a lot more muddied and it leads to disputes over valuations and other transaction terms, with sellers saying they've never paid certain taxes and buyers wanting to err on the side of caution.

However, arguably the biggest growing pain is quality control as the network expands. One private equity investor recalls conducting preliminary due diligence on a company that tutored students sitting certified financial analyst (CFA) examinations and sending a team member along to one of the classes. "He said, ‘We can't invest because one of the instructors is a sophomore I tutored in college and who doesn't have a CFA," the investor relates. "There are a lot of quality issues."

For some investors, the solution is not to pursue scale at any cost. RISE wanted to establish a presence in lower tier markets in order to strengthen the brand and offset the threat of local copycats without overstretching itself financially and operationally. Recruiting franchisees was the logical solution.

Bain's Wang does not expect the company to aggressively expand its directly-owned business in these cities because of quality and cost issues and so as not to undermine existing franchisees.

RISE will primarily focus on its core markets, where demand among its current client base remains untapped. The company has introduced summer programs whereby students spend time in English-speaking countries and also a middle school program - covering K7 and K8 - for those who want to continue in the RISE system with a view to pursuing higher education overseas.

"If you can keep kids in your school longer it is much more profitable. We have a 70% renewal rate, compared to the industry average of 30-50%, and that means we don't have to spend as much on sales and marketing," Wang says. "With a large school base we generate enough cash to open new schools - and we are not talking 20-30 a year, but less than 10. We are happy to invest but there are natural constraints in terms of quality principals and teachers."

The tech effect

Technology is potentially the great leveler, but online models don't work for all. A seven-year-old in RISE's programs can't spend an hour in front a computer screen; besides, parents are also paying a premium for classroom interaction.

ZhenFund claims to have found a middle ground and it lies in standardization and what Zheng describes as "flipping the classroom." One of the fund's portfolio companies, 17zuoye.com, works with more than 10,000 primary schools nationwide on English and mathematics tuition. It supplies targeted education programs comprising lesson plans and test materials that are intended to change the classroom from teacher-led to activity-led.

"Traditionally the teacher has been the biggest obstacle to scalability," Zheng says. "The businesses we are trying to invest in position the teacher more as an organizer and this lowers the requirements. This lowers the cost of the classroom and raises the efficiency of the learning process."

It is part of a wider theme that involves targeting businesses with the potential to lead their respective segments, steering clear of mature and competitive areas such as test preparation. This may lead investors into specialist areas - both RISE and ZhenFund are interested in teaching methods that are more holistic, removed from the learning by rote still popular in state schools - but it is not an obstacle to achieving scale.

TutorGroup started as an offline business in Taiwan and expanded online as it launched in the mainland. The company, which now specializes in English-language training for adults, is now moving into Chinese language services as well as exploring opportunities teaching English in non-Chinese markets.

Qiming's Gan notes that Alibaba Group's marketplace Taobao and US-listed social network YY.com have launched platforms that essentially link teachers with students across multiple academic and vocational pursuits. It is too early to say whether these giants will end up dominating pure online education but their ambitions do encourage specialists to remain specialized.

"The days of the big education providers going public in the US and having lots of centers nationwide offering test preparation and after school services everywhere - that situation bolted a long time ago," says KPMG's Ip. "The type of players you have left are probably going to be more technology-driven, with some sort of competitive advantage that could make it easier to scale a business."

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• Topics
• Greater China
• Consumer
• Venture
• Buyout
• Education
• Consumer
• China
• Venture
• buyout
• Qiming Venture Partners
• Baring Private Equity Asia
• Bain Capital Asia