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Nisha Gopalan is a Bloomberg Gadfly columnist covering deals and banking. She previously worked for the Wall Street Journal and Dow Jones as an editor and a reporter.

Not-for-profit industries are hardly associated by most investors with rising returns. Not so in China, whose private-school sector has become initial public offering gold in Hong Kong.

Knowledge Is Money
China Yuhua Education and Wisdom Education are among the biggest IPOs so far this year in Hong Kong
Source: Bloomberg

Two of the city's five biggest IPOs so far this year have been of Chinese nonprofit school operators: China Yuhua Education Corp., which made its trading debut this week, and Wisdom Education International Holdings Co.

Learning Curve
Private school operators in Hong Kong trade at higher price-to-earnings multiples than the benchmark index
Source: Bloomberg

That brings the number of Hong Kong-traded Chinese school companies to four. China Maple Leaf Educational Systems Ltd. was the first to float, in 2014, followed by Virscend Education Co. last year. Maple Leaf's shares have climbed 76 percent since listing and Virscend has gained 113 percent. Yuhua has risen almost 3 percent from its IPO price this week, while Wisdom is little changed since its January debut.

The companies are proving winners in the aggregate even though Chinese private schools aren't allowed to distribute profits or pay dividends. The reason? Use of offshore vehicles and service contracts that enable income to be funneled out of the mainland.

All private schools in China are nominally nonprofit, though some have been permitted to remit "reasonable returns" to their providers of capital, according to law firm Hogan Lovells. What exactly constitutes reasonable remains unclear.

Operating through that gray area, private school companies have tapped into a lucrative business. China's education needs are huge, and the rigid curriculum of state schools has prompted parents to seek alternatives. Beijing has been encouraging private providers to fill the gap.

Because of their nonprofit status, school operators can't raise fees without government permission, but they do get cheap land and pay low tax, similar to public-sector schools. 

Starting September 2017, private school companies will have a choice of converting to for-profit businesses, gaining more control over their fees and assets.

But those that take that option will lose the right to offer education for children in grades 1-9 (the compulsory years) along with other government privileges. Wisdom, which says it hasn't yet decided whether to convert, noted in its IPO filing that private operators may enjoy less support than not-for-profit schools.

Yuhua's listing prospectus shows how attractive the business can be. Not only are fees higher than in the state sector, they are virtually guaranteed to rise every year, providing a certainty in cash flows that's valued by investors.

The company said its primary school fees rose to a maximum of 39,000 yuan ($5,663) in 2016-17, from 30,000 yuan in 2013-14, an increase of 30 percent. Those fee hikes appear to run little risk of driving parents away. Total revenue generated by the mainland's private education industry grew to 287.9 billion yuan in 2015, from 174 billion yuan in 2011, a compound annual growth rate of about 13.4 percent, according to a report from market researcher Frost & Sullivan cited by Yuhua.

What enables the companies to translate nonprofit domestic operations into profits for foreign shareholders is their structure. As with overseas-listed technology companies -- another area where foreign investment is heavily restricted by China's government -- investors own shares not in the underlying assets but in an offshore vehicle known as a "variable interest entity." These structures, usually incorporated in an offshore tax haven such as the Cayman Islands, are entitled to "service fees" that are generally equal to almost all the school operator's income.

Those fees provide the funds to pay dividends to investors in the listed company. Wisdom, owned by a property developer in the southern province of Guangdong, has said it may pay out annual dividends of at least 30 percent of its net profit.

The risk for these companies -- and their investors -- is that the government will push them to adopt for-profit status after September, driving up their land and tax costs. That would be a harsh lesson for an industry that's been doing very comfortably under the nonprofit model. Like China's famously well behaved pupils, their best bet may be to put their heads down, keep working diligently and hope they don't get noticed.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nisha Gopalan in Hong Kong at ngopalan3@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net