Investors should beware of broader private sector crackdowns in China

China’s tightening grip on private companies is forcing international investors to rethink their strategies. This trend could have serious consequences depending on the course charted by the leadership in Beijing.

For 30 years, China’s emerging companies have absorbed funds from global investors looking for high-risk, high-return projects, grown, and then profited investors. Now that virtuous cycle could fall apart.

Since last fall, Chinese leaders have tightened their control over internet giants such as Alibaba Group Holding, Tencent Holdings and Didi Global using antitrust laws, overseas listing regulations, nonbank financial regulations, and rules for handling personal data. They have moved forward in implementing “strengthened antitrust efforts and the prevention of disorderly expansion of capital,” the key policies laid out by the Chinese Communist Party last December.

Furthermore, regulations on private tutoring schools announced by the party and government on July 24 seem to indicate a wider scope of “disorder” and “expansion of capital” to be controlled. “The tutoring sector has been hijacked by capital,” authorities said, criticizing current conditions in which companies profit from education costs, which average households are struggling to pay. Based on this understanding, the government has outright banned for-profit tutoring institutions for elementary- and middle-school students.

A similar sentiment was evident on Aug. 3, when the Economic Information Daily, a newspaper sponsored by the state-run Xinhua News Agency, published an article critical of the gaming industry, describing online games as “spiritual opium” while pointing to Tencent.

There is growing concern in the market that anti-capitalist policies attacking businesses will become more widespread. Industries such as health care and real estate, where there is significant social dissatisfaction and a strong public interest, may be the next to come into regulators’ sights. A medical data company has reportedly frozen its plan to go public in the U.S. for fear of attracting the leadership’s ire.

The stock market has been rocked by the clampdown on for-profit businesses. Prices of listed Chinese stocks have plummeted, and market players have been forced to change how they invest in emerging Chinese companies.

If for-profit businesses are prohibited based on the nature of their operations, the “correctness” of the businesses engaged in by both portfolio companies and potential investment targets needs to be reevaluated. Some also fear the chilling effects on entrepreneurs and existing founders, which may lead to less ambitious business plans. Investors have begun adjusting their portfolios to increase their exposure to India and Southeast Asia.

One investment manager believes that Chinese unicorns — private companies with a valuation of $1 billion or more — are at a high risk of being labeled as pursuing “disorderly expansions.” U.S. hedge funds and private equity funds and SoftBank Group, which hold large amounts of stock in Chinese unicorns, may well be forced to redraw their startup investment strategies.

Understanding the basic rules of doing business in a particular country is fundamental when making equity investments there. With these rules shifting so dynamically in China, investors must be vigilant.