The Growth Enterprise Market (“GEM”) is opening soon. Will it be a good exit for foreign PE? In addressing this issue, this article shows that Chinese GEM does make it possible for foreign PEs to exit from the company they invested in a reasonably short time. However, if it were not well structured, the PE investors might fall into a legal trap which would hold them off for years. Good structuring is essential for PE investors to reap the GEM.

I Chinese GEM Overview: from a Comparative Perspective

On March 31, 2009, China Securities Regulatory Committee (“CSRC”) released the Provisional Measures on Administration of Initial Public Offering and Listing on the Growth Enterprise Market (“Provisional Measures”). The promulgation of the Provisional Measures, which will take effect on May 1, 2009, means the long awaited Growth Enterprise Market (‘GEM”) will finally go on the stage after 11 years’ debate and preparation.

Similar to other overseas alternative or secondary markets, China’s GEM is positioned to be an avenue for growth companies to raise capital. Therefore, the thresholds for listing on the GEM are much lower than those for listing on the main boards of both Shanghai and Shenzhen stock exchanges (see chart below).

The above chart also shows Chinese GEM sets a relatively higher financial threshold than most other alternative or secondary markets, which usually require an operating history of not more than 2 years and do not require the issuer to have achieved a record of profitability as a condition of listing, The Hong Kong GEM, for example, requires the applicant shall have an adequate trading record of at least two fiscal years comprising a positive cash flow generated from operating activities in the ordinary and usual course of business. The aggregate cash flow for the two fiscal years immediately preceding the issue of the listing document must be not less than HK$20 million. In comparison, Chinese GEM’s criteria are much more stringent. The Provisional Measures also require that listing candidates demonstrate an ability to continue to operate profitably.

It is commonly accepted that these stricter requirements are necessary to maintain the quality of listed companies and the healthy development of China’s GEM.

II Using GEM as an Exit: Structuring Matters

In addition to its function in raising capital, GEM provides an exit for venture capital and private equity firms as well. The listing rules for GEM have not released yet. However, it is anticipated that the post-listing lock-up period for non-controlling shareholders will be one year, as that applies to main board listings. It seems most prior-IPO investments could be sold out within 3 years as long as the investment was not made in a too early stage.

But for foreign investors, it is another story. In this situation, the timely exit demands delicate structuring.

According to the Provisional Measures, a GEM listing candidate must be a company limited by shares. The establishment of a foreign invested company limited by shares (“FICLS”) is not only subject to China’s Company Law, but also regulated by the Provisional Regulations on Certain Issues Concerning the Establishment of Foreign Invested Companies Limited by Shares, which was promulgated in 1995 by the MOFTEC (the predecessor of the Ministry of Commerce, MOFCOM). The MOFTEC set very high criteria for FICLS, including a minimum capital requirement of RMB30 million, not less than 25% shareholding by foreign investors. If a FICLS is converted from a foreign invested enterprise (“FIE”, usually taking the corporate form of “limited company” instead of “company limited by shares”), the FIE must have a record of being profitable for the past three consecutive years. In addition, promoters of the FICLS are forbidden to transfer their shareholdings in the FICLS within 3 years from its incorporation. These high criteria and the forbidding procedures for incorporation, capital change and equity transfer, which all require the approval of MOFTEC, make FICLS a last choice in terms of corporate forms. Most companies prefer the limited company form when they plan to start up for a venture, and only when they decide to go public on domestic stock exchanges, will they convert themselves to the FICLS form.

It should be noted that these provisions were in line with China’s Company Law then in effect. Nevertheless, the Company Law has been comprehensively revised and most of the corresponding requirements have been relaxed or abolished. But the MOFTEC’s provisional regulations on FICLS are still effective.

PE investors are usually fond of target companies planning to go public in near future, which will enable them to exit in a not too long period of time. However, with the above provisions of the MOFTEC, together with the practice of the CSRC in reviewing and approving an IPO application, it must be extremely careful in structuring an investment.

Let me illustrate this with an example: L is a limited company with three years of operating history and has been profitable for the fiscal year of 2008. It is regarded as having met GEM’s listing requirements. L decides to go public on China’s GEM in near future. P is a PE investor who has reached an agreement with L on investment in L, which will be made no later than June 30, 2009, and P will get 10% of shareholding in L. L is still under control of its original shareholders. My analysis infra will show different structures will result in quite different lock-up period for P’s investment.

1. A. P invests in L before transforming of L into a FICLS

Under this structure, the earliest time for L’s IPO and listing would be in the first half of 2012, and P will have to keep its shareholding in L till 2014. A rough schedule is as follows:

Recently, we noticed that the MOFCOM has shown some flexibility in enforcing its provisions on FICLS. For example, a FIE with only two consecutive years of being profitable might be accepted as meeting the requirements for transforming into a FICLS. However, as long as these provisions are still in effective, such flexibility might leave difficulty for later IPO and listing.

1. B. P invests in L after L has been transformed into a company limited by shares

Under this structure, L might be able to get listed on the GEM by March 2010 and P might be able to sell its shareholding in L by March 2011.A rough schedule is as follows:

III Conclusion

As illustrated above, Chinese GEM does make it possible for foreign PEs to exit from the company they invested in a reasonably short time. However, other regulatory rules and practices might make things much more complicated. Good structuring is essential for PE investors to reap the GEM.

The analysis also demonstrates that it is time to repeal the MOFTEC’s 1995 provisions on FICLS. These provisions proved to be unreasonable and in contradiction to China’s promises for entry of WTO when the Company Law has dropped the corresponding requirements for domestic investors.