A decade after the initial proposal and following years of anticipation, the launch of China’s Growth Enterprise Market (GEM) is finally within view. The country’s top stock market watchdog — the China Securities Regulatory Commission (CSRC) — published rules governing listings on the board at the end of March, and they take effect on May 1. Meanwhile, more rules on auditing committees and sponsors have also been released.
The exchange will focus on small, finance-starved innovative start-ups with strong growth potential. The move has been widely applauded by venture capitalists in China, but some investor representatives worry that too many of the companies listed will be high risk. They also voice skepticism over the GEM’s prospects, given the poor track record for similar efforts in other countries. Yet one thing seems clear as the market gets ready for take-off — the pool of candidates for listing on China’s GEM will likely be large.
Supporters, such as Wang Shouren, Secretary-General of the Shenzhen Venture Capital Association, believe that launching the GEM will more effectively allocate financial resources and “promote the transfer of resources to productive uses, which will be an important driving force for a second industrial revolution.” He also believes that “now is good timing” for the launch. With hundreds of billions of dollars of stimulus in the pipeline, and the Shanghai Stock Market Composite Index rallying gradually to above 2,300, “investor confidence is on the rise.” That’s certainly better than late 2008, when the index fell to nearly 2,000.
Joe Tian, Managing Partner of DT Capital, a venture capital and private equity company based in Shanghai, agrees this is a good time for the launch, and notes that demand is high for the kinds of issues most likely to come to market. “The demands for financing for public companies or to exit in the public market have just accumulated to the degree that they cannot be ignored by decision makers,” Tian notes. “It’s certainly a good thing. The more exit channels there are, the better for our returns, and the greater the value of investments. It’s as simple as that.” Tian acknowledges, however, that funds denominated in foreign capital will not benefit directly.
Companies Can’t Wait
The new regulatory measures stipulate a range of conditions for issuers: Either cumulative net profits in the preceding two years must be at least 10 million yuan and growing, or net profits in the most recent year must be at least 5 million yuan, with revenues of at least 50 million yuan, and revenue growth of at least 30% in the past two years. In addition, the total issued share capital must be at least 30 million yuan, and the issuing company ideally should have its business focused in just one main area. The GEM will also establish criteria for risk tolerance of investors on GEM. Further layers of detail are expected to be released soon, including listing application documents and prospectus guidelines.
Expect a large pool of companies to be eligible for listing on GEM. Ba Shu Song, vice chairman of finance for the State Council’s Development Research Center, noted during a recent program broadcast by China Central Television that the country’s “direct financing mechanism is not very well developed.” As a result, a huge number of companies meet the GEM’s financing criteria. “Based on the current standard, we have at least 3,000 to 5,000 [eligible] companies, and almost 10,000 enterprises that are financially ready for listing on the GEM.”
Shenzhen city alone has 1,100 companies that meet the GEM’s financial requirements, while around 100 companies have started restructuring to meet the guidelines and 35 companies are now in the pipeline, according to Shenzhen officials. In Hunan province, roughly 100 companies are ready to apply for GEM listing, while over 50 have signed pre-listing guidance deals with security firms. In Jiangsu Province, 130 companies have already signed deals. Ping An Securities has placed more than 100 companies in the pipeline, says Xue Rong Nian, company president, and nationwide it has at least 1,000 companies waiting to get listed on GEM, estimates suggest.
Will the GEM help solve the difficulties Chinese small and medium enterprises (SMEs) are facing regarding access to finance? Shanghair-based Fisher Zhang, manager of a Hong Kong investment fund, thinks the answer is “yes,” at least for some companies. “The banks don’t lend them the money. Private equity is insufficient. Underground lending is not legal. So they can only go to the GEM. But with a narrow pipeline for the GEM, not every company that is hungry for money will be able to get it there.” The Gem also opens up a new channel for domestic investors, who have limited investment options.
But don’t expect the launch of the GEM to be anything like a cure-all for SMEs’ financing problems. At the Boao Forum, an executive meeting on China’s development that took place in mid-April, Yao Gang, vice president of the China Securities Regulation Committee, said if SMEs can improve themselves and optimize resource allocation through the capital markets, that will boost many other industries. Add in greater involvement by venture capital and private equity funds in the market, and the net result is a large, positive ripple effect, Yao predicts. Yao, like many government officials, believes that that the success of the GEM cannot be judged simply in terms of the amount of capital raised, nor by how many companies are attracted to the market. Instead, look for more general, wider positive effects on the economy when judging success.
Roller-coaster Risks
Despite the palpable air of excitement in the venture capital world, however, many market participants and observers also see potential pitfalls ahead. “China’s stock market is like roller coaster — it gets bumpy fast and then plummets, with few returns for the investors in average terms,” notes Zhang. “The companies listed on the GEM will mostly be mediocre ones, and they will already be priced at a premium in the primary market. My view is that there will be some value for investors in the near term, but I am not sure about the long-term value.”
“It might not be as ideal as we imagine,” Zhang cautions. “Regulation on our main board is not yet well-established, but the GEM will place higher demands on regulatory capabilities due to the high-risk nature of the listed companies. Those small and risky companies need stronger and stricter regulations.” Regarding information disclosure and insider trading: “There is a lot to be done. The main board has not addressed these issues yet. How do you expect the GEM to be able to do it?” he asks. Still, stock markets inevitably take time to mature. The same will be true of the GEM, he points out.
According to Shui Ping, a well-known financial commentator and chief editor of Hua Xia Times, two key issues on the main board are yet to be addressed: the issuing system and the question of what to do with untradeable stocks. Shui thinks it would have been better to resolve these two problems before the GEM was launched. His views are echoed by Lu Zhiming, a researcher on capital markets at Shanghai’s Fudan University: “It’s more important to improve the listed companies on the main board and to establish the mechanism of the main board first.” Otherwise, the GEM will be like any other super-speculative market, Lu adds, “and will not bring true value to real investments in high-tech startups.”
By the end of 2008, about a dozen GEMs around the world had closed, and some of the survivors are struggling. Hong Kong’s GEM, for instance, is widely acknowledged to have failed, having attracted only a few companies to list on it in recent years.
The main board’s chief problems, meantime, revolve around the regulation of information disclosure and inadequate protection of investor interests, Lu argues. “One of the main reasons why some companies cook their books,” he says, “is because penalties are too light. The regulators have to adopt much more severe means of punishment in today’s environment.” In fact, the only great GEM is the Nasdaq in the U.S., according to Lu. “Most GEMs in other jurisdictions have failed. Why? The reason is simple: They cannot control the quality of listed companies or investor speculation.”
DT Capital’s Tian disagrees. “We are more positive about the quality of companies listed on the GEM than the investors on the secondary market are. When we look at companies, we first look at the quality of the team. If they can do well even before the company goes public, why would they suddenly start running the company poorly after listing? If the team is not up to that level why should we invest in them? We generally evaluate them by the standard for a listed company. So, at least in terms of people, we are confident.” But, in the end, will a start-up grow into a really successful giant like Microsoft or Google? “The odds are not 100%,” he says.
Higher Risk but Higher Reward?
Tian also points out that high-growth-potential companies offer greater opportunities. “If you look at the growth pattern of most of the start ups, you will see a slow rise and then very steep ascent, then explosive growth and then a plateau.” Time the initial public offering right, he says, and the entrepreneurs, shareholders, investors and venture capitalists all benefit. But of course, start-ups at this stage also can easily fail, Tian acknowledges. “There will always be risks in terms of market, technology or the macro environment. The GEM is a high-risk, high-return board.”
Still, SMEs are the most dynamic, diligent and innovative sector of the economy, Tian notes. “Decision makers are fully aware of the contribution that SMEs make to the whole of society, while SMEs get little support and backup from government policies.” The Gem can offer some support.
More Demand on Regulators
Cheng Jian, an investment manager in Shanghai, says the top task for regulators will be to control the quality and growth potential of companies on the GEM. Ba Shusong of the state council stressed that the most important thing is to make sure that the GEM and the existing SME board — also located at the Shenzhen Stock Market — are positioned differently. On the other hand, Ba noted that the CSRC has increased the requirements placed on GEM sponsors — a widely supported step that Ba believes will alleviate some risk for investors.
One of the biggest steps officials could take to help reduce risks would be to strengthen the regulations covering delisting. Dong Dengxin, a professor at Wuhan Technology University, argues that high risks imply a high number of failures and thus a high delisting rate. The GEM therefore needs to set up rigorous delisting standards that are strictly implemented, he says.
Andy Xie, an independent economist and commentator on China’s economy, agrees the delisting mechanism should be strengthened to avoid the GEM becoming purely a money game. At present, it’s easy to get listed on China’s stock markets and easy to remain eligible. But delisting rules are sketchy. The GEM should take into account the hard lessons learned on the main board, he adds. Nasdaq, the star performer among the exchanges for growing tech companies, has spawned pioneers like Microsoft, Apple and Google. Supported by venture capital and direct investment, investors have enjoyed long-term benefits, and the ultimate key to success has been innovation.
So why have the GEMs in Japan and Germany not equaled this success, Xie asks? He thinks the answer lies in the domination of long-established enterprises by large companies. In this environment, small enterprise growth is inhibited. So the issue, then, is how much a society can tolerate the growth of small private businesses. Xie believes that most countries share similar values as Japan and Germany.
In the end, Tian says, the GEM will require, in the Chinese phrase, a “feeling the stones to cross the river” approach: You can definitely get across, and it’s good to go forward, but you must anticipate that there will be complications. Over-reactions and non-reactions from the market are both risks.
At this stage, it’s too early to know what the market will look like, or how it will behave. But Tian believes that based on his contact with regulatory officials, “decision-makers have taken the lessons from GEMs in other jurisdictions very much to heart.” Investors will certainly hope so.
