A Gem of an exit
June 06, 2009 | BY
clpstaff &clp articles &A new junior board will open in Shenzhen later this year and will provide a reasonably quick exit for foreign private equity firms. But good structuring is vital to avoid years of delays
The Growth Enterprise Market (Gem) will open in Shenzhen soon. The new junior board will make it possible for foreign private equity houses to exit from their investment in China in a reasonably short time. But if the exit is not well-structured, the investors may find themselves caught in a legal trap which could lead to delays of many years.
Post-listing restrictions on transfer of shares
On March 31 2009, the China Securities Regulatory Committee (CSRC) released its Tentative Measures for the Administration of the Initial Public Offering of Shares and the Listing thereof on the Growth Enterprise Market (首次公开发行股票并在创业板上市管理暂行办法). Four days after they took effect on May 1, the Shenzhen Stock Exchange released its draft Gem listing rules for comment. It is anticipated that Gem will greet its first listings in a couple of months.
China's Gem opens an avenue for growth companies to raise capital. It also provides an exit for venture capital and private equity firms. According to the Shenzhen Stock Exchange's draft listing rules, the post-listing lock-up period for non-controlling shareholders will be one year. For shares issued within six months before the date on which an application for an IPO has been officially accepted by the CSRC for processing, in addition to the one-year post-listing lock-up period, there is another restriction: the transferable shares within the first 12 months immediately after the lock-up period shall not be more than 50%. Therefore, most pre-IPO investments could be sold out within three years, as long as the investment was not made at too early a stage.
Restrictions from elsewhere
But for foreign investors, it is another story. In this situation, a timely exit demands delicate structuring.
According to the Tentative 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 the PRC Company Law (中华人民共和国公司法), but also regulated by the Certain Questions on the Establishment of Foreign-funded Companies Limited by Shares Tentative Provisions (对外贸易经济合作部关于设立外商投资股份有限公司若干问题的暂行规定), which was promulgated in 1995 by Moftec (the predecessor of Mofcom, the Ministry of Commerce). Moftec set very high criteria for FICLS, including a minimum capital requirement of Rmb30 million (US$4.4 million) and not less than 25% shareholding by foreign investors. If a FICLS is converted from a foreign-invested enterprise (an FIE, usually taking the corporate form of a limited company instead of a 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 three years from its incorporation.
Private equity investors are usually fond of target companies planning to go public in the near future, as this enables them to exit in a reasonably short period of time. But with the Moftec provisions mentioned above, investors must be extremely careful in structuring an investment.
Take the following example: L is a limited company which has operated for three years 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 Gem in the near future. P is a private equity investor who has reached an agreement with L on investment in L, which will be made no later than June 30 2009, through which P will get a 10% shareholding in L. L is still under control of its original shareholders. Different structures will result in quite different lock-up periods for P's investment:
Route A: P invests in L before transforming 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.
| Closing month | Milestone result | Notes |
| June 2009 | P closes its investment in L and becomes one of L's shareholders. L becomes a foreign invested enterprise. | This timing was given by the example |
| March 2011 | L submits application for transforming into a FICLS. | According to Moftec's provisions on FICLS, L has to show its record of profitability for the past three consecutive years. This means L has to wait at least another two years before it can submit a transforming application to Mofcom. The earliest practical time for submitting the transforming application would be in March 2011, when L has the audit report for its financial statement of 2010. |
| June 2011 | L completes its transformation and is registered as a FICLS. | It would be very tight but still possible to finish the whole transforming process in three months. |
| August 2011 | L submits application for IPO and listing to the CSRC. | It is possible to meet the schedule as long as L prepares for IPO at the same time as it handles the transforming matters. |
| March 2012 | L's IPO and listing is approved and L gets listed on Gem. | The review and approval procedure by the CSRC is time-consuming and it would be lucky to get approval within six months. |
| June 2014 | P is able to sell its shareholding in L. | When L transforms itself into a FICLS, P, together with other shareholders, will have to serve as a promoter – a promoter is forbidden by Moftec's provisions to transfer its shareholding within three years. |
Recently, 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 effect, such flexibility might leave difficulty for later IPO and listing.
Route 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 Gem by March 2010 and P might be able to sell its shareholding in L by March 2011.
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