The Growth Enterprise Market (GEM) provides a capital raising avenue for smaller companies in Hong Kong. BDO’s Andrew Lam discusses the listing requirements for companies and outlines key investor concerns.
The prospect of a higher return, albeit at a higher risk, is a more tempting proposition in this lowinterest environment. Individual retail investors however should remain cautious when delving into the Growth Enterprise Market (GEM), a secondary board of the Hong Kong Stock Exchange (HKSE) which operates on a very much “buyer beware” philosophy.
The GEM board was established in 1999 to provide a capital raising avenue for growth companies that do not fulfill the profitability and track record requirements for the main board. Perhaps the timing of the board’s launch was a portent of risks to come: the GEM board was launched during the ‘Internet bubble’ of the late-1990s, and the bubble’s subsequent burst and resulting economic downturn has been associated with the board ever since. “The timing wasn’t very good,” says Andrew Lam, Director of Assurance Services at BDO Limited, an accounting GEM board were technology-related and collapsed due to the bubble bursting.” Simply put, the board did not start off well.
The ensuing years have seen the GEM board evolve in its purpose and role for smaller companies and enterprises looking to make a step up to the next level and raise public capital but without facing the rigorous requirements of the main board.
Performance in volatile markets
In the face of turmoil across global equity capital markets, the GEM board is surprisingly resilient. “The activity on the GEM board has been positive in the past few years,” says Lam. “Though there are concerns over size and market capitalization, as with most smaller companies, the GEM board is affected less by overall weaker capital markets and crises.”
As far as the level of opportunity to be found on the GEM board is concerned, Lam is optimistic. “The overall market improved faster than expected during the beginning few months of 2012, but we still haven’t seen large IPOs in the market. A strong demand for the GEM
board remains. The global economy has not been great for some companies, and for those who were originally in the pipeline for a main board listing may only qualify for GEM board listing now.”
A main board listing has financial requirements of at least HK$50 million in the last three financial years, whereas a GEM board listing requires a positive cashflow generated of at least HK$20 million in aggregate for the past two financial years. These simpler rules make the board more appealing to aggressive startups.
“Once these companies satisfy the GEM board requirements, they can then list and make use of the capital raised and eventually migrate to the main board,” says Lam. The GEM board is increasingly seen as a ‘springboard’ for the main board, rather than a destination for companies. BDO reports that in the past four years, 50 GEM board listed – over a quarter of the total number of listed companies – have successfully migrated to the main board.
For investors, the GEM board, with its higher risk and smaller investor pool, poses more governance concerns, and consequently there are stricter reporting criteria for GEM board listed companies. “GEM board companies are required to submit quarterly reports; those on the main board are only required to submit every half year,” says Lam. At its heart, the best corporate governance is not perfect though. “There are no fool-proof ways to tell if listed companies are going to fail,” says Lam. Not all of the reasons are due to corporate governance either, he notes.
It is important for investors to understand that the regulations develop over time and shift as market demands change. One example that Lam brings up is the HKSE’s amendment of rules to accommodate and facilitate the listing of mining and projects companies. “The previous rules for listing were designed for companies with more predictable cash flows such as manufacturing companies,” he says. “For mining and projects, the initial capital investment is very costly and is often the driver for capital raising.
Thus exceptional cases are reviewed for these companies that do not meet the profit track record.” “There are checks and balances to evaluate these companies, and special requirements are imposed to balance the lack of a profit track record,” says Lam. But with these changes and allowance for flexibility, a broader range of companies who operate in different sectors can thus list on the HKSE.
Investors should be aware of these rule exceptions – after all, one might have taken comfort that a company listed on GEM must have met certain cashflow requirements. But “caveat emptor” is the rule and investments should be more thoroughly checked out than investments in other main boards.
The most common challenge for smaller companies listed onto the HKSE is not the listing process, but rather the continued monitoring that comes with being a listed company. “A lot of companies have anticipated the process and difficulties for IPO, but then they underestimate the cost and time required to run a listed company,” says Lam. Most of the corporate governance issues arise after the listing, he says. “This is probably because people overlook the importance of these monitoring processes and resources and time required to maintain them.”
The monitoring process and rigor does not differ between GEM board listed companies and main board listed companies, and the perception of GEM board listed companies being higher risk leads to more stringent measures.
Retail investors should approach the GEM board with caution despite the existing regulatory regime. “The obvious drawback of a second board (GEM board) is that of a limited investor pool,” says Lam. “Certain funds and investors may not be able to invest in smaller companies due to the naturally higher operational risk.” This lack of support in turn deters retail investors, leading to a naturally smaller investor pool. The largest determinant for the GEM board is not regulators, but market forces and transactional volume. A company’s failure is not easy to predict through a regulatory lens, and one of the main reasons that retail investors should take extra caution in investing in GEM. BM