I have no experience of using Win ME on a VM, however I can remember using Win ME natively, around 20 years or so ago as an operating system in its own right....
My memory on some of the details may be tad flakey, but maybe the following thoughts may help.
1 Win ME was the first Windows operating system to automatically include System Restore (System File Protection?)
2 Basically it had the ability ( usually!) to set back the computer in time to a similar state as existed just before the system Restore Point was created
3 It was a powerful tool and technicians urged folks to create a System Restore Point before making adjustments on their computers, so that if things went wrong the system could be set back in time, to how it was when the System Restore Point was created. It was especially useful when inexperienced folks tried tinkering with Registry!
4 For example if you installed a program and you had the foresight to create a System Restore Point immediately prior to the installation then it would have the ability to set back the computer in time and thus remove the installed Program and its component parts should things go wrong.
5 It was ( and still isn't) a totally 100% solution to all and every problem but it has sure got a lot of folks out of trouble over the years
6 If you create a System Restore Point prior to installing Service Pack 1.05 and then choose to set back the computer in time using the System Restore Point then Yes it will have the effect of taking out the Service Pack.
7 The System Restore Points ( some folks refer to them as snapshots) take up hard drive space and I think originally approx 15% of the hard drive was allocated to them. If space on the hard drive became insufficient then some of the earlier ones were likely to be deleted.( although a useful tool it is no where as good as having good up to date disc images, but is often an effective adjunct to them.
8 If System Restore was turned off then it had the effect of deleting all the stored System Restore Points...
9 If a machine acquired a Virus or other items of undesirable code and was subsequently cleaned of the undesirable/malicious code then subsequent to that a System Restore point was activated then the machine would be set back in time to just before the System Restore Point was created and this could mean that the virus or other malicious code would be put back as well!
10 In recent times the System Restore Utility has been disabled by default upon for example installation of the operating system... and to take advantage of its facilities it has been necessary to switch it on. ( Turning it on is what I recommend for a lot of ordinary folks)
I hope these thoughts provide an insight into how it works but post back if you require further information