Analysing Dependency on Government Grants and Subsidies in Sponsor Due Diligence

The SFC’s December 2024 circular on sponsor due diligence (SFC, “Circular on Sponsor Due Diligence in Relation to Reliance on Government Grants and Subsidies”, 12 December 2024) has introduced a new layer of scrutiny for listing applicants whose revenue models depend on non-commercial income streams. This circular, effective immediately, mandates that sponsors must now conduct a granular, forward-looking analysis of an applicant’s dependency on government grants and subsidies, moving beyond simple historical disclosure. The trigger for this heightened focus is the increasing number of Main Board and GEM applicants, particularly in the biotechnology, renewable energy, and new materials sectors, where government grants can constitute 30% to 60% of total revenue in the Track Record Period. The SFC’s concern is not merely the quantum of the grant but the sustainability of the business model: if a material portion of revenue is contingent on a discretionary policy decision, the sponsor must assess whether the applicant can operate as a going concern without that support. This article examines the specific regulatory requirements, the analytical framework sponsors must adopt, and the practical implications for due diligence work programmes.

Regulatory Basis and Scope of the Circular

The SFC’s circular is anchored in the existing framework of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the Code of Conduct), specifically paragraphs 17.1 to 17.6, which set out the sponsor’s duty to exercise reasonable skill, care, and diligence in verifying material information. The circular does not create new legal obligations but clarifies that the assessment of grant dependency falls squarely within this existing duty. For a sponsor to satisfy this requirement, the due diligence must extend beyond verifying the existence of grant agreements and the receipt of funds.

Distinguishing Materiality from Disclosure

The circular draws a critical distinction between disclosure and due diligence. An applicant may have fully disclosed its grant income in the prospectus, including the amount, source, and terms. However, the sponsor must independently assess whether that income is material to the applicant’s financial position and business viability. The SFC’s benchmark for materiality is not a fixed percentage but a qualitative assessment: if the withdrawal or reduction of a grant would have a “significant adverse effect” on the applicant’s operations or financial condition, the grant is material. In practice, the SFC has indicated that grants exceeding 20% of total revenue or 30% of net profit in any single financial year within the Track Record Period should be subject to enhanced scrutiny. This aligns with the approach taken in HKEX Listing Rules Chapter 13, which requires disclosure of any material change in the applicant’s financial condition.

The Forward-Looking Assessment Requirement

The most significant departure from prior practice is the requirement for a forward-looking assessment. Sponsors must now evaluate the probability of the grant being renewed, extended, or replaced. This is not a simple recitation of the grant’s expiry date. The sponsor must analyse the policy environment, the government’s stated objectives, and the applicant’s track record of compliance with grant conditions. For example, a grant tied to a specific R&D milestone that has already been achieved may be less likely to be renewed than a grant linked to ongoing operational subsidies. The SFC expects the sponsor to document this analysis in the due diligence work programme, including the sources of information relied upon, the assumptions made, and the sensitivity of the applicant’s financial projections to changes in grant income.

Analytical Framework for Grant Dependency Assessment

The sponsor’s work programme must be structured around a three-tiered analysis: quantitative dependency, qualitative dependency, and contingency planning. Each tier requires specific evidence and documentation.

Quantitative Dependency: Revenue and Profit Concentration

The first step is to quantify the applicant’s dependency on grants. This involves calculating the grant income as a percentage of total revenue, gross profit, and net profit for each year of the Track Record Period. The sponsor must also analyse the trend: is the dependency increasing, stable, or declining? For example, an applicant that derived 25% of its revenue from grants in Year 1, 35% in Year 2, and 40% in Year 3 presents a clear risk profile that requires deeper investigation. The sponsor should also calculate the grant income per share and compare it to the applicant’s earnings per share. If grant income per share exceeds EPS in any period, the applicant’s profitability is entirely dependent on grants. The SFC’s circular provides an example: a biotech company whose only revenue is a government R&D grant of HKD 50 million per year would fail this test, as the grant represents 100% of revenue.

Qualitative Dependency: Policy Risk and Grant Conditions

The qualitative assessment examines the nature of the grant and the risk of its discontinuation. The sponsor must identify the granting authority (e.g., the Innovation and Technology Commission, the Hong Kong Science and Technology Parks Corporation, or a PRC provincial government), the legal basis for the grant (e.g., a specific ordinance, a policy directive, or a discretionary fund), and the conditions attached to the grant. Key conditions to review include: performance milestones, clawback provisions, change-of-control clauses, and restrictions on the use of funds. The sponsor must also assess the political and economic environment. For example, a grant from the PRC’s Ministry of Science and Technology under the “Made in China 2025” initiative carries a different policy risk profile than a grant from the Hong Kong government’s “Technology Voucher Programme”. The former is subject to geopolitical shifts and trade restrictions, while the latter is a domestic policy with a defined budget. The sponsor should obtain written confirmation from the granting authority, where possible, regarding the likelihood of renewal.

Contingency Planning: Scenario Analysis and Mitigants

The final tier requires the sponsor to construct a scenario analysis. The base case assumes the grant continues at the current level. The downside case assumes a 50% reduction in grant income. The severe case assumes a complete cessation. For each scenario, the sponsor must model the impact on the applicant’s cash flow, working capital, and solvency. The applicant must demonstrate that it has a viable plan to replace the lost income, such as through commercial revenue from product sales, licensing fees, or service contracts. If the applicant’s business plan is predicated on continued grant income, the sponsor must assess whether that assumption is realistic. The SFC expects the sponsor to include this scenario analysis in the due diligence report submitted to the Listing Committee.

Practical Implications for the Sponsor’s Work Programme

The circular has direct implications for the sponsor’s work programme, the engagement letter, and the internal compliance review.

Enhanced Work Programme Documentation

The sponsor must now include a dedicated section on grant dependency in the due diligence plan. This section should identify the specific grants, the granting authority, the materiality threshold applied, and the sources of information used. The work programme should also specify the procedures for verifying grant conditions, such as reviewing the grant agreement, the applicant’s compliance records, and any correspondence with the granting authority. The SFC expects the sponsor to conduct site visits to the applicant’s operations to verify that the grant-funded activities are actually being carried out. For example, if the grant is for the construction of a laboratory, the sponsor should physically inspect the laboratory and confirm that the equipment has been purchased and installed.

Increased Reliance on Third-Party Confirmations

The circular emphasises the importance of third-party confirmations. The sponsor should obtain a letter from the granting authority confirming the current status of the grant, the conditions attached, and the expected renewal process. If the granting authority is unwilling to provide such a letter, the sponsor must document the reasons and assess the impact on the reliability of the due diligence. In practice, this may be difficult for PRC government grants, where the granting authority may not have a formal process for providing confirmations to external parties. In such cases, the sponsor may need to rely on the applicant’s management representation, but this must be corroborated by other evidence, such as the applicant’s history of successful grant applications and the consistency of grant income over time.

Impact on the Sponsor’s Independence

The circular also touches on the sponsor’s independence. If the sponsor has a relationship with the granting authority, such as having previously advised the authority on the grant programme, this must be disclosed in the due diligence report. The SFC expects the sponsor to maintain a clear separation between its advisory role and its sponsor role. The circular does not prohibit the sponsor from having such a relationship, but it requires full disclosure and a robust conflict-of-interest management process.

Case Studies and Market Examples

The SFC’s circular is not merely theoretical; it responds to specific enforcement actions and market observations. The SFC’s 2023 enforcement action against a sponsor for inadequate due diligence on a biotechnology applicant (SFC, “Statement of Disciplinary Action”, 15 March 2023) highlighted the risks of grant dependency. In that case, the applicant’s sole revenue was a government R&D grant of HKD 80 million, which was due to expire 12 months after listing. The sponsor had not assessed the likelihood of renewal, nor had it modelled the impact of the grant’s cessation. The SFC fined the sponsor HKD 15 million and suspended its licence for 12 months. This case is now the benchmark for the enhanced scrutiny required by the 2024 circular.

The Biotech Sector: A High-Risk Area

The biotechnology sector is particularly vulnerable to grant dependency. Many biotech applicants have no commercial revenue and rely entirely on government grants to fund their R&D operations. The SFC’s circular explicitly addresses this: sponsors must assess whether the applicant can continue its R&D activities without the grant, and whether the applicant has a realistic path to commercialisation. For example, a biotech company developing a gene therapy for a rare disease may have received a HKD 100 million grant from the Hong Kong government’s “Health and Medical Research Fund”. The sponsor must assess whether the grant will be renewed after the initial three-year term, and whether the company has alternative funding sources, such as venture capital or licensing deals.

The Renewable Energy Sector: Policy Risk

The renewable energy sector is another area of focus. Many renewable energy companies derive a significant portion of their revenue from government subsidies, such as feed-in tariffs or renewable energy certificates. The sponsor must assess the policy risk: is the government committed to maintaining the subsidy scheme? For example, the PRC’s “13th Five-Year Plan for Renewable Energy” included a target of 500 GW of wind and solar capacity by 2025, but the subsidy scheme was scaled back in 2022. A sponsor assessing a solar farm operator whose revenue is 40% dependent on feed-in tariffs must model the impact of a reduction in those tariffs, and assess whether the operator can operate profitably at lower tariff levels.

Actionable Takeaways for Sponsors

1. Integrate a grant dependency assessment into the standard due diligence checklist for all Main Board and GEM applicants, with enhanced procedures for applicants in the biotechnology, renewable energy, and new materials sectors where grant income is likely to exceed 20% of total revenue.

2. Obtain a third-party confirmation from the granting authority regarding the current status, conditions, and renewal prospects of each material grant, and document any refusal to provide such confirmation in the due diligence work programme.

3. Construct a formal scenario analysis modelling the impact of a 50% reduction and a complete cessation of grant income on the applicant’s cash flow, working capital, and solvency, and include this analysis in the due diligence report submitted to the Listing Committee.

4. Conduct a physical site visit to verify that grant-funded activities are being carried out as described in the grant agreement, and document the findings with photographs and written notes.

5. Review the applicant’s compliance history with grant conditions, including any clawback events, change-of-control clauses, or restrictions on the use of funds, and assess whether any non-compliance could trigger a loss of the grant.