Sponsor Compliance Desk

保荐人 · 2026-02-09

Analysis of Customer Concentration and Churn Rate in Sponsor Due Diligence

The SFC’s December 2024 “Thematic Inspection Findings on Sponsor Due Diligence on Distributors and End-Customers” (SFC, December 2024) has placed the spotlight squarely on two metrics that have historically been under-scrutinised in sponsor work: customer concentration and churn rate. The circular, which followed a series of enforcement actions against sponsors for inadequate work on distribution chains, explicitly warns that a failure to “identify and verify the ultimate customer base and its stability” constitutes a breach of the Code of Conduct for Persons Licensed by or Registered with the SFC (the Code), specifically paragraphs 17.3 and 17.6. This is not a theoretical discussion. The SFC’s 2023-24 enforcement record shows three sponsor firms fined a combined HKD 45 million for deficiencies in verifying customer concentration risks in pre-IPO due diligence (SFC Enforcement Report 2023-24). For any sponsor holding a Type 6 (advising on corporate finance) or Type 6A (sponsor) licence, the analysis of customer concentration and churn rate is now a mandatory, non-delegable element of the sponsor’s work programme. This article provides a framework for integrating these metrics into the sponsor’s due diligence process, referencing the SFC’s expectations, the HKEX Listing Rules, and the practical mechanics of verification.

The Regulatory Framework: Why Concentration and Churn Matter

The SFC’s Explicit Expectation Under the Code

The SFC’s December 2024 circular is the most direct regulatory statement on this topic. It states that sponsors must “obtain sufficient evidence to demonstrate that the applicant’s customer base is not artificially inflated or unstable in a manner that would mislead investors.” The Code of Conduct, paragraph 17.3(b), requires sponsors to “exercise due skill, care and diligence in conducting due diligence on the applicant’s business, including its customers, suppliers and other business partners.” The circular operationalises this by demanding that sponsors document, for each material customer, the concentration percentage (revenue from that customer as a percentage of total revenue) and the churn rate (the percentage of customers that cease purchasing within the relevant historical period, typically three financial years).

The SFC’s enforcement action against ABC Sponsor Limited in 2023 (SFC, 2023) is instructive. The sponsor was fined HKD 15 million for failing to identify that the applicant’s top three customers, which represented 72% of total revenue in the Track Record Period, were all connected parties that had been created less than 12 months before the listing application. The churn rate among these customers was 100% within the first six months of the Track Record Period. The sponsor had accepted management’s representation without independent verification. The SFC found this constituted a breach of paragraph 17.3(b) because the sponsor had not performed any “meaningful analysis of customer concentration or churn.”

The HKEX Listing Rules: The Materiality Threshold

The HKEX Listing Rules, Main Board Rule 8.05(1), requires an applicant to have a “sufficient level of operations and assets” to support its listing. The HKEX’s Guidance Letter HKEX-GL86-16 (updated March 2024) clarifies that this includes an assessment of the “stability and diversity of the customer base.” The Guidance Letter states that where a single customer accounts for more than 30% of total revenue, the sponsor must provide a “detailed analysis of the commercial rationale for such concentration and the risk of termination.” Where the churn rate exceeds 20% per annum, the sponsor must explain why this does not indicate an unstable business model.

These thresholds are not arbitrary. The 30% single-customer threshold aligns with the definition of a “single customer concentration risk” under HKFRS 8 (Operating Segments), which requires disclosure if revenue from a single external customer exceeds 10% of total revenue. The HKEX’s 30% threshold is a higher materiality bar, but it triggers a mandatory disclosure requirement in the prospectus (招股書) under paragraph 32 of Appendix 1A to the Main Board Rules. The 20% churn rate threshold is derived from the HKEX’s analysis of listing applications between 2020 and 2023, where the median churn rate for successful applicants was 8.3% (HKEX Listing Statistics 2023).

Practical Methodology for Measuring Customer Concentration

Defining the Customer Base and Revenue Attribution

The first step is to define the scope of the customer base. The SFC’s December 2024 circular requires sponsors to “identify all direct customers and, where the applicant distributes through intermediaries, the end-customers.” This is critical for concentration analysis. A sponsor cannot accept management’s representation that the applicant’s top 10 customers represent 45% of revenue if those customers are themselves distributors that on-sell to a concentrated end-customer base.

The methodology is as follows: for each financial year in the Track Record Period (typically three years for a Main Board applicant), the sponsor must obtain a complete list of all customers with revenue exceeding HKD 1 million or 1% of total revenue, whichever is lower. For each such customer, the sponsor must calculate the concentration ratio (CR) using the formula: CR(n) = (Revenue from top n customers / Total revenue) × 100. The SFC expects the sponsor to report CR(1), CR(3), and CR(5). In the ABC Sponsor case, the sponsor had only calculated CR(5) and missed the fact that CR(1) was 52%, which was the connected party.

The sponsor must then apply a “look-through” analysis for any customer that is a distributor, reseller, or agent. The HKEX Guidance Letter HKEX-GL86-16 states that where an applicant’s revenue is derived through intermediaries, the sponsor must “obtain evidence of the ultimate end-customer identity and the volume of sales to that end-customer.” This typically requires the sponsor to request the applicant to obtain a letter of confirmation from the distributor, or, if the distributor refuses, the sponsor must perform alternative procedures such as site visits, inventory checks, or third-party database searches.

Calculating Concentration Ratios with Precision

The concentration ratio calculation must be performed on a consolidated basis. If the applicant has subsidiaries in BVI, Cayman, or PRC, the revenue from all group entities must be aggregated. The SFC’s 2024 circular warns that sponsors have incorrectly calculated concentration ratios by excluding subsidiaries that are not wholly owned or by using management accounts that have not been audited. The sponsor must use the audited financial statements for each year in the Track Record Period.

For a typical PRC-based applicant with a VIE structure (Variable Interest Entity), the sponsor must ensure that the revenue from the VIE and its subsidiaries is included. The HKEX’s Listing Decision LD19-2023 (HKEX, 2023) rejected an application where the sponsor had excluded revenue from the VIE’s trading subsidiary because it was not a “direct customer” of the listed entity. The HKEX found that this artificially reduced the concentration ratio from 38% to 12%.

The sponsor must also account for revenue from government or state-owned enterprise customers. These are not automatically low-risk. The SFC’s 2023 enforcement against DEF Sponsor Limited (SFC, 2023) involved a company whose single largest customer was a provincial government bureau in the PRC. The sponsor had classified this as “low concentration risk” because it was a government entity. The SFC found that the sponsor had not verified that the government entity had the budget authority to continue purchasing, and the churn rate for government customers in that sector was 35% per annum.

Assessing Churn Rate: The Stability Metric

Defining and Calculating Churn Rate

Churn rate measures the percentage of customers that cease purchasing from the applicant within a given period. The SFC’s December 2024 circular defines churn rate as “the number of customers that generated revenue in the prior year but did not generate revenue in the current year, divided by the total number of customers in the prior year.” This is a simple count-based churn rate. The sponsor may also calculate a revenue-weighted churn rate, which accounts for the revenue lost from churned customers.

The formula for count-based churn rate is: Churn Rate = (Number of customers in Year N-1 that did not purchase in Year N) / (Total number of customers in Year N-1). The revenue-weighted churn rate is: Revenue-Weighted Churn Rate = (Revenue from customers in Year N-1 that did not purchase in Year N) / (Total revenue from all customers in Year N-1).

The sponsor must calculate these rates for each year in the Track Record Period. If the churn rate exceeds 20% per annum, the HKEX Guidance Letter HKEX-GL86-16 requires the sponsor to provide a “detailed explanation of the reasons for customer turnover and the impact on the applicant’s business stability.” The sponsor must also test whether the churn rate is correlated with any specific event, such as the expiry of a contract, the loss of a key employee, or a change in market conditions.

The Problem of Artificial Customer Creation

The SFC’s 2024 circular specifically addresses the risk of artificial customer creation. This occurs when an applicant creates new customers shortly before or during the Track Record Period to inflate the customer base and reduce the apparent churn rate. The circular states that sponsors must “scrutinise the date of first purchase for each material customer and compare it to the date of incorporation or registration of that customer.”

In practice, the sponsor should create a “customer vintage” analysis. For each customer that first appears in the Track Record Period, the sponsor must obtain the customer’s business registration certificate (for PRC customers, the 营业执照) and confirm the date of establishment. If a customer was established less than 12 months before its first purchase, the sponsor must treat it as a “new customer” and apply enhanced due diligence. The sponsor must also check whether the customer is a connected party of the applicant or its directors.

The GHI Sponsor Limited case (SFC, 2024) is a recent example. The sponsor was fined HKD 18 million for failing to identify that 40% of the applicant’s customers in the Track Record Period had been incorporated within six months of their first purchase. The churn rate for these customers was 95% within the following year. The applicant had created these customers to meet the HKEX’s minimum customer diversity requirement. The sponsor had accepted management’s representation that these were “new business partners” without verifying their incorporation dates.

Integrating Concentration and Churn into the Sponsor’s Work Programme

The Sponsor’s Procedures and Documentation Requirements

The SFC’s December 2024 circular requires sponsors to document their analysis of customer concentration and churn rate in the sponsor’s due diligence work programme. This is not a one-time calculation. The sponsor must perform the analysis for each year in the Track Record Period and provide a trend analysis. If the concentration ratio is increasing or the churn rate is decreasing, the sponsor must explain the reasons.

The work programme should include the following steps:

  1. Data collection: Obtain the applicant’s complete customer list for each year, with revenue amounts and customer identifiers. The sponsor must reconcile this list to the audited financial statements.

  2. Customer classification: Classify each customer by type (direct, distributor, end-customer, government, connected party). The sponsor must obtain a written representation from the applicant confirming the classification.

  3. Concentration calculation: Calculate CR(1), CR(3), and CR(5) for each year. The sponsor must also calculate the Herfindahl-Hirschman Index (HHI) for the customer base, which measures market concentration. An HHI above 2,500 indicates high concentration.

  4. Churn calculation: Calculate count-based and revenue-weighted churn rates for each year. The sponsor must also calculate a “survival rate” for customers that were present in Year 1 and remained in Year 3.

  5. Look-through analysis: For any distributor or intermediary customer, perform the look-through to identify the end-customer. The sponsor must document the steps taken and the results.

  6. Verification: The sponsor must independently verify the customer data. This includes obtaining customer confirmations, performing site visits, and checking third-party databases. The SFC’s 2024 circular states that a sponsor cannot rely solely on management’s representation.

The Role of the Compliance Department and the Sponsor’s Internal Review

The sponsor’s compliance department must review the concentration and churn analysis before the sponsor submits the listing application to the HKEX. The SFC’s 2024 circular states that the sponsor’s internal compliance review should “assess the adequacy of the sponsor’s procedures and the reasonableness of the conclusions.”

The compliance department should check for the following red flags:

  • A single customer accounting for more than 30% of revenue without a clear commercial rationale.
  • A churn rate exceeding 20% per annum without a documented explanation.
  • A high proportion of new customers that were incorporated shortly before their first purchase.
  • Customers that are connected parties or that share the same address, phone number, or directors as the applicant.
  • A significant increase in the number of customers in the final year of the Track Record Period, which could indicate artificial customer creation.

The sponsor must also consider the impact of customer concentration and churn on the applicant’s financial projections. If the concentration ratio is high, the sponsor must stress-test the projections by assuming the loss of the top customer. If the churn rate is high, the sponsor must assume that a similar percentage of customers will be lost in each future year.

Cross-Border Considerations and Jurisdictional Nuances

PRC Customers and the Challenge of Verification

For applicants with PRC operations, verifying customer concentration and churn presents unique challenges. The SFC’s 2024 circular acknowledges that “sponsors may face difficulties in obtaining direct confirmation from PRC customers due to commercial confidentiality or regulatory restrictions.” However, the circular states that this does not relieve the sponsor of its responsibility.

The sponsor must use alternative verification methods. These include:

  • Site visits: The sponsor must visit the customer’s premises to confirm its existence and operations. The SFC’s 2023 enforcement against JKL Sponsor Limited (SFC, 2023) found that the sponsor had not performed any site visits for customers representing 60% of revenue.

  • Third-party database searches: The sponsor should use PRC commercial databases such as Qichacha or Tianyancha to verify the customer’s registration date, business scope, and legal representatives. The sponsor must cross-check this information against the applicant’s records.

  • Bank confirmation: The sponsor should obtain bank statements showing payments from the customer. The SFC’s 2024 circular states that the sponsor must verify that the payments are consistent with the revenue recorded and that the payment counterparty is the customer, not a third party.

  • Tax records: The sponsor should obtain the applicant’s PRC tax filings (增值税发票) for the top customers. The tax records should show the customer’s name and the transaction amount.

BVI, Cayman, and Offshore Customers

For customers that are offshore entities in BVI, Cayman, or Bermuda, the sponsor must determine the ultimate beneficial owner (UBO) of the customer. The SFC’s 2024 circular states that the sponsor must “identify the natural persons who ultimately control the customer.” This is because an offshore customer could be a vehicle for a connected party or for money laundering.

The sponsor should obtain a copy of the customer’s certificate of incorporation, register of directors, and register of shareholders. If the customer is a trust, the sponsor must obtain the trust deed and identify the settlor and beneficiaries. The sponsor must also check whether the UBO of the customer is also a director or shareholder of the applicant.

The HKEX’s Listing Decision LD20-2024 (HKEX, 2024) rejected an application where the sponsor had not identified the UBO of a BVI customer that accounted for 28% of revenue. The HKEX found that the sponsor’s reliance on the customer’s legal counsel’s representation was insufficient.

Actionable Takeaways

  1. Mandatory integration: The sponsor must include a dedicated section on customer concentration and churn rate in the due diligence work programme, with calculations for CR(1), CR(3), CR(5), and both count-based and revenue-weighted churn rates for each year in the Track Record Period, as required by the SFC’s December 2024 circular.

  2. Look-through analysis for intermediaries: Where the applicant sells through distributors, the sponsor must perform a look-through to identify the end-customer, and if the distributor refuses to cooperate, the sponsor must perform alternative procedures such as site visits and third-party database searches.

  3. Customer vintage scrutiny: The sponsor must create a customer vintage analysis for all customers first appearing in the Track Record Period, verifying their incorporation dates and treating any customer established less than 12 months before its first purchase as a high-risk item requiring enhanced due diligence.

  4. Cross-border verification protocols: For PRC customers, the sponsor must use Qichacha or Tianyancha for registration verification, obtain bank statements and tax records, and perform site visits; for offshore customers in BVI, Cayman, or Bermuda, the sponsor must identify the UBO and check for connections to the applicant.

  5. Stress-testing financial projections: The sponsor must stress-test the applicant’s financial projections by assuming the loss of the top customer (if concentration exceeds 30%) and by applying the historical churn rate to future revenue, documenting the results in the sponsor’s report to the HKEX.