US-listed Chinese companies: Compliance costs

IDreamSky claims to be the largest third-party mobile game publisher in China. Revenue ballooned to RMB984.1 million ($158.5 million) last year as the company strove to maximize scale ahead of its listing. These customer acquisition efforts weighed heavily on the bottom line: as a result of marketing and administrative costs, iDreamSky slipped from a RMB27.8 million net profit to a RMB16.7 million net loss.

The IPO represented a liquidity event for the company's VC backers, Legend Capital and Redpoint Ventures, although they had yet to start unwinding their positions. For Michael Chen, the company's chairman, CEO and single largest shareholder, in retrospect it might seem something of a damp squib.

IDreamSky sold it shares at $15.00 apiece and they closed at $15.94 on the first day of trading. A peak of $23.66 came last September but since then iDreamSky has trended downwards. It closed at $10.53 on June 9 before a small surge ahead of Chen submitting a take-private offer of $14.00 per share.

Clearly Chen, like many of his fellow founder-entrepreneurs of US-listed Chinese companies, feels he can getter a better valuation by listing the business back home. IDreamSky is essentially consumer-facing so it may get more traction with retail investors that know the company first-hand. And then, at least when the take-private bid was submitted, China's public markets were soaring.

Valuation arbitrage aside, the increasingly onerous reporting and transparency requirements for US-listed companies are a source of frustration for many smaller Chinese companies. Even though they may recognize the need to cover themselves they may question whether the time and money is worth it.

The US Securities and Exchange Commission estimates that the average cost of achieving initial regulatory compliance for an IPO is $2.5 million, followed by an ongoing annual compliance cost of $1.5 million. These expenses are described as generally higher than those in other markets.

A 2014 Heritage Foundation study looked at the impact of the annual compliance cost in greater depth. Say a company with $10 million in shareholders' equity and a 20% return on equity earns $2 million. Subtract $1.5 million and earnings and return on equity fall to $500,000 and 5%, respectively. Without scale it hardly seems worthwhile.

Other studies have questioned whether the one-off 2.5 million and ongoing $1.5 million figures are even accurate. Being publicly-listed means higher wage bills because CEOs, CFOs and other financial professionals cost more and new members added to the board of directors must be compensated. Compliance may also involve investment in better IT systems and the recruitment of investor relations executives.

The SEC might relax its requirements in time, but it is difficult to say where the line should be. Under a disclosure-based system, investors rely on companies providing sufficient information for them to make decisions. But excessive disclosure imposes heavy costs on smaller companies and there comes a point when investors are wallowing in so much information that it results in confusion rather than insight.

A US listing is not for every Chinese company, and it could be argued that compliance is the cost of entry: an exchange can't call itself gold standard if the protections offered are not top rate.

And as China alters the rules of its own bourses, transitioning from an approval-based to a registration-based system, similar issues will emerge. It is one thing for a company to say it would prefer to be listed domestically because the valuation will better reflect the qualities of its business. Moving for the sake of a cheaper and easier compliance protocols raises questions about the quality of those protocols.

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• Topics
• Exits
• Greater China
• North America
• Regulation
• IPO
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• regulation