Commentary on Political Economy

Sunday, 5 April 2020


 Luckin Coffee scandal catches out world’s most powerful investors BlackRock, GIC, Louis Dreyfus backed chain that aimed to displace Starbucks 

 Luckin Coffee was founded in 2017 by Lu Zhengyao and had more than 4,000 outlets by the end of 2019

The accounting scandal at Luckin Coffee, a start-up that aimed to displace Starbucks in China, has caught out several of the world’s most powerful investors.  BlackRock and Singaporean sovereign wealth fund GIC were among those who invested in private funding rounds in the months before Luckin’s initial public offering last year. Louis Dreyfus, one of the world’s biggest traders of orange juice and coffee, and Melvin Capital and Centurium Capital were also backers. Shares in Luckin crashed more than 70 per cent on Thursday after it disclosed that an internal investigation had uncovered Rmb2.2bn ($310m) in fabricated transactions. Several employees, including its chief operating officer, have been suspended and its previous financial statements can no longer be relied on, the group warned. The disclosure casts considerable doubt over the future of the unprofitable group, which was founded in 2017 by Lu Zhengyao and had more than 4,000 outlets by the end of 2019. In the prospectus for its initial public offering last year, Luckin declared that the coffee chain would be the largest in China by the end of 2019 as it disrupted the “status quo of the traditional coffee shop model”.

 Not all of the backers will have lost money. BlackRock sold its main stake, held by its private equity fund, earlier this year, but retains a position via other active and index funds. GIC sold down its direct stake to less than 1 per cent but still holds an indirect stake through an investment in Centurium Capital Partners, according to people with direct knowledge of the matter. BlackRock, GIC and Melvin Capital declined to comment.  David Li, Centurium Capital’s founder and former head of private equity firm Warburg Pincus’s Chinese operations, was “shocked” to learn of the alleged fabrication, his spokesman told the Financial Times.  Centurium led both A and B financing rounds for the group in 2018 before it went public, investing about $180m in total. Mr Li still serves on Luckin’s board of directors but sold down a small portion of his firm’s stake in the company earlier this year for $232m, his spokesman said. LDC said it was too early to conclude what the allegations would mean for its investment with Luckin. “LDC considers the quality and integrity of financial reporting to be an essential pillar of any business and looks forward to receiving the full findings of the investigations, as soon as they are available, in order to assess the situation fully,” said a spokeswoman.  “LDC remains committed to the development of coffee, as well as juice, in China, where it sees material demand growth,” she added.

 However, several investors who turned down the chance to back Luckin over the past two years said stated revenue growth of more than 500 per cent had been a red flag. “It is the typical excess that you find at the end of a bull market,” said one investor, who declined to put money in the coffee chain. Warburg Pincus, Mr Li’s former employer, looked closely at Luckin at the time of its IPO, according to an executive at the firm. However, a glance at the prospectus convinced the firm to steer clear. Warning signs included a business model that relied heavily on subsidies and the lack of regulatory approval for many facilities, according to two senior executives at Warburg Pincus. “There was always chatter about the business model and management,” said an adviser whose bank pitched to work on the IPO but did not win the mandate. With the US stock market soaring last year, shares in Luckin barrelled higher and reached a record in January. However, questions over its accounting surfaced in January when US short seller Muddy Waters, run by Carson Block, made public an anonymous report pointing to possible fraudulent behaviour at the company.  The report stated that an anonymous research group had a team of more than 1,500 people monitoring the number of customers going to some of its outlets and found the company was overstating its business. At the time, Luckin denied the allegations, describing them as “misleading and false”. As Wall Street digested the revelations, shares in Hong Kong-listed China Auto Rental, where Mr Lu is chairman, plunged on Friday as investors cut their exposure to the entrepreneur’s businesses. Mr Lu could not be reached for comment. Luckin said that the investigation by a special committee, which has retained Kirkland & Ellis as outside counsel, would report further findings from the probe. “Investor trust and confidence needs to be rebuilt,” said Drew Bernstein, co-chairman of MarcumBP, an accounting firm focused on Chinese pre-IPO and publicly traded companies.

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