Deal focus: Centurium, Joy re-up in China's Luckin Coffee

Luckin rose from nothing to become the country’s second-largest coffee shop chain within the space of 18 months. It raised more than $500 million in PE funding and listed in May 2019. However, the company came crashing back to earth in 2020 by revelations that RMB2.2 billion ($310 million) in sales booked for 2019 – three-quarters of the annual total through September – had been fabricated.

Two months before the fraud was exposed, Luckin raised $460 million in convertible senior notes. The new investment is part of a restructuring agreement with holders of these bonds. Centurium has subscribed to $240 million in senior convertible preferred shares and Joy will take $10 million in senior preferred shares. They may be able to upsize the investment by $150 million, a filing said.

A portion of the capital will also help make payments to the US Securities & Exchange Commission (SEC) as part of a $180 million settlement. Luckin will then be able to focus on its balance sheet and the continued execution of its revised business plan.

“The investment in Luckin Coffee by existing institutional investors demonstrates their optimism about the company’s business model and long-term business development prospects,” Centurium said in a statement.

The private equity firm invested approximately $180 million in Luckin and was the largest institutional investor post-IPO with an 11.9% stake. It realized proceeds of $231.8 million in 2020, completing a private placement alongside the senior notes offering, reducing its holding to approximately 7%. The new investment will take it back up to 17%.

Centurium, which backed Luckin out of its first fund, was forced to delay Fund II – with a first close of $2 billion imminent – when the scandal hit. The firm is now in talks with LPs about relaunching the process, a source close to the situation said, noting that two liquidity events are in the pipeline as corporate training business Yunxuetang and ANE Logistics both prepare for IPOs.

One LP questioned the “optics” of the latest investment in Luckin, suggesting that the introduction of an external investor could offer reassurance. The source close to Centurium acknowledged that third parties have expressed interest, adding that a decision was made to keep it in-house “for efficiency and process management reasons.”

Luckin is currently in provisional liquidation in the Cayman Islands and in February it filed for bankruptcy protection in the US. This was done to allow centralized administration of its assets and consolidate the various class-action lawsuits outstanding into a single restructuring scheme.

The company’s day-to-day activities were not impacted and there is evidence of stability at the operational level. Steps were taken to reduce cash burn, including the introduction of a store optimization plan that led to the closure of uneconomical outlets and a pared-down marketing strategy that enabled the customer base to grow, but at a lower cost.

According to a report filed by the provisional liquidators in late 2020, Luckin had 3,898 self-operated stores as of November, down from 4,267 in June. Of these remaining outlets, 60% were profitable. Moreover, 70% of its 894 franchisee stories had reached the gross profitability threshold at which they are required to share some upside with the parent.

Revenue was RMB1.15 billion for the three months ended September 2020, up 35.8% year-on-year. Estimated revenue for the 2020 financial year is RMB3.8-4.2 billion. The company reported revenue of RMB2.93 billion for the nine months ended September 2019, up from RMB375 million a year earlier. Its net loss widened to RMB1.76 billion from RMB950 million.

Luckin’s stock was relegated to the over-the-counter market, but the price reached $9.42 in December following publication of the report, up from $1.38 in June – though still down on the record high of $50 in January 2020. The stock closed at $8.84 on April 16, giving the company a market capitalization of $2.2 billion.

Luckin is targeting 4,800-6,900 self-operated stores by 2023, by which point the provisional liquidators hope the company will have achieved overall profitability. The source close to Centurium suggested this could happen even earlier. “By and large, the business model underwritten when the first investment was made is proven and continues to be proven,” the source added.

The business model was controversial because of the speed at which Luckin achieved scale and the apparent disregard for near-term financial sustainability. Expansion costs were substantial, but advocates argued that these would be brought under control through economies of scale and by leveraging technology to deliver supply chain efficiencies and better consumer insights.

The source stressed that the asset-light, data-heavy approach – Luckin’s outlets are small and have relatively few staff, emphasizing collection and delivery and digital payments – lends itself to rapid expansion. However, it is acknowledged that execution could have been more cautious.

“Some stores shouldn’t have been opened or opened in better locations. The store optimization plan is intended to address that,” the source said. “The company, under new management, is focusing on efficiencies rather than scaling up.”

Indeed, it is claimed that some aspects of the Luckin model have been adopted by other industry participants, including aggressive digitalization and a direct-to-consumer approach. Last year, Starbucks teamed up with Sequoia Capital China to invest in next-generation food and retail technology companies. The goal is to drive the coffee shop chain’s digital innovation in China.

The alleged architects of the Luckin fraud, the CEO and COO, were removed from their positions, as were various more junior staff members. Zhengyao Lu, the chairman and largest shareholder in Luckin, was removed from the board and his shares have been seized by creditors. Lu previously established China Auto Rental and chauffeured car services business Ucar, and the senior management of Luckin was largely drawn from these companies.

The board now comprises three management representatives and four independents – Centurium and Joy have yet to return – and it is working to clean up the governance, the source said. Meanwhile, investors have assisted in the recruitment of independent directors and management professionals and improvements in compliance and internal controls and strategy reformulation.

It is stressed that Luckin’s revival is far from complete. The new investment coincided with a change in auditors after the incumbent – while having no disagreements on accounting practices or financial disclosure – felt it had not gathered enough third-party data or completed sufficient procedures to complete an audit. Luckin has taken steps to improve controls.

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• Topics
• Greater China
• Expansion
• Consumer
• Technology
• Regulation
• China
• Centurium Capital
• Joy Capital