Painful lessons from the Luckin Coffee scandal

When one Hong Kong-based hedge fund founder was reviewing the prospectus for Xiamen-based Luckin Coffee’s New York listing in May last year, his first thought was the revenue numbers were exaggerated. “The performance seemed overdone,” he recalls. “Overdone — but not criminal.”

Anybody familiar with consumer tech companies, a group in which Luckin claimed to belong thanks to its cashless stores, will recognise that investment manager’s assessment. Until recently, many of these businesses — whether in ride sharing, food delivery or online education — boasted of their sales prowess, even as they heavily subsidised those sales. They were caught in a trap: the more they sold, the more money they lost, whether the product was cars or coffee. Revenues never turned into profits.

The listing of Uber — down more than 40 per cent from its float price last May — was the first sign that public market investors were less forgiving of such business models than investors in private markets. But with the debacle of the scrapped WeWork initial public offering and its effect on the fortunes of SoftBank, which did more than any other investment firm to enable such business models, sentiment began to shift. Money began drying up.

Luckin — which said last week that hundreds of millions of dollars of sales had been fabricated — should prove to be another nail in the coffin of the growth-without-profits business model. The effects of its fraud will have profound reverberations, particularly in the private market for young start-ups in Asia and for the venture capitalists who invest in them.

“Traffic matters less than the ability to monetise that traffic,” says one Beijing-based investor for one of the major international private equity firms.

A public company, especially one listed in the US, has strict rules to follow on sales volumes and revenues. To make up numbers is to take a step across a red line into accounting fraud. Yet the line in private markets, pre-listing, tends to be more blurred.     

If, for example, a client cancels a contract with an online education company midway through the stipulated period, how promptly does a company reverse the sale and the revenue it recorded?

A lot of the numbers “do not pass the eye test”, says the head of south-east Asia for one major private equity firm that invests in young tech companies. Some of them “juice” results, the investor says, with metrics like WeWork’s notorious “community adjusted” ebitda.

“These are disinformation campaigns — and sometimes their investors condone it,” the investor says.

Had Luckin stayed private, it might have been able to get away with its fictitious numbers for longer. From its debut on Nasdaq 11 months ago, it was clear that the executives at the company had been in a hurry to go public.

On the sidelines of the listing ceremony in New York, I asked finance chief Reinout Schakel why the chain was selling $561m of shares at a time when its losses were widening and it still had not received regulatory approvals for many of its facilities, according to its own disclosures. But he declined to answer. He also declined to comment on curious related-party transactions such as a Rmb148m ($21m) loan to a group affiliated with the chairman.

After years of venture capital investment, the deflation of China’s start-up valuation bubble is combining with the effects of the pandemic to inflict even more hardship on many consumer tech firms. Investors will be faced with difficult choices on which ventures to support and which to abandon. 

“We will see internal rounds at a discount,” predicts the head of Asia for one Silicon Valley-based investor. “And entrepreneurs will resist because they won’t want to be diluted.”

Big investors will still be there to offer cover to some businesses suffering from the slump in consumer demand. Last month, for example, Sequoia led a $200m follow-on investment in the business behind Guazi, a used car platform, in the face of an economic downturn.

But other start-ups may struggle. Most investors say they anticipate distress both from companies that lack a clear path to profitability or a deep-pocketed backer. Many fundraisings, both for VC firms and newly minted entrepreneurs, are on hold at a time when financial centres remain in lockdown.

There will also be consolidation as the strong acquire the weak, whether the predators are financial investors such as buyout firms, or strategic investors such as tech giants Tencent or Alibaba.

In the past, investors took comfort from another tech behemoth, Amazon, which burnt cash prodigiously before its cloud services division provided another firm prop to its business model. There is no such salvation for Luckin — or its investors.