In January, days after the shares of Luckin Coffee Inc. hit a record high on the Nasdaq Stock Market, giving the company a $12bn valuation, a cryptic email arrived in the inboxes of multiple short sellers.
“A new generation of Chinese Fraud 2.0 has emerged,” it said. “Companies that start off as fundamentally and structurally flawed business model [sic] that evolves into fraud.” The author offered to share customer receipts and videos from Luckin Coffee outlets, attached a long report about the company and said the short-sellers could publish and take credit for it.
Several American money managers reviewed the report, which accused Luckin of inflating its sales. Carson Block of Muddy Waters LLC published it, posting the 89-page report on Twitter on Jan. 31. Luckin’s auditor subsequently discovered that several employees had faked revenue and expenses and on April 2, the company disclosed that as much as $310m of its 2019 sales were fabricated. Its shares collapsed, less than 11 months after the company went public, and will soon be delisted.
The stunning fall of Luckin, an upstart rival to Starbucks in China that touted itself as the country’s largest coffee chain by stores, has sparked a lot of investor soul-searching. Should they have followed the recommendation of Block, who has bet against multiple listed Chinese companies? Should they have doubted the company when it refuted the allegations in the anonymous report? Could they have done more due diligence to determine whether Luckin’s reported growth was too good to be true?
Well-known investors who lost money when Luckin’s shares plunged include Stephen Mandel Jr.’s Lone Pine Capital and Steve Cohen’s Point72 Asset Management. Commodities-trading giant Louis Dreyfus—which entered into a coffee-roasting venture and juice business with Luckin—and two top Chinese private-equity firms also had sizable equity investments in the company.
Several money managers who earlier invested in Luckin said they had little reason to doubt the company because it also had the backing of other prominent investors like BlackRock Inc. and Singapore sovereign-wealth fund GIC Pte. Ltd.
Some American hedge funds, wary of getting burned after previous frauds involving listed Chinese companies like Sino-Forest Corp. that also inflated sales, said they subjected Luckin to extra scrutiny before deciding to invest.
One fund’s work included spot checks on individual stores, taking note of crowded ones and the ubiquity of Luckin’s blue-and-white coffee cups. Independent data they reviewed showed a growth in downloads of Luckin’s mobile app—used by customers to order products and make payments—that tracked the company’s reported growth in sales.
Some investors who visited Luckin stores in person had reservations about the company’s business and strategy.
Baillie Gifford & Co., a large UK money manager, sent an analyst to China last year to visit several companies including Luckin, according to an article on its website. The analyst, who speaks Mandarin, met with Luckin’s management, went to one of its shops in Shenzhen and spoke with customers. Baillie ultimately passed on making an investment.
BCC Global, a Shanghai-based due diligence and research firm, in September 2019 contacted some investment funds with an offer to monitor customer traffic and sales at a carefully selected sample of Luckin’s cafes. After receiving interest in its proposal and doing its research and analysis, BCC found discrepancies with Luckin’s reported figures, according to emails reviewed by the Journal and people familiar with the company.
When the anonymous report that Muddy Waters eventually tweeted made the rounds early this year, some short sellers were sceptical about claims that Luckin inflated its sales. Andrew Left, who runs Citron Research and back in 2015 drew attention to questionable sales practices at Valeant Pharmaceuticals International Inc., said he decided to buy Luckin shares after speaking to one of its top shareholders. The individual, whom Left didn’t identify, assured him that it had run channel checks and believed the company’s financial results were accurate.
Block of Muddy Waters said it was the first time he took a trading position based on someone else’s research while circulating it.
“It wasn’t anything glorious we did here. We just felt confident that the report was directionally correct, so we decided we’d be a good platform for it,” Block said in an interview. He declined to disclose the identity of the author, whom he said he has known for several years and believed is credible.
Recipients of the anonymous report got it from an email address containing the phrase “coffeeforclosers.” Its author signed off as “GLEN,” according to a copy of the email obtained by The Wall Street Journal.
They were apparent references to the line “coffee’s for closers” from the 1992 American film “Glengarry Glen Ross,” about four real-estate salesmen who use aggressive and high-pressure tactics to close deals.
The anonymous Luckin report was produced by Snow Lake Capital, a Chinese hedge fund with offices in Beijing and Hong Kong, according to people familiar with the matter. The firm was founded in 2009 by Sean Ma, its China-born and US-educated chief investment officer who previously worked at a hedge fund for Ziff Brothers Investments, a New York-headquartered family office.
A spokesman for Snow Lake declined to comment. The firm has about $2.5bn under management, according to its website. It made most of its money on Luckin in early April when the shares lost most of their value following the company’s disclosure of fabricated sales, according to a person familiar with Snow Lake’s returns. Its flagship China fund, however, was down 1.3% in the year through May, another person said.
It isn’t known why Ma and Snow Lake didn’t want to take credit for the Luckin research, though short sellers sometimes choose to hide their identities to maintain access to company executives and avoid regulatory scrutiny.
The Luckin report was the result of an elaborate undertaking during the fourth quarter of 2019 that involved more than 1,500 individuals, who fanned out to about 15% of Luckin’s more than 4,000 outlets across China, according to the report.
They counted customers in the stores, recorded more than 11,000 hours of videos and collected scores of customer receipts. After analyzing all the data, the report’s author concluded that Luckin had inflated its sales because the channel checks indicated that sales at its outlets were far lower than what the company had reported.
It didn’t have insights into what Luckin was actually doing behind the scenes to boost its reported sales.
Last month, The Wall Street Journal reported that a group of Luckin employees began engineering fake transactions ahead of the company’s May 2019 IPO. They first used individual accounts registered with cellphone numbers to buy vouchers that could be exchanged for cups of coffee, then used many little-known companies to make bulk purchases of vouchers, according to documents reviewed by the Journal and people familiar with the matter. Most Luckin employees were unaware of the scheme.
In some ways, Luckin was exceptional. Relatively few companies accused by short sellers of accounting chicanery ultimately disclose wrongdoing. In addition, shares of many companies accused by short sellers of accounting misdeeds have gained in value over time.
Between 2017 and 2019, short-sellers accused 32 US-listed companies of accounting misdeeds, according to Breakout Point, a data provider that analyses short-selling trends. In the six months following those allegations, 25 of the stocks gained and the rest declined.
Luckin’s shares fell in February after the anonymous report came out before rising again. Credit Suisse Group, the investment bank that led Luckin’s 2019 IPO and a follow-on sale of shares and convertible notes in January 2020, published a research report defending the company
“We found no hard evidence in the short-seller report to prove Luckin’s business as fraudulent, and some of the allegations are baseless or have major flaws, in our view,” a Credit Suisse report said on Feb. 4, maintaining an outperform rating on the stock. Morgan Stanley, which also underwrote Luckin’s share sales, didn’t address the allegations but kept the equivalent of a hold rating on Luckin in a report issued that month. After the company disclosed its accounting misdeeds, analysts at the two banks suspended coverage of the stock.
A Credit Suisse spokeswoman said the firm was one of five brokers with a buy or outperform rating on Luckin’s stock as of March 2020. Its research analysts based their views “on information prepared by management and financial data reviewed by the company’s auditors,” she added.
Accounting firm Ernst & Young Hua Ming LLP in April said it uncovered evidence that some Luckin employees had fabricated revenue and certain expenses. But just a few months earlier, the auditor reviewed the company’s interim financial statements that were included in a January 2020 prospectus for a share sale and issued a private “comfort letter” that indicated it didn’t have any issues with the numbers, according to a person familiar with the matter. A spokeswoman for EY declined to comment, citing client confidentiality.
“There’s very deep prejudice running through the industry that the big banks are the white shoes, well-pedigreed with good education, and the independent research firms are unwashed and not to be relied on,” said Anne Stevenson-Yang, co-founder of J Capital, a short seller that earlier this year also alleged that Luckin was inflating its sales.
Ultimately, it is difficult for even the most sophisticated investors to avoid falling prey to a publicly listed company that is determined to cheat, said JP Gan, a Chinese venture investor and founding partner of Shanghai-based INCE Capital.
“The basic principle of capital markets is trust. The default assumption is everyone is good because the bad apples have been screened out, or it won’t be listed,” he said.
Write to Jing Yang at Jing.Yang@wsj.com, Juliet Chung at email@example.com and Julie Steinberg at firstname.lastname@example.org
This article was published by The Wall Street Journal.