HONG KONG - Wall Street bankers are stuck with Luckin Coffee’s murky dregs. Morgan Stanley, Credit Suisse, Goldman Sachs and others face big losses after the founder of Starbucks’ Chinese rival defaulted on $518 million of loans amid a growing fraud scandal. How seasoned Western finance professionals got so badly burned will be a due diligence case study for the ages.

Co-founders Lu Zhengyao and Qian Zhiya seduced backers with an irresistible pitch: Luckin could leapfrog Starbucks in China using tech savvy and discounts, and develop a new generation of Chinese coffee drinkers in the process. Early investors included heavyweights like Singapore’s foreign reserve manager GIC. It helped too that the company’s initial public offering in New York last year featured Credit Suisse, Morgan Stanley, Barclays , and other reputable banks as sponsors.

The reality is that Luckin is just a loss-making food and beverage business with an app. The company heavily relied on subsidised cappuccinos - a problematic strategy typical of mainland technology startups, many of which have toppled. It now turns out that some 40% of its annual sales were completely fabricated, the company admitted last week. Shares have cratered over 80% since then.

The brightest red flag was Lu’s demand that banks grant him a $200 million personal loan in exchange for a piece of the IPO mandate. For Wall Street, margin loans are good business, and helping executives can open doors to more business like private banking and underwriting debt. But the loans ultimately added up to a whopping $518 million in credit to Lu’s family. Luckin’s market value is now only $1.1 billion.

The lenders are now stuck trying to liquidate the loan collateral: roughly a third of Luckin’s outstanding American depositary receipts, worth around $333 million at current prices. And offloading so many shares in a company some worry might not survive this scandal, in a traumatised market, might require deeper discounts. But that’s what you get when you put more energy into chasing fees than doing the financial homework.

CONTEXT NEWS

- Luckin Coffee Chairman Lu Zhengyao and Chief Executive Qian Zhiya have handed over shares in the embattled Chinese coffee chain to banks after a company controlled by Lu's family defaulted on $518 million in loans, Reuters reported on April 7. The lenders include Goldman Sachs, Morgan Stanley, Credit Suisse, Haitong, China International Capital Corp and Barclays, sources told Reuters.

- Luckin said on April 2 that much of its 2019 sales were fabricated, sending shares plunging as much as 90% from a January peak in U.S. trading and sparking an investigation by China's securities regulator.

(Editing by Robyn Mak, Jamie Lo and Sharon Lam)

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