King of Good Times' Gives Diageo a Hangover -- WSJ -2-

By Daniel Stacey Features Dow Jones Newswires

Liquor giant's deal with Indian tycoon brings booming market, legal mess

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This article is being republished as part of our daily reproduction of WSJ.com articles that also appeared in the US print edition of The Wall Street Journal (June 23, 2017).

MUMBAI -- India's liquor market was for years a thorn in the side of Diageo PLC, the world's largest spirits maker. Then it met the "King of Good Times."

Vijay Mallya, a billionaire fond of mullet haircuts, diamond earrings, sports and lavish parties, invited Diageo executives to his Mumbai residence in early 2012 and offered them a deal for a majority stake in India's largest liquor maker, which he controlled.

Diageo was desperate to break into India and had long coveted United Spirits Ltd. As the two sides began discussions, the challenge of absorbing the company and its freewheeling founder became increasingly obvious. The liquor company was intricately, and confusingly, intertwined with Mr. Mallya's wider business empire, which was crumbling.

His airline company was low on cash. To prop it up, he had advanced money from his liquor business, recording the payments on a handwritten ledger he showed the Diageo executives gathered in his home, according to two people familiar with the meeting and the ledger itself, which was reviewed by The Wall Street Journal. The Diageo executives also learned payments were being made to political figures in some key Indian states where United Spirits operated, the two people say.

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Diageo subsequently bought a 55% stake in United Spirits for $3.2 billion, the largest food-and-beverage transaction in Indian history. Five years later, its gamble on Mr. Mallya's business has made India the second-largest market for its brands, which include Johnnie Walker whisky and Smirnoff vodka. The man who orchestrated the deal for Diageo, then-Chief Operating Officer Ivan Menezes, has become chief executive.

Yet the commercial success has been accompanied by lots of trouble. Diageo is in the crosshairs of Indian authorities and entangled in multiple legal proceedings stemming from the acquisition. The authorities are looking into whether Mr. Mallya used the deal to launder money, and Mr. Mallya's creditors have sought the return of shares purchased by Diageo.

Mr. Mallya, who Diageo alleges diverted nearly $500 million from United Spirits and didn't pay it back, said in an email to the Journal that Diageo had "complete knowledge" of the money he had taken out of the company to support his other businesses. Diageo was "happy with the transactions happening at United Spirits" and "analysed all the underlying documents" before signing a deal, he said.

Diageo spokesman Dominic Redfearn disputed Mr. Mallya's version of events. "At no time were we made aware of the diversions of funds that Dr. Mallya now suggests Diageo was 'happy with'," Mr. Redfearn said in an email. "His claims that we 'analysed all the underlying documents' and were therefore 'happy with the transactions happening at USL' are false." He said "evidence of diversion of funds only became clear after the closing of the transaction."

Unpaid debts

London-based Diageo cut ties with Mr. Mallya last year, and he left India amid criminal investigations of unpaid debts and possible money laundering and tax evasion. He resurfaced in a London townhouse filled with impressionist art. India sought extradition, and bank creditors who claim they are owed $1.6 billion say they hope to see him imprisoned. In April, he was arrested in London and released on GBP650,000 bail, pending an extradition hearing. Mr. Mallya has said he did nothing illegal.

Other Western firms betting on the world's fastest-growing large economy also have run into trouble in India. Last year, BP PLC was hit with a $1.55 billion fine in connection with a gas-drilling joint venture in India. Vodafone PLC, after buying India's largest telecommunications company for $16.4 billion, received a $2.2 billion tax bill when India changed its tax laws in 2012. BP and Vodafone say they are contesting the findings.

Diageo's spokesman said the United Spirits transaction, despite its complexity, "was a fantastic opportunity in a key market." He said the company "knew from the start there were aspects of governance and controls that would need to be brought into line with international best practice." Since Diageo took control, he said, United Spirits has strengthened its corporate governance, compliance practices and controls systems, and its board has ordered two forensic audits of the company, sharing the results with Indian authorities.

One Indian court handling claims by Mr. Mallya's creditors has ruled Diageo's deal to buy United Spirits was designed by Mr. Mallya's holding company to "keep creditors in the dark." In February another court paved the way for a group of Indian state banks to demand at least $350 million worth of shares Mr. Mallya sold to Diageo.

An Indian money-laundering investigation of Mr. Mallya, in cooperation with the U.K.'s Serious Fraud Office, is broadening to look at whether Diageo helped him shift assets offshore through side deals connected to the United Spirits takeover, according to an official at India's Enforcement Directorate. The Serious Fraud Office declined to comment.

In January, India's securities regulator announced it had ordered Diageo to compensate United Spirits shareholders for a $140 million payment it made last year to pay off one of Mr. Mallya's overseas debts. Diageo is appealing.

Mr. Mallya said he had become "a political football."

United Spirits' share price is 25% lower than when Diageo bought its last tranche of company stock in July 2014. Annual profits are below where they were before Diageo agreed the deal in 2012. Diageo said United Spirits revenue rose last year and it is "confident for the future."

In late 2012, before the deal was struck, Paul Walsh, then Diageo's chief executive, met with United Spirits executives over drinks at their company's Bangalore headquarters and was adamant about getting into the booming India market, says a former United Spirits' executive who was there.

Diageo had launched a wine business in India in 2006, but closed it after only three years. A joint venture with the country's second-biggest liquor firm was wound down in 2011. French liquor giant Pernod Ricard SA, Diageo's rival, owns one of India's biggest liquor businesses.

Diageo had long had its eye on United Spirits, according to executives from both companies, but it wasn't until 2012 that Mr. Mallya looked to Diageo as a potential savior.

Mr. Walsh assigned Mr. Menezes, an Indian-born, U.S.-educated Diageo veteran, to seal the deal.

Some India states still have prohibition laws, but many eliminated them relatively recently. Mr. Mallya embodied India's new spirit. Parties at his villa in Goa drew business and political luminaries and featured performers such as Enrique Iglesias and Bollywood's Sonu Nigam.

He owned more than 200 luxury and vintage cars, a 311-foot yacht, a French castle and a Formula One team, Sahara Force India. He personally selected each air hostess at his airline company, Kingfisher Airlines, according to local news reports.

Kingfisher Airlines, however, was in financial trouble. Crippled by high fuel costs and a slump in the Indian economy, it was on the brink of bankruptcy in 2012, court documents indicate, forcing Mr. Mallya to consider a sale of United Spirits to raise cash.

In United Spirits' Bangalore headquarters, Diageo's finance team pored over the liquor company's accounts, while Mr. Menezes listened to presentations there and at Mr. Mallya's Goan villa, says a former United Spirits executive. Mr. Menezes, a 57-year-old graduate of Northwestern University's Kellogg School of Management, peppered United Spirits senior managers with questions. Mr. Mallya occasionally chimed in to offer his views, the former executive says.

Seeking to comply with the U.S. Foreign Corrupt Practices Act, one of Diageo's in-house lawyers requested sales records from distributors and interviews with individual distillers, according to internal emails reviewed by the Journal. A year earlier, Diageo had been fined $16 million for breaching that U.S. law after being caught paying bribes in India and elsewhere.

India's liquor trade is rife with unorthodox practices and allegations of corruption. Political figures in states with monopoly retailing laws often have sought payments to allow drinks brands to sell their products there, local court records show.

At the meeting in Mumbai in early 2012, Mr. Mallya pulled out a handwritten document that two people in attendance say outlined diversions of money aimed at propping up non-liquor businesses of Mr. Mallya's that were struggling. It also outlined some payments to people in India's political system that Mr. Mallya said were to secure distribution rights, according to those two people and a document reviewed by the Journal.

Mr. Menezes looked at the document, the two people say, and left it with Mr. Mallya. One person with close knowledge of the meeting says the Diageo executives didn't want to get into the details of the payments at that time.

Before the deal closed in May 2013, Diageo received a spreadsheet listing transactions that didn't conform to standard accounting. The spreadsheet, which was reviewed by the Journal, showed that a range of manufacturing and distributing partners, from a bottling plant in the northern state of Uttar Pradesh to a sugar factory in the southern state of Karnataka, had received advances from United Spirits and then lent the money to Mr. Mallya's other businesses.

The spreadsheet indicated that Utkal Distilleries Ltd, a rum maker in India's south, had advanced $8 million from United Spirits to another company controlled by Mr. Mallya. Internal forensic audits ordered by the Diageo-appointed CEO later concluded that most of the money had been used to pay jet-fuel bills. A bottling plant had borrowed $7 million to upgrade its facilities, then advanced the money to Mr. Mallya's holding company, the spreadsheet and other company documents showed. Auditors later concluded the cash had been sent to Kingfisher Airlines.

Overall, United Spirits had advanced $340 million to Mr. Mallya's other companies and creditors, the spreadsheet showed.

Mr. Mallya said Diageo received this spreadsheet "periodically during due diligence." The Diageo spokesman said the company hadn't received it until later, after agreeing to the terms of a deal in November 2012. Diageo bought its first tranche of shares in May 2013.

Diageo offered Mr. Mallya a range of sweeteners to get the deal done. Its lawyers helped draft a new $75 million sponsorship deal between United Spirits and a holding company for Mr. Mallya's Formula One team that increased payments fivefold, documents viewed by the Journal show. Diageo agreed to buy his South African brewery assets, to keep Mr. Mallya as chairman of the company indefinitely, and to allow him to retain benefits, including access to luxury properties owned by United Spirits, according to Diageo filings.

The two companies agreed to a deal in November 2012 that called for Diageo to buy shares in United Spirits. Diageo bought one tranche of shares from another company of Mr. Mallya's. Court documents from a subsequent judicial action by creditors show that Diageo knew the creditors considered those shares collateral against their unpaid loans, and that Diageo might have to give the shares back to those creditors later.

Strategy conflicts

Conflicts soon erupted over the strategic direction of United Spirits. The company's Diageo-appointed CEO and board hired forensic auditors to comb through accounts. They confiscated hard drives of United Spirits' top executives and, using Mr. Mallya's emails, began piecing together a picture of his collapsing empire, according to documents reviewed by the Journal.

The emails appeared to show that Mr. Mallya cajoled and pressured his management team to divert money from United Spirits to save his other ventures, even as he was wrapping up a deal with Diageo.

In July 2012, when Diageo was still doing due diligence, Mr. Mallya emailed United Spirits' chief financial officer asking for $1.5 million to pay salaries at his U.K.-based Formula One team. "The Brits will be very upset," he wrote. "You need to perform some magical balancing act." In another email, he instructed the CFO to send $7 million to pay for taxes owed by his airline.

According to auditors, Mr. Mallya secretly pledged thousands of crates of whiskey to an Indian billionaire in exchange for a $30 million loan to his airline, and he asked India's cricket board to use $12 million owed to a cricket team owned by United Spirits to pay off a sponsorship agreement his airline was struggling to pay.

Mr. Mallya said in his email to the Journal that forensic auditors "didn't understand the underlying business principles of United Spirits and so jumped to wild conclusions."

After its first forensic audit in 2015, United Spirits' board asked Mr. Mallya to step down as chairman. When he refused, the CEO wrote to the chief of Bangalore's police department, alleging money had been "wrongfully diverted" as part of a "criminal breach of trust." Diageo never filed an official complaint with the court. Mr. Mallya resigned as chairman in February 2016, after agreeing to a $75 million severance package.

Forensic auditors brought in by United Spirits after the deal allege at least about $500 million was advanced from United Spirits to Mr. Mallya's other companies and never paid back.

In February, Mr. Mallya's other creditors won the right to liquidate one of Mr. Mallya's companies that sold shares to Diageo, and are seeking to have 7% of United Spirits' shares returned to them, or to strike a cash settlement with Diageo, says a person familiar with the situation. In its 2016 annual report, Diageo said it believes it will remain in control of United Spirits regardless of the outcome of the litigation.

--Saabira Choudhuri contributed to this article.

Write to Daniel Stacey at daniel.stacey@wsj.com

(END) Dow Jones Newswires

June 23, 2017 02:47 ET (06:47 GMT)