* China Mengniu to boost stake in Modern Dairy for $410 million
* Move designed to ensure quality milk supply
* U.S. private equity firm seen as biggest winner from deal
By Donny Kwok and Michael Flaherty
HONG KONG, May 8 (Reuters) - China Mengniu Dairy Co Ltd's deal to buy a $410 million stake in China's largest unpasteurised milk producer is a strategic move to rebuild trust after a series of scandals left local brands' reputations in tatters.
Mengniu, twice hit by accusations it sold tainted milk, said on Wednesday it would buy 26.92 percent of China Modern Dairy Holdings Ltd from private equity firms KKR & Co LP and CDH Investments. The deal will lift Mengniu's stake in China Modern to about 28 percent.
For Mengniu, whose liquid milk products rank first in China by sales volume, the purchase is an attempt to ensure control over its milk supplies and win confidence among consumers in a market that is growing at about 20 percent a year.
For KKR, the storied New York private equity firm, the deal is another lucrative transaction following its relatively late arrival in Asia in 2007. After Modern Dairy's 2010 IPO and the current deal, KKR will have almost tripled its original investment, according to a person with direct knowledge of the matter.
"It is a deal which benefits all parties, of which the private equity funds are seen to be the biggest winner," Sunwah Kingsway Group Research analyst Steve Chow said.
"Chinese dairy products makers are racing to secure reliable and high-quality raw milk sources, in particular from overseas."
Mengniu's main competitor, Inner Mongolia Yili Industrial Group, has gone overseas to secure quality milk. It was granted approval to build an infant milk formula plant in New Zealand last month.
Headquartered in China's eastern province of Anhui, Modern Dairy sells almost all its raw milk products to Mengniu.
The HK$2.45 per share purchase price is a 12.1 percent discount to Modern Dairy's previous closing price - a rarity in M&A where acquisitions usually come with a roughly 25 percent premium.
Modern Dairy's share price has soared since the end of last year, from HK$2 to HK$2.79 at Tuesday's close. Speculation about talks between Mengniu and Modern Dairy first surfaced in last August.
"The increase of Mengniu's stake in Modern Dairy is to secure both quality and quantity of raw milk sources," Sun Yiping, chief executive officer of Mengniu said in a press release.
Shares in Modern Dairy fell nearly 12 percent to HK$2.46 on Wednesday, while Mengniu Dairy's stock rose 1.6 percent. The Hang Seng index was 0.62 percent higher in intra-day trade.
Standard Chartered said in a research note that part of KKR's rationale for accepting a discount was to build a long-term relationship with COFCO, the state-owned enterprise which is the top shareholder in China Mengniu.
In addition, KKR has already earned a "quite reasonable" return on its investment, the bank added.
KKR and China-focused private equity firm CDH bought stakes in Modern Dairy after the country's milk industry was battered by a 2008 scandal involving chemical-laced products. KKR paid $150 million in cash for a 34.5 percent stake, which it sold down to 24 percent after Mengniu's 2010 IPO. CDH paid $50 million for its holding.
Mengniu was one of about 20 companies implicated in that scandal, when the lacing of milk with the industrial chemical melamine killed at least six children and sickened nearly 300,000 people. The company now says that enhancing the quality of its milk supplies is a key focus for management.
Mengniu teamed up with Danish-Swedish dairy group Arla Foods in June last year to develop dairy products in China, in another bid to regain consumer confidence.
But late last year Mengniu apologised after a government quality watchdog found that some of its products contained aflatoxin, a substance produced by food fungus that can cause severe liver damage, including liver cancer.
It is not alone in facing quality-control problems. China's Bright Dairy & Food Co Ltd recalled batches of sour milk in September last year after it received hundreds of customer complaints, while Inner Mongolia Yili Industrial Group recalled baby formula tainted with "unusual" levels of mercury in June.
China's dairy market is still relatively young, with consumption of dairy products growing at an annual compound rate of 20 percent, a stark contrast to U.S. and European markets where demand has been shrinking in the past decade.