The last 12 months have been a brutal year for high-growth tech companies. Upstart Holdings (UPST -1.97%), whose stock price was up by more than 2,000% after its initial public offering (IPO), has seen its share price fall by 77% from its peak, as of this writing.
While existing investors bleed, bargain hunters are eager to scoop up shares on the cheap. Still, they should not be too excited, at least not until they consider these two risks that could jeopardize their investment in the company.
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Upstart has enormous concentration risks
Upstart uses data science and big data analytics to match borrowers to lenders. Through Upstart's platform, a customer can apply for a loan and have it approved by the banking partners almost instantaneously. In return, Upstart receives a fee from the bank for every successful loan originated from its platform.
This business arrangement works well for Upstart since it can operate a capital-light model with almost no credit risk. Still, there is a significant concentration risk here that investors should know about. Consider this: In 2021, Cross River Bank and another bank that Upstart hasn't identified originated 55% and 36% of the loans on Upstart, respectively. Consequently, these two banks contributed 83% of Upstart's revenue in 2021.
With such a heavy dependence on two partners, Upstart has to work hard to keep them happy. If Upstart loses either of these partners, or if the partners decide to reduce their loan quota on Upstart's platform, it would cause enormous disruption to the business.
For example, if Cross River Bank decides to reduce its loan origination by 50%, Upstart will see its loan approvals reduced by about 20%. This will impact Upstart in terms of financial performance and customer satisfaction -- the customer who cannot get a loan on Upstart will naturally move to another platform. In other words, such disruption will have short- and long-term implications for the tech company.
Still, this is not the end of the world -- Upstart can still recruit new partners to compensate for the loss in funding. It will just have to take some time to do so. Besides, the company is already reducing its concentration risk. For example, Cross River Bank originated 89% of loans in 2019, but that percentage has since fallen to 55% in 2021. This will likely fall further in the coming years.
Upstart's business model needs some stress testing
Upstart has had early success scaling its business through its AI-powered loan platform and capital-light business model. While the online lender does not have exposure to credit losses -- it primarily earns fees through loan referrals and servicing -- it must consider credit risk in its model. After all, it must refer the right customers (those with the appropriate credit risks) to the banks in exchange for a fee.
So far, Upstart's approach has worked well, which explains its rapid expansion in the last few years -- loan volume surged from 215,000 in 2019 to 1.3 million in 2021. Still, it's probably too early to declare victory here. The company is still very young -- it did not get into consumer lending until 2014 -- and has generally been operating in a benign market condition. Thus, Upstart's risk model has yet to demonstrate its effectiveness in challenging situations such as a rising interest rate or a recessionary environment.
If the risk model fails to perform under stressful conditions -- for example, it fails to predict the appropriate credit losses during a recession -- banking partners would incur higher-than-expected loan losses. When that happens, these partners might lose confidence in the company. At best, they might recategorize Upstart as a high-risk platform and reduce their loan allocation. At worst, they might end the business relationship. The result? Upstart suffers a loss of funding, a disruption in its lending business, and a drop in revenue and profits.
On a slightly positive note, Upstart should be able to survive the above-mentioned disruption since it has no exposure to credit losses. Still, it will need to upgrade its AI model with new variables and data sets. Also, it will need to sign on new partners to strengthen its funding sources. While the potential damage to Upstart is unlikely to be terminal, investors still need a lot of guts to stomach such a risk.
