In previous articles I've written about the artificial intelligence (AI)-assisted lending platform Pagaya (PGY 7.33%), I expressed concerns about the company's formerly high valuation for two main reasons.
The first was regarding the stock's incredibly small public float after completing its merger with a special purpose acquisition company, which ultimately took it public. The other had to do with macroeconomic concerns that I thought might impact its business model. Since early August, shares of Pagaya have plummeted from close to $30 to about $1.14 now.
But the business has actually held up better through the third quarter than I might have expected and the valuation is clearly much more attractive. Still, I think questions remain about how well the company can perform in the future. Here's why.
Business performance affected in 2022
Pagaya sits in between banks and fintech companies and institutional investors, running a business-to-business-to-consumer model, which helps banks and fintechs originate more loans and earn additional revenue, while also helping investors make risk-adjusted returns.
Image source: Getty Images.
Essentially, a borrower might submit an application to one of its banking partners for a personal loan, which is Pagaya's most mature product right now (it also processes auto loans, mortgages, credit cards, and point-of-sale loans).
That application is then handed off to Pagaya, which uses its technology and underwriting models to make a recommendation on whether or not its partner should approve the application. Pagaya then goes one step further and facilitates the funding of that loan by placing it with an institutional investor on its network, which is why the model is heavily dependent on being able to obtain funding.
A lot of other players in the space, such as Upstart Holdings, have really struggled with funding issues this year because rising interest rates have increased the cost of capital for institutional investors and made loan losses more likely, especially with many expecting a recession next year or in 2024. But Pagaya partly solves this issue by securing funding in advance, which allows the company to lock in a cost of capital early and therefore know the kind of return thresholds investors need in order to purchase loans.
Since 2020, Pagaya has raised $13 billion of capital, including $2 billion in the third quarter of 2022. Management said on the company's third-quarter earnings call that it had raised $1 billion in the fourth quarter as of Nov. 10.
Now, the business isn't completely immune to broader macro conditions. Pagaya's conversion rate of accepted loan applications fell 45% year over year in the third quarter, as the company seeks higher-quality and more resilient borrowers given the worrying economic outlook.
But the funding side of the business seems to have held up better than some of its peers, and network volume -- which is a good indicator of revenue -- only fell about 1% from the second quarter despite tough conditions in the capital markets. Furthermore, management said it still expects to hit the full-year guidance it provided in the second quarter, albeit in the lower range of the guidance.
Questions remain for Pagaya
There are several other minor concerns I'm watching at Pagaya. First, although the lockup period for a big chunk of Pagaya's shares expired in September, freeing up half of the lockup shares, the remainder of those shares will be free to trade on Dec. 19. Now, who knows if investors are going to want to sell at such a lower valuation, but it's something to watch.
Another concern is stock-based compensation, which has hampered the results of a lot of newly public tech companies. Through the first nine months of the year, Pagaya has had more than $223 million of stock-based comp expenses, up from just shy of $60 million in 2021.
Finally, and most related to Pagaya's core business model, I am still concerned the company could run into funding issues if there is a rapid deterioration in credit quality or a severe recession. Locking in capital upfront can help smooth out some of the volatility in the capital markets, but it's not bulletproof. I do think Pagaya has potential and the valuation is somewhat attractive right now, but the company is still nowhere close to profitability, so I don't think I'm ready to pull the trigger just yet.
