August 08, 2022
Editor’s note: Upstart Co-Founder and CEO Dave Girouard shared thoughts on second quarter 2022 during the company’s quarterly earnings call. To read more about Upstart’s Q2’22 earnings, visit here.
Good afternoon, everyone. Thank you for joining us on our earnings call, covering our second quarter 2022 results. I’m Dave Girouard, co-founder and CEO of Upstart.
Today we reported a decline in revenues, which is obviously disappointing and unacceptable to us. I want to explain where this decline came from and what we’re doing to address it. It may be natural for you to question whether Upstart’s AI powered risk models aren’t working as designed, but we’re confident this isn’t the case—that in fact our models continue to improve with respect to accuracy and risk separation. But there is no getting around the fact that a decline in revenues is a business problem that we need to address—and today we’ll share with you the actions we’re taking to address it.
Today Sanjay and I will discuss a variety of topics, including credit performance, loan funding, lending partner sentiment, and some of the actions we’re taking right now to make sure Upstart’s future is bright. I also want to share with you the progress we’ve made in many important aspects of our business and how they’re setting the stage once again for growth in Upstart’s future.
The pandemic cycle
I don’t want to spend too much time restating what you’ve already heard about the current economic climate. Given the nature of our product and our borrower, we do however have a unique lens into what’s transpired in the last two plus years and what may transpire in the coming months and years.
We believe we’re at the end of a unique economic cycle related to the pandemic that included two distinct phases. The first phase was triggered by pandemic-constrained consumer spending and unprecedented government stimulus throughout 2020 and early 2021. These together drove significant improvements in consumer savings levels and liquidity, which in turn led to dramatic over performance of credit during this phase—our platform experienced about a 50% reduction in credit defaults compared to the pre-COVID timeframe.¹
In the second phase, toward the end of 2021 and into 2022, this effect began to unwind as stimulus was discontinued and consumers began to travel, dine out, and spend once again. And as expected, default rates returned to pre-COVID levels or in some cases even higher. While virtually all consumers benefited financially from reduced spending during the early stages of the pandemic, this cycle was concentrated in consumers who received government stimulus checks, a demographic which is also more likely to be Upstart borrowers. Our risk models largely captured these effects and performed admirably—though not perfectly—throughout. But I’ll get to that in a bit.
We believe we’re now at the end of this two-phased cycle and an important question for all of us is what’s next. Will efforts to slow inflation lead to recession and unemployment? While no one knows the future, we do expect a significant slowing of the economy and a “worse than normal” macro for the next year and beyond. We’ll speak to that as well.
Our job through all of this is to ensure the future of our platform and to protect Upstart’s ability to pursue our mission for years to come.
Alongside our earnings release, we today shared some responses to important questions regarding credit performance on Upstart’s platform. It goes without saying that measuring credit performance is vital—and it’s also non-trivial. Comparing one platform to another can be challenging: different products, different borrowers, different return targets, months on book, prepayments, hardship policies, and more. There’s no simple apples-to-apples comparison.
We believe the essential measurement for credit performance is actual dollar returns compared to the lender’s or institutional investor’s target at the time of origination. Full stop. And today, we provided this information for all Upstart cohorts going back to the beginning of 2018.
The bottom line is this: Our 70 plus bank and credit union partners, who typically retain loans in the lower risk grades appropriate to their businesses, have seen, to date, portfolios consistently meet or exceed expectations since the program began in 2018.
And how have our institutional loan buyers done? Against a target of approximately 8% gross return since Q1 2018, institutional buyers have so far seen 12 quarterly vintages overperform, with 5 expected to underperform.²
It’s important to highlight that a loan buyer who invested equally in all cohorts since Q1 2018 would have experienced a positive return on all vintages thus far, with an overall 9.8% gross annualized return. This compares to a return of less than 3% in the US High Yield Bond Index over that same period.³
Lastly, we believe it’s not reasonable to expect above-target loan performance irrespective of the economic cycle. So it’s fundamentally important to separate the impact of macro conditions from imperfections in a credit model. The essential litmus test for model performance is separation of high and low risk borrowers. As demonstrated in the loss rate by grade and AUC metrics we shared today, our model is positively differentiated in this respect, and it continues to improve. In an effort to deliver unparalleled transparency and analytics, we will provide this detailed information to each of our lenders and loan buyers.
Moving toward committed loan funding
Today, we’re in a funding constrained environment, which is the primary cause of our revenue shortfall. I want to share some thoughts on this situation and actions we’re taking to address it. First, as we’ve said recently, our goal is to operate as a marketplace for credit over the long run. We want loan transactions to take place when they make sense for the borrower and the lender. And certainly, lending is a category which we’d expect to experience some volatility over time due to macroeconomic factors.
Having said that, in the last few months, lenders and institutional credit investors reacted more quickly and abruptly than we anticipated. Despite the fact that our bank partners have seen consistently strong credit performance—meaning portfolios performing at or above plan across quarterly cohorts—several of them have paused or reduced originations due to fear about the future of the economy. To be clear, these lenders and institutional investors have not left Upstart’s platform, but have temporarily paused or reduced their originations.
As we shared in our Credit Performance FAQ today, we believe our models are well calibrated to the current economic environment, and in fact include a generous accommodation for a recession over the next 18 to 24 months. And given funding constraints, we believe the opportunity for lenders to generate strong returns on Upstart is unusually high right now. Yet the reaction of lenders is often binary in nature, more so than we would have anticipated.
As a result, we’ve concluded that we need to upgrade and improve the funding side of our marketplace, bringing a significant amount of committed capital onboard from partners who will invest consistently through cycles. We’re currently evaluating a variety of opportunities to do just that, though we expect this will take some time to bring to fruition.
Furthermore, while we continue to believe that it doesn’t make sense for Upstart to become a bank, we’ve decided it may make sense to, at times, leverage our own balance sheet as a transitional bridge to this committed funding. I acknowledge that this is a shift relative to what we planned and communicated earlier this year, but a changing and volatile environment suggests we need to be flexible and responsive in our approach.
We’re taking this step for a few reasons: first, there’s an obvious information asymmetry, where we understand better than anybody how our model is performing today and how well it’s calibrated for the current economic environment. Second, we believe the opportunity to generate outsized profits on our platform is unusually high right now. And third, we can bring a level of stability to our business that’s important to our longer term goals while we work to put these committed capital structures in place. Sanjay will share some more about this in his remarks shortly.
I want to also highlight that we’re building a business that can survive and thrive through a variety of market conditions to make sure we achieve these ambitious long-term goals. Our fixed costs are low and our gross margins are strong, so we can continue to invest in our roadmap and in our future through a variety of macro environments.
New product progress
We continue to make rapid progress in the newer parts of our business, and we’re optimistic that this progress is setting up the next stage of growth for Upstart, which I’m sure you’re all looking forward to.
First, we continue to add new lenders to our marketplace, with a total of 71 banks and credit unions as of today, up from 57 when we last spoke to you in May. Despite the cautionary outlook in the financial services industry, forward-thinking banks and credit unions continue to choose Upstart.
We now have 640 dealerships using Upstart Auto Retail Software. And just a few weeks ago, industry analyst “Automotive Market Data” declared that Upstart was the nation’s fastest growing auto retail software provider in the second quarter. Subaru and VW were the latest OEMs that announced support for Upstart Auto Retail, joining Toyota, Lexus, Mitsubishi, and Kia, as well as top franchised dealers from 37 brands including Ford, Honda, and BMW.
We also expanded our Auto Retail lending product out to 29 dealerships and saw the first $10M in retail loan originations in the second quarter. In just the last couple of weeks, we merged our machine learning model for automated income verification, originally developed for our personal loan product, into our auto retail lending flow. We expect this improvement to more than double the percent of applicants for whom we can automatically verify their income.
I’m also pleased to announce that we quietly launched our small business loan product at the end of June, well ahead of schedule. We’ve already seen more than 40 small business loans originated—totalling more than $1M in principal—in just a few weeks. That team is quickly ironing out operational issues with an eye toward rapidly expanding this product in the coming months and years.
Lastly, the small dollar loan team launched support for Spanish-speaking applicants, another giant step toward serving those left out of our country’s mainstream financial system.
Some of you have questioned whether Upstart veered too quickly into lending to riskier borrowers in 2021 in order to grow in our post-IPO phase. But I believe we’ve done exactly what we set out to do and what we said we would do.
Upstart’s mission is and has been to leverage modern technology and data science to improve access to affordable credit. There are tens of millions of Americans who deserve access to reasonably priced credit from our nation’s banking system, yet are denied access through no fault of their own. We’re unique among our FinTech peers in that we aim to tackle this problem directly.
The terms non-prime, near-prime, and sub-prime—these are words the industry invented to describe people that our current systems don’t understand. The truth is that the vast majority of these Americans are entirely creditworthy. Upstart’s mission is to identify those borrowers, and provide them with access to affordable credit—and we haven’t wavered from that challenge.
How does growth fit in? We approach our business as a waterfall of priorities, in a way analogous to structured credit. Upstart’s highest priority—our A bond, if you will—is credit quality. Our goal is to reliably deliver the return the lender or investor expects for a specific allocation of risk. Our B-bond, or next highest priority, is unit economics or gross profits. We don’t strive for loan transactions that lose money for Upstart and generally seek to avoid them. And finally, whatever is left over goes to platform transaction growth—our residual, so to speak. In truth, growth isn’t a specific target for us—it’s a plug based on our waterfall of priorities. The reasons for this ordering are clear: without strong credit performance and solid unit economics, growth over the long term would be unsustainable.
To close, I want to acknowledge that we’ve experienced some setbacks in our business. But our fundamental economic engine is strong, our risk models are better than ever, and I’m confident we’ll be on the growth path again soon. We’re taking decisive action to bring committed capital to Upstart. And to those who say that we should focus on the traditionally prime market, I say that there are plenty of others focused on that. Improving access to credit for all Americans is too important to go ignored. And Upstart has the right stuff to get it done.
² Based on Upstart internal performance data as of July 29, 2022. Gross annualized return is based on an Upstart internal calculation including assumption of future cash flows based on most recent performance data. See Second Quarter 2022 Credit Performance, page 7 for further information.
This post contains forward-looking statements, including but not limited to, statements regarding our outlook, growth opportunities, the performance of our AI models and our future plans. You can identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. These statements may include words such as “anticipate”, “estimate”, “expect”, “project”, “plan”, “intend”, “target”, “aim”, “believe”, “may”, “will”, “should”, “becoming”, “look forward”, “could”, “would”, “can have”, “continue”, “likely” and other words and terms of similar meaning in connection with any discussion of the timing or nature of future operating or financial performance or other events. Forward-looking statements give our current expectations and projections relating to our financial condition; macroeconomic factors; plans; objectives; product development; growth opportunities; assumptions; risks; future performance; business; and any investments. Neither we nor any other person assumes responsibility for the accuracy and completeness of any of these forward-looking statements. The forward-looking statements included in this post and on the related teleconference call relate only to events as of the date thereof. Upstart undertakes no obligation to update or revise any forward-looking statement as a result of new information, future events or otherwise, except as otherwise required by law.
All forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those that we expected. More information about factors that could affect our results of operations and risks and uncertainties are provided in our public filings with the Securities and Exchange Commission, copies of which may be obtained by visiting our investor relations website at www.upstart.com or the SEC’s website at www.sec.gov. These risks and uncertainties include, but are not limited to, our ability to sustain our growth rates; to manage the adverse effects of macroeconomic conditions and disruptions in the credit markets; our ability to maintain diverse and robust loan funding programs; the effectiveness of our credit decisioning models and risk management efforts; our ability to retain existing, and attract new, bank partners and lenders; and our ability to operate successfully in a highly-regulated industry.