2 Important Risks Investors Should Be Aware of Before Buying Upstart Stock

The last 12 months have been a brutal year for high-growth tech companies. Assets received ( UPST -4.33% )whose stock price rose more than 2,000% after its initial public offering (IPO), has seen its stock price drop 77% from its peak, at the time of this writing.

As existing investors bleed, bargain hunters are eager to pick up stocks on the cheap. Still, they shouldn’t get too excited, at least not until they consider these two risks that could jeopardize their investment in the business.

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Upstart has huge 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 banking partners almost instantly. In return, Upstart receives a commission from the bank for each successful loan from its platform.

This business arrangement works well for Upstart as it can operate a small capitalization model with almost no credit risk. Yet there is significant concentration risk here that investors should be aware of. Consider this: In 2021, Cross River Bank and another bank that Upstart did not identify originated 55% and 36% of loans on Upstart, respectively. Therefore, these two banks contributed 83% of Upstart’s revenue in 2021.

With such a reliance on two partners, Upstart has to work hard to keep them happy. If Upstart loses any of these partners, or if the partners decide to reduce their lending quota on Upstart’s platform, it will be very disruptive to business.

For example, if Cross River Bank decides to reduce its loan approvals by 50%, Upstart will see its loan approvals reduced by approximately 20%. This will impact Upstart in terms of financial performance and customer satisfaction – the customer who cannot get a loan on Upstart will naturally go to another platform. In other words, such a disruption will have both short-term and long-term implications for the tech business.

Still, it’s not the end of the world – Upstart can always recruit new partners to make up for the loss of funding. It will just take a little time to do it. In addition, the company is already reducing its concentration risk. For example, Cross River Bank issued 89% of loans in 2019, but this percentage has since fallen to 55% in 2021. This percentage is expected to decline further in the coming years.

Upstart’s business model requires stress testing

Upstart quickly succeeded in scaling its business with its AI-powered lending platform and low-cap business model. Although the online lender is not exposed to credit losses – it mainly earns commissions through loan and service referrals – it must factor credit risk into its model. After all, he must refer the right customers (those with the appropriate credit risks) to the banks in exchange for a commission.

So far, Upstart’s approach has worked well, which explains its rapid expansion over the past few years – loan volume has grown from 215,000 in 2019 to 1.3 million in 2021. Still, it is probably too early to claim victory here. The company is still very young – it only got into consumer finance in 2014 – and has generally operated in favorable market conditions. Thus, Upstart’s risk model has not yet demonstrated its effectiveness in difficult situations such as rising interest rates or a recessionary environment.

If the risk model fails under stressful conditions – for example, it fails to predict appropriate credit losses during a recession – banking partners would experience higher than expected loan losses. When this happens, these partners can lose trust in the business. At best, they could reclassify Upstart as a high-risk platform and reduce their loan allocation. At worst, they could end the business relationship. The result? Upstart suffers a loss of funding, an interruption in its lending activities and a drop in revenue and profits.

On a slightly positive note, Upstart should be able to survive the aforementioned disruption since it is not exposed to credit losses. Nevertheless, he will have to update his AI model with new variables and new datasets. In addition, it will have to sign new partners to strengthen its sources of funding. While the potential damage to Upstart is unlikely to be terminal, investors still need a great deal of courage to bear such a risk.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end consulting service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.

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