Upstart Holdings, Inc. Q2 FY2023 Earnings Call

Good day, and welcome to the Upstart Second Quarter 2023 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Jason Schmidt, Vice President of Investor Relations. Please go ahead.

Good afternoon, and thank you for joining us on today's conference call to discuss Upstart's second quarter 2023 financial results. With us on today's call are Dave Girouard, Upstart's Chief Executive Officer; and Sanjay Datta, our Chief Financial Officer. Before we begin, I want to remind you that shortly after the market closed today, Upstart issued a press release announcing its second quarter 2023 financial results and published an Investor Relations presentation. Both are available on our Investor Relations website ir.upstart.com. During the call, we will make forward-looking statements, such as guidance for the third quarter of 2023 relating to our business and our plans to expand our platform in the future. These statements are based on our current expectations and information available as of today and are subject to a variety of risks, uncertainties and assumptions. Actual results may differ materially as a result of various risk factors that have been described in our filings with the SEC. As a result, we caution you against placing undue reliance on these forward-looking statements. We assume no obligation to update any forward-looking statements as a result of new information or future events, except as required by law. In addition, during today's call, unless otherwise stated, references to our results are provided as non-GAAP financial measures and are reconciled against our GAAP results, which can be found in the earnings release and supplemental tables. To ensure that we can address as many analyst's questions as possible during the call, we request that you please limit yourself to one initial question and one follow-up. Later this quarter, Upstart will be participating in the Goldman Sachs Communacopia + Technology Conference, September 7; and the Piper Sandler Growth Frontiers Conference, September 12. Now, I'd like to turn it over to Dave Girouard, CEO of Upstart.

Good afternoon, everyone. Thank you for joining us on our earnings call covering our second quarter 2023 results. I'm Dave Girouard, Co-Founder and CEO of Upstart. I told you last quarter that I was hopeful Q1 was a transitional one for Upstart, and I continue to believe that's the case. I'm pleased we delivered quarter-on-quarter growth in Q2 for the first time in over a year, and more importantly, we achieved record high contribution margin and positive cash flow, a result of our efforts over the past year to improve efficiency and operating leverage in our business. This is despite an environment where banks continue to be super cautious about lending. Interest rates are as high as they've been in decades and capital markets remain challenged. A close look at our financials in Q2 suggests that Upstart has the opportunity to grow quickly and profitably when we return to a normalized economy. I'm also pleased to see clear signs that inflation is easing despite a continued strong labor market. Our lens on inflation is different from that of others. From our point of view, wage growth in excess of goods inflation is a new and positive development, particularly for the less affluent segments of the U.S. that we tend to serve. The market is increasingly optimistic that the Fed can achieve their 2% inflation target without a serious recession. While the recession remains a possibility, our view is it's likely to be a shallow white-collar recession, one less likely to result in significant unemployment for less affluent Americans. And unlike 18 months ago, the Fed now has readily available tools to handle a significant slowing of the economy. They can lower rates to spur growth once again. We continue to be confident that our core personal loan risk models are properly calibrated and have been so since November of 2022. Thus, we expect these recent vintages to deliver at or above target returns. Funding markets remain cautious and risk-averse. Banks and credit unions are generally focused on deposits and liquidity, while capital markets are beginning to show signs of normalization. We added another committed capital partner in July and are in conversations with several more interested parties. We also completed a securitization after the close of Q2 with significantly tighter spreads than our prior deal earlier in the year. Meanwhile, we continue to manage Upstart cautiously, but optimistically in a funding-constrained environment. Every week I remind the Upstart team to focus on improving every aspect of our business, strengthening our company for a time when the markets will inevitably return to center. As I said to you last quarter, I focus our team's energy on improving Upstart in four key dimensions. First, best rates for all. The core thesis of Upstart is that superior AI-enabled risk models will improve access to credit for all. And the company that can build superior risk models faster than anyone else stands to benefit from this dramatic transformation of the lending industry. In this light, I want to share an exciting breakthrough, something we call parallel timing curve calibration. This is a technique aimed at accelerating the pace of model calibration and thus model development. The challenge with launching a new model in lending is that you have to wait many months to see how it performs in the real world. If you're originating three-year loans, then you need to originate some loans and then watch them perform for 36 months to have clear feedback on model calibration across the timing curve. But with parallel timing curve calibration, the new model can be used to re-underwrite all in-process loans from the past, generating new predictions for how they will perform in their remaining months. This is not a back test. The new model is used to predict how all outstanding loans in the platform will perform in the coming months, not how they performed to date. In this way, within a few months, you can have a clear signal as to calibration across all months in the timing curve. This results in a dramatically faster calibration process for new models. From the point of view of our lending partners and credit investors, this is a significant win because it means we provide a tighter and faster feedback loop regarding model performance. We're very excited about its potential to extend our leadership in AI lending and are in the process of patenting this technique. Next, more efficient borrowing and lending. Last quarter, we reached an all-time high of 88% of unsecured loans fully automated. That means instant and automated approval with no waiting, no documents to upload, and no phone calls. This matters a lot because even the most accurate loan pricing model is useless if applying for a loan is too time-consuming or laborious. The notion of building an entirely software-driven credit origination process, one that can run 24/7 in a fully lights-out environment, has been with me since Upstart's founding and was inspired by my years at Google. Please bear with me as I share a short story. In 2003, I was interviewing for a role at Google. The company was still private at the time, so the world knew little about the financial giants that were growing in Mountain View. At one point in the process, the external recruiter said that I couldn't interview that week at Google because the entire company was skiing at Lake Tahoe. I thought to myself, that's a great company. Then she said, but get this, the company is still making $7 million or $8 million a day in revenue. I thought to myself, no, that's an amazing company. And the idea has stuck with me since. So, how have we done? In 2016, we began to pursue the goal of fully automated loans, zero human involvement from rate request to transfer of funds, approved in a matter of seconds, lights out. By Q2 2017, 29% of our unsecured loans were fully automated; in Q2 2019, it was 64%; in Q2 2021, it was 69%; and in Q2 2023, this past quarter, it was 88%. Automation doesn't just allow us to scale originations faster than headcount; it creates a wow moment for consumers who have never experienced such a fast and effortless loan application process. Recently, we began to brand this Fast Track, something we should probably have done years ago. This breakthrough experience is a signature of Upstart and the lenders that we serve. Next, more resilient. In addition to ongoing initiatives to strengthen the funding side of our marketplace, we continue to optimize our fixed costs. This increases the leverage in our business so that Upstart can thrive across future economic cycles. In Q2, we identified another $7 million in annual technical infrastructure costs that we can eliminate, bringing our total annual cost savings in tech expenses to nearly $17 million. We continue to hire very modestly and only in strategic situations. We also achieved a contribution margin of 67%, our best ever by a long shot. This is a sure sign that our focus on efficiency is bearing fruit. A principal driver of this record contribution margin was our efforts to build a stronger relationship with our existing customers. As a result of these efforts, 38% of our originations in Q2 came from repeat borrowers, also a record for us. And as a consequence of that, we also saw record low acquisition cost per loan in Q2. Next, expanding our footprint. We continue to make progress in our newer products and are excited to see the progress we'll make through the rest of 2023. In the second quarter, we made significant strides in our auto retail lending business. We expanded our footprint from 39 rooftops with Upstart lending implemented last quarter to 61 rooftops today. We also added 12 additional states we now support, covering more than 65% of the U.S. population. We launched new risk models for both our auto refinance and retail lending products, delivering as much accuracy improvement as we've seen in the last year from our personal loan models. We continue to improve our auto recovery performance, reducing delays in recovery cycle by 75%. On the feature side, we launched a new device-agnostic in-store application that expands access to desktops, laptops, and tablet browsers. We also brought on our second and third lending partners for auto retail, no easy feat given the current market environment. We're also making rapid progress on our small dollar relief loans. These loans start at just a few hundred dollars and are currently offered only to Upstart applicants who don't qualify for our mainstream personal loans. For this reason, they're entirely incremental to both our approval rates and our model training set. Our first vintages have now fully reached maturity and our model is now fully calibrated with observed losses in line with expectations for our most recent model version. In a first for Upstart, we began using cash flow data as part of the risk model for small dollar loans. This incremental data has led to increased approval rates and will eventually become available for all our loan products. Our fully automated rate in Q2 for small dollar loans was 90%, an incredible achievement that demonstrates the power and impact of AI in lending. In Q3, we'll move beyond offering this product exclusively to those declined for personal loans and will finally enable direct consumer applications. Last but not least, I'm happy to let you know that our home equity product is officially off the ground, with the pilot program in the state of Colorado. We expect a fast follow with the state of Michigan and also hope to be in a handful of additional states by the end of Q3. This is the first Upstart product specifically designed for prime borrowers, where a superior process enabled by automation is a richer source of differentiation than loan pricing itself. As a reminder, I mentioned last quarter that we're targeting online approval in less than 10 minutes and a closing process of less than five days for an Upstart powered HELOC against an industry average closing time of more than a month. To wrap up, we're not yet certain the economy is headed to a better place. So, we continue to be cautious while investing for the long term. And you're now beginning to see the benefits of our disciplined approach. Regardless of the economy's direction in the coming months, I'm confident that we're building a better, stronger enterprise for the future. We're in the pole position to lead the industry to an AI-enabled future, one that represents a giant leap forward for both borrowers and lenders. And we do this not simply because of a fascination with AI, but because of what brought us here—the potential to dramatically improve access to credit for tens or even hundreds of millions of Americans. There are many dimensions along which you can weigh our efforts to make Upstart stronger: speed of model development, strength of unit economics, low fixed costs, demonstrable leverage in our business, improved funding supply, and growing product diversity. But the dimension that gives me confidence more than any of these is talent density at both the executive and individual contributor level. For those excited about AI and passionate about its potential to improve lives, we know of no better place than Upstart to build a career. And while we're hiring strategically and with extreme caution, our digital-first approach is enabling us to hire top talent across the country. More than 90% of job candidates have accepted our offers in recent months, an incredible success rate. While much of the world is debating how to return to the office full time, we're very happy with the results of our digital-first approach. I will close with a huge thank you to all Upstarters as well as the family and the friends that support them. We're on an incredible mission together and it wouldn't be possible without each of you. Thank you. And now I would like to turn it over to Sanjay, our Chief Financial Officer, to walk through our Q2 2023 financial results and guidance.

Thanks, Dave, and thanks to all of you for joining us today. We're pleased with our return to sequential growth and EBITDA profitability this past quarter, as our work to unlock committed funding, rationalize our fixed cost base, and expand margins begins to bear fruit. We accomplished these objectives despite ongoing macro challenges for our lending partners, and despite a U.S. borrower whose recovery from the stimulus-driven effects of 2021 and 2022 has yet to fully materialize. Our best measure of borrower delinquency trends, the Upstart Macro Index has tread water over the past few months, and in fact, even seen a more recent seasonal increase versus earlier '22 and '23 levels, as we came off of the favorable tax refund seasonality that ran through April. Despite a continuing recovery in disposable income stemming from the ever-strengthening labor market, any incremental earnings over the past quarter have been directed almost entirely towards higher consumption, which has continued to increase in lockstep. And consumer balance sheets have not benefited from incremental savings as they had earlier in the year. Despite these latest dynamics, we believe our underwriting models remain well calibrated to this environment, and we are expecting our vintages since late 2022 to deliver or exceed their targets. On the funding side of the ecosystem, banks remain conservative in managing the asset side of their balance sheets, generally seeking to rationalize loan positions and conserve cash in aggregate. The ongoing supply of loans on offer in the secondary markets by sellers anxious for liquidity contributes to a challenging market dynamic. With loan books being sold at bargain prices, it creates no shortage of buying opportunities for selective investors. Our view is that it will take some time for the market to work its way through this surplus of cheap available yield. Despite this, we continue to pursue a number of promising discussions with prospective funding partners, aimed at bringing more committed capital to the platform and believe that we will be well positioned once the loan market returns to a more traditional state of pricing equilibrium. With these items as context, here are some financial highlights from the second quarter of 2023. Revenue from fees was $144 million in Q2, comfortably above our guided expectation of $130 million, aided by a beneficial mix shift towards institutional funding as well as ongoing take rate optimization. Net interest income was negative $8 million, largely owing to higher-than-expected discount rates and unrealized fair value adjustments on some existing assets, as well as the impact of rising borrower charge-offs, particularly in our legacy R&D portfolio. Taken together, net revenue for Q2 came in at $136 million, slightly above guidance and representing a 40% contraction year-over-year. The volume of loan transactions across our platform in Q2 was approximately 109,000 loans, up roughly 30% sequentially and representing over 43,000 new borrowers. Average loan size of $11,000 was up 4% versus the same period last year, but down sequentially due to growth in small dollar loans. Our contribution margin, a non-GAAP metric, which we define as revenue from fees minus variable costs for borrower acquisition, verification, and servicing, as a percentage of revenue from fees came in at 67% in Q2, up 20 percentage points from 47% last year and 7 percentage points above our guided expectation for the quarter. Continued investment in loan processing automation and fraud models have led to a new high in fully automated rates at 87%, bringing down loan onboarding costs and improving the conversion efficiency of our marketing costs. Higher numbers of repeat borrowers have similarly improved our overall cost per acquisition. And a mix shift towards institutional funding has benefited our take rates. Taken together, our contribution margins are stronger than they have ever been. Operating expenses were $169 million in Q2, down 35% year-over-year and 28% sequentially, as workforce restructuring initiatives announced in Q1 are now translating into reduced operating burden. In addition, as Dave alluded to, we have done a significant amount of work to improve efficiency and decrease the overall expense of our technical infrastructure, which represents a large portion of our fixed cost base. Declines in other categories, such as sales and marketing and consumer operations, were largely in line with the decline in the loan volumes that drives them. Altogether, Q2 GAAP net loss was $28.2 million and adjusted EBITDA was positive $11 million, both comfortably ahead of guidance. Adjusted earnings per share was $0.06 based on a diluted weighted average share count of 91.0 million. We ended the quarter with loans on our balance sheet of $838 million, down sequentially from $982 million the prior quarter. Of that amount, loans made for the purposes of R&D principally within the auto segment represented $493 million of the total. Just after quarter close, we completed a one-off $200 million ABS transaction, funded entirely from our own balance sheet. As you may recall, we traditionally sponsor ABS transactions on behalf of our loan buyers who are usually the principal economic agents and loan contributors to the transaction. In this case, we took the unusual step of funding a deal from the Q2 vintages accumulated entirely on our own balance sheet. We did this both to reset the market understanding for how our more recent vintages should be expected to perform, as well as to serve as a visible signal to the market of our confidence in the adjustments that have been made by our own underwriting models and adapting to the new environment. Our corporate liquidity position at the end of Q2 remains strong with $510 million of total cash on the balance sheet and approximately $558 million in net loan equity at fair value. Looking ahead, while there remain good reasons to be optimistic about the general longer-term direction of the U.S. consumer, in the short term, we remain circumspect about the timing of the recovery of borrower delinquency trends and the recovering health of the funding markets more broadly. In particular, until we see a definitive inflection and reversal in the trajectory of UMI, we will continue to err on the side of being very conservative in our assessment and pricing of borrowers. With this context in mind, for Q3 of 2023, we expect total revenues of approximately $140 million, consisting of revenue from fees of $150 million and net interest income of approximately negative $10 million; contribution margin of approximately 65%; net income of approximately negative $38 million; adjusted net income of approximately negative $2 million; adjusted EBITDA of approximately $5 million; and a diluted weighted average share count of approximately 84.5 million shares. Notwithstanding the promising direction this past quarter, there is still much work to be done to restore our business to the scale and growth that we aspire to. We have made encouraging recent strides in execution, operational discipline, technological innovation, and deal making. And while we await emergence from the combined challenges of the funding macro and the borrower delinquency trends that are running their course, we will continue to push for further progress in all of these areas. When we are finally clear of the environmental turmoil around us, we are convinced that our business will be as formidable as ever. Thanks to all of the teams at Upstart, who continue to execute ahead of expectations. This has obviously not been an easy past few quarters, but I am confident that we are pointed in the right direction and that we have the right people in place to seize the once-in-a-generation opportunity that remains before us. Or as we like to say internally, 'We are under the Maple Tree.' With that, Dave and I are happy to open the call to any questions.

Thank you. We will take our first question from Simon Clinch with Atlantic Equities. Please go ahead.

Hi, everyone. Thank you for allowing me to ask my question. I'm very interested in understanding how you respond when you notice the UMI start to stabilize or improve. What actions can you take? Additionally, how should we view the pace at which you can begin to recover your conversion rates, overall loan growth, and market share increases as a result?

Thanks, Simon. This is Dave. We are monitoring UMI trends and working to maintain what we hope will be a buffer between the assumptions in our new loan model and the current trends in UMI. As we expect UMI to trend down over time, we want the underlying assumptions in our models to align with that. Our goal is to always keep a buffer in place, and we anticipate that UMI should indeed decrease. UMI reflects the overall conditions in the economy, so we strive to stay ahead of these changes. The best way to do this is to ensure UMI is as accurate and up-to-date as possible, which is why we continue to innovate in this area. UMI will provide a valuable indication of when we can incorporate the right assumptions into the new loans we are originating.

Okay. I understand. And just as a follow-up, I was wondering if Sanjay could explain the slide on the long-term funding commitments and your share of the risk, to ensure we understand what is happening in that particular situation as an example.

Yeah. Hey, Simon. This is Sanjay. Happy to do it. Yeah, so we have a new slide in our materials that's meant to sort of pull together the punch line for, essentially, what we have at risk as part of our committed capital partnerships. They're a little bit hard to pull together in the financials directly because the contracts are all a little bit different and they're all accounted for a little bit differently. But I guess at a headline level, as part of those deals, we have invested or co-invested to date on the order of $40 million. So that, I guess, you can think of as the maximum exposure we have. That $40 million over time will be worth as little as zero or as much as around $80 million or $83 million, I guess, depending on the timing extent to which these loans over or underperform. Our best current estimate given the trends is that, that $40 million, we believe, is on track to be worth about $52 million. So, some marginal overperformance there. But that's something that we will obviously forecast and track for you guys over time.

Okay. Thanks, guys.

We will take our next question from Lance Jessurun with BTIG. Please go ahead.

Hey, thanks for taking my question, guys. First one is just around kind of the governor on your growth right now, which is at 36% APR. Any commentary or color around how many you kind of have to turn back right now? Because the risk model is turning them above 36%. And how should we kind of think about that going forward in the coincident of where you see Fed funds going?

The 36% APR cap, along with the current levels of UMI, is a major limitation for our business. Right now, it's probably the most significant barrier to growth on our platform. It severely impacts our approval rates, which are currently quite low. In terms of how this will evolve, the 36% APR cap will remain unchanged, as it's a fundamental principle for us. As UMI decreases over time, in line with Simon's question regarding the macroeconomic conditions returning to equilibrium, we will lower the forward assumptions in our model. This adjustment will lead to reduced loss estimates over time, allowing borrowers currently outside our credit criteria to re-enter the approval process. This is how we anticipate growth as loss rates decrease and UMI falls.

Got it. Thank you. And then in terms of July data, I know there's been some alternative data sources out there, but anything you can kind of frame around July data and where it's come in and how do you kind of see that in terms of a quarter or in terms of a monthly run rate through August and September?

So, you're asking about July data, Lance?

Yes.

I don't think we're in a position to comment on the July numbers. Hopefully, we'll have a good report for you when we discuss Q3.

Got it. Thanks.

We will take our next question from Ramsey El-Assal with Barclays. Please go ahead.

Hi, thanks. This is John Coffey on for Ramsey. I was wondering, Sanjay, if you could tell me a little bit more about the loan balances you have on the balance sheet. I know some came off in Q2 I think from some of your new partners. And clearly, those got built up a little bit again. Could you just maybe talk briefly about how we should think about the cadence of those loans in the balance sheet for the remainder of the year? And if that like $1 billion mark is still sort of like maybe sort of informal high watermark that you won't go beyond or have you rethought that a little bit?

Hey, John. I guess, a specific comment and a general comment. The comment specific to Q2 would be, yeah, it is true that while the net loan balance from Q1 to Q2 went down, we sort of went down further and then built it back up. One of the things we were doing very deliberately was to build up some very, very fresh collateral to be able to put into an ABS deal. And that ABS deal, as I said in my remarks, happened after the end of the quarter. So those loans sort of sit on our balance sheet at the end of the quarter and shortly after we put them into an ABS deal. It's a bit unusual for us to run an ABS deal off of our own balance sheet, as I said, but there's a couple of important reasons for why we wanted to do it. We wanted to put fresh collateral into the securitization reporting so that people could see how the models have changed and how they might expect freshly originated loans to perform. So that's maybe one dynamic that's specific to the quarter. More generally, I think our construct has not changed. We're comfortable going up to a number around $1 billion or so in loan assets. And that's the number that leaves us with still, I think, a comfortable amount of cash to continue running the business and add some safety stock. And within that parameter, we'll sort of flux up and down as we believe benefits the business.

All right. Thanks, Sanjay.

We will take our next question from Rob Wildhack with Autonomous Research. Please go ahead.

Hi, guys. Just another question about the committed capital co-investment. I do appreciate the detail in the slides there. How are changes to that reflected in the income statement? And does that mean that there's a plus-$11.5 million impact in the second quarter from the mark up over the $40.2 million?

Yeah. Hey, Rob. So, the short answer is, no, that impact is not in the P&L. I wish it were that simple. The reality is we've done a couple of different deals. And contractually, they'll have their nuances. I think the result of that is that they're all being accounted for in slightly different ways. Some of it is showing up on the balance sheet as a beneficial interest. Some of it is showing up on the balance sheet under our restricted assets. Some of it is being fair valued, some of it is being carried at cost. So, I think the difficulty of trying to pull all those different accounting treatments together and create a clear picture is the reason why we're just going to put it on one slide for you. But the short answer to your ultimate question is, no, it's not really hitting the P&L in a way where fair value is being recognized in the net interest income line.

Okay. Thanks. And then, of the $2 billion longer-term funding commitment you announced in May, how much of that was funded in the second quarter?

I would say approximately a quarter if you exclude the back book component from that original deal.

Okay. So, one quarter in excess of the $352 million that you sold?

Got that, Rob.

No, I think you dropped from me quickly.

Oh, sorry. I just said that that's correct. The statement you made beyond the back book sale, it was about a quarter of the remainder.

We will take our next question from James Faucette with Morgan Stanley. Please go ahead.

Thank you very much. Just hoping to get a little bit of clarification really quickly here. And maybe I missed it. In the guide, you're looking for around minus $10 million net interest income in the third quarter. Is that being driven by loans on the balance sheet or the way that the funding commitments work through the P&L? Just trying to make sure I understand that mechanism.

Hi, James. A significant aspect of that figure is our balance sheet, especially after completing the ABS deal, which allowed us to eliminate most of our recent core personal loans. What remains primarily consists of R&D, much of which is well-established. Some older auto loans from about a year and a half ago are seeing increased charge-offs. This is partly due to their origination during a time when our models were still being refined and also because they were originated in a rapidly deteriorating environment. You could view this somewhat as part of the cost associated with our R&D efforts, as we now have a portfolio of R&D loans, and the elevated charge-offs reflect that.

Okay. Great. And then I guess just as related to demand and originations, like how are you thinking about the impact from higher take rate? And how should we think about how those could move and how overall origination should trend at least on a sequential basis through the rest of this year and into '24? Thanks.

Hey, James. Our rates are currently at some of the highest levels we've seen, largely due to UMI being very high. Additionally, the market's return requirements are significantly elevated, which is connected to Fed rates, and our take rate is also high. All three factors are contributing to these elevated rates. We expect these elements to eventually decrease together. As UMI trends downward, interest rates might also decline, and our take rate is likely higher than it would be in a normalized market. These three factors are all driving prices up. However, it’s important to note that loan demand is very strong, which is why we are experiencing low customer acquisition costs. Currently, credit prices are extremely high, demand remains robust, and that sums up our current situation.

Okay. Thank you.

We will take our next question from Reggie Smith with JPMorgan. Please go ahead.

Hey, thanks for taking my question, guys. I guess kind of a follow-up to the last question. It sounds like, obviously, pricing is up right now. How do you guys think about managing adverse selection? Maybe talk a little bit about some of the sensitivity people may exhibit to price? I see that your approval or conversion rate is down. And I know there's two components to that. I would imagine approvals are down, but maybe you could talk a little bit about the acceptance of these offers as well to kind of give us some color there. And I have a follow-up. Thank you.

Yeah. Hey, Reggie. Sure. So, let's see a little bit about adverse selection. Adverse selection tends to be an impact that is greater where the market or the segment is more competitive. So when there's a lot of sort of competing alternatives and you try to raise your rates, you'll typically suffer from adverse selection. And of course, when segments are less competed, adverse selection is less of an effect. In our case, for a lot of the segments where we tend to learn a lot of volume, even with higher rates, we tend to still have the best rates available. So, even with higher take rates and higher loss assumptions, we, in many instances, are still significantly below what you might think it was the market clearing rate out there based on the credit scores. And so in that instance, there's not a lot of discernible adverse selection. And if we were to try and raise our take rate significantly in very highly competed segments, very prime borrowers, then it's something that we would be thinking about a lot more.

Understood.

And your second question, Reggie, was about acceptance rates?

Yes.

Yes. I mean it's very simple. It's a pretty classic sort of supply and demand construct, where we raise our rates. And not only do our approval rates go down because of the 36% APR cutoff, but for those who remain approved, they'll be less likely to take a loan. And typically, at least what we've observed in our data is that people who don't take loans with us don't necessarily take them from a competing source. The majority of them just don't take the loan. So it causes people's demand to reduce.

Sure, I understand. I have a quick follow-up regarding the co-investment, and I appreciate the information provided. How should we view that book? Are these loans subordinate to the rest of the structure? Is there a specific ratio that you need to maintain in relation to what you process through the committed facility? Any insights you could provide would be helpful for modeling and understanding that. Thank you.

Certainly. They typically fall into the equity category during a loan transfer, alongside senior and mezzanine financing. These areas are primarily associated with equity. There aren't any specific ratios involved. Each time our capital partners make an investment, our co-investment amount varies based on the relationship we have with them.

Understood. So I guess there's no way to kind of think about or know how large that could be? Like do you have expectations over the next few quarters, like how big that could be?

None that we're talking about explicitly. But I guess I would say, like we consider this to be a part of the overall sort of risk budget of the business, and we've talked about sort of making sure we stay at or under a level of about $1 billion in asset risk. And this is part of that envelope. So, I would anticipate over time, more of our capital sort of falling into this category, maybe less under direct loan assets, where we can sort of use our capital to unlock broader pools of capital and co-invest, as opposed to having loans directly on the balance sheet. But I think what we're going to try to do with you guys is have a conversation about the overall sort of risk position and risk budget of the company, and we'll certainly have some views on how big we would ever want that to get.

Okay. That's super helpful. Quick follow-up. So the take rates, presumably from the mix shift in funding, it wouldn't be unreasonable to assume that the take rate holds or even gets better going forward? Just want to confirm that. Thank you.

I guess, in aggregate, you can see that we've sort of guided to a relatively flat contribution margin next quarter, maybe marginally lower. And so I think you could probably infer from that that our take rates, we're assuming that they're going to be roughly stable to this quarter. In the medium to longer term, as Dave said, we would expect with a normalizing economy for our take rates to slowly subside.

We will take our next question from Simon Clinch with Atlantic Equities. Please go ahead.

Hi, everyone. Thank you for taking my follow-up questions. I was hoping, Dave, you could explain more about the parallel time and curve calibration. I admit I'm not particularly tech-savvy, and it sounded a lot like back testing to me, but you mentioned it isn't. I would really like to understand how it differs and why it isn't considered back testing. Also, what does this mean for your ability to navigate the next wave and manage through the upcoming cycle more effectively than you have in the past couple of years?

Yes, sure, Simon. It ultimately comes down to the ability to quickly calibrate a model, which allows for the development of the next model. At its core, it's about the speed of model development. Generally, a back test involves applying a new model to a set of old loans to see if it can accurately predict their outcomes. This process is essentially how models are developed, akin to a large back test, which is similar to AI training. However, in this case, we are not predicting the past but rather forecasting the future of loans originated by different models. This means that, normally, if you have loans with a 36-month period, to assess accuracy, you would need to wait 36 months to evaluate the model's performance along the entire timing curve. But with a diverse set of loans from various times in the past, you can gain insights into all 36 months of the timing curve from even the first month. This is because you are re-underwriting loans that were initially done under a different model. The focus is on predicting future performance for loans not originally used for their origination. This unique approach provides significantly more data regarding the performance of your loans, particularly concerning the timing curve, which would normally take much longer to gather. This concept is quite innovative and allows for a clear and rapid understanding of how your model is performing, contributing to increased speed.

Okay. Great. Thanks. I might have to go back to school on that one. Thank you.

And that concludes today's question-and-answer session. I will turn the conference back to Dave Girouard for any additional or closing remarks.

Thanks to everybody for joining us today. I'm confident that financial services and lending in particular will be one of the bright shining stars for AI in the coming years and in the coming decades. And we believe there's no company better positioned to lead that transformation than Upstart. So thanks for joining us today. We'll see you next time.

This concludes today's call. Thank you for your participation, and you may now disconnect.