All right, we'll go ahead and get started here. Thank you very much for joining us this afternoon with Paul, co-founder and CEO of Upstart. I'm James Fawcett, Senior FinTech Analyst here at Morgan Stanley. And before we get started with Paul, a couple of disclosures I need to read. First, our disclosure for Morgan Stanley. Please see the Morgan Stanley Research Disclosure website at morganstanley.com slash researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. And then also for Upstart, just a reminder, today's discussion may contain forward-looking statements that relate to future results and events, which are based on Upstart's information available as of today and are subject to risks and uncertainties. Actual results may differ materially from those forward-looking statements. The discussion may also include non-GAAP financial measures, which are not a suitable, not a substitute, excuse me, for GAAP results. Please refer to the company's filings with the SEC and its IR website for additional information, including GAAP to non-GAAP reconciliations, along with other disclosures. So with that out of the way, Paul, thanks for being here. Appreciate it. Thanks for having me. Yeah. So just, I wanted to kick off, I mean, you've obviously been at Upstart since the beginning, co-founder, et cetera, stepping into a new role as CEO. Love to just get a minute or two of your reflections on that journey thus far with Upstart and then the transition and kind of the implications for you and maybe what shareholders should be aware of?

Yeah. Well, Dave and I started this company back in 2012, over 14 years ago. So we've been doing this for a while and working in close partnership for that entire time. I was very early in my career at that time, a recent college dropout with Peter Thiel's 20 Under 20 program. And so it was a real privilege for me to be able to learn from Dave all these years. And, um, uh, as, as we built the business together through so many stages, um, I think we chose, uh, a business that, uh, was probably unusually hard to build. I think it was a lot of the ways in which it was hard. Uh, we didn't even realize when we started just, just because, you know, essentially we chose this, this market, you know, that kind of made a lot of sense, you know, this consumer lending market, we said, Hey, you can go into this market. And what we're going to do is we've noticed that the sort of existing traditional players haven't really done much to adopt machine learning technologies or new sources of data. And if we use those things, then we're going to be able to pick up a bunch of advantage in being able to underwrite more people at much better rates, much faster than traditional players can. It just seems like a straightforward application of technology to an industry where there's a lot of opportunity let's just go do it and what we learned after we started doing this is that well there's a bunch of reasons that no one wants to innovate in this space along these dimensions and it comes down to the fact that there are a lot of a lot of sort of third parties that have to believe that your thing works so if you want to be in this business obviously you have to be able to attract loan funding that loan funding often depends on financing sources which in turn often depend on ratings from third-party rating agencies. There's often a high degree of regulation. A lot of the institutions involved are heavily regulated financial institutions that have to show their regulators that what they're doing makes sense. And on the technical side, maybe not so surprisingly, you can build these models, and what happens is the first version of these models, invariably, they're bad. They make bad loans, and you lose money on the loans. And so now you're sort of in the situation where you're going to be going through this multi-year process of iterating through bad models in order to collect the training data you need to build good models, all while there are all of these third parties kind of scrutinizing whether your thing actually works. And so you're losing money and you're losing credibility all at the same time for a period of many years before you can actually get to the promised land. right and um and so certainly as a private company we just went through a lot of years where it was very hard um to raise any kind of money get anyone to believe that this these models work in part because maybe they weren't working that well in the very early years and it took a long time before you could overcome you know all of that to get to the place that um that we are today and one of the questions i get asked the most is like um you know why uh why i'm still doing this after 14 years. And so much of the answer has to do with the fact that, you know, after those first few years, we kind of realized that on the one hand, the size of this problem and the opportunity were just enormous. Like this is the sort of oldest industry in the world. Like everyone needs credit. And it's probably among the very most important things you could, you could work on to impact the greatest number of people in the greatest way. And also that this was going to take a really long time. Like this isn't the sort of business that you're just going to build in two years and, you know, have it reach the potential it can reach. It was going to be something that was going to take multiple, you know, legs of the journey. And, um, and so one of the great advantages that Dave and I had as a team is, you know, our, um, uh, you know, is that we could, we could run this race in multiple legs.

And so that's a little bit, what's happened here is that, um, uh, you know, we, we, we did these 14 years together and, um, and then, uh, we think there's just so much more opportunity to do a second leg of this so yeah no like it's an interesting perspective because as you said is like um i think you know what i what i take from your comments is that you're probably blessed or or lucky with your naivete as you entered the entered the market some of that yeah but you also uh have adopted more of a like it's definitely like not just a marathon but an ultra marathon type distance and and and it's kind of really like we were talking the other night about Capital One and the development, for example, of that business. That's been a lifelong pursuit for some of those people, right? And I think that's probably true here as well. So really interesting perspective. So let's talk about a couple of the things you mentioned, outside capital as well as credit performance. So let's start with private credit. That's been kind of a concern to your point of investors generally maybe doesn't have anything directly to do with you, but there's concerns in the market around availability of capital and some of what's happening from a redemption perspective. And some of the recent reports indicate actually that redemption pressure in semi-liquid private credit is accelerating a little bit, like we saw that in some of the initial reports here in the second quarter. Against that backdrop, though, Upstart has just signed more than $4 billion of committed capital, including its first 24-month forward flow commitment, and recently completed an oversubscribed securitization. How should investors monitor whether private credit redemptions could begin to impact your credit availability and or the pricing of the capital? Like, help us get comfortable that the headlines maybe that we're seeing in private credit are not impacting upstart adversely?

Yeah. Fundamentally, capital is going to tend to flow to the places with the best risk adjusted returns. And if you look at our results, we have for a number of years here delivered really consistently very high spreads against treasuries. I mean, I think you'd be very hard pressed to find spreads that are almost always like 400 basis points, averaging 600, 650 basis points above benchmark. I mean, there are just not a lot of at-scale places that you can consistently get returns like that. And so I think our capital partners that have done business with us have been very pleased by the returns. And you see that in the 100% renewal rate that we have with our partners, that in spite of, for them, it being a relatively more challenging environment to maybe raise capital overall, that they want to do bigger and longer deals with Upstart. That 24-month deal that you alluded to, that was a big focus of ours. You know, when we think about these renewals, what are the deal terms we're really focused on? One of our top priorities has been getting the duration of these deals to be longer, the commitment periods to be longer, because we know that capital markets are finicky. And, you know, even if we're in a place where the business is very strong, credit is strong, you can be in a place where the market has liquidity challenges for three or six months at a time. And we want to make sure our business is never in a position where a three or six month seize up in the markets can have a very significant negative effect on us. And so getting committed capital deals to be a year long, 18 months long, 24 months long, that is a major solve to that problem. And I think our ability to do that in spite of the challenging backdrop for a lot of these institutions is a testament to how strong the performance has been for them.

So from your perspective, at least right now in this most recent deal, how should we think about the sacrifices, if any, that you had to make from a potential profitability standpoint, spread perspective, anything like that? Because I think we're all accustomed to, obviously, longer duration tends to mean giving up some economics. On the other hand, as you said, it seems like there's a gravitation towards the kind of performance that Upstart's being able to deliver.

Yeah. In recent deals, we've been very happy with the progression of our deal terms. Now, this is a relatively new and innovative structure in this market. So I don't think you see a lot of it. And so a couple of years ago, when we started doing deals of this flavor, it is true that, I mean, you give up something in exchange for that duration of commitment. And generally what we're giving up is we're saying we are going to put some skin in the game. And so we have a component of these deals, which is risk capital that comes from Upstart, primarily funded by the contribution profits we make from loans that are getting originated, but we are putting a lot of those profits at risk in these deals. And so that's kind of like our give to it. And when we set up the structure, we kind of knew that was the fundamental trade here. And it was a good trade from our perspective. This is capital that is going to earn a very good return, including ours. And it buys us this sort of commitment that resolves one of the largest risks with the business, which is that we have no control over what is going on in the exterior markets. And we want that to be less of a risk for us. from there, of course, you know, it just like with every business, you know, it's our objective that we can prove that everything works as expected. You know, the first deal is generally not going to have your best terms and we're going to expect to improve from there. And so that's, that's been true for us. And it's continued to be true in this environment, even as it's gotten more challenging just because of how strong our results have been.

So let's talk about at least high level, some of those results. Is there anything that you would call out in your own repayment data that would either validate or, I guess, contradict the broader market concern that consumer or private credit performance is deteriorating? Are you seeing anything in your results or feedback in payment terms?

Yeah, so we publish an index called the Upstart Macro Index. That's something that gets published, really updated every week, published every month, and it's pretty close to a real-time view of what we think is going on in the sort of overall macro consumer health. We think it's probably one of the fastest moving indicators that anybody has on this. And so that's a pretty close to an encapsulation of our view on what's going on with the consumer. Broadly, we've seen that over the last couple of years, we've been in this normalization post the sort of end of COVID stimulus and that big period of inflation. Notably, in the most recent handful of weeks and months here, with the energy shock that we've experienced this year. We have seen some sort of pressure put on the consumer from that. UMI has gone up a little bit as a result. And we think that's probably a real effect. The only sort of silver lining to that is to say that over the last few years, if you look at the period of time when we had a 1.6, 1.7 type UMI, meaning consumers were 60 or 70% more likely to default than in pre-COVID normal times. Those times came in a world where inflation was near 10%. It was a pretty dramatically different world than the one we live in today. And I think even though you've got headlines like today where you're saying, hey, inflation's at 4%, 4.5%, that's double the Fed's target. Yes, that's not ideal, but it's still, there's a large space between 4 and 10. And I think it would be very difficult for an energy shock alone to move us to a 10-like number just because energy is only a modest fraction of the overall cost portfolio. And so at present, we don't see anything that suggests we're going to get back to a world that looks like that. And from our perspective, the most important thing is just if macro is kind of like stable-ish, you know, we're really happy because our business grows primarily from generating kind of compounding secular technology advances, things that improve conversion rates, make better underwriting, get higher levels of automation, get better targeting. Those things are kind of durable wins that are true in any kind of macro climate. And generally we're doing those at such a pace that, you know, some modest amount of macro fluctuation isn't really going to be a big problem for our business. But yes, there ultimately is, of course, always some level of consumer deterioration, which would be a big problem for us and really probably for most businesses.

Got it. I want to come back to as UMI moves and how that factors into your underwriting models, et cetera, because I think you guys are quite dogmatic about sticking with the models, et cetera. But before we go there, I want to return a little bit to funding and capital intensity, et cetera. And so just a moment ago, we touched on new capital commitments, longer duration, including a 24-month commitment. In the past, you've talked about 100% renewal rate since you did the first forward flow agreement in 2022. What level and duration of committed capital would make you comfortable that funding can support the three-year growth plan, even through a weaker credit cycle, like how much cushion do you need?

Yeah. Um, we have, uh, we have very ambitious growth plans. You know, we have guidance out there to grow, uh, the business at, you know, on the top line at 35% a year for three years. Um, and, you know, we think that the TAMs across our various products are large enough to support a high growth rate for a long, long time to come even beyond that. So, uh, we certainly expect that over time, the scale of this business could be one that is going to make it one of, if not the most important source of yield for a lot of our partners. And so that means we're thinking pretty hard about what the right structure, what the right blend is. And one of the things that we think is this committed capital is really important for us because we want to make sure that any kind of market liquidity sees up we can get through. But we also don't want to be so committed in a bidirectional way that there's no ability to flex up or down. And so we don't think 100% is the right number for this. We do want, you know, so it's just a question of, you know, in the worst kind of market sees up where there maybe actually is something going on in the world, you know, how much like sort of downward and upward flex do you want? And so we want almost certainly a majority of our capital to be like long dated and committed, but it's definitely not a hundred percent. And so somewhere in there is, is the right number for us. Um, and so we're, you know, we're working to, to make that the real mix for us. Um, we are going to have to onboard plenty of capital. Um, and the good news is like, we're, we're doing that. I think in normal times, this actually really isn't a constraint on our growth because again, to this point that capital is going to tend to flow to the places with the very best risk adjusted returns. I mean, And I think we've got it. And so as long as the markets are functioning properly, like that capital is going to flow in as we're able to underwrite and originate and acquire borrowers that, you know, that meet the bar. And that is our limiting factor most of the time. And and so it's it's a it's a good way to run the business. Got it.

So, you know, with that being said is you are pursuing bank charter, right? And so you've emphasized that this is a regulatory and operating efficiency strategy rather than a balance sheet funding strategy. What are the most important milestones investors should track between application, approval, launch, and then getting the benefits? And I guess that focus on it not being a balance sheet strategy, explain why that is. Because a lot of times you see fintechs kind of askew that strategy just because they're reticent to engage the incremental regulatory oversight, et cetera.

Yeah. Maybe on the first, I would say, I don't actually think there are that many milestones around this that are worth tracking. There is a regulatory process. We're in it. And I don't necessarily expect tons of incremental updates along the way. I do think some of that timeline is ultimately in the regulators' hands. I think the regulators have been really constructive with us and with other fintech companies that have been seeking bank charters. And so we're hopeful and optimistic about it, but ultimately, you know, that timeline is going to happen when it happens. That the benefits of the bank, you know, we view as significant, but also just sort of part of the portfolio of bets that we've got going over the next couple of years. It's sort of factored in how we think about guidance and where the business can get to already. And it's just, it's just, these are just some of the bets in the mix. And, you know, all of the bets will either play out or not, and they'll play out on a certain timeline. And you need, you know, we need some of them to land in order to hit the guidance and you don't need all of them to land. And I don't think of the bank as like qualitatively different than the other bets that we have going. So maybe that's sort of a high level comment about how I think about that. And then to the point about the purpose of the bank and why isn't it the balance sheet strategy, the most fundamental reason is just that we have ambitions for the business to be extremely large. You just look at the sort of world of consumer credit, how much opportunity there is. You look across our different products in unsecured and auto and home and sort of the size of the business that we see over time is such that it would be almost impossible in the short term for that business to be funded in a balance sheet centric way where, you know, yes, a bank brings great, super efficient cost of funding on the sort of financing piece, but you still need to have equity. And, you know, One thing we care a lot about as a company is just being really, really efficient with equity. We want to maximize returns on equity. We want to maximize returns for shareholders. We want to maximize any kind of measures of per share earnings or adjusted earnings or anything like that over time. And so that just means we want to be really, really careful about how we use equity capital. And at the same time, we look at the scale of the opportunity and our ambitions, and there's just really no way to square those two things unless you say, we're going to fund this with primarily with third-party capital. The only alternative is to grow slower and we don't want to choose the grow slower path. So I think, and I think actually it's, it does come down to the fact that you just don't see that many credit adjacent businesses that can sustain this level of growth at this scale for a long time. And we think that that's us, that can be done. And, and that comes along with this implication for the right funding strategy.

So talking just quickly on funding, I know that it's something that investors pay a lot of attention to, and that is the amount of loans that are held on your own balance sheet, at least as of right now. And that was just over a billion dollars last quarter. And you've said that you expect some reduction over the remainder of the year, but what's the right steady state balance sheet size relative to your originations, especially when you look at newer products like auto and HELOC and cash line, et cetera?

Yeah. So, um, yeah, we, we have said that we do expect some reduction in the balance sheet. I would describe that as like tactical more than strategic. Like I don't really think that there is, you know, it's not that we think a number modestly lower than the current number is like more theoretically ideal than, than, than the number we're at today. I don't really think there's fundamentally anything wrong with the number that we're at today. I do think that, you know, it is to the point earlier about, you know, being really efficient about equity, like that to me is like really the limiting factor is just like as long as we're operating within that constraint, you know, that number is, you know, hopefully, and we expect going to grow over time, the amount of, you know, equity that is in the business just as a result of generating profits and retained earnings. And like, you know, the business will have more equity to use. And so one of the things that it can be used on is R&D in the balance sheet. And, um, that's, I think, uh, a good sensible use of funds in certain cases. And so we'll kind of like opportunistically, um, use it for that purpose. You know, when we roll out new products, obviously there's a lot of return and value in improving things out. Um, occasionally, you know, and kind of like, um, occasionally in doing some aggregations and stuff for, for sales, when we think that those are good channels for us to fund loans, you know, we'll, we'll use it. Um, and then, you know, very occasionally you might have some like money that is essentially just being parked and earning some return. And that's not terrible either. But I view that as all kind of just tactical. The only really strategically interesting point for us is we're going to make sure to be super efficient about the total amount of equity that the business needs. And within that envelope, it'll kind of go up and down. And I think as long as we manage that, it's not a major consideration in the business.

Got it. So let's talk about the actual underwriting in the models. First and foremost, talk a little bit about how you've constructed models and why be so, like I used the word earlier, dogmatic about having models adjust to UMI and that kind of thing. How frequently should we expect model updates? Why take that approach and what do you think comes next?

Yeah. Um, I mean, I think for us, credit is just non-negotiable. Um, and, uh, you know, you never get credit perfect because the world is always changing a little bit. Um, I think the best you can do is respond to the world as fast as you possibly can. And I think if you create processes that stand in the way of that, where, you know, you're saying, Hey, I need to manage to this quarterly earnings number. So I, you know, I or not, I better close my eyes on what's going on in credit. I think that's how you get into trouble. And we're here to build a business that's going to be here for a very, very long time through hopefully many, many, many credit cycles. And so I think if the best thing that we can do on credit is be the very fastest and first to respond and respond as precisely as possible, we're just going to do that. And if it comes at the cost of a little bit more volatility in the short term, So be it. I think that the right investors and partners in this business are going to be people who like the fact that we take credit so seriously and respond to it as precisely as we possibly can and recognize that the real value from the business comes over multiple years as you compound these technology advantages, which are orthogonal to whether you're getting headwinds or tailwinds of the macro.

Got it. Just a quick question on UMI. Is there a point at which resetting that makes sense? Just because we're kind of using pre-COVID as a reference time, and you're obviously a lot larger. The landscape is a fair amount different. Would that ever make sense, or how do you think about that? Not that it would make that much difference in the underwriting, but...

Um, uh, I think, I think maybe, um, I, I do think that we believe that the, this whole period of time since COVID started has, uh, has had unusual features. And so, um, we don't want to get over indexed to like any of those particular windows of time, but I mean, ultimately it, you know, it's just kind of like, that's, that's kind of just, just math moving. Right, right.

That's right. Yeah. Okay. So let's talk about, um, the model, um, long runway, um, for gains there. And you've talked about lending model improvements as having, you know, as I said, a very long runway for improvements. With traditional models, you've talked about having a 95% error rate and Upstart still leaving around roughly 86%. Just contextualize for us what that error rate represents and how you've driven variance versus the market and what is the cadence for model improvement.

Yeah. So we have a metric that we've developed internally that essentially, if you boil it down, it is looking at the difference between the net present value of the cash flows that you expected versus the net present value of the cash flows that you got. And that is really ultimately what anyone should care about if you're in the business of credit is you're expecting a certain set of cash flows. You got a different one. And how different that is when discounted to present, That's what matters. And so on that error metric, when we talk about, you know, 100% is a totally random model just means like, you know, if you just kind of randomly guessed what cash flows you would get from any given loan and compared them to the actual ones, you know, 95 is kind of where traditional models sit. And then Upstart is at that 86% number. So we call that, you know, almost three times as smart or as accurate as traditional models. And that's measured as, on sort of the one minus the amount of error that remains. And so that tells you two things. One is that Upstart has built a fairly significant advantage over the past decade plus we've been doing this. And second, that there's still a lot of room to go. And I think one of the pretty remarkable things about the business is that contrary to, I think, maybe what many people would have thought, we didn't just get this zero to one moment where we found one nice variable or one sort of clever insight and use that to arbitrage the market. It was like we have just continuously found ways to improve the model at a pretty consistent, almost linear pace over the years as time has gone on. And we've continued to bring that number down. And we think that can go on for a long time just because you're only at 86 out of 100.

Got it. So let's talk about the core business, personal loans. You've called that your superpower, if you will, and first priority as CEO from a product perspective. What are the specific indicators that investors should watch, see whether the ambition for reacceleration is coming from model gains, marketing efficiency, borrower demand, or funding availability? How do you rank order those as drivers?

Yeah. So for us, we do generally think of technology improvements as the primary driver of the business. That means, you know, you get better models. Those models can allow you to either approve more people, offer them better prices, give them a more automated instant experience or, you know, target them better. And that tends to be the single most important factor in the business. And it shows up in the form of efficiency. So these are improvements that, you know, are maybe different from improvements where, you know, you're just achieving them by virtue of spending more money on marketing exclusively, therefore driving up your, your cats. And I think what investors should look at, you know, to see if we're succeeding in this is just to see, you know, how much of our growth going forward starts showing up, you know, progressively as you move progressively down the income statement. And, you know, I think with less efficient types of growth, growth that is like less technology driven, you're just gonna, it's not gonna show up in the way that you like, you know, you'll see more of it on the top line, less of it as you move down. And I think throughout the course of this year, investors should look and hope to see that we're going to show not just what we've recently shown, which is that we have the ability to continually grow the top line really nicely, but that starts to sort of walk down the income statement as you go throughout the year.

So I want to talk about that. And I like how you characterize it and how to evaluate it as like, let's look at it at the P&L. And specifically, particularly contribution margin was roughly 50% in Q1. And you've talked about that being the low point for the year, assuming no macro change. What level of contribution margin should investors think as being sustainable, particularly as auto, home, prime personal loans, cash line become a larger mix of the originations? Help us think through the contribution margin differences in different products? And then what are going to be the drivers of improvement, at least in assuming no macro change? Yeah.

So a big part of the story of what's happened to our margins in recent periods does have to do with the mix across these products and segments. The go forward story on these is pretty different. So I want to take a moment to break them out. Within personal loans, there's a really big difference between the margins we get on our core business and the margins we get on the super prime segment. Super prime, not surprisingly, is a very competitive market. Um, it doesn't tend to come with very high margins. And, um, frankly was, you know, if you look at the numbers, the place that as a company, we put a lot of focus and got a lot of growth in over the last year. Um, and going forward, you can expect that, you know, our focus is going to flip the other way. And we, uh, we, we, we will care much more, invest much more and be focused much more on growing the core segment than the super prime segment. We have, I think, achieved some great things with the super prime segment. You know, two years ago, if you went to Upstart as a super prime person, you would have found a terribly non-competitive rate. I think that translated into a certain inability to use generalized marketing channels. It came with a certain brand reputation that didn't lend itself to being the very best. And I think today we have established a product that any American can go to Upstart and find some of the very best rates that you can anywhere for anybody, and that's really powerful. It unlocks much more generalized forms of marketing, which are useful even in core business. But from how much market share, how much growth do we need to do there perspective, I would call it mission accomplished, and that is no longer going forward our top priority. Now, then there are these new products, in particular, AutoPurchase and HELOC and this sort of emerging cash line product. These products we're really optimistic about. We think these products are going to be a really important part of the future. These products are still relatively new at different parts of the life cycle, but their contribution margins still have a lot of room to improve. And I want to maybe anchor everybody to this sort of point that our personal loan margins were improving for almost a full decade. Since we started the company, they were, it's not like personal loans was a business that got to mature margins after two years and then just scaled. It was scaling while it was improving its margins. And that's because the amount of margin you can take is so deeply tied to the amount of tech differentiation that exists because that tech differentiation is what unlocks pricing power, right? It's like when our rate is so much better than anybody else's rate, that's why we can afford to take some of the highest take rates that exist in the industry on that product because the next best alternative is so much less good than what we offer now in personal loans. And so I expect that same dynamic to play out in these products. I think in the very near term, their margins will improve very rapidly because they're quite negative today, frankly, on these new products. And so they'll have a period of rapid improvement and then they'll just continue to improve. And I think they'll probably should improve for years and years to come here. So I don't think we're going to reach like a mature margin anytime soon, but I do think we're going to get a much higher margin soon and that's going to help out sort of the near term financials of the business relatively quickly.

So help me in just the last minute, balance this out. So I get like, as you kind of go to the core part of your market, that that has better margins. And so that'll be an uplift on a contribution margin versus where you have been. It sounds like you're going to see improvement on new products as well. But yet, even as they grow as a percentage of revenue, they're still probably dilutive to overall contribution margin. So it's a little bit of a combination there where if you were just going, changing the mix on personal loans, you probably could improve contribution margin faster, but then you're growing and then, and you're going to get improving margins. And so the amount of dilution will come down, but it's, they're still going to be diluted for a while. Is that how we should think about it?

Yes, that's true. And the sort of exact net effect does depend a little bit on, you know, how, how fast they're growing. But I mean, there is definitely, I mean, you do get, you do get a benefit from moving from deeply negative, you know, like that, you know, that, that helps you a lot. So, so I do think there's, you know, we, we have a lot of reasons that we feel good about, you know, where, you know, where the lower half of the income statement is going this year. And that's, this is, these are some of the reasons.

Got it. Well, we're out of time. Thank you so much, Paul. I really appreciate you being here and telling the Upstart story has been really fascinating. Thank you. Great. Thanks.