2 Reasons You Should Be Extremely Cautious About This Hot New Fintech SPAC

You may have recently heard of the latest hot new fintech to hit the market after it put its name on the map by partnering with SoFi Technologies  in November 2021 and followed that up by partnering with Visa in February 2022. The company’s name is Pagaya Technologies (NASDAQ: PGY), and management designed its business model around using artificial intelligence (AI) to help offer financial products to more people while also reducing risks for banks, fintechs, merchants, lenders, and other businesses. 

Israel-based Pagaya might be one of the most promising new companies in today’s market. But should you buy it? Here are two reasons you should be extremely cautious about investing your hard-earned money in Pagaya.

Image source: Getty Images.

1. Pagaya came public via a SPAC merger

Pagaya used a special purpose acquisition company (SPAC) merger to become publicly traded in the U.S. markets. And while many companies like using the SPAC process because it is faster than an initial public offering, has lower fees, and has fewer regulatory demands, there are good reasons for investors to be wary of SPAC mergers.

First, sometimes companies using the SPAC merger aren’t really prepared to operate as a public company, lack the internal controls and governance necessary for financial reporting, and mislead investors with exaggerated growth projections. Consequently, many people consider SPACs high-risk investments.

Second, most companies that have used the SPAC process to go public over the last several years have performed very poorly. For example, according to a Renaissance Capital report, 199 companies went public using SPAC mergers in 2021. Of those companies, only 11% trade above the offer price. Even worse, the group lost an average of 43% as of April 2022.

Third, one feature of a SPAC merger is that institutional investors can sell their shares after voting to approve the merger but before public investors can trade the stock. As a result, institutional investors commonly get their money back when they don’t believe the stock will rise — which was the case for Pagaya.

For example, Pagaya’s stock dropped 40% after the merger with EJF Acquisition was approved but before the public could trade it — indicating institutional investors were selling the stock. Moreover, the institutional investor sell-off of Pagaya was a foreshadowing of Pagaya’s stock performing poorly after becoming publicly traded on June 22.

PGY data by YCharts

2. Pagaya has an unproven business model over the full interest rate cycle

Pagaya had two tailwinds in its favor in 2021 that may not exist in 2022. The first is that from the second half of 2020 to the end of 2021, the company had a favorable environment of low interest rates, a growing economy, and rising employment. So it was a layup for Pagaya to increase loan approvals for its financial partners when the risk was low that the loans would default. 

The second tailwind is that lenders are eager to find a way to become more financially inclusive. For years, social justice movements pushed for more financial inclusion and a fairer system for making loan decisions, as credit scores are perceived as biased. Pagaya’s AI platform could potentially provide that solution. 

It is obvious that Pagaya has attracted interest from banks and other financial institutiona. According to Pagaya’s Security and Exchange Commission (SEC) filing Form F-4, 2021 revenue rose 379% to $474.7 million from 2020 revenue of $99 million — beating the company’s revenue projections by 17%. Pagaya Chief Financial Officer Michael Kurlander credited the revenue growth to greater use by new and existing clients. 

However, the favorable economic tailwinds have now turned into headwinds of rising interest rates and a possible recession in 2022. Pagaya said in its September 2021 investor presentation that it has yet to test its AI platform during down-cycle economic conditions. And if the technology does not accurately model a borrower’s credit risk in poor economic conditions, loan performance could be worse than anticipated. Consequently, financial institutions may not view Pagaya as a solution if it underperforms traditional measures such as the FICO score in a down market.

Is Pagaya a buy?

Pagaya has an unproven business, and its top management has little experience running a public company in the U.S. The company also has a relatively limited operating history. As a result, most investors would be better off steering clear of this unprofitable company for now, especially as the country is headed into a potential recession.

Rob Starks Jr has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Visa. The Motley Fool has a disclosure policy.

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