2 reasons why you should be extremely careful with this new, new Fintech SPAC

You may have recently heard of the latest hot new fintech coming on the market after putting its name on the map by partnering with SoFi technologies in November 2021 and followed it up by collaborating with Visa in February 2022. The company name is Pagaya Technologies (PGY -1.49%)and management developed their business model around the use of artificial intelligence (AI) to offer financial products to more people, while reducing the risk for banks, fintechs, merchants, lenders and others companies.

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

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1. Pagaya went public via a SPAC merger

Pagaya used a SPAC (Special Purpose Acquisition Company) merger to be listed on the US markets. And while many companies like to use the SPAC process because it is faster than a listed offering, has lower fees and has fewer regulatory requirements, there are good reasons for investors to be wary of SPAC mergers.

First, sometimes companies using the SPAC merger are not really prepared to operate as a public company, lack the internal control and governance necessary for financial reporting, and mislead investors with excessive growth forecasts. Consequently, many consider SPAC’s high-risk investments.

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

Third, a 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 often get their money back when they do not think the stock will rise – which was the case for Pagaya.

For example, Pagaya’s shares fell by 40% after the merger with EJF Acquisition was approved, but before the public could trade it – indicating that institutional investors sold the share. In addition, the institutional investor sale of Pagaya was a warning that Pagaya’s share was performing poorly after being listed on the stock exchange on 22 June.

PGY data by YCharts

2. Pagaya has an unproven business model throughout the 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 with low interest rates, a growing economy and increasing employment. So it was a plan for Pagaya to increase the loan approvals for its financial partners when the risk was low that the loans would default.

The other 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 offer that solution.

It is obvious that Pagaya has attracted interest from banks and other financial institutions. According to Pagaya’s Security and Exchange Commission (SEC) filing form F-4, 2021 revenue increased 379% to $ 474.7 million from 2020 revenue of $ 99 million – beating the company’s revenue forecasts by 17%. Pagaya’s CFO Michael Kurlander credited the revenue growth to greater use of new and existing customers.

However, the favorable economic tailwind has now turned into headwinds with rising interest rates and a possible recession in 2022. Pagaya said in its investor presentation in September 2021 that they have not yet tested their AI platform under declining economic conditions. And if the technology does not accurately model a borrower’s credit risk under poor financial conditions, loan performance may be worse than expected. Consequently, financial institutions may not view Pagaya as a solution if it underperforms traditional goals such as FICO scores in a low market.

Is Pagaya a buy?

Pagaya has an untested business, and the top management has little experience of running a public company in the United States. The company also has a relatively limited operating history. As a result, most investors will be better off steered away from this unprofitable company for now, especially as the country is heading into a potential recession.