Pagaya Technologies (PGY) 12 Nov 242024 Q3 Earnings call transcript

Ladies and gentlemen, greetings, and welcome to the Pagaya 3Q 2024 Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Josh Fagen. Thank you. Please go ahead.

Thank you, and welcome to Pagaya's Third Quarter 2024 Earnings Conference Call.

Joining me today to talk about our business and results are Gal Krubiner, Chief Executive Officer of Pagaya; Sanjiv Das, President; and Evangelos Perros, Chief Financial Officer.

You can find the materials that accompany our prepared remarks and a replay of today's webcast on the Investor Relations section of our website at investor.pagaya.com.

Our remarks today will include forward-looking statements that are based on our current expectations and forecasts with respect to, among other things, our operations, the financial performance, including our financial outlook for the third quarter and full year of 2024.

Our actual results may differ materially from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially from our expectations include, but are not limited to, those risks described in today's press release and our filings with the U.S. Securities and Exchange Commission. We undertake no obligation to update any forward-looking statements as a result of new information or future events. Please refer to the documents we file from time to time with the SEC, including our 10-K, 10-Q and other reports for a more detailed discussion of these factors.

Additionally, non-GAAP financial measures, including adjusted EBITDA, adjusted EBITDA margin, adjusted net income, fee revenue less production costs, or FRLPC, FRLPC percentage and core operating expenses will be discussed on the call. Reconciliations to the most directly comparable GAAP financial measures are available to the extent available without unreasonable efforts in our earnings release and other materials, which are posted on our Investor Relations website. We encourage you to review the shareholder letter, which was furnished with the SEC on Form 8-K today for detailed commentary on our business and performance in conjunction with the accompanying earnings supplement and press release. With that, let me turn the call over to Gal.

Thank you, and good morning, everyone. I hope you had a chance to read our shareholder letter. With our strong third quarter results, Pagaya is at an approximate annual rate of $1 billion of revenues, $400 million of fee revenue less production costs and $220 million in adjusted EBITDA. Pagaya is now reaching the next level of scale and profitability. This is the result of both increasing demand for our products and laser-focused execution of our financial goals to improve fee generation, funding efficiency and drive economies of scale, all of which sets Pagaya to deliver positive total cash flow and GAAP profitability during 2025. The momentum of the business is driven by the value that our unique product brings to our lenders as they are always looking to improve the value they can offer to their customers. The use of our product since we started has generated over $24 billion of loans with approximately 2 million new customers added or retained by our partners.

As our network grows and our data moat is becoming bigger, we are enabling our partners to acquire and serve more customers with each application they are sending our way. The engine is perpetual and only getting more powerful with time. Existing lending partners are looking to Pagaya to play a critical role in their 2025 growth plan.

As part of these plans, partners are asking for more of our products, creating additional revenue opportunities for both Pagaya and our partners and in return, enhancing the lifetime value of their customers' relationships.

We expect next year to have over 8 relationships generating over $500 million per year of network volume, channeling the power of our existing customer franchises. Growth of our pipeline is a key driver of our long-term growth. In line with our strategy, we continue to make inroads with the largest bank in the country. The onboarding of a top 5 bank in our point-of-sale vertical continues to progress well.

Additionally, following multiple quarters of onboarding and integration, I'm also happy to report that Elavon, U.S. Bank's point-of-sale arm is now live on our network.

In terms of future prospective lending partners, we are currently in term sheet-level discussions with several other top 20 lenders across personal loan, point-of-sale and auto. And we are expecting to be able to announce some of these names next year. Sanjiv will speak more about our pipeline and product expansion momentarily. I could not be more optimistic about the opportunity in front of us. Between the ongoing expansion of our network, combined with the improving macroeconomic backdrop, the conditions are right to extend access to credit for more consumers.

As important as the growth opportunity is our laser focus on profitability and cash flow generation. We transitioned Pagaya this past year to a business that can sustainably convert revenues into profits and cash flows. I want to be clear. This is without raising external equity capital.

All of that brings me to our core 2024 financial strategy to improve fee generation, funding efficiency and drive greater economy of scale. I will split this into 3 areas of focus.

First, we are earning more fees on every dollar of network volume we generate, reaching a record level this quarter. Cost savings has amplified the benefit of higher fees on our bottom line results.

Next, in terms of our funding, we have demonstrated consistent improvement in our ABS execution as well as adding more diversified funding sources to our network.

We have achieved this through structural changes in our ABS program.

For example, achieving a AAA rating on our personal loan program and a AA rating on our auto loan program.

We have also broadened our funding channels to forward flow, managed funds and pass-throughs.

All of this resulted in a material improvement in our both funding costs and the lowest risk retention level in over 2 years.

In addition to that, this has created a significant cushion against future impairments on our risk retention assets.

Lastly, our balance sheet that has become much stronger as a result of a series of transactions we announced in September to refinance high-cost debt, reduce interest expenses and unlock additional balance sheet liquidity. EP will discuss the significance of this in a moment. In parallel to these initiatives, we continue to iterate on our underwriting model, leveraging our unparalleled and growing data advantage. The improvement in performance from adjusting our model over the last 18 months has helped us to demonstrate significant stronger and stable credit performance. All in all, we have created a sustainably profitable business with growing fees, increasing operating leverage and capital efficiency. 2025 will showcase the true earnings potential of the business as our growth continues and the negative impact of all the risk retention positions are behind us, which we expect by the end of 2024.

As with any business, the successful build-out of our franchise came with a significant investment. The cost of that investment, some of which was credit-related and is impacting our financial results today has delivered massive returns. We grew our network of top lenders and institutional investors, enhanced our underwriting capabilities with a richer data set and are strongly positioned to take advantage of the improving environment. I am proud of our team for sticking to the vision on our journey to offer one of the most in-demand lending technology solutions in the U.S. and become a multiproduct lending technology enterprise. I have never been more excited as we turn the corner to a year when we start to demonstrate the true earning power of our company in 2025. To close, I could not be more confident about the future of our company and our ability to consistently deliver value to U.S. consumer, our partners, our investors and our shareholders. With that, I will hand it over to Sanjiv to say a few remarks.

Thanks, Gal, and good morning, everyone. I want to spend a few minutes on our multipronged and focused growth strategy and provide an update on our progress with new and existing partners as well as exciting developments on our new products. It is important to understand how our products do more for our partners than just growing their originations through incremental loan conversion.

Our products are increasingly being used as a catalyst for additional growth within the portfolio of our existing partners.

We are helping our partners to expand the breadth of credit solutions they can offer their existing customers without taking the associated balance sheet risk. The most common benefit our partners are looking for is in increasing the lifetime value of a customer. This includes retention of existing customers and increasing additional revenue opportunities by offering credit products responsibly.

Additionally, in the case of banks, retaining valuable depositor relationships and creating fee-based revenue is of great importance to their growth, especially in a regulatorily constrained environment.

As a result, we are seeing Pagaya's products being increasingly offered to existing customers within our lending partners, the potential of which is multiplicative. At this time, we are witnessing an increasingly normalizing macroeconomic backdrop. This is driving banks and lenders to more vigorously compete for consumers and valuable deposit funding that is so critical to the stability and growth of their businesses. These enterprises are increasingly leaning on Pagaya to grow and strengthen their product offerings with existing customers.

In fact, because of this phenomenon in the third quarter, we surpassed a record $200 billion of quarterly application volume. And indeed, as our 31 partners are finalizing their plans for 2025, we see that Pagaya's products are increasingly an integral part of their growth strategy. This tailwind from existing partners will result in propelling Pagaya's growth in 2025 and beyond.

Turning to new partnerships.

Our pipeline is strong, and it includes recognizable and notable brands across all asset classes.

First, I'd like to discuss some highlights of structural changes we are witnessing in our pipeline.

We are seeing exceptionally high levels of demand for our point-of-sale product, comprising roughly 1/3 of our pipeline. This includes a mix of great global payments brands, major money center banks and regional banks.

The other notable change is growing demand from regional banks. In light of continued regulatory uncertainty and balance sheet constraints, a large number of regional banks have approached us to partner with them to create fee-driven revenue growth and boost customer value. Currently, 1/3 of our new partner pipeline is comprised of large regional banks across all asset classes. We look forward to helping these banks continue to serve the local and regional needs of American communities. And now turning to growth from existing partners. Starting with our point-of-sale business, our volumes grew by 67% year-on-year and 51% sequentially this quarter, and that's ahead of the real ramp in this business.

Our partnership with Klarna is now at a point where we expect a significant ramp in volumes.

We are working to include additional products that are focused on larger ticket size and longer duration loans. Elavon, the U.S. Bank point-of-sale financing arm, has completed tech onboarding and will begin to contribute to our results in the fourth quarter.

Additionally, we are currently in late stages of onboarding the payments business of a top 5 money center bank. The auto lending sector has faced challenging conditions over the last couple of years with volatility in both the macroeconomic backdrop and vehicle values. Returns are now more stable and our partners are looking to Pagaya to achieve more normalized growth expectations.

We are mainly focused on premier lenders on our platforms such as Ally, OneMain and Westlake.

Over the next 12 months, we expect noticeable growth in this market with a focus on extremely prudent underwriting. Personal loans, which are currently our flagship asset class, has now achieved our company's highest FRLPC percentage of 6.6% in the third quarter, demonstrating the value we bring to our partners. Overall partner demand has increased, a trend which we expect to continue into 2025. But before I hand it over to EP, I want to take a moment to discuss our product road map, specifically our prescreen product. This is a product I'm extremely excited about based on our early successes. This product is designed to enable connected partners to offer Pagaya products to their existing book of customers, creating more lending opportunities across other segments. In the third quarter, we expanded the reach of our prescreen offering from 1 to 2 live partners, and we have 7 more in the pipeline.

We expect a ramp in integration and utilization of this offering, which can ultimately be leveraged across all our franchise of 31 lenders. What I'm most excited about is that the prescreen product epitomizes the power of Pagaya's network to use existing connectivity and trust to drive further lifetime value to all our partners. And when our partners win, we win. With that, let me now hand over to EP to discuss our financial results.

Thank you, Sanjiv, and good morning, everyone. We reported third quarter total revenue of $257 million, fee revenue less production costs of $100 million and adjusted EBITDA of $56 million.

Before I walk through this quarter's results, I want to discuss the progress we made to achieve our 2 key financial milestones, sustainable total cash flow generation and GAAP profitability, which we expect to reach during 2025. This progress is due to focused execution on our financial strategy that we set out at the beginning of the year.

First, on unit economics.

Third quarter fee revenue less production cost was a record $100 million at 4.3% of network volume with increased fees across multiple partners and channels.

Next, on operating leverage, we took action to reduce core operating expenses by approximately $25 million annually, a portion of which was reflected in the third quarter, driving improved overall operating efficiency.

In terms of capital efficiency, we've optimized our ABS structures and diversified our funding sources to lower the use of our capital while reducing the potential for future impairments related to our risk retention portfolio. Last, we optimized our corporate capital structure and derisked our business. We achieved this by paying down expensive debt and unlocking liquidity through the release of securities that serve as collateral against that debt.

In addition, the debt paydown is expected to reduce interest expense by approximately $30 million, an opportunity we highlighted on our second quarter earnings conference call.

We have positioned our company to leverage demand for our products and to produce sustainable and profitable growth. This will become increasingly evident as we enter 2025. In 2024, we recognized losses related to vintages originated in 2023 and prior when capital market conditions were much more challenging. Based on the seasoning of these vintages, we expect to book the majority of any remaining fair value adjustments on these securities in the fourth quarter of 2024. This, coupled with the cushion we have created in our portfolio against future losses, further supports our path to GAAP net income profitability, which we expect to reach during 2025.

Turning to third quarter results. Network volume of $2.4 billion grew by 11% year-over-year with continued strength in our personal loan and POS businesses, up 15% and 67% year-over-year, respectively. Total revenue and other income grew 21% year-over-year to $257 million, with revenue from fees up 24% to $249 million. Fee revenue less production costs grew 38% year-over-year to $100 million, which was meaningfully higher than the growth in our network volume and revenue. Fee revenue less production costs as a percent of network volume expanded by 83 basis points year-over-year to a record 4.3% towards the high end of our second half 2024 target range of 3.5% to 4.5%. The growth in our fee revenue less production costs continues to be driven by fees from our lending partners, which comprised 71% of total FRLPC in the quarter versus 60% in the prior year. It is important to note that our largest and most mature vertical, personal loans, generated an FRLPC of 6.6% of volume.

Looking forward, we anticipate improving unit economics from both our auto and point-of-sale businesses as we further scale growth in a more favorable macroeconomic backdrop.

While FRLPC grew 38% in the quarter, core operating expenses were flattish year-over-year and down 5% sequentially. This demonstrates the strong operating leverage embedded in our business, along with the benefits of the cost savings initiatives we announced in June. Core operating expenses were 52% of FRLPC, down from 72% in the prior year quarter and the lowest level since going public. Total operating expenses in the quarter were impacted by whole loan losses of $12 million related to loan purchases from older ABS transactions. The combination of higher fees and continued operating leverage drove a 61% incremental adjusted EBITDA margin in the third quarter. Adjusted EBITDA of $56 million grew by $28 million year-over-year, a margin of 21.8%, up 846 basis points. Net loss attributable to Pagaya was $67 million in the third quarter compared to a net loss of $22 million in 3Q of 2023. Credit-related fair value adjustments reported in other expense amounted to negative $70 million, net of noncontrolling interest. Adjusted net income, which excludes share-based compensation and other noncash items such as fair value adjustments was positive $33 million, showcasing the underlying earnings power of the business.

While we expect credit losses to be a normal part of our business, as is the case for all lending businesses, we expect that with continued top line growth, we will reach sustainable GAAP profitability during 2025.

Now moving on to credit performance.

We have seen a significant improvement and stability in credit trends over the last 18 months. The combination of both the shift in our portfolio to more resilient borrowers and an improving macro environment has driven notable improvements relative to peak losses in both our personal loan and auto loan portfolios. The latest data for our 2023 personal loan businesses show that CNLs have improved by 20% to 40% relative to peak levels we saw in 2021. The latest data for our auto loan businesses show an improvement of 30% to 50% relative to the peak levels we saw in 2022. Credit performance across all our 3 products is now in line with our expectations.

Turning to funding. We've made significant progress this year in terms of capital efficiency by optimizing our ABS program and diversifying our funding sources. At the same time, demand for consumer assets continues to strengthen and pricing has meaningfully improved compared to 2023, which was a far more challenging environment for the industry.

As of year-to-date September 30, we have issued $4.4 billion in our ABS program across 12 transactions. In the third quarter, we closed our second AAA-rated ABS deal, a $500 million transaction that was significantly oversubscribed. It was priced at the lowest cost of capital we've seen since early 2022, and our effective net cash risk retention came in at about 4%.

Looking ahead, barring any significant changes in the funding environment, we expect our net risk retention on these personal loan ABS deals to remain around 4% to 5% of the notional size. In October, we successfully completed our second pass-through securitization of the year valued at $100 million. These transactions have minimal net risk retention at just 1% of the total notional amount. We anticipate executing 1 or 2 more such transactions in the next few months with plans to further scale the program in 2025. At the same time, we will continue to expand our privately managed funds and forward flow programs, which require little to no risk retention. In total, we expect non-ABS funding channels to account for 30% to 40% of our total funding in the fourth quarter and anticipate net risk retention levels to be around 2% to 3% of total network volume, which represents our average target range over the cycle.

Turning to our balance sheet. In September, we announced a series of opportunistic transactions, raising an exchangeable note of $160 million, upsizing our term loan by $70 million and executing an expected sale of approximately $100 million in balance sheet securities. Proceeds will be used to pay down high-cost borrowings. These transactions meaningfully strengthen our balance sheet, improve access to liquidity with the release of high-quality collateral and excess cash and are expected to reduce annual interest expense by approximately $30 million.

We expect to complete these transactions by the end of the year.

This quarter, we recognized a fair value impairment net of noncontrolling interest of $70 million.

We also reported a change in our gross unrealized loss of $19 million booked in other comprehensive income and shareholders' equity. These charges were primarily related to our 2023 vintage securities. The remaining fair value of our 2023 securities as of September 30 was approximately $275 million.

As I noted earlier, we expect the majority of any remaining fair value adjustments related to these vintages to be recognized in the fourth quarter of 2024, setting us up to better demonstrate the true earning power of the business in 2025. These 2023 ABS structures were issued in a high cost of capital environment. The relative high sensitivity to even small changes in losses resulted in credit-related impairment charges.

As Gal mentioned, during that time, we continue to invest in the growth of our franchise with a focus on building long-term shareholder value.

Our step change improvement in capital efficiency, coupled with more normalized capital markets results in a much higher cushion against future impairments, which coupled with ongoing growth in our business will enable us to reach positive GAAP net income during 2025.

Now let me close with our outlook for the remainder of the year.

For full year 2024, we are narrowing our target ranges across all of our key metrics.

As we stay laser-focused on accelerating cash flow generation and profitability, we are directing our production to our most profitable channels.

We expect full year network volume to range between $9.5 billion and $9.7 billion.

We expect total revenue and other income to range between $1.01 billion and $1.025 billion.

We expect adjusted EBITDA to range between $195 million and $205 million. To close, we are excited about our trajectory to achieve accelerated profitable growth and all of the milestones we have achieved towards that goal.

We expect to turn to positive GAAP net income during 2025 and will provide formal 2025 guidance at our next quarterly results. With that, let me turn it back to the operator for Q&A.

[Operator Instructions] The first question comes from Joseph Vafi with Canaccord.

Nice to see progress along many facets of the business here. Thought maybe we just start on the funding side.

Now it sounds like you've got -- you developed a nice set of different funding sources. Could maybe we go a little bit more deeper into the mechanics of how loan volume, network volume is allocated across some of these funding sources? And then maybe a little bit on economics for you on the various funding sources other than the traditional ABS? And then I'll have a quick follow-up.

Joe, thanks for the question. I'll take that one. This is EP. Yes.

So we're very excited about where we are currently in terms of our funding. On one side, we have obviously optimized significantly our ABS structures, which we expect to now -- as we're looking at [ Q2 ] exit rate and Q4 to range at 4% to 5%, which combined with diversified funding sources from forward flow, pass-through structures and all of that, we expect the blended mix to be around 2% to 3% across our entire volume.

We continue to scale these programs. We see significant opportunity and demand to grow the pass-through programs in particular, and we're in discussions to explore further forward flow agreements.

All of that hints at a significant demand, obviously, from investors, which we're very excited about. And any changes in the pricing and all of that amongst the different structures is already reflected in our guidance of 3.5% to 4.5% of FRLPC as a percent of volume.

Got it. Is there any way that -- maybe just a little more there, EP, on how you -- how volumes get allocated across these different funding vehicles, like a little bit more detail there.

Sure. And we have provided some information in our letter as well, but I would think about ABS being approximately 60% -- 60% to 70% of our volume currently with the alternative sources across pass-throughs, forward flows and our privately managed funds taking the remaining 30% to 40%.

Got it. And then one on point-of-sale. It sounds like there's a lot of point-of-sale in the pipeline. Obviously, you've got some big logos already signed up there. How should we think about network volume and point-of-sale over time compared to maybe some of your other loan cohorts like personal loans? Could it be that large one day? Or how do you see it relative to some of the other loan types?

This is Sanjiv. I'll take that.

So yes, I totally agree with you. The new growth area for us, the new emerging asset class, which is super exciting is obviously point-of-sale or BNPL as many people describe it. That, as you know, we have a relationship already with Klarna that's going to grow very substantially because of the way we've sort of set it up. And as I said, we'll also go into longer duration, longer ticket size loans. Same with Elavon.

We are seeing that phenomenon happen at most of the banks that are getting into payments and -- getting into or have been in payments for quite some time in a very substantial way. We see this across major money center banks. We see that across regional banks.

And so -- and the fact that we are increasing the loan size and duration makes it appear in some ways like behave a little bit like personal loans if we really think about it. And the short answer to your question on whether or not it will be as big as personal loans, we absolutely believe that it will. This is an area that is very, very, very strongly adjacent to the credit card business, [indiscernible] lending partners. They are investing a lot of money in that and so are we. And we totally believe that this will be at least as big as PL business and equally as profitable, and we look forward to that.

The next question comes from Mark Palmer with Benchmark.

I have one question and then a quick follow-up. The company has done a great job of creating operating leverage through expense reductions, and that's really shining through in terms of profitability. How are you thinking about the balance between expense control and additional investments in the platform going forward? And what's the implication with regard to the company's margins?

Mark, it's Gal here. Thank you for the question.

So I will take it first from a business perspective, and then we'll hand it over to EP for a few financial remarks.

So from a business perspective, I think this is one of the biggest differentiator pieces of Pagaya.

As you think about it from an infrastructure perspective, the reality is that to manage 31 partners or 50 is not that different.

So it's not to say that we don't have 5% or 10% higher amount of expenses needs, but it's 0 related to the scale and the magnitude of that. And think about it that we build an engine that knows to onboard or add something between 2 to 4 a year.

So from that perspective, our cost is mainly going to stay flat, while the additional revenues or net revenues, whatever you want to call it, should continue to grow in the high single -- sorry, high double-digit numbers. The only other piece I wanted to add to that is that the reduction in force that we did and where we are staying today with the platform, especially as Sanjiv came into effectively in his role, is not a place where we are running lean right now. That's how we view the business. That's what we view the expense basis to be. And that's where we believe we can execute in front of many more strategic initiatives.

In addition, for even more products and more asset classes down the road that could be in the same concept because it's really high leverage to our ability to build a scalable business, and that's the story of Pagaya.

Yes. And I want to double down on one thing that Gal said, it's the business has an inherent operating leverage and it's a key differentiator. It's less about managing expenses down. It's more about our ability to continue to deliver on our strategy and take advantage of the growth opportunities without necessarily any incremental investments.

If you look at costs year-over-year, they're about flat, yet fee revenue less production costs has driven -- has grown by more than 38%. The point of this is that we can continue to execute on our strategy and take advantage of all the growth opportunities ahead of us without any incremental or material incremental investment on our cost infrastructure.

And one quick follow-up question.

We are now a week since the U.S. presidential election.

Just wanted to get your initial thoughts on what the expectations are for the operating environment for Pagaya under the new administration from a regulatory perspective, in particular.

So Mark, sure.

So I think generally speaking, right, and without speaking about politics, we are really in a situation that from a market perspective, there is a very, I would say, strong belief that regulatory will be more constructive and that in the same time, the belief that growth should happen in the U.S. is there.

For our perspective, as you think about that these 2 different type of narratives that fit well for Pagaya, we are supportive of a strong consumer that will have the ability to take the debt and to pay it properly. And in the same time, as you can imagine, and as a disruptive in this space, for us to bring more technology and more capabilities into the banks and into the other pieces is definitely a strong tailwind for us.

So all in all, the ability to actually drive more value by exploring and opening technology into the different ecosystems and banks is definitely something that is a tailwind for us.

The next question comes from John Hecht with Jefferies.

Congratulations on continuing to execute against the growth plan. Maybe just because I know that the personal loan product, it's more mature, it's more scaled. Maybe can you talk about like the FRLPC with that versus like the other new products? And also, maybe talk about the risk retention across the different product lines.

John, thanks for the question.

So today, as you saw, right, we reported in the third quarter a record FRLPC across the entire company of 4.3%, which is closer to the upper end of the range. When you try to dissect that across our products, personal loans, which is a more mature product, it's close to 6.6%. And then as it relates to auto and POS, these are areas where we continue to see significant more opportunity to grow the unit economics as we're moving forward. These are still investment areas for us, but we see that opportunity to basically apply the same road map that we had on personal loan. It's just a few quarters behind. From a risk retention perspective, what I would say is there is a little difference between the different products. What I would say is if you take a personal loan as an example, at 6.6% FRLPC and a risk retention close to 2% to 3%, we're already looking at a product that's significantly profitable. And we expect to replicate that success in the other products as well as we continue to mature in those fronts.

Okay. That's helpful. And then maybe can you talk about the conversion rate? It's still very conservative. It's been on a downward trend despite the fact that you've had very solid volume growth. Where are we in the cycle that you might -- we might see a reversal of that trend in the conversion rate? And what might that -- what kind of opportunities does that present to you guys?

Yes. Listen, as you may have seen a little bit, we continue to see significant growth opportunity, right? We have built now a franchise that looks at more than $200 billion of application flow coming in through our 31 partners per quarter. And our conversion rate, to your point, continues to be in that sort of a little bit less than 1%, materially lower than what it used to be. We obviously have the opportunity to change that and grow, but we want to make sure we do that in the form of profitable growth and not at the expense of profitability and returns.

As we continue to move on and we get more flow and some of the relations with our newer partners mature, we will naturally start increase -- you naturally see an increase in that conversion ratio coming up [ surely -- ] particularly in 2025.

The next question is from the line of Sanjay Sakhrani with KBW.

This is actually Steven Kwok filling in for Sanjay. I guess I just want to drill down on credit and the credit impairment this quarter. It seems like credit metrics seem to be trending fine.

Just curious as to what's led to the credit impairment this quarter. And it seems like it was related to the 2023 vintage. If we could just drill down on -- was it on the personal loan side or auto side? If you could just provide some more details.

Sure. I'll take that [indiscernible].

So look, the impairments were mainly related to the 2023 vintages. And I want to underscore that either way, the company as a business today is very well positioned to drive to GAAP net income profitability in 2025 and reflecting impairments, if any, in the future.

In addition, and I want to make clear, and we provided a lot of information on that is that our credit performance continues to improve and has been improving for multiple quarters. When you look at the 2023 vintage CNLs across all our products, they are significantly better than the 21s or 22s in the range of 20% to 40%, even 50%.

So this was not related specifically to credit. What you have here is these positions, risk retention position that we took related to the '23 is -- was done in a very challenging funding environment. Effectively, you're having investors looking at very high expected returns to underwrite these types of assets. And from our perspective, Pagaya was continue to invest during the environment in the growth of our franchise, and we're focusing on building up liquidity and planting for future growth.

So even though we didn't anticipate those losses, what you have here is ABS structures that left us effectively susceptible to impact -- financial impact even from small changes in the credit performance.

So that's what drove these impairments and obviously, as I said, primarily driven by 2023s. The key question here is where we are today. A couple of things there.

First of all, obviously, the capital markets and funding environment is significantly better and positive. But most importantly, we have significantly optimized our funding structures and diversified our funding, all of that leading to a significant cushion against any future impairments.

So as I noted on the call, as it relates to the 2023 vintages, we expect the majority of any remaining impairments for that vintage to be taken in the fourth quarter. And we obviously want to take that sort of noise away to demonstrate the earnings power of the business going forward and leading to GAAP net income profitability in 2025.

Got it. And as of today, do you have any preliminary expectations of how large the credit impairment in the fourth quarter could be?

Yes. No, we can do that, and I can give you that guidance. We still need to mark the position. And in order to do that, we need to get more data as this risk retention position season, particularly the second half of 2023. And that's important for us to get there to really be predictive in terms of the magnitude of the impact. What I would highlight is, and we did that provide that clarity is today, the 2023 portfolio stands on our balance sheet at approximately $275 million total. And as I pointed out earlier, we expect majority of any remaining impairments to be taken in the fourth quarter.

The next question is from the line of David Scharf with Citizens JMP.

I wanted to kind of revisit the FLRPC outlook, particularly as the asset class mix evolves. I mean it sounded like you're expecting auto to accelerate, very bullish commentary on point-of-sale. And as the business evolves to the point where personal loans are a lower part of the mix, I'm wondering, should we be thinking about a lower kind of weighted average FLRPC margin? Or conversely, based on the 6.6% you recorded in personal loans this quarter, as the other products scale, should we be thinking about the long-term margin structure above the current 3% to 4% outlook?

David, it's Gal here.

So I want to take it from a business perspective for a second. What we are building here is one of the most unique infrastructure and platform of credit generation in the United States. And that comes across, as you mentioned, in the same concept, but with 3 different major markets, all of them are very big and growing, personal loan, auto loans and point-of-sale. The reality is that when you get to the right scale and to the right size, because all of these assets are rather complicated asset to produce that you will need to have very intense infrastructure for that, the profit or the contribution margin or the FRLPC or any way you want to put it is actually more or less over the lifetime, the same.

So you should expect to see autos reaching closer to these numbers.

You should expect point-of-sale to reach to that number.

Now do remember, there are a lot of modifications or normalizations for different duration or different credit spectrums.

So by that, I mean that you should not think about a point-of-sale of a 6-month loan, the same way you think about a personal loan of 36. But if you take all of that into consideration, you will see that while creating the same high double-digit returns, together with efficient funding, which is way below that, the excess spread and the ability to provide profits to Pagaya will remain at the 3.5% to 4.5% over all asset classes and will drive higher and bigger as we mature more the markets as we did with personal loan, you should expect the same to happen in auto and thereafter with point-of-sale. I hope that gave you the clarity.

And if I can just add to what Gal -- this is Sanjiv. I just wanted to add to what Gal just said, which I think was spot on. Obviously, the summary of what Gal said was the asset classes will kind of converge to roughly the same kind of performance -- financial performance. But I will say this in defense of personal loans that by no means have we even reached the potential of where personal loans could go. Gal talked about it. I talked about it in terms of the prescreen product.

So as we are getting into all of our lending -- existing lending partners, I'll give you an example. The very large bank, we are now starting to talk about offering Pagaya personal loans as an unsecured home improvement loan to their entire portfolio. That's very, very powerful in terms of growth in an existing partner.

So personal loans has a very long trajectory to go.

As you all know, the TAM of the auto market is also extremely large. And of course, POS is the newly emerging asset class. But the point is that all 3 asset classes will grow because of the way we are growing horizontally now across personal loans, which is a much more mature product with strong FRLPCs. And of course, the economics will more or less converge because these products are more or less [indiscernible] to Gal's point.

So just want to [ reiterate ].

Got it. No, no, that's very helpful. And maybe just as a follow-up, shifting to the demand side. There's been a lot of private credit flowing into the personal loan sector lately, not just Pagaya's flow partner, but a lot of other primary lenders. Are you seeing any change in behavior approval rates by some of your lending clients. Obviously, you had a very robust application volume of second looks coming your way. But are you noticing any pickup in approval rates among the lending partners you serve as they become better capitalized?

Yes, David, it's Gal here.

So first, I want to take the first question.

So you're right.

We have heard with many of our peers, et cetera, that private credit shops and generally alternative lending is starting to be much more constructive and therefore, what we call leaning in. That leaning in will, at the end, result in a growth for the sector and for the different lending pieces.

So this is a phenomena that we see. We see -- well, we are at the efficacy of it because we have over 120 different partners. And you will be surprised, these days, every public shop wants to have a private shop.

So we are a very good enabler and connectivity tissue even, if you will, between that private credit phenomena and flowing into the consumer credit assets. The one thing I do want to call out is that we are not yet in an environment where lenders are starting to increase massively their approval rates. And the reality is that we are still in a high interest rate environment and things are starting to become much more constructive as we go forward.

So we expect people to open their boxes. They did started to do so. But on the margins, obviously, we're happy to see that because it means much better environment for the consumer, many more opportunities for them to get financed and refinance. That in return is another phenomena that could reduce losses even further in the future.

So all in all, to your question, we don't see a massive phenomena as such. But definitely, the growth mode have started, have started with us, have started with other, but it is prudent growth and not irresponsible growth.

The next question is from the line of Hal Goetsch with B. Riley Securities.

I want to go back to the fair value marks again. And I want to make sure I heard you guys correctly. Like 2023 was an extremely difficult year. We still had fears of interest rates going higher, inflation staying high, then we had a banking crisis in the middle of the year that caused a lot of poor environment for consumer credit on bank's balance sheets. Am I hearing you right that you did deals to invest in the business to support your customers that had structures that were much more sensitive to small changes in credit performance and the structures you're doing today aren't as sensitive, and that's what's helpful to your outlook for 2025. That's what I want to get a...

Hal, we clarify that.

So...

20-year event and the market's hung up on that, and I wanted to get your thoughts on that.

Yes.

So let's name it out.

So let's start from the past. The reality -- what is Pagaya? Pagaya business is a network. In a network, you need to make sure the network is flowing all day, every day, no matter what. That's our responsibility for both our partners and investors to deliver to them the best flow and the best return. In 2023, which was a unique time where it was a really big gap, we filled the gap. That is an investment. We did that because we believe that the investment we'll do is going to end itself in a much massive outcome, which is the enterprise value that you see here today, 31 different partners, U.S. Bank, many others and in the same time, happy investors from 2023. Every investor you're going to speak with in that invested in a Pagaya security in 2023 will tell you great platform, great returns. And these are the investors that are looking now to open their deployment, as you heard David speaking about.

So we are the first choice.

So we did all of that to get ready for that particular moment in time to make sure we are capturing that momentum very well. Two things left to speak about. One, what is giving us the confidence that in the next cycle like that, we're not going to be in the same situation. The reality is that the structural changes that we did, the diversification of the funding to forward flow and many others, the new type of funding vehicles and some internal things about how we manage risk and how we are managing our production have got us to a situation where we are even in the future different cycle, are going to have much less potential impairment losses even if nothing is changing.

We are talking just for you to reference, 40% less risk retention dollars that we are putting now on our balance sheet versus what it used to be a year ago just because of all these different structural changes that I shared with you.

Now the last point that is left to figure out is how the production of today is behaving and what should we expect from that on the impairment level of the future.

So put it in a different word. The 40% versus what last year that you are putting on your balance sheet, what's the probability of that to get impaired. And the answer to that and what EP said before is that the likelihood of them to get impaired is much, much, much lower. Why? Because these different structural things we did in the ABS made that the first dollar loss is much more far away from a potential losses happening than what it used to be in 2023. And therefore, when we speak about 2025 and when we think about what is our expectation, our expectation is from the operational leverage that we have that generates strong cash flows and strong profits, even taking into consideration some normal risk retention write-downs, we are expecting the company to be GAAP net income. And for a platform like us, which is rather young and one of the leading fintech, it's a very impressive target to put out there as we think about 2025, and we're saying that with a full confidence.

As there are no further questions, I would now like to hand the conference over to Gal Krubiner for closing comments.

Thank you very much, everyone. And to close, I just want to say that I'm very proud of what we have achieved this year. We successfully executed against every one of our 2024 goals. We positioned the business to deliver sustainable, profitable growth in 2025 and beyond. The growth opportunities ahead of us are massive and the demand for our product, as you heard in this call, is stronger than ever. Thank you, as always, for your partnership and looking forward to catching up with you very soon.

Thank you. This concludes today's teleconference.

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