Finance is probably one of the most exciting spaces to be involved in today: a lot is being built and essentially every existing problem is being re-analyzed and solved in a new way.
The current year has seen a humongous flow of VC capital towards Fintech: in the first 3 quarters of 2021, Fintech startups raised more than $90B, almost doubling the total capital raised in 2020 (source CBInsights – LINK).
Among the products that emerged in the last decade of Fintech innovation, it is fair to say that the one that got most traction has been the so-called “Buy Now, Pay Later” (from now on BNPL). The success of this product is also demonstrated by the big jump that POS financing made in the unsecured lending space. Looking at the US market, POS lending more than doubled from 2016 to 2020, and the trajectory promises to remain the same for the next few years.
BNPL companies like Affirm, Klarna and AfterPay reached impressive valuations and, in some cases, very generous exits. Other companies are running to enter the space: Visa, Monzo, Revolut, N26, Bank of America.
The goal of this post is to provide a guide on what BNPL is, which are its main dynamics, why it is so successful and how profitable it will stay in the longer run.
What is BNPL?
A buy now pay later product is a payment option that allows customers to buy a product, deferring the payment of X days (usually 30 days) or splitting the payment in a fixed number of installments. All without being charged a penny. Pretty convenient right?
In the backend, a BNPL is nothing but a loan, disbursed to a consumer in the checkout phase, linked to a specific transaction and ultimately funded by the merchant.
How does it exactly work?
I’ll be using an online commerce example, but a BNPL can also be used for offline transactions – with a slightly different flow.
When a customer approaches the final phase of their online purchase, they enter what is called a checkout page. On the checkout page, there are usually a number of payment methods that the user can use to pay. A BNPL is nothing but another payment method from a customer pov.
The difference between the BNPL payment method and the other ones on the page is that, if the user selects BNPL, they don’t pay immediately but in a deferred future time (usually 30 days).
There is another side to this transaction: the merchant. The merchant, who is selling something to the user, doesn’t wait 30 days to get the money, which is immediately disbursed by the BNPL provider. The provider will then collect the money from the consumer in due time. The amount received by the merchant is not the entire amount of the transaction, but it is reduced by a fee. Essentially the BNPL provider charges a fixed percentage for each transaction to the merchant, so the merchant gets the transaction amount minus a certain percentage (usually between 3 and 6%) – a cut that will fund the liquidity provided and remunerate the services offered by the BNPL provider.
In this sense, the financial enabler of the transaction is something more than a simple payment process: the user gets a liquidity buffer that they will pay back over time, but this liquidity buffer is not for free, it is provided by somebody and it accrues interest – so it is formally a loan. Yet the user doesn’t pay any extra amount in the form of interest to the BNPL provider, this interest is indirectly paid by the merchant.
Why are merchants accepting to let go of a piece of their margin?
BNPL exists to make consumption easier on the consumer side, facilitating conversion and revenue generation for merchants. Merchants have measured that allowing users to defer and/or split their payments increases their conversion rates and has a net benefit: they make more money from BNPL-driven sales than what they spend on BNPL fees.
The pain of paying
Buy now pay later has been terribly successful, as we’ll see in numbers later in this post, and I believe the main reason behind its success among consumers is what Prof. Zellermayer defined as the pain of paying.
In 1996, Ofer Zellermayer, a PhD candidate at Carnegie Mellon University, coined this new term to identify the negative emotions experienced during the process of paying for a good. Further studies conducted also by professor Casey Morewedge, demonstrated that handing over money is perceived from our brain akin to losing money, and following the prospect theory – theorized by Kahneman and Tversky – this is processed as a negative feeling.
This negative emotion is counterbalanced by the positive feeling that we experience when we consume or plan to consume stuff.
This ambiguous relation is elegantly solved by payment methods that decouple obtaining the good/service from paying it: credit cards in the 20th century and BNPL in the 21st century.
In addition to these behavioral economics reasons, I believe that the current historical context helped the spread of the product.
The Great Financial Crisis defined the relationship with money that millennials have, especially in Western countries. After 2008-2010, a new generation of workers entered the job market with less opportunities and more debt than the previous ones.
These new consumers had a more skeptical approach towards debt, especially towards credit products with unclear and untransparent terms and conditions – such as credit cards. For this demographic, BNPL has proved to be a terrific product: it guarantees access to credit (without calling it credit), but with a modern interface and with transparent pricing and schedule – people always know what they are paying for and when.
The 3 BNPL giants have incredible valuations, so I decided to deep-dive in their annual statements to understand their business model. Unfortunately, Klarna is not a public company, so the picture is not entirely clear, but it is clear enough to draw some conclusions.
The key to understanding BNPL unit economics is to understand what is the net margin of a $ transacted through their platform. For this purpose, I reclassified their operating costs: with a back of the envelope calculation that I made starting from the official annual reports, what emerges is a net transaction margin that goes above 2% for Afterpay and 5% for Affirm (numbers for Klarna fall in a similar bracket).
This number is interesting but wouldn’t be that appealing if it wasn’t paired with another core number which is frequency of transaction: BNPL users do many many transactions per year, and older cohorts transact more than newer ones.
Very high frequency correlates with a very short repayment cycle, essentially BNPL companies have a very high velocity of reusing capital: the cycle of lending out and being paid back, that a bank makes in 1 year, takes much less for Affirm or Klarna (few months, probably less). This means that the transaction margin that we have seen above has to be multiplied many times per year, resulting in a super-efficient allocation of the capital and a much higher ROA.
Customer engagement and frequency, more than anything else, really explain the fantastic valuations that BNPL companies achieved.
Buy Now Pay Later companies are very interesting organizations: they offer a financial product that is internet-native and fully use the distribution capabilities provided by the net, to offer a convenient service to both consumers and merchants.
Their model is very appealing and consumers are getting used to merchants subsidizing their credit, leaving traditional credit providers in a very difficult situation as they lose both revenues and distribution channels.
Still BNPL companies face some risks.
First, regulation is still very light, but the first signals of a change are already visible – FCA just announced a future review of the rules (https://www.ft.com/content/dd2f16f3-8b6b-4f08-aca1-88021b54f08c). Second, no significant financial downturn ever happened since these companies were created, thus there has not been a real test for their credit underwriting capabilities yet. Third, BNPL is not really a product, it is a feature that could be integrated into more complex financial products like bank accounts or wallets, and this is a clear weakness to the defensibility of BNPL incumbents’ competitive advantage.
Users want BNPL and this payment method is here to stay. We will see, over the next few years, if it will be dominated by Klarna, Affirm and Afterpay or if financial incumbents will have taken it over.