There’s a dazzling new ride traversing the e-commerce town, and everyone wants to get on board! We’re of course talking about Buy Now Pay Later (BNPL) payment services, a not-so-new idea that has recently evolved into a trendy financial offering. Nearly 40% of US customers now use BNPL services to pay for their purchases, an ascending trend that has seen the red-hot sector grow by a whopping 85% in just 5 quarters. So, what’s the fuss all about and what should investors look for if they want to invest in this lucrative space? In part 1 of our BNPL series, we explore all that and more.
An overview of the red hot consumer BNPL sector
To say that Buy Now Pay Later is the new kid on the e-commerce block would be a bit inaccurate. The concept of paying for purchases in installments has been around for decades now. What’s changed with BNPL is the ease with which this kind of financing can now be obtained. Traditional consumer financing is inundated with exclusionary processes, time-consuming paperwork, hidden fees, and interest rates that can take the shirt off your back. Against this harsh borrowing landscape, BNPL positions itself as an interest and hassle-free financing alternative that customers (even those without good credit) can obtain in a matter of minutes. And while formal financing was typically available only for larger purchases, BNPL services allow customers to stagger payments for almost any purchase, from a smoothie to a car and everything in between.
This ease of use and accessibility proved to be a great selling point for the industry during the Covid-19 pandemic. With tightened purse strings, consumers saw BNPL services as a knight-in-shining-armor product that allowed them to buy the things they needed (or wanted) online without maxing out their credit cards. Consequently, the sector experienced exponential growth. BNPL companies such as Afterpay and Splitit saw an over 200% increase in their customer base between 2020 and 2021. In the US, BNPL payments are set to exceed $100 billion this year.
All of which explains why the sector has become such a lucrative space for investors looking to make inroads into the financial services market. Predictably, VC funding in the sector skyrocketed in 2020. Last year, BNPL companies pulled in a record $1.5 billion in funding, an increase of over 40% from 2019. And just recently, fintech company Square acquired BNPL provider Affirm for $29 billion, a hefty price tag that reflects the sector’s future growth potential. This was quickly followed by another eyebrow-raising moment when e-commerce giant Amazon announced in September 2021 that it would partner with Afterpay to offer BNPL services to its millions of customers worldwide.
Pros of foraying into the BNPL space
A payment methodology that is here to stay
The BNPL business model is incredibly customer-focused. Here, it is the merchants who pay BNPL providers a fee to utilize their services. Putting the profit-making onus on the merchants allows BNPL companies to provide interest-free loans to their customers. Avid shoppers know a good bargain when they see it and BNPL offers such folks the best kind of bargain there is – extra purchasing power at no extra costs. This is even truer for Gen Z and millennial shoppers who are risk-averse and vary of taking on too much credit card debt.
On the merchant side of the equation too, it is a win-win scenario. BNPL services are proven to increase average order values by around 60% and cart conversions by 20%. So, while merchants do have to part with a percentage of their profits, the resulting benefits far outweigh the costs. Add to this mix the fact that online shopping is here to stay, and it’s easy to see why the BNPL payment methodology isn’t going away anytime soon. In fact, given its advantages, it could well become the payment process of choice in the future.
A fast-growing market with room to grow
A raging pandemic that forced everyone online, the digitalization wave, and consumers with a subscription mindset all created perfect conditions for the BNPL sector to experience exponential growth in the last 18 months. And this upward growth trajectory isn’t expected to die down quickly. According to Allied Market research, the global BNPL market will grow at a CAGR of over 45% to become a $3 trillion industry by 2030.
There are multiple reasons for this astronomical projection. For one, consumers and merchants alike are just waking up to the wonders of the BNPL offering. As it stands, about 60% of shoppers say that they are likely to use BNPL financing soon. Merchant adoption is also on the upswing. So, there is plenty of room to grow here and the future appears bright. Another reason underpinning growth in this sector is the multigenerational and cross-income appeal that BNPL seems to have. BNPL adoption among Gen Xers, millennials, and Gen Zers has increased two to six-fold in the last 2 years.
An opportunity to serve the underserved
According to the New York Federal Reserve, over 55 million Americans find it difficult to qualify for loans and credit cards. BNPL services do not have the same exacting underwriting standards as incumbent banks do. They also do not use traditional loan-approval parameters such as credit scores and payslips and instead rely on more inclusive information such as rental and phone payments. This approach allows them to speed up the loan approval process significantly. More importantly, it makes fair financing available to a huge swath of the population that is traditionally underbanked and often overlooked. This not only helps financiers tick the all-important financial inclusion box but also opens their platform to a whole new and previously untapped consumer segment.
Cons of foraying into the BNPL space
A highly competitive and unproven market space
There’s no doubt that there is a feeding frenzy going on in the BNPL sector. What was once the sole domain of a few independent players, has now morphed into an overcrowded market space. As of October 2021, there are over 170 companies fighting for a piece of the pie with new startups popping up regularly every month. In addition, the sector’s stratospheric growth has made financial incumbents sit up and take notice with heavyweights such as PayPal, Visa, Mastercard, Citi, American Express, and Apple Pay all stepping into the fray.
The result of all this increased competition is reduced profit margins for all involved. Consequently, profitability is still a distant horizon for a lot of the players. In Australia, where the BNPL craze started, the industry is still operating on a negative profit margin of around -2.5%. And despite being a bumper season for BNPL, firms such as Klarna, Affirm, Afterpay, and Zip are yet to turn a profit. This is largely a reflection of the increased sales and marketing dollars being spent trying to capture market share eating into revenue growth profits. Still, the unproven nature of the game is making pundits question whether the sector is a cash cow or a money pit.
Increasing regulatory attention
So far, the BNPL industry has slipped under the regulatory radar and has managed to operate with limited oversight. All that is set to change though. According to Credit Karma, over 40% of BNPL users in the US have missed at least one payment and around 70% have seen their credit scores negatively affected by them. Regulators in the UK, US, Europe, and Australia are now taking a closer look at default numbers such as those.
UK legislators announced proposals early this year to place BNPL service providers under the authority of the Financial Conduct Authority. Countries such as Sweden now have laws prohibiting merchants from promoting BNPL as the premier payment methodology. And recently in the US, Afterpay was found guilty of funding illegal loans by the California Department for Business Oversight (DBO). As part of the settlement, they had to pay back nearly $1 million in refunds and administrative fees. It’s hard to say what the impact of regulatory oversight on this burgeoning industry will be. What is sure is that once such changes set in, BNPL firms will need to adjust their business models and rates accordingly. This in turn could affect everything from merchant participation to sales and profit margins.
Growing concerns about debt fueled by the BNPL movement, especially amongst younger customers, and an overall lack of consumer protections in the industry are factors that keep ethically minded investors up at night. Just because you can, does not mean you should – such is the argument made by detractors who contend that BNPL encourages people to take on unnecessary debt. There is a clear difference between needs and wants. For users caught up in a consumerist mentality, BNPL options can blur the lines between the two significantly. Another major concern is the late payment fees that become applicable when a user misses a payment. Thankfully, the industry has moved to address this particular issue by capping the late fees to 25% of the transaction.
What to watch out for when investing in the BNPL sector?
So, is the BNPL sector the goose that lays the golden egg or a lame-duck offering that falls flat on profit potential? Given its meteoric rise, is it another credit bubble waiting to implode? It is too soon to give a conclusive answer just yet. With regulators closing in, there is an undercurrent of nervousness in the BNPL business environment. Another challenge facing such providers is the influx of established finance and payment gateway companies such as Visa and Mastercard.
These mainstream players already have the credibility, infrastructure, and processes in place to exploit and a ready clientele to market to. This gives them a huge advantage over the new players who need to start from scratch. PayPal launched its BNPL offering ‘Pay in 4’ late last year and in less than a year’s time has already captured a sizeable market share in the US. It now has over 25 million more BNPL users than competitors such as Klarna who have been in the space much longer.
All this is not to say that independent players cannot survive in this space. But to do so, they must be constantly evolving. For example, Affirm is all set to launch its debit card service later this year, thus ensuring they don’t have all their eggs in the BNPL basket. Companies that offer multiple functionalities and enhanced solutions that boost customer engagement are the ones that are most likely to thrive in this market.
Another essential component that investors should watch out for with such companies is their ability to de-risk. It is imperative that BNPL providers have tech-backed credit de-risking solutions in place that maximize their returns. In addition, given projected growth rates, it is also essential that such companies have a business model that is scalable. This ensures they can take on more volumes and expand their services into new segments and markets seamlessly.
The BNPL payment methodology looks like it is here to stay. Current market size and growth projections point to a future where this is the case. That said, it is still early days for this red-hot sector. Investors looking to make inroads into this space must look for companies that can manage the highs and lows of the industry efficiently using technology-driven processes that can control credit risks while still providing the customer empowerment that the industry is known for.
Watch out for our next blog where we will take a look at the commercial BNPL space!