The Lure of Buy Now, Pay Later (#17)

Origins, growth, and challenges of BNPL as alternative credit

Nov 08, 2020

Usually, forcing any change into the payment systems and consumer habits takes decades. But today, we are living in a particularly interesting time where the shift to mobile and online has brought along a host of alternate payment options.

The latest, and perhaps the most disruptive, being the Buy Now, Pay Later (BNPL). On the first look, the name suggests a simple credit alternative. But that misses the trees for the bush. The nature of merchant and consumer agreements under BNPL and the usage pattern are particularly unique.

Given the fascination around and the potential impact of BNPL, I plan to deliberate in detail on the payment method in this article.

Origins: The Klarna Story

When Sebastian Siemiatkowski, Niklas Adalberth, and Victor Jacobsson pitched the idea of Klarna in a “Shark-tank”-style competition held at Stockholm School of Economics in 2005 – no less than in the presence of King of Sweden - there was little interest. Their pitch came last in the competition, and one man even came forward to suggest that “the banks will never do it”, i.e. never allow for buy now pay later schemes.

Disheartened but still determined, the Klarna team – then called Kreditor Europe AB – moved ahead. Soon, they got angel funding to build on their vision of making online payments easier and safer, both for consumers and retailers.

The first product was a mellowed down version of the BNPL we see today. Consumers would provide Klarna with the bill details, Klarna would pay the merchant – and the customer would reimburse Klarna within 14 days of invoice issue. For merchants, this was an immediate win – the checkout conversion rates grew 20% because of the added flexibility to the consumers, while the credit risk merchants had to undertake was limited.

Little by little, the team expanded the service to customers and retailers in other Nordic countries, to ones in Germany and The Netherlands, and the UK. By 2013, the company had become a unicorn and gathered over 10 million customers, a number bigger than the population of Sweden, where Klarna originated. Since, the team has continued that growth – raising hundreds of millions from investors, servicing over 60 million customers and 75,000 merchants, and raking in a valuation of over $10 Billion. [The company – now a bank – also offers deposits today].

As Klarna expanded, there were tweaks in merchant and consumer agreements for pay-later services, but certain solutions were common across geographies:

Pay in four: customers could split their repayments for buy now, pay later purchases in four equal instalments
Long-term financing: customers could finance large purchases over 3-36 months

The success of these products has been staggering. Klarna today processes over half the online payments in Sweden and has a presence in most countries in Europe, with billions in loans sitting on its balance sheet. Besides, the company claims a 68% increase in checkout conversion rate and a 58% boost in order value for merchants, along with a ~20% increase in repeat transactions. A win-win for the merchants.

This success story, however, has hardly stayed hidden.

The BNPL Frenzy

Afterpay, an Australian giant founded in 2014, is another BNPL leader and commands a market capitalization of ~$28Bn today. At the same time, Affirm – founded in 2012 – is aiming for a >$10Bn valuation with an IPO soon. Zip Co. Ltd., Lazybuy, and Sezzle among others are major players in the industry with a customer base of millions. Not surprisingly, we are also seeing fintech behemoths such as PayPal,Visa, and Citi entering the fray given the hype.

In India, although there are few data centers, a sign of turning tides towards Pay Later options in the country is visible in how Pine Labs processed ~INR 1,700 crores worth of purchases through Pay Later options in October 2020. The number was equal to ~14% of the total sales processed worth ~12,900 crores by Pine Labs in the same period. Moreover, purchases of durables and essentials alike through Pay Later options have seen double digital growths during the pandemic. Pushing the growth have been players such as ZestMoney, Ezetap, Simpl, and LazyPay that offer interest-free credit at the point-of-sale. And this growth is furthered with e-commerce giants Amazon and Flipkart doubling down on instalment-based pay later options.

Source: Flipkart Pay Later

Payments industry experts expect this trend towards Pay Later options to continue at a high pace . In fact, Worldpay Global Payments Report 2020 expects BNPL schemes to be the fastest-growing online payment preference in the next five years.

Understanding the Growth: What does BNPL offer?

Common across the buy now, pay later schemes is the idea that a customer can finance a purchase at the point of sale by paying later in instalments. Klarna, for example, provides a facility for payments in four instalments, with the first transaction made at the point-of-sale, and the next three in gaps of two weeks. All at no-interest and no transaction fees.

Source: Klarna Website

The periods and number of instalments vary across BNPL schemes, but what remains common is the interest-free staggered payment facility. This is quite similar to credit cards, with the addition of instalments.

So why are people running after buy now, pay later?

It is true that much like credit cards, BNPL schemes charge late payment fees – although certain issuers feel proud of offering low interest or low fixed payments for missed deadlines with BNPL compared to high-interest rates on credit cards. At the same time, there are associated monthly account-keeping or payment processing fees on most BNPL schemes, similar to the annual fees and transaction fees on credit cards. But the differences arise in the business model and the implementation of BNPL. These quirks of BNPL separate it as a Pay Later option and are highlighted below.

Business model built on consumer welfare
Most BNPL schemes like Afterpay charge a 4-6% commission on pay later sales from merchants, and this forms the majority source of revenues for them. Klarna, for example, sees 70% of its revenues from merchant fees, and only a quarter for late charges.
Unlike credit cards, where the revenues for network processors rely on keeping consumers in debt and revolving their balances, the BNPL schemes encourage consumers to repay in time by setting up incentives such as freezing customer accounts on payment defaults. This is an important distinction.
With the revenues reliant on sales commissions, the business model ensures that all efforts are aligned to reduce repayment defaults and to increase sales frequency and transaction sizes. Moreover, while the merchants are expected to pay a high share of sales as commission for Pay Later, the expected increase in conversions at checkout and repeat purchases make BNPL a desirable payment option for retailers.
Convenient On-boarding
Another differentiator for BNPL schemes is the ease of signing up, where a customer only needs to set aside a few minutes and give out basic information to set up an online account. On the other hand, credit cards require you to fill an application form with multiple documents and to wait days to complete registration. This convenience is well-appreciated by Gen-Z and young millennials.
To add, the target segment for BNPL schemes has particularly been the low-income and younger crowd, who lack good or long credit history for traditional credit cards or personal loans. Buy now, pay later – although performs credit checks – allows for more flexibility in issuing credit, tempting consumers to avail them at the checkout. And contrary to belief, despite lower credit checks, the schemes have been successful in keeping the default rates down to less than 5%.
Transparency in Costs
Young people’s distrust of established financial institutions is at the core of many fintech trends today including neobanks and digital lending. For pay later options, the transparency in costs and benefits upfront is pushed as a major incentive and benefit versus the credit card – which traditionally has been seen as highly opaque. Validating this narrative, young customers increasingly prefer not to hold credit cards or use revolving credit forms today, and see BNPL as a more convenient alternative to the long-term commitment or high-interest rates that credit cards feature.
Awareness of End Use
With the lack of a network processor to allow acceptance on millions of merchants for BNPL schemes, the merchant agreements are formed based on the preferences of target customers. While this limits the applicability of BNPL across retailers, the lenders such as Afterpay and Klarna assume more control and visibility of the end-use of the money by clearly specifying the merchants that offer BNPL service on their apps and websites. This is unlike the traditional loans and credit lines, where the lender has no control over where the fund is used.

Combined, all these factors help distinguish BNPL from a traditional credit product. In addition, the overwhelming shift to mobile shopping for young millennials and Gen Z customers along with applications on big fashion, food, and entertainment merchants make BNPL an option more favourable for many than the traditional Pay Later or Pay Now alternatives.

Overspending, Budgeting, and Expanding Categories

Australia has emerged as the leader in BNPL adoption, with >30% of Australian adults now using at least one Buy Now, Pay Later account. In an interesting survey of the country’s consumers by neobanks Monzo last year, we see a few notable behaviours that have been validated in other geographies since:

Overspending: Over half the consumers using BNPL admitted to spending more than they did with debit and credit cards. This trend point towards the young customers overspending with BNPL due to credit flexibility. This is likely to increase the debt burden on customers, but given the low default rates – merchants are not complaining.
Luxury Purchases: Clothing (32%), appliances (20%), and home & entertainment (13%) combined to form ~2/3rd of all BNPL spend, with ~60% of the consumers classifying their purchases as a luxury. The high share of clothes, appliances make luxury goods an important driver of BNPL purchases.
Budgeting Purchases: While the positioning of certain BNPL schemes is as a revolving credit line, most players offer BNPL as a budgeting tool. Famously, this positioning of Afterpay has helped fight the rhetoric that BNPL is for the reckless, and has been a big pull for young consumers who demand tools for managing their finances. One survey highlighted that ~57% of Afterpay’s customers use it for budgeting.
New Categories: the expectations for BNPL use were similar to credit cards, and so the daily purchases such as groceries were not seen as drivers for BNPL use. But today, we are seeing industries such as grocery, food & liquor, and department stores increasingly adopt BNPL – a shift perhaps in how BNPL services are seen, and towards debit use cases.

The Retailers Rejoice

We have reflected on the benefits for consumers with BNPL. But regardless, the biggest beneficiaries of the entire deal seem to be the merchants.

With the incentive of a better customer checkout experience, increased sales, and higher frequency of repeat purchases – merchants are quick to adopt BNPL schemes and to pay high commissions on sales. Apart from the higher sales, there are a few other reasons why the retailers have grown keen to accept BNPL payments for their sales.

Reduce card abandonment: allowing consumers to break payments into three or four instalments, BNPL encourages higher checkouts and lower cart abandonments
Higher ticket size: not only are the frequency of purchases from a retailer offering BNPL go up but without the fear of incurring interest and the ability to pay in instalments, the purchasing power of customers seems to go up as they increase the transaction size of their purchases. A survey by Splitit noted that ~55% of consumers are likely to buy or spend more with the option to pay in instalments.
Build brand loyalty: as the merchants offering BNPL are limited today, the ability to differentiate your services with BNPL can set a retailer apart. Merchants can also build brand loyalty using BNPL since customers are more likely to purchase from the same merchant with the instalment option.

Future of BNPL

The buy now, pay later services are at a nascent stage today, despite the strong growth over the last five years. Reports put the BNPL spend at less than $100Bn annually, compared to over $10Tr that credit cards process today. This highlights the small size and the potential for growth in the next decade for BNPL.

The challenges will further remain in determining the oversight guidelines for BNPL lending, with many operators loosely conducting credit checks. Importantly, educating the customers about the pitfalls of unsecured credit with digital lending will be an important activity for companies concerned. This will allow them to ensure that young customers do not fall into debt traps. Moreover, how the BNPL spend behaviour impacts the credit history remains an issue for discussion. Companies such as Afterpay have been pushing the narrative of low bad debts to influence regulatory decisions as well, while the concerns around credit regulations remain. The Parliament of Australia has deliberated considerably on the buy now, pay later regulations and market.

Regulations aside, the incumbents face pressures due to rising competition from big fintech players – with technology giants and payments, lending leaders leveraging their large networks to offer payment instalment services.

Lastly, the buy now, pay later schemes benefit from a business model that relies greatly on merchant fees, not requiring consumer cross-subsidisation. This will remain a key advantage over credit cards, which rely on revolving customers to subsidise everyone else. With complete visibility over the consumer lending habits, a growing customer segment preferring mobile purchases, and conversion rates supporting high merchant fees – I am safely betting on BNPL services to become a major force for online payments.

Unit Economics

Discussion about this post