What is BNPL, really? A 3200-words deep-dive
A 3,200 words deep-dive
What is BNPL, really? A 3,500 words deep-dive
This article might have come a tad late, given all the previous hype about buy-now-pay-later (BNPL) and current public equity (under-) performance of companies like Klarna and Affirm.
However, BNPL is a largely misunderstood business model by most. As shoppers and consumers, we can see how it works on a superficial level. Instead of paying for a product 100% at the start, you pay for it in instalments - sometimes with added interest, sometimes with zero interest.
BNPL Business Model Deep Dive:
Overall basic summary for BNPL
What are the various business models for BNPL?
What are the different product types for BNPL? The different distribution models?
Who are the different parties involved in a BNPL transaction? Why do these parties use BNPL?
What are the illustrative unit economics in a BNPL transaction? What are core revenue and cost drivers? What is the path to profitability?
What are the sources of capital for BNPL platforms?
What are core operating metrics? What are public comparable & multiples used?
How do you approximate the total addressable market for BNPL? How do you define and size this market?
What are the broad trends and challenges for BNPL?
What are future scopes to explore?
We have a lot to unpack, let’s dive right in.
Business Model Types
There are 6 main business model types:
Integrated shopping apps (Klarna, Affirm): this is the kind we are most familiar with, the one used for consumer shopping
Card-linked offerings: offered during point-of-sale (POS) financings, using credit cards
Off-card financing - direct competition to credit cards
Virtual rent-to-own: arrangement for consumers to make payments for products they want to own; once all the payments are done, then the purchase is deemed complete
Vertical-focused: specific higher-value sub-category plays (healthcare, veterinary, home improvement) where ticket sizes tend to be larger
SME sales financing: B2B BNPL (not the scope of this article)
We will dive deeper into the different revenue streams for each of this BNPL business model.
Given the various business models, there are a few possible distribution channels for BNPL:
Merchant-facing (payment check-out option)
Consumer-facing (via the BNPL app itself)
Integration with payment networks, alongside point-of-sales (POS) terminals
Traditional banks (via credit cards)
White label BNPL enablement
BNPL Product Offerings
There are 4 main product categories offered in BNPL:
Split-now or pay later (in 14, 30 days duration): typically used for smaller purchases (below $300). This is offered as a payments product, not a lending product.
Short-term 0%: 0% interest loan for larger purchases typically used for longer-term financing. It is offered as a loan, so for BNPL fintechs that do not have any licence yet, they might work with a bank to originate the loans.
Longer-term 0%: similar to (2), but the term lengths tend to be longer for the consumer to pay and the MDR rates charged to the merchant tend to be higher.
Simple, interest-bearing loans: very similar to credit card payments where the consumer has to pay an interest for these types of loans. However, unlike credit cards that revolve, the consumer has to pay the instalments during the repayment schedule.
Affirm’s product offerings
The merchant discount rate (MDR) is a term used in the payments world. MDR is a fee charged on the merchant for the payment processed, for services rendered to the merchant by the payment gateway. For instance, if a product costs $100, the consumer will pay the $100 via his/her credit card, and the merchant will receive $97.10 - assuming the MDR is 2.9%.
APR (annual percentage rate) refers to the yearly interest generated by the loan amount that is charged to the borrower (the consumer/shopper in this case). It is used as a baseline comparison to compare amongst different credit products. The higher APR, the more interest the borrower will pay.
Let’s dive a bit deeper into the mechanics of each product type.
Product Type #1: Split Pay
The typical Split Pay (or Pay in 4) is designed as a payment product and not a lending product. This is an important distinction. As a payment product, it is more readily and legally available in most jurisdictions. A lending product is more tightly regulated under stricter consumer laws.
The world of payment processing is a complicated one, with many different opportunities for fraud. Consumers (“bad actors”) might file fraudulent chargebacks and/or refunds, where the card network then has to settle disputes with the consumer’s bank. For a credit card fraudulent transaction, the merchant or bank has to bear the 100% charge.
For a Split Pay (pay-in-4) BNPL transaction, there are definitely certain risks and safeguards:
If a consumer defaults on 1 instalment payment (or pays on time), he/she cannot access the platform again until repayment
Bigger BNPL platforms partner with many merchants and the BNPL agreement is typically exclusive, so a consumer cannot shop in other merchants on the BNPL merchant network
These are safeguards, but might not be sufficient because this Split-Pay has little underwriting, especially if we want to make it easy for consumers to pay to increase payment conversion
However, BNPL has a better advantage than conventional credit cards for the merchant and payment platform.
BNPL platforms do get performance feedback faster than conventional credit cards. Given that each 1/4 instalment must be paid first and paid earlier, it is earlier to tell if this particular borrower is a bad-borrower and limit this borrower from doing BNPL loans on the other merchants in the BNPL network.
Product Type #2 & 3: Short-term & longer-term 0% loans
0%-interest BNPL loans do sound strange. If it’s a 0% loan and the borrowers/consumers do not pay any interest, who pays?
0% loans make sense for products with higher gross margins, so the merchant can afford the higher MDR. For instance, the gross margins for a $100 sofa could be up to 30-40%, which is rather comfortable margins. In this case, the merchant is willing to pay the higher MDR (often up to 10-15%) for a successful transaction like this. For products with higher ticket size, the margins are typically better but the conversion rate tends to be lower. Merchants typically do not mind paying a higher MDR %, to increase the sales conversion %.
Alternatively, it could be possible the BNPL platform is “subsidising” the MDR rate to achieve higher merchant adoption and GMV volume.
Product Type #4: Simple interest-bearing loans
Interest-bearing loans charge both the merchant a MDR and the consumer/borrower an explicit interest rate.
Type 4 is typically used for larger-ticket size products and a longer loan repayment period.
Different parties in a BNPL transaction
There are typically 5 parties in a BNPL transaction:
Consumer
Merchant
BNPL platform
Originating bank
Securitized loan buyer
1. Consumer/Shopper
For the consumer/shopper, it is a simple value proposition. BNPL exists as a payment option alternative compared to the other options (bank transfers, credit/debit option, country-specific payment networks, e-wallet amongst others). They can then choose amongst the various BNPL product types (pay-in-4, 0% short-term, interest-bearing longer term loans).
Once the transaction is completed with the BNPL payment option, the goods and services are then provided by the merchant and sent to the consumer/shopper. The consumer then settles the payment transactions, according to the repayment schedule with the BNPL provider (and not the merchant).
Why consumers/shoppers like BNPL
Psychologically easier to choose a split-payment, over a full payment (especially for larger ticket size)
No access to credit cards
Ease cash flow, since payments are in transactions
Easier, less-friction payment methods
2. Merchant
For the merchant, they then receive the product cost, less the MDR fees depending on the arrangements with the BNPL provider. Usually, the BNPL transaction is considered completed in this case and the merchant is out of the picture then. However, things get complicated when there are refunds or chargebacks.
Why merchants like BNPL
Additional payment option for buyers (especially if requested)
Improved conversion (assuming it’s psychologically easier for buyers, if BNPL transaction)
Higher AOV in transactions
New buyer segments (theoretically those with more subprime credit)
Better understanding of customer data
Better repeat purchase rates
3. BNPL Platform
The BNPL platform (Klarna, Affirm) is the main liaising party that onboards merchants and handles the remaining payments with the consumer/shopper.
The revenue and cost model for the BNPL platform will be explained later.
4. Originating Bank
The 4th party is the originating bank. For BNPL product type #2-4 (0% interest, or interest-bearing), the loans typically originate from a partner bank. For BNPL product #1 (split-payments), since it is structured as a payment and not credit product, typically there is no need for an originating bank.
The BNPL platform purchases the 0% APR loan from the originating bank, and either chooses to keep the loan on their own balance sheet, or sell it off to another party (the loans buyer).
Amortising the BNPL loans is complex and I will write a separate deep dive on loan amortisation and securitization.
5. Securitized Loans Third-Party Investors
The BNPL platform might choose to securitise (or package) the BNPL loans and sell it off to a third-party. Securitization is complex and deserves a deep-dive piece on its own.
In a nutshell, securitization simply means that the BNPL platform packages the loans, sells them to a third-party investor so the loans do not appear on the BNPL platform’s balance sheet anymore. Usually, there is a gain on loan sales and is recognized as revenue.
Unit Economics for BNPL
Given the various product types and parties involved in a BNPL transaction, primary revenue streams typically include:
MDR - merchant fees
Interest income - interest fees from consumers (for interest-bearing loans)
Late fees - if consumers pay late (applicable to all 4 BNPL product types)
Interchange fees - if credit cards are used as part of the transaction
Gain on sales of securitized loans to third party
Other incomes - integrated shopping BNPL platforms (like Klarna) could offer affiliate marketing services, by charging a % of successful sales
The costs for BNPL platforms include:
Payment processing fees - BNPL platforms pay card networks a fee, if credit cards are used
Loss provisions - In events of consumers’ defaults, loss provision (as % of GMV) is “written off”
Servicing & recovery fees - In events of consumers’ defaults, usually third-party collection agencies are engaged to recover back the loans
Fraud & dispute charges - If merchants or shoppers conduct frauds and/or refunds
Funding costs - Cost of capital to maintain the capital required for BNPL loans (will be explained more later)
When put together, an illustrative unit economics breakdown looks like this:
As seen, the unit economics for “pure-play” BNPL players are very tight and are only theoretically profitable at a huge scale.
Charging late fees and high interest fees to consumers is legally challenging and feels predatory, so authorities usually push back and regulate the amount of late fees charged on consumers. This leaves MDR as the highest % of revenue for BNPL platforms.
Assuming on a per-transaction basis, the BNPL platform charges merchants a 5% MDR and accept credit cards costing 2.9% fee, gross-margins for BNPL are only 2.1% per transaction for borrowers who pay on time.
This 2.1% margin has to be sufficient for other major costs: credit losses (if buyers default), fraud (if merchants/buyers conduct fraud), servicing & recovery fees (if the BNPL platform needs to hire third-party debt collection agencies), costs of capital (to maintain a capital pool). It is indeed a very tight-margin and challenging business model.
This is why BNPL platforms have to explore different revenue streams and be an “ecosystem” play, as compared to a pure BNPL platform - as we will explore later.
Sources of Funding for BNPL, “Capital Strategy”
Any credit platform requires a large pool of capital to function. When the platform is in its early stage, it can use its own equity. However, there is a cost to equity and using its own equity leaves it vulnerable to cash flow issues and limited cash for scaling the business. Most large credit platforms borrow and use debt as their funding.
Using Affirm as an example, there are various sources of funding:
Managing a BNPL platform’s capital strategy is extremely challenging and subject to external factors. Different options have their use cases.
However, this is outside of the focus for this BNPL 101 - something that I would love to get back on.
Key Operating Metrics & Valuation Multiples for BNPL
In trying to analyse and benchmark different BNPL platforms, I like to use this framework:
There could be more metrics, but I feel these few metrics are enough to compare against various BNPL platforms.
Net Transaction Margins (NTM) is a metric unique for BNPL.
Here, you can see an example of the NTM margins from Afterpay:
What makes BNPL interesting to investors, theoretically?
But here comes the big reveal that gets investors salivating about the BNPL business model.
It boils down to the BNPL platform’s velocity of recycling capital.
Traditional banks make money by earning the difference of interest between what they charge to borrowers (mortgage holders), versus what they pay to depositors (savers). Most banks make a net interest margin of ~2% per annum.
BNPL Company makes in 6 weeks. Customers are required to repay BNPL Company over 42 days (6 weeks), and BNPL Company makes the same amount of commission even if they decide to pay it earlier.
In fact, it’s better for BNPL Company if customers pay off their debt faster, because it means that BNPL Company can redeploy the capital faster.
To put this in practical terms, let’s assume that a consumer spends on average $100 per transaction via BNPL Company.
If this consumer only uses BNPL Company 1x per year, BNPL Company makes $2.25 per year of transaction margin and a 2.25% Return on Capital (ROC) before operating expenses:
However, if the same consumer makes 10x transactions, the NTM per transaction remains the same but it’s 10x in 1 year. In theory, this makes the ROC way more attractive at 22.5%!
Sizing the Market, thinking about industry drivers
It is always fun to think and imagine how the future can turn out for a business model like BNPL.
Ultimately, the BNPL market size has a few key drivers:
BNPL Key Revenue Drivers
(Overall eCommerce GMV) * (% BNPL payment) = (BNPL GMV)
BNPL revenue levers = (BNPL GMV) * (% MDR) + (% Interest Income) + (% Interchange fee) + (% Late fees)
Other revenue = (Other merchant revenue) + (Other consumer fintech revenue)
BNPL costs levers = (% Loss Provision) + (% Funding Costs) + (% Servicing Costs) + (% Fraud) + (% Funding Costs)
Expanding revenue streams:
There are few options, of course this list is non-exhaustive:
Expand in merchant services
Expand in consumer services
Example of BNPL flywheel
Merchant Ecosystem Play
Will a BNPL platform be successful in its merchant ecosystem play, like Klarna? This is the strategy of “expanding the pool”. If Klarna can help merchants be more successful, it can expand the GMV pool, so there will be more overall transactions (and BNPL transactions). Can a BNPL platform expand beyond BNPL towards becoming a merchant’s partner? Apart from being a conversion tool, can it help merchants to drive more awareness and acquisition of shoppers? Can it move more towards pre-purchase and post-purchase, along the integrated shopping consumer journey?
Consumer Neo-Bank route
Alternatively, can the BNPL platform grow towards the consumer neo-bank route? Since the BNPL platform has acquired customers for cheap (by partnering with merchants) and has collected data on these consumers, can they offer more consumer financial services?
Unfortunately, there is too much to unpack within this article - so we will leave this for next time.
Broad Risks & Challenges
BNPL industry is facing huge challenges, both on the business model & profitability front, but also on the equities market in 2022. To be fair, most tech companies are facing the same challenges as well.
There are 3 broad groups of challenges for BNPL companies.
1. Margin Compression
Regulations (late fees, interest incomes) - as regulations protect consumers more, governments have been regulating the max interest & late fees these BNPL platforms can earn
Consumer Defaults - as we go into a recession in 2022/2023, consumers’ ability for repayments will naturally go down. This will reduce BNPL platforms’ returns (leading to higher loss provision %) but also increase costs in terms of third-party collection fees.
Cost of funding
Securitization harder - as consumer defaults rise, selling securitized loans to third-party buyers will naturally be harder. These buyers will expect higher, better-performing loans.
Bank interest rates will rise - leading to an overall higher cost of funds for these BNPL partners.
2. Strategic Challenges
Huge incumbents creating their own BNPL -
Concentration risks in huge merchants (Apple, Peloton) - the largest merchants in BNPL networks occupy ~5-10% of their GMV. With Apple doing their own BNPL, who’s to say Peloton will not partner to do their own BNPL as well? Will this be a white-label model and reduce margins even more?
3. Slower rate of capital recycling
More competitors offering BNPL - ultimately, BNPL products are not hard to create. As of now, there are more than ~10-20 BNPL platforms in Southeast Asia. This ultimately gives the consumer more choices and reduce the rate of capital recycling for these BNPL platforms, bringing down margins.
My hypothesized trends for BNPL (in 2022/2023):
++ Increased GMV (for less credit-worthy consumer segments)
++ Late fees (but dependent on government regulation)
— Higher rates of consumer default
— Higher third-party collection fees
— Higher costs of funding
— Reduced rate of capital recycling (less transactions/user in a year)
This will greatly impact BNPL platforms’ path to profitability.
Scope to be explored further
BNPL is part payment, part credit. It is part merchant, part consumer. It is a business model that is closely related to other fintech and consumer sectors.
Within this piece, I want to give a hopefully deeper overview as to what BNPL is, beyond the superficial understanding of BNPL = instalment payments.
Hopefully this gives a starting framework as to how to analyse BNPL (or business models) better.
I have briefly touched on these parts earlier, but will analyse these more in the future:
1. Credit scoring & measuring portfolio quality
What is credit-scoring, exactly? For a BNPL transaction, what are the data points used? How does scoring different as compared to payment networks?
How do you measure the portfolio quality? What are more in-depth metrics to analyse the loan quality?
2. Securitization
What is asset securitization? What is the overall flow/process? What are the revenues and risks for securitization? How does portfolio quality relate to securitization?
3. Cost of funding + capital strategy
Building on securitization, what other funding sources are there? What are the pros and cons of each funding source? What are the considerations? How do considerations change, given the low or high interest rate environment? How do you calculate the blended cost of funding?
4. Merchant expansion strategy
Merchant expansion is part of the whole “Shopify”/broad commerce thesis that I will want to think deeper about.
5. Consumer “neobank” expansion strategy
How big is consumer finance services? Again, something that I will like to think about more comprehensively.
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Great deep dive into the unit economics of b2c BNPL. How do you think b2b BNPL could differ in terms of margins?