BNPL – From Hype to Bubble Bursting

In the last few years investors have become enamored with, and clamored over themselves to invest in, Buy Now Pay Later (BNPL) companies. And you can certainly understand why. According to research analysts this sector is expected to be worth $166 billion by 2023. In the US alone, the number of BNPL users increased 81% year over year (YoY) in 2021, while in the UK, BNPL transaction value reached £6.4 billion in 2020, around 70% up from the previous year.

Equally, for consumers and retailers, BNPL certainly has a lot of appeal. Consumers like the simplicity of payment at the point of sale and the opportunity to manage their funds by spreading out payments. For retailers, BNPL can help drive purchase conversion and average order value, with some reporting up to 20% - 30% more spent per order than via card payments only. In addition, referrals and partnering on marketing activities is helping introduce new customers to participating retailers.

 It felt like there was a new BNPL funding round almost every week last year, as both dedicated providers and existing fintechs seek to capitalize on the seemingly lucrative space. Is it a gold rush, or a fear of missing out?  In theory, BNPL ticks many of the boxes investors are looking for. It has significant untapped potential, a growing user base, and selling points for both direct and indirect customers. But scratch under the surface and there is also a lot to dissuade investors.

First, while the market is booming, more and more players are joining the bandwagon. Pioneered by dedicated BNPL providers like Clearpay, Laybuy and Openpay, the approach is now attracting the attention of bigger financial services players, with PayPal, Klarna and Monzo also launching new offerings. So as the price of getting involved with early movers steadily increases, the actual potential for business growth is diminished as more people fight over what is still an admittedly sizable market.

The flaws in the business model

Second, there is the fact that the entire BNPL business model has yet to be truly tested from a risk perspective.

BNPL is a fast way for consumers to access small amounts of financing almost instantly. While individually these amounts will not be particularly high, the most due diligence providers could facilitate would be soft credit checks, which leave no mark on the applicant’s credit record but also do not unearth significant information.

That is a necessity, because it is the only way to deliver the seamless experience consumers love about BNPL. Yet it is also a risk – BNPL is part of a much larger, and growing, debt puzzle, with mortgages, credit cards, personal loans and other financing schemes all contributing. According to recent research, U.S. consumer debt is approaching a record-breaking $16 trillion. Critically, the rate of increase in consumer debt for the fourth quarter of 2021 was also the highest seen since 2007.

Is history repeating itself?

Exploding energy prices and rising inflation across the board are combining with spiraling interest rates for mortgages and debt, all creating a toxic mix for consumers. It is a powder keg, waiting for a spark – could that be BNPL?

It is true that not every interest rate hike results in a recession, but what we have seen is that almost every time the usually upward-sloping yield curve has instead been inverted an economic downturn has followed within 14 to 18 months.

The BNPL model in its current iteration has not been through such a crisis, so all associated risk management tools and processes have not yet been truly tested.  Investors also need to consider the lack of experience in BNPL management teams, and if we are being honest, their own relative lack of experience. Most venture capital managers and BNPL management teams have never experienced a real credit crisis or recession, and the devastating economic impact this could have on consumers, debt providers as well as investors.  

Experience holds the key

It is no wonder that regulators, such as the Financial Conduct Authority, are getting more involved in the space. Yet what impact will that have on the user experience? It is regulation that demands extensive checks on potential customers for banks and other financial product providers, and while much is happening to make that experience easier, there will always be more steps required in crisis mode. The summary of the overall debt position as well as stress testing this against a worst-case scenario should be necessary risk management tools. If left unchecked, BNPL providers will be able to load up increasingly stretched consumers with more debt at a time of spiraling inflation and interest rates.

This situation has all the ingredients of a toxic cocktail that could provide ruinous not just for BNPL operators, but investors as well. If the worst does come to pass, and we have a repeat of 2008 credit crunch, we could well see a huge consolidation of both BNPL and other debt providers, with a raft of insolvencies and a lot of write-offs for the investment community.

The huge investment hype in the BNPL may suggest that there is enough opportunity for all, but investors would be wise to remember that there is no such thing as a risk-free investment, particularly when we’re talking about the debt sector. Investors and operators should be better prepared for very stormy weather ahead, but if people start to panic even that preparation may not be enough.