Buy now, pay later – but at what cost?

“Buy now, pay later” platforms may be a boon, but are these fintech disruptors laying a consumer credit trap? Adam Courtenay outlines the risks for boards and directors operating in this under-regulated environment.

Unless you’ve completely shunned the local sharemarket this past 12 months, you could not have failed to spot a relatively unknown tech company enter into the top ranks of Australian corporations. That company is Afterpay, a global payment platform whose most exciting new proposition is to offer online consumers the ability to stagger payments on products they want now.

The buy, now, pay later (BNPL) concept is hardly revolutionary. Afterpay and its swelling number of listed buy now, pay later peers including Zip, Humm Group and Sezzle, offer a digital form of layby, a “tech layer” turning a purchase into a number of instalments. The IP for this kind of technology is said to be very basic with a low barrier to entry.

It’s not a recent development either — Affirm launched in 2012, Klarna launched in the US in September 2015 and Afterpay launched in Australia the same year. New or not, it’s a strong enough proposition for investors to swell Afterpay’s market capitalisation to around $30b over several months, making it bigger than Coles, Qantas and AGL Energy.

Back in March 2020, when the COVID-19 crisis hit, the local share market tanked, taking everything down with it. Afterpay, which had listed in mid-2016 at $1 per share, dropped from around $40 to $8.90 per share. And yet within weeks, its share price came roaring back. The market realised that the doom of COVID-19 was a boon for online payment systems. Anything that eased the pain of repayment — as the BNPL platforms purported to do — became hot property. At the time of writing in early January, the share price stood at just under $120.

To many, the rise of this sector is a classic case study in overheated investment. Others say we are witnessing the genesis of a great new disruptive industry, one which will supplant credit cards and grow at an exponential rate.

“We’re more like a credit card, but [we’re] fairer, more transparent, and not requiring a relationship with a bank,” says Zip corporate affairs director Matthew Abbott.

These fintech upstarts are here to stay. Afterpay’s customer numbers are now climbing beyond the 11 million mark worldwide. In FY20, it transacted $11.1b in underlying sales, a 112 per cent lift from the previous financial year.

The company is not alone. Zip and Sezzle have also enjoyed healthy share price increases. They are joined on the bourse by Humm Group, Openpay, Laybuy (NZ), Splitit (US, UK) and Zebit (US).

All are listed in Australia, but only four of them operate in the Australian market. There are more coming. Look out for initial public offerings from Bright, Bundll, CreditLine, deferit, Payright, Roar, Inkpay and Pay It Later.

Jack be nimble

Talk to the players in this sector, and its all about being “nimble” and “agile”. Late last year, Payright and its broker Bell Potter showed just how “agile” and “nimble” they can be. In mid-October, they closed a pre-IPO round. Initially Payright was targeting $5m, but they managed to take in $7m.

Two weeks later, they were on the road again, seeking to attract another $20m before the planned pre-Christmas listing. Such a deal would imply about a $110m market capitalisation for Payright, which was founded in 2016 by Melbourne-based brothers Piers and Myles Redward.

The strategies of these players do not differ enormously. Stage one is to take in as much investment money as possible. Stage two is to sign up consumers and merchants en masse at breakneck speed — before any competitor does. It’s the digital equivalent of a land rush. Profits, they all say, are stage three. But none seem to be in a hurry for stage three. “Of the eight listed stocks, none have made a profit, none are looking like making a profit and the markets aren’t demanding that they do so,” says Grant Halverson, CEO of specialist retail and payments consultancy McLean Roche.

Combined, Halverson says, the listed BNPL players have a market capitalisation of $35b with total revenues of $891m. Their bad debts are already at a combined $267.8m — 30 per cent of revenues.

By way of comparison, CBA’s latest revenues were $23.9b — actual bad debt write-offs were $1.01b, or four per cent. Yet the the world believes wholeheartedly in the forward earnings potential of BNPL, fattening the players’ share prices accordingly.

Halverson believes the sector is a bust waiting to happen. Many of the founders will enrich themselves by cashing in on overvalued stock ad infinitum, simply charging the employee stock ownership plan (ESOP) to their expenses. “ESOP is the second-biggest expense after bad debts,” says Halverson.

This, of course, is not the scenario painted by the platforms. Nor is it a sin for listed companies to “defer” profits as they drive for growth. The current buzzwords among the platform providers are “market acceptance” and “validation”.

“We’re reinvesting money into sales and marketing,” says San Francisco-based Splitit CEO Brad Paterson. “At the moment, it’s all about acceptance and usage. For the first three to five years, we will choose that path. As long as you know there’s a path to profitability — and we can see that through gross margins and keeping fixed costs in line — we’ll be fine.” Paterson believes that once consumers convert en masse to this form of payment, there will be plenty of room for everybody “to profit”.

Online godsend

What is not in doubt is that these platforms have been extremely handy to many during the darkest times of COVID-19. Credit card usage, which charges exorbitant interest over extended periods, has been deteriorating. The alternative seems so much easier. The BNPL apps will typically ask the buyer to lay down just a quarter of the cost of any big-ticket item, thereby “helping” them budget the next three instalments.

The retailer also seems to be part of this win-win situation. The app will typically charge them four to six per cent of the ticket price — what many say is a “sustainable” hit to their margins.

The apps take on all the responsibility for the consumers’ debt. There are fees for non-payments or late payments, but all providers baulk at the idea that this is a core part of revenue streams.

Francine Ereira, who heads Klarna in Australia and New Zealand, says the company does not generate any revenue from late payments.

Likewise, Rebecca James, the CEO of Humm Group, says late payments constitute only two per cent of revenue. “The system only works if people repay,” she says.

Abbott stresses that Zip makes less than one per cent of its revenue from late fees. “In other words, Zip’s business model does not rely on consumers falling behind,” he says.

That said, almost 21 per cent of Australian users ended up being charged a fee in 2020, paying BNPL companies as a whole $43m in fees.

With its global purview, Afterpay charged its customers $68.8m in late fees. This was a 49 per cent increase in dollar terms from the previous year, but based on a a big rise in customer numbers — and thus a lower percentage of total income. Fees, it seems, do account for something.

It’s also apparent that online retailers are generating sales through these apps like never before. US research by the Baymard Institute shows that nearly 68 per cent of online shopping carts are abandoned at the last hurdle when consumers baulk at the full amount they have to pay. The various BNPL options have drastically lowered cart abandonment rates.

Retailers, meanwhile, are moving products out of inventory at a speed they could only dream of before. Everyone, it seems, is being looked after in this new consumer “experience”.

“Consumers are looking to partner with a BNPL provider that offers them a personal relationship; one that understands what they’re looking for and which gives them constant feedback,” says Ereira. “Before, they felt that all they had was a transactional relationship. Our option is built around personalisation and bringing in the world we offer — it’s experiential.“

Serotonin hit

Adding in rewards, personalising spending habits and giving feedback is part of the game, but some say there is still a widespread misunderstanding as to what consumers are in for.

Financial literacy advocate Nicole Pedersen-McKinnon, author of How To Get Mortgage Free Like Me, says that by not charging interest, the companies effectively escape capture by the National Consumer Credit Protection Act 2009. The players tend to do little more than a “soft check” of people’s ability to repay — the types of checks that do not reflect on personal credit ratings.

Pedersen-McKinnon is no fan of the sector. “They’re a little like pay-day lenders...” she says. “It’s a serotonin hit for the customer. They get to bag the goods, paying it off over the next eight weeks. But consumers often hook the BNPL debt to a credit card. Debt then mounts on debt.”

The younger crowd, who tend to be the biggest users of the apps, often use as many as five different providers, says Pederson-McKinnon.

BNPL players fiercely reject accusations they are the harbingers of spending profligacy. Quite the contrary, they say they’re helping consumers budget responsibly. All the same, many say they are going upmarket, directing their marketing efforts to more salubrious clientele — those who would already have been thoroughly credit checked and who likely already own credit cards. Splitit, as an example, will only stall payments on an existing credit card. Zip, too, asserts it credit checks all users.

James at Humm says the company is now focused on larger transactions, which means they’re prepared to finance products and services up to a value of $30,000 — with repayment times as short as 10 weeks or as long as 60 months.

“We’re trying to broaden the appeal and offer the service to a greater number of industries that would have never have used this form of payment before,” she says. “This is not about paying for fast fashion, but for people who want it for furniture, dental treatment, vet care and home improvements, to get their car serviced or pay for solar energy. Now, they can use a BNPL instead of just putting it, as always, on a credit card.”

This is the big new idea of the BNPL platforms — expand the markets and services in which consumers can deploy the product and thereby improve their lifestyle choices. It’s a self-fulfilling scenario between app, consumer and retailer.

For big-ticket and lifestyle items, the merchant’s fees will always be much higher than the standard four per cent. For a 12-month term, the fee taken from the retailer might be seven per cent, but for longer terms than this, it can go all the way to 16–17 per cent, says James. She is adamant that many higher-margin industries can support higher BNPL fees — that it’s still a win-win situation. “Retailers and merchants are becoming big advocates because it increases the average sale and increases conversions at the point of sale,” she says.

Regulatory issues

No other financial sector of late has been the subject of so many probes as the BNPL platforms. It’s as if regulators and consumer groups have a natural suspicion of them. They’re new and different, and thus naturally suspect. It all comes down to whether BNPL players should be regulated by credit laws. Until that happens, it seems there will always be questions over their business.

In September, a federal Senate inquiry into the sector came to no real conclusion other than to allow it to operate as is. It was inappropriate, the inquiry stated “to force each innovation into a one size fits all approach... Industry self-regulation can be an efficient way for innovative products in the financial services sector to emerge, while ensuring adequate protections for consumers.”

Around the same time, the Reserve Bank was considering whether BNPL platforms should face restrictions on their ability to ban merchants from including a surcharge.

In June 2020, AUSTRAC appointed an external auditor to look into “historical breaches of money laundering” at Afterpay. By October, the regulator declared it would be taking no legal action.

In November, an ASIC survey reported that one in five BNPL users was missing payments. Half of users aged 18–29 were said to be actually foregoing essential items to cover repayments. In 2019, more than one million transactions had incurred multiple missed payment fees, ASIC reported.

ASIC’s response was to outline new “design and distribution” obligations — which come into effect in 2021 — to rein companies in on the “appropriateness” of their customers. Providers would be obliged to monitor those who repeatedly missed fee payments or when the percentage of fees as part of the payment became “significant”.

A new code of conduct is being developed by the Australian Finance Industry Association for ASIC to apply to the sector. But many critics, including consumer groups, believe it will be toothless.

Most BNPL players reject mandatory credit checks. Afterpay CEO and co-founder Anthony Eisen has been quoted as saying credit checks were “a lagging customer indicator... unhelpful for younger adults with no credit bureau history, and often provide an incomplete picture of a customer.”

Zip’s Abbott disagrees. “Zip has always done credit and ID checks on every single applicant,” he says. “The result is that only one in 100 Zip customers is late each month compared with one in five for credit cards or other BNPL players.”

Splitit also has a distinct advantage in this area in that its model splits payments via the purchaser’s credit cards — which are clearly covered by credit laws. Paterson believes wholeheartedly in doing the checks.

“When a new line of credit is created, the rules should apply to those extending them,” he says. “That credit line should be governed by the same regulations that govern credit cards and other forms of credit. We, as an industry, need to do more.”

Issues for boards & directors

There is a reason why the fintech sector is under scrutiny, not just in Australia, but around the world. It has a chequered history.

In June last year, German fintech Wirecard collapsed, taking US$12.5b of value with it. Grant Halverson at McLean Roche cites a number of overseas fintech losses, which include Lending Club (whose stock lost US$9.8b) and Ezubao, whose fraud cost the company US$7.6b. “In all, if you take all the losses over the past decade of these fintechs, they’ve lost a combined US$51.8b,” says Halverson.

Halverson cites what he calls “fintech risks”. This could be huge CEO/senior management compensation packages that have not been tied to cashflow or earnings but just to sales and/or the stock price. He also cites management compensation way out of line with peers despite notably less profitability, as well as glossy future projections that have a habit over a long period of being proven too optimistic.

He also questions the “reach” of Australian BNPL board members. “Many of the BNPL companies operate in overseas markets — Afterpay is in nine markets, Zip is in four — so the regulatory environment is multiplied by the number of markets,” he says. “Four of the public BNPLs do not have any business in Australia. Therefore, any director of these BNPLs needs to understand international consumer markets and/or have specific experience in retail banking, consumer payments or consumer credit in a number of markets.”

Is this fair? Certainly the boards of both Afterpay, Zip and Humm Group have a number of highly prominent individuals with a wide range of expertise. Matthew Abbott at Zip says the company has a practice of using experienced external search consultants “with a global presence to help identify suitable directors”.

Afterpay recently took on the highly experienced Elana Rubin FAICD as its independent chair. With director experience at Telstra, Mirvac, ME Bank and Slater & Gordon, it was Rubin who led the Afterpay board’s response to the AUSTRAC AML/CTF investigations. Zip recently appointed former investment banker Pippa Downes GAICD as a non-executive director. “She’s an experienced company director and will be a tremendous asset to the Zip board as the company executes its global expansion strategy,” says Abbott.

“Zip will expand its board to add non-executive directors with international experience to provide diversity of thought and insights into the global markets in which the company operates.”

Humm Group’s Christine Christian AO MAICD, who is the group’s deputy chair and chair of its risk and compliance committee, says this sector is developing quickly compared with other financial sectors.

“There’s no doubt it presents a different rhythm for directors compared with other sectors,” says Christian.

Humm maintains a “skills matrix” that it applies when considering directors.

“The board is always looking at the composition of the directors, both from a succession planning perspective as well as adding new directors — should there be a benefit for the future direction of the company,” says Christian.