Buy Now, Pay Later (BNPL) – also known as “point-of-sale” loans – are a form of short-term consumer financing. But the companies offering them are thought of as technology or finance related tech firms (i.e. “FinTech”) rather than as pure finance providers. Klarna, Afterpay, and Affirm are some of the providers touting their abilities to match algorithmic efficiency and access to customers.
THE BNPL PLAN
BNPL plans are widely available when purchasing online from retailers or via mobile apps. The flexible BNPL plans allow a customer to pay typically 25% of a purchase upfront, with the remainder repaid to the BNPL provider over a series of usually interest-free payments over a specified time period. The ease of the BNPL application process and the absence of stated interest payments has helped the sector to grow rapidly – though with some questions about whether customers fully understand the implications of this form of credit. According to a report by IBIS World, industry revenue is forecast to grow at an annualised 9.8% over the five years through 2024-25, to $1.1 billion.
Applying for a BNPL plan is straightforward and relatively quick. After selecting a BNPL plan at checkout, the BNPL provider performs a cursory credit check based on the customer’s details. Within minutes the retailer has received full payment upfront and the BNPL provider has secured a credit agreement to receive the remaining balance.
BNPL providers earn a fee from retailers for facilitating the purchases made using their plans, which is relatively high and in the order of 3-6% of the transaction value (Redwheel, 2022) . BNPL providers set a credit limit for each customer, based on their proprietary algorithms and a user’s credit rating. BNPL payment plans don’t currently impact a person’s credit score, unlike traditional forms of credit. And as the credit checks are less thorough, it is generally easier to be approved for BNPL than other forms of credit.
BNPL plans can expand retailer customer bases by attracting customers who may not have otherwise made a purchase. We see that BNPL service providers are likely to have benefited from customers using their services for essential items, with some customers even utilising BNPL services for groceries amid tougher economic conditions such as the COVID-19 pandemic that swept across the world. However, such loans are not limited to individuals with less liquidity. In the UK, even Harrods – the designer stalwart of Knightsbridge, recently announced its partnership with Klarna. Given the choice, could it be that even the most affluent of shoppers, when presented with the option to ‘Pay in 3’, are engaged and perhaps encouraged to stretch that little bit further with their luxury purchases than they would otherwise?
Despite the comparatively high fees payable to BNPL providers, retailers achieve additional benefits from customers using this form of credit. They receive the security of up-front and in-full payments, achieve higher conversion rates due to the ease of financing for customers, and, as we have seen, higher average transaction values from an expanded customer base. It is, after all, within our human nature to prefer instant over delayed gratification – especially in a materialistic world, perpetuated by rapidly changing trends and fashion portrayed across social media.
Yet is there really a free lunch when it comes to providing short-term credit to consumers?
‘’We see that BNPL providers have faced questions and scrutiny over the nature of the credit check process and where BNPL providers stand to make fees from customers.’’
Source: Redwheel as at 15th January 2022
If the customer does not repay on time, there are often hefty late-payment fees attached. These are explained but in the small print of each agreement. Our analysis did focus on how (and if) the BNPL providers can build a sustainable revenue stream that is not linked to fees from late or missed payments that might be perceived as predatory or unethical.
Afterpay, an Australian-listed firm, gave the convertible market its first pure-play BNPL provider when it raised AUD1.5bn in its February 2021 convertible raise. The final deal was priced at 0% coupon and with a 45% conversion premium. From the company’s perspective, the convertible bonds represented inexpensive equity-replacement at a time when their share price was accelerating upwards. We participated in the deal at launchand could see the phenomenal traction BNPL was gaining as a theme and the impressive revenues Afterpay was posting. Further research gave us a chance to understand the business model of the firm, but as a new issuer we concluded that it was possible that Afterpay might earn back the conversion premium of the bond with some of the stratospheric share price rises we had witnessed across technology names in recent months.
Turning to Affirm, the US-based company sought to raise $1.25bn from convertible markets in November 2021 and upsized the deal to $1.75bn convertible bond with a 0% coupon and 55% conversion premium. This structure gave the convertible bond equity sensitivity of around 50% with a bond floor in the low 80s. In our view, balanced enough to allow for participation along with equity upside but with a good level of downside protection. The timing of the deal -following an enormous expansion in Affirm’s market cap – encouraged us to take caution regarding its valuation and leave the deal to be considered in secondary rather than primary markets. You could also argue versus the earlier Afterpay deal that the structure of this issue from Affirm was slightly more skewed in favour of the issuer rather than of us as a bondholder.
Affirm’s revenue model benefits from both merchant fees – earned when they help a retailer convert a sale and facilitate a transaction -and (consumer) interest income – from simple interest loans that Affirm purchases from originating banks. Affirm prides itself on not charging excessive fees to customers, as well as choosing not to charge compound interest. Its FY21 figures are hard not to be impressed by: $8.3bn gross merchandise volume, $871m total revenue, 7.1m active consumers and 29,000 active merchants. In the spirit of true FinTech innovation, in February 2021, Affirm announced its own debit card which offers a Pay in 4 feature.
The information shown above is for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice.
BNPL & CONVERTIBLE BONDS
Of course, with convertible bonds the relationship between an underlying stock price and a position’s equity sensitivity can determine its weight in our portfolios and ultimately drive overall conviction levels. If the conversion premium is simply too high (especially in the context of its current market cap, where investors have already priced in considerable growth) and we feel that we are overpaying for the embedded call option – our appetite is restricted. At least with convertible bonds provided one has enough confidence in the credit of the issuer to warrant a holding, then the bond floor should insulate from any share price reversals.
At present, tech and FinTech firms face their own reckoning with lofty valuations. Investor confidence in Afterpay and other BNPL operators such as Zip Co may have outpaced the growth outlook for the industry. From the trough immediately after the COVID-19 sell-off witnessed across equity markets in Q1 2020, to peak valuations in early 2021, Afterpay’s share price was catapulted from AUD8.90 per share to AUD 158.47 – a cool 1680% increase (23/03/20 – 10/02/21) (Bloomberg, 2021). Given the enormous sums invested in marketing and technology BNPL providers remain reliant on debt and equity to fund their operating expenses. It is therefore unsurprising that with the recent weakening in markets – particularly across tech names that did very well in 2021 – BNPL companies too have seen negative pressure on their share prices where some investors are starting to figure valuations may be stretched.
We do believe that the Buy Now, Pay Later industry will continue to gather momentum and companies such as Affirm will continue to grow their top lines, but currently intensive technological and marketing expenditure restricts the bottom-line expansion at this stage of their growth.
In relation to the recent Affirm bond offering, the profile simply did not represent the asymmetric payoff we are searching for and the downside risk is too great for us at these valuations. The bond issued at par and at the time of writing trades at $84 (per $100 of par), which now puts the conversion premium somewhere in the region of 150%. Our decision not to allocate has proved to be correct.
From an ESG perspective, we continue to monitor the social implications of BNPL products. Due to the ease of acquiring these loans – unlike with consistent repayment schedules as with a credit card – some consumers could end up with multiple outstanding loans and may have to juggle multiple due dates. Due to the lack of disclosure in credit reports and speed with which credit decisions are made, there is a danger that individuals may find themselves in a mountain of debt, further perpetuating the underlying potential credit crisis which rumbles beneath the surface, as some consumers enjoy seemingly endless liquidity after the many lockdowns…
The risk, however, is not with exorbitant APRs – in fact, BNPL providers cleverly bridge the gap between incumbent, steady lending models and the opposite side of the spectrum: where many pay-day lenders utilise predatory tactics – irrespective of affordability. For BNPL, it is a volume game and the differentiator between these companies is not the fees that they charge but the power of their tech and ability to match retailers with customers.
We have not seen the last of BNPL or other FinTech innovation in convertible bond markets and we continue to look for the best risk-adjusted way to participate when the timing is right.
No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment
The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. This article does not constitute investment advice and the information shown is for illustrative purposes only.
Unless otherwise stated, all opinions within this document are those of the RWC Convertible Bonds team as at 21st January 2022.