Afterpay Aftermath Afterwards

Buy now, pay later contracts are point-of-sale installment loans that allow consumers to make purchases and pay for them at a future date. Consumers typically make an upfront payment toward the purchase, then pay the remainder off in a predetermined number of installments.

An Expensive Acquisition

Square (SQ) announced their plans to acquire buy-now-pay-later (BNPL) operator Afterpay (APT) in a $29 billion deal that will help Square participate in a fintech wave that has transformed the payments experience in Afterpay’s native Australia and started to gain traction in the U.S. SQ was up 10+% on a 42x revenue multiple deal or a 30% premium to Afterpay’s last close. SQ is using the appreciation in their currency wisely. When your currency has quintupled in less than a year, a buy-versus-build strategy makes complete sense.

The market has spoken, but a healthy dose of introspection and skepticism is never a bad thing. But first, a simple example to explain what BNPL really is:

An Example

Consider spending $100 at Dick’s that goes through a BNPL lender. If the arrangement is for a 6% discount, Dick’s receives $94 net and takes a charge (sometimes to marketing expense) for $6 which is a service fee paid to the BNPL provider. And the customer in turn gets 2 weeks to pay off the purchase cost over 4 interest-free payments. If they miss it, late payment fees will further increase their payment burden, really a charge that is akin to - you guessed it - interest payments.

Some Introspection

So let’s ask a few questions out of curiosity, at the very least, to stoke a debate.

How do you compute a buyer’s creditworthiness on the AFX highway?

Heck, nobody knows.

For the underbanked, there is no such thing as creditworthiness or a credit score. Said differently, it’s the Wild Wild West - an unstructured environment. If you don’t have a credit score, would you classify as a sub-prime borrower? Does that mean that every BNPL provider will have its own “credit scores” and “credit rating systems”?

We think: Creating one’s own ‘credit scores’ is expensive, so BNPL providers may have to use third party systems to determine ‘credit worthiness’ anyways. And if you don’t fall in the underbanked category, your switching costs to the BNPL network may be high enough to prevent defection.

Who then is left holding the bag when the “fit hits the shan” - you catch the drift?

Is it the merchants themselves? In some cases, like in credit cards, yes, but in most BNPL cases merchants are paid in full minus a 4% - 8% service fee, which is much higher than traditional credit card fees. So then, is it the bank or the BNPL provider? The answer is they both are. The BNPL provider charges the merchant more as insurance money to take on the customer’s credit risk. So how much cash buffer does the BNPL provider need? We don’t know yet - but rest assured capital requirements are going up.

The ‘banking charter’ might have to be invoked here to calculate reserve requirements for the BNPL provider or the neo-bank or whatever cool moniker you want to call them by. It is the cash that they are incidentally borrowing from banks at near-nothing interest rates today which is the buffer. In case customer defaults cannot be covered by BNPL reserves, the risk automatically is transferred to the financiers who are funding the BNPL provider - read banks or equity holders.

We think: Customer credit will be impacted if they miss payments, but magnitude of the credit score impact for microloan violations is unclear.

Where’s the credit default protection money?

Bruh, where’s the mob when we need’em? Does this industry need regulation? How regulators implement controls will be interesting to watch. In the current form, BNPL is not a long-term sustainable model. That does not mean it is not an excellent retailer payment option, it just means that the process will evolve. Will the network challenge Mastercard, Visa, Discover, or American Express? Probably, and the payment networks will take the challenge seriously and are unlikely to cede the space easily.

Is it really interest-free?

There is no such thing as a free lunch. Horses come in different colors. Lo and behold, if customers are late making these installment payments, the present value of the late-payment penalty, we believe, is way higher than any credit card fee or loan interest on an annualized basis. Think double-digit percentages. Interest, late-payment fee, deferred payment plans - same difference!

Our take: For the simple reason that building this ‘afterpay’ infrastructure is expensive and at some point, paying customers will have to defray these costs.

The new “wave” is upon us?

So was the case when credit risk became a systemic problem during the sub-prime mortgage crisis. The leaders at the helm of some of the neo-companies today are not experienced enough to know what transpired back then or they’ve chosen to ignore the real risks of BNPL. Time will tell.

Companies to watch: Affirm, Quadpay, Sezzle and Klarna.

Final Thoughts

Too early to tell how wildly popular BNPL will be. But isn’t this just another way of replacing credit card debt with ‘after pay’ debt? And is it not likely to stick only in the case of small principal point of sale (POS) loans? And isn’t it more expensive and shorter-term in duration? And does this indeed imply that financial hedging and pinpoint Treasury management services will be required to keep the BNPL providers safe from default? And shouldn’t customers beware? The power of compounding works both ways and it goes against you quickly if you are late in making these payments!