CRISIL Ltd, one of the largest and most reputed CRAs of India which is also an analytical company that mainly provides rating, research and advisory services. The company is largely owned by S&P Global (67.4 % ownership as of May 2020), a US based CRA.
It was the first credit rating agency in India, introduced in 1988 by ICICI and UTI jointly with share capital coming from SBI, LIC and United India Insurance Company. In April 2005, US based credit rating agency S&P acquired the majority shares (51 % back then) of company.
The company has 10 subsidiaries (all 100% owned) as of May 2020, including the newly formed 'CRISIL Ratings' on June 3 2019 after SEBI mandated to segregate the rating and non-rating business for Indian companies.
CRISIL is mainly into the business of (i) Ratings (ii) Research and (iii) Advisory services. For keeping the article short and more accurate, let's group the segments (ii) and (iii) as 'Research and Advisory'.
Below chart gives an overview of how different product segments contribute to the company's revenues and profits. (i) PRODUCT -
The company reported PBT of Rs. 219.54 cr from Ratings in 2019 v/s Rs. 184.17 cr in 2018 marking a growth of 19.21%. For Research and Advisory, the company reported PBT of Rs. 246.41 cr in 2019 vs Rs. 318.35 cr. in 2018 marking a de-growth of -28.42%. The segment wise performance will be discussed later in detail in their respective areas.
NOTE: The company uses calendar year and not business year, i.e. annual reports are released as 'data as of December 20xx' and not March 20xx.
The company doesn't earn all of its income from India. (ii) GEOGRAPHIC -
CRISIL earns revenue in India as well as from North America, Europe and rest of the world. On the left side, this is the chart which represents the % of revenues earned from different geographies.
CRISIL earned roughly 33%~ each from India and North America and 25%~ from Europe for 2018 and 2019.
Subsidiary Holding structure
CRISIL has total 10 subsidiaries out of which subsidiaries #1, #2 and #3 are Indian subsidiaries whereas the rest are foreign subsidiaries. S&P holds 67.4% in CRISIL and CRISIL further holds 100% stake in all its subsidiaries.
Subsidiary #1, CRISIL Ratings was incorporated recently with the objective to take over the ratings business of the company. Rest all other subsidiaries are engaged in the business of 'Global Research & Analytics (GR&A)' and 'Advisory services'. Main subsidiaries for the company are (i) Crisil Irevna UK Ltd (ii) Crisil Irevan US LLC and (iii) Coalition Development Ltd which contribute 75%~ of the 'Subsidiary profits' or 17%~ of the 'Consolidated profits'.
While S&P assigns ratings to instruments on a global scale, CRISIL assigns ratings on its national scale.
According to company website, since CRISIL only gives rating on national scale. Therefore, while considering foreign subsidiaries of Indian parent companies, CRISIL considers ratings given by let's say S&P and maps it to the scale used by CRISIL.
In India, there are total of 7 CRAs which are allowed to give ratings. The ratings market is actually dominated by 3 of them, (i) CRISIL (ii) ICRA and (iii) CARE who cover 95% of the industry, CRISIL being the market leader (45% market share based on revenues).
CRISIL earned roughly 47%~ of its reported PBT in CY2019 from Ratings. But before getting into the details of the company performance, let's try to understand the business of credit rating agencies.
There are 2 main business models in the credit rating business:
(i) Issuer pay model - The issuer / borrower will pay to get credit rating for the instrument. This business model allows issuer-pay credit rating agencies to make their ratings freely available to the broader market i.e. investors.
(ii) Subscription model - The investors / interested parties will pay CRAs to get a credit rating on a company instrument. The credit rating agency does not make its ratings freely available to the market, so investors pay a subscription fee for access to the ratings.
Both business models have their own set of advantages and disadvantages. Currently, we are following issuer pay model in India. Critics argue that the issuer-pays model creates a potential conflict of interest because the agencies are paid by the organisations whose debt they rate. However, the subscription model is also seen to have disadvantages, as it restricts the ratings availability to only paying investors. Issuer-pay CRAs have argued that subscription-models can also be subject to conflicts of interest due to pressures from investors with strong preferences on product ratings.
Rating fees structure
Although CRISIL hasn't disclosed their rating fees structure, we found out that CARE anually charges 0.1% on initial ratings of bonds (subject to minimum flat fee on specific issue size) and 0.03% annually (to be paid quarterly) on the recurring ratings. (These are rough estimates, fees structure varies based on instrument type, their complexity, their issue size etc.) Therefore, there are 2 types of fees charged by CRAs. One being, 'initial fees' in which the instrument / company is getting rated for the first time. The other is 'surveillance fees' which is charged to give revised ratings on quarterly basis. Initial fees is usually higher than surveillance fees. Having a variable fees structure, it makes CRA's revenues directly proportional to the size of issues they rate.
Factors affecting CRA business
Let us start with what all instruments are rated by credit rating agencies. The below list provides some of the main products rated by CRAs:
Bank Loan ratings (BLRs)
Long term debt instruments - Long-term Bonds, NCDs, Preference Shares
Short term debt instruments - Commercial Paper (CP), Short term NCDs and Bonds
SME ratings and Fixed deposit ratings
Others - Structured products etc.
Major source of revenues for CRAs are Bank Loan Ratings (BLRs) and Corporate Bonds (both short and long term). Therefore, the biggest factors affecting the credit rating business is the 'growth and issuance in corporate bond markets' as well as 'growth in bank credit in the economy'. Both these factors are further impacted by several other factors like interest rate movements, general business activity occurring in the economy, demand for credit, rate of investment, maturity of the debt markets etc.
Let's look at how credit growth in India affected CRISIL Ratings revenues in the past -
Here we see that how the general non-credit growth (and NBFC credit growth) is highly correlated with that of Rating revenues for CRISIL. The excess variation reflected by company's revenues are because of operating leverage in play. More credit disbursement in the economy would mean more issuance of debt which further translates to more debt that needs to be rated before getting issued.
During the COVID-19 period, focus will completely shift to risk management and conservatism. It is now becoming evident that investors are not willing to finance debt of companies as they look to park their money in safe haven. This will negatively impact CRISIL as the volume of debt being issued will significantly go down which will result in decline in ratings revenues for CRISIL. But what about the future? Lets take a look -
Future of Indian Bond Market
Since a big pie of the rating revenues for CRAs come through bond markets, lets see what future holds for them: The Indian bond market has just started to develop, thanks to some of the measures taken by RBI. For one, Insolvency and Bankruptcy Code (IBC) will be a game changer. So what exactly is IBC?
The Insolvency and Bankruptcy Code, 2016 (IBC) is the bankruptcy law of India which seeks to consolidate the existing framework by creating a single law for insolvency and bankruptcy:
Insolvency Resolution : The Code outlines separate insolvency resolution processes for companies. The process may be initiated by either the debtor or the creditors. A maximum time limit for completion of the insolvency resolution process has been set for corporates and individuals. For companies, the process will have to be completed in 180 days, which may be extended by 90 days, if majority of the creditors agree.
Procedure : A plea for insolvency is submitted to the authorities by debtors / creditors. The maximum time allowed to either accept / reject the plea is 14 days. If the plea is accepted, the tribunal has to appoint an Interim Resolution Professional (IRP) to draft a resolution plan within 180 days following which the Corporate Insolvency Resolution process is initiated by the court. For the said period, the board of directors of the company stands suspended, and the promoters do not have a say in the management of the company. The IRP, if required, can seek the support of the company's management for day-to-day operations. If the CIRP fails in reviving the company the liquidation process is initiated. (Source: https://en.wikipedia.org)
Impact on Indian Bond Markets?
First thing first, what IBC aims to do is to reduce the time spent on resolution, restructuring and liquidation process of Indian companies. According to World Bank study, it used to take on average 4.3 years to complete the process. IBC has given guidelines to reduce it to 180 days (90 days extendable). Although companies say it is not yet that effective and takes longer than 270 days, it still is much shorter than 4.3 years.
For the year 2019, World Bank reported the time spent on resolution at 1.6 years. Ireland tops the list with 145 days roughly. As per the same report, NPA recoveries earlier stood at 25% for India before IBC came into effect. Now, for the year 2018-19, NPA recoveries stood at 56% according to an article published on - https://www.thehindubusinessline.com
- Before IBC, many of the institutional investors have been refraining from investing in the corporate bond markets due to higher probability of risk of insolvency combined with no law which can carry the resolution process effectively. IBC will make the process smoother.
CRISIL on IBC in their 2019 Earnings Call -
We have seen in the UK in the 80s and Malaysia recently that, after five years of bankruptcy law coming in, the bond market gets a substantial uptick.
As per Ajay Tyagi, Chairman of SEBI, corporate bond market could get a boost if sectoral regulators of pension funds, provident funds and insurance firms could allow their regulated entities higher exposure in the segment. Institutional investors such as pension funds, provident funds and insurance companies can generate 'far higher demand' for longer dated corporate issuances. Relaxation of norms to allow higher allocation to the corporate bond market would help earn incremental returns and generate demand for corporate bonds.
More importantly, since these institutions are long-term investors and typically hold investments till maturity, they can act as ideal counter parties to infrastructure firms that require funding through longer-dated instruments. Successful implementation of the IBC will increase confidence among investors, including foreign ones, and is likely to increase liquidity in low-rated papers.
- Secondly, in late 2018, another important measure taken by SEBI is that they have mandated large corporates to raise 25 % of their financing needs from the bond market. Defining a large corporate, SEBI said such firms need to have an outstanding long-term borrowing of at least Rs 100 crore; a credit rating of 'AA and above and target to finance themselves with long-term borrowings (above 1 year).
India is still a developing country with relatively high interest rates. As the country continues its growth trajectory, the interest rates will slowly come down along with systematic risks and map to what we are currently seeing in countries like US making borrowing from bond market attractive. We believe that the Indian bond markets are still in its early stage and in the coming years, the bond market will grow substantially as most of the issuers will prefer borrowing from bond market rather than bank credit or equity.
Argument against the Ratings Industry
Now that we know that the rating revenues for CRAs in India is highly linked to how credit grows in the economy and how the bond market of India develops, lets not forget the below:
As and when economies grow larger and mature, initial high credit growth eventually slows down and settles at a nominal rate. There are several factors causing the credit growth to slow down when economies become large, the biggest one being, the potential investors in the economy rise whereas the number of highly profitable opportunities decline. Therefore, no. of highly profitable investments go down as more and more people look to invest in different projects thereby forcing others to take risky bets by over spending on unnecessary projects which in turn creates a bubble in the economy. (based on Austrian economics, a very interesting and compelling way to look at economies work)
To summarise, Indian bond market is still underdeveloped and SEBI / RBI has been taking aggressive actions to develop the bond market. This will have a significant positive impact on revenues for CRAs when more instruments get issued over the long term. However, over the long term, when the bond markets get developed and economies mature, credit growth seems to settle at a nominal rate. This phase is still far away for India.
Next, Why Quality Matters?
Lastly, let's try to understand why quality of ratings really matter in this business. If my play here is really on the ratings industry, i should have gone for CARE Ratings who earn 97%~ on revenues from ratings or ICRA Ratings who earn 71%~ from ratings, right?
Well, it is because of the quality of ratings and excellent corporate governance practises followed by CRISIL that we chose to go with this company. Think of this - Does cost of getting rated really matters in a credit rating business?
We believe that except for some SME businesses who might think it's a complete wastage to spend on getting a stamp on the paper, it really shouldn't matter. We shared the pricing structure for CARE Ratings which is 'roughly' 0.1% for initial fees and 0.03% for surveillance fees. CRISIL might be charging a little more than this. For businesses like large corporates and bank loans whose borrowing ability and credit worthiness is literally dependent on the kind of ratings they get, fees shouldn't really matter. Ratings matter. Thats why they go for rate shopping.
What matters in the credit rating space is (i) reliability of its ratings which is built over time (ii) reputation of the CRA in the market and (iii) its relationship with existing clients. Think of this, if you're an investor, would you be comfortable relying on a CRA who just gave AAA+ credit rating to a fraud business in the prior months and then cut down their rating abruptly to D- when the scam uncovered? Or rather go with some other CRA, which is clean of this kind of act, whose management is more reliable and ethical on this front i.e. does not promote rate shopping?
When the reputation of a CRA gets dented, its not just the investors who refrain from using their ratings, it is the businesses as well who prefer CRAs with good reputation. Why? Because they are also aware of the fact that nobody would be willing to finance their borrowings if they get a credit rating from a CRA who was involved in giving an incorrect rating to a scam business just for higher fees. Even if that CRA corrects its way of doing business, it takes years to build back the kind of reputation where investors and businesses would be willing to come back.
The same if the case for HDFC Bank who benefitted from the Yes Bank case. Industries like credit rating and banking are built on 'trust' and whenever trust gets hampered in one company, people eventually flock to the most trustable business of their industries. (Lets save this discussion for sometime later)
CRISIL on ratings quality in their 2019 Earnings Call -
I would say that standards would go up and that is good news because the arbitrage on account of poor quality had to stop sometime.
This is how, we believe, CRISIL would benefit from the recent IL&FS crisis and has indeed benefitted as well (reflected in annual results; CRISIL gained market share). In the long run, it is the good quality businesses with strong moats who consolidate and dominate their industries.
RESEARCH & ADVISORY BUSINESS
This segment forms a significant part of the company business. CRISIL did see some contraction in 2019 in their 'Research' division due to increasing competition combined with deteriorating margins. Let's take a look -.
NOTE: The company hasn't disclosed how much revenue it earns from each product segment from each geography so it's not possible to decode how much revenue % each country contributes to each product segment.
Here's how the Research & Advisory (R&A) division has been contributing to the total PBT as compared to the Ratings division -
The Global Research and Analytics (GR&A) business facing some headwinds from 2016 along with improved performance of Ratings division in 2018-19 resulted in the R&A business PBT contribution decline from 70% in 2016 to 53% to 2019. Let's look at what the company has to offer in their R&A division.
Company Offerings + Recent Performance
CRISIL's R&A department can be broken down into 2 main parts (i) Research and (ii) Analytics. The company offers research and analytics support to various financial institutions like banks, investment banks, buy side and sell side firms etc.
1. Research - On the buy side, the company helps Asset Managers in overcoming challenges like alpha generation, fee pressure, emerging gaps in research coverage and increased regulatory requirements. The company services include Equity research, Fixed income and credit research, Economic research, Sales and Marketing, Risk management etc. On the sell side, CRISIL offers help in financial modelling, database management, Idea generation, soft coverage, Ad-hoc research etc.
2. Analytics - The company also offers various analytical solutions in terms of Risk analytics, Competitor and client analytics, Country analytics etc.
The company is mainly growing inorganically in their R&A department. A series of acquisitions and their integration strengthened the research capability and widened the product portfolio. It acquired 'Pipal Research' (a Chicago-based leading knowledge services firm delivering high- quality research to organisations worldwide) in 2010 and 'Coalition' (a UK-based analytics firm serving leading global investment banks) in 2012. CRISIL being an asset light business with high ROCE, it is able to generate high levels of cash which can be then used by the management either for acquisitions or for paying out dividends.
CRISIL has been facing headwinds in the Research segment lately due to following reasons:
Sell side firms have been consistently cutting their overall research budgets and moving the research in-house.
The company is facing margin pressures mainly as competition in research intensified and existing players struggled to maintain their wallet share, thus creating undue pricing pressure on the industry (MiFID impact - see below for detail)
Even on the buy side, firms have started slowly reducing reliance on the investment bank research and use more data to power up internal research.
Talent acquisition costs have started increasing again creating margin pressure for research firms.
Performance of the Research industry is more or less correlated to how economies are performing. Whenever firms face difficulty in maintaining their business margins, research budget is one of many which gets reduced that ultimately translates to lower revenues for companies like CRISIL. One of the recent and most prominent factors affecting the research industry currently is 'MiFID II'.
--> What exactly is 'MiFID II' ?
A. In short, MiFID II is a legislative framework instituted by the European Union (EU) to regulate financial markets in the bloc and improve protections for investors. Its aim is to standardize practices across the EU and restore confidence in the industry, especially after the 2008 financial crisis.
MiFID II will require research costs to be priced separately from execution and trade costs to clients in order to ensure transparency. This represents a major shift from today’s practice whereby research is supplied as part of a bundle of services, with no explicit charge or well, you can say transparency.
Impact of MiFID II on Research ?
Over time, this regulatory change is likely to have strategic implications. The total amount of research consumed is likely to fall. This is because, with transparency, asset managers and research consumers will be compelled to reduce their research costs they pass on to their clients or take the burden themselves. If they do pass on the costs to clients, they will need to justify the spend on how it contributes to the differentiated performance.
According to https://www.oliverwyman.com, research providers and investment managers expect to see a reduction of between 10-30% in research spend after these regulations. Research providers offering access to quality content at competitive prices will be well placed to meet the needs of its customers, the biggest blow being felt by low quality research providers.
Although the regulation covers only the EU from which CRISIL roughly earns 25%~, the regulation will have a direct and indirect impact on the foreign firms as well. The true impact of how the research industry will change is uncertain but we are quite comfortable in judging that in the coming times, margins will remain under pressure and only quality research providers will thrive.
Lets talk about Analytics...
During good times, businesses look to invest in R&D and improve their performance but during bad times, the focus shifts to analytics and risk management. This is exactly what we are currently seeing right now. During the year 2018 and 2019 when the economies had started experiencing slowdown, the demand for risk solutions and analytics provided by CRISIL picked up and as a result this segment performed well during this period.
The company introduced a series of analytical tools recently as the global markets saw rapid shift in investor preferences. While the research consumed was slowly going in-house, the demand for automation based solutions, database management, self learning models etc increased on account of businesses trying to gain competitive edge, cost efficiencies and improve their customer experience. As a result, CRISIL introduced the following tools -
RAM (Risk Assessment Model) - The Risk Assessment Model (RAM) facilitates credit risk appraisal of a borrower through a judicious mix of objective and subjective methodologies and acts as a comprehensive database for borrower’s rating information. RAM is the largest deployed internal risk rating solution in India.
Brecon (Early Warning System) - Combines external developments with the financial institution’s (FI) internal customer data and draws conclusions by fusing these with CRISIL's expertise in the credit and research domains like alert for NPAs.
Quantix - CRISIL’s integrated data and analytics platform, is designed to empower high-quality, efficient decision-making.
SMART (Simple, Modular, Analytics & Research Toolkit) - Innovative financial research platform powered by cognitive automation that enables analysts to emulate certain tasks and optimise decision making for many others. Reduces the turnaround time for analyst workflow tasks and assist them to focus on differentiation and idea generation.
CRISIL on their Analytics segment in their 2019 Earnings Call -
There is a changing environment and technology has changed, the way customers expect traditional offerings to be delivered. We saw this trend coming up a couple of years ago and have started investing in creating these product solutions and analytics. Anybody who starts early is able to capitalise on the opportunity, but commercialisation takes time because with every change you see the change first and you see the benefits accruing over time.
Now lets discuss one of the most important and material development planned to happen in a year that will have a huge impact on CRISIL's analytics segment:
--> LIBOR Transition
The London Interbank Offered Rate (LIBOR) is the reference interest rate for tens of millions of contracts worth more than USD 250 trillion, ranging from complex derivatives to residential mortgages. LIBOR is also hardwired into all manner of financial activity, such as risk, valuation, performance modelling and commercial contracts. It has been called the “world’s most important number”. In 2017 the UK’s Financial Conduct Authority (FCA) announced that after 2021 it would no longer persuade or compel panel banks to submit the rates required to calculate LIBOR.
Then what is the problem?
The underlying market LIBOR measures is no longer liquid. Significantly reduced volumes of interbank unsecured term borrowing, which is the basis for LIBOR, is calling into question its ability to continue playing this central role. Companies have started using alternative rates like SONIA or SOFR as per their industry standards which makes LIBOR unreliable.
The transition from LIBOR will bring considerable costs and risks for financial firms. Since the proposed alternative rates are calculated differently, payments under contracts referencing the new rates will differ from those referencing LIBOR. The transition will change firms’ market risk profiles, requiring changes to risk models, valuation tools, product hedging strategies.
Even more, renegotiating a huge volume of contracts that currently reference LIBOR would be a tedious process, requiring complex valuation models, database management systems, risk management systems etc into place. Financial firms will also face a serious communication challenge with retail customers. Not going into further details, CRISIL is likely going to benefit from the move as businesses will demand more analytics, data management and risk management products. Their products like RAM and QUANTIX have been designed for such purposes.
The current COVID-19 crisis also, will indeed force many businesses to re-think their practises and policies on risk management. This crisis will leave a long lasting impact on how important it is to have adequate checks and controls in the business. There will be many more companies that will subscribe to analytics and risk management in the coming times as they become more conservative while doing business.
- The company also provides Advisory services which contributes roughly 7-8%~ of the company revenues. Advisory is mainly into providing infrastructure advisory services to governments, multilateral agencies, investors, large public and private sector firms etc. CRISIL Infrastructure Advisory provides a comprehensive range of advisory services in urban, energy and natural resources, transport and logistics, and infrastructure financing across India and other emerging countries. In the interest of keeping the article short, this segment will not be covered in depth.
Let's first take a look at how the company performed in CY 2019. Figures in Cr. -
CRISIL reported a minor Revenue decline in 2019 along with PBT of Rs. 492 cr. in 2019 vs Rs. 502 cr in 2018. The relative bigger fall in PBT in 'Research' division was offset by an increase in PBT for 'Ratings' division. Margins remained same during the years. A key change in the balance sheet was the increase in cash and cash equivalents for CY 2019 from 18%~ to 29%~.
Segment Wise performance -
Here's how PBT margin evolved over the years for their main segments, Ratings & Research:
As per CRISIL's reported numbers, margins for Research division looks to be under pressure from 2018 where the margins fell from a long term average of 30%~ to 22%. As stated above, we believe that margins took a hit mainly on account of (i) fall in demand for research due to global slowdown (FIs shifting focus to risk management) (ii) impact by MiFID II regulations introduced in 2018 by EU. Operating leverage increases the impact of these factors.
Expansion in margins in the Ratings division was possibly on the account of huge increase in bond issuance by the NBFC sector during 2017-2019. Since most of the costs for CRISIL are fixed (employee costs), operating leverage helped the company to expand their margins. The year 2019 gave some pricing power when the IL&FS fiasco unfolded, giving rise to the demand of quality r