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Crisil Ltd | Quality Matters - Part 2

If you haven't read Part 1, read that here.


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 decipher how much revenue % each country contributes to each product segment.


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:

  1. Sell side firms have been consistently cutting their overall research budgets and moving the research in-house.

  2. 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)

  3. 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.

  4. 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' ?

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 -

  1. 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.

  2. 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.

  3. Quantix - CRISIL’s integrated data and analytics platform, is designed to empower high-quality, efficient decision-making.

  4. 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.


Disclaimer: This post originally appeared on The Alpha Investor written by Anirudh Jindal and has been reproduced here (with certain minor edits) with his kind permission. Also note that this post should not be construed as investment advice from Galactic Advisors.

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