One key habit which helped me improve my equity analysis immensely was reading letters written by investors far more experienced than me. I feel this habit is especially important for individual investors who are new to the field. One such letter I recommend everyone read is by 2Point2 Capital. Their Q2FY21 letter was highly illuminating in many ways. In this they discuss the investment mistakes they’d made since the start of their PMS in 2016. One such mistake they discussed was CARE Ratings. Here’s an excerpt of what they wrote:

While we were aware of the inferior quality perception of CARE, we had failed to anticipate the extent to which CARE’s business was dependent on rating weaker corporates. We had drawn comfort from CRISIL’s large stake purchase in CARE at a price of Rs 1660 (vs CMP of ~360). Weak external environment coupled with internal issues have led to a significant decline in revenues over the last 3 years. The operating leverage that we believed would benefit CARE has instead led to a steeper decline in profitability.

Despite the challenges and large loss, we haven’t sold any of our CARE investment over the last 4 years. The reluctance to sell has been primarily due to our view that despite the challenges, CARE’s intrinsic value is much higher.

It intrigued me that while they classified CARE as a mistake they didn’t sell their holdings. This prompted me to have a deeper look at this company. Here’s what the numbers looked like at the time:

No sales growth to speak of over the last 7 years and margins almost halved! Safe to say that this didn’t look like a ‘compounder’. What stood out was that despite sales declining by 25% from the peak and pre-tax profits halving, this business was still earning a return on capital (excl. idle cash and investments) of 60%. 2 key questions should arise at this point - why is it able to do so, and is it sustainable? Before answering these let’s have a brief look at CARE’s historical numbers placed against the context of the industry.

Evolution of the Credit Rating industry in India

CRISIL was the earliest entrant into the industry in 1987 and has throughout remained #1 in terms of revenues. ICRA and CARE came in a few years later (1991 and 1993 respectively) and have fought it out over the years for the #2 spot.

The first major boost to the industry came after RBI implemented the Basel 2 guidelines for bank loans beginning in April 2007, and the need for ratings exploded. CARE’s revenues went up over 8x in 6 years from FY07 (42% CAGR). This is also the period in which CARE outgrew ICRA and took the #2 spot, a title it still holds today. Most companies usually float an IPO amidst a nice bullish phase in their industries, and CARE was no different and it came out with its offering in Dec 2012. The years after this IPO present the perfect cautionary tale for investors blindly looking to invest in IPOs today:

Far from the 42% CAGR, this was a phase of 7 years with almost zero growth in revenues. Margins took a dive as well, reflecting the high operating leverage on which the company was sitting at the beginning of the period. Employee costs went from 27% of revenue in FY18 to 47% in FY20. There were 2 reasons for this slowdown in revenues - one was due to a systemic slowdown in bank loans and the second was due to major defaults in the bond markets. Some part was also played by the rising competitive intensity due to new entrants.

The relevant segment of bank loans to look at from the perspective of a rating agency is outstanding bank loans to industry. RBI, in the Handbook of Statistics on Indian Economy, has provided these figures starting from 1979-80. For every 10 year period since the 80s the annual growth rates have hovered around 14-16%. Even 5 year periods show similar growth rates without much variation. For the decade of the 2000s bank loans to industry (outstanding) grew at 25% annually, whereas for the decade of the 2010s this rate slowed down to 8% annually. If we zoom in with 5 year periods, the contrast becomes evident. From FY05 to FY10, the growth rate was a scorching 30% per annum. The after effects of this credit binge were felt from FY15 to FY20, when the growth ground to a halt with a 2% CAGR. This 5 year period was dotted with events such as major corporate defaults, PSU bank recapitalizations and RBI initiating the Asset Quality Review. The second part of their revenue stream, i.e. bond issuances also suffered due to IL&FS defaulting on its commercial paper in Sep 2018. ICRA and CARE had given it a rating of AAA. The other major default came in 2019 with the collapse of DHFL and here too CARE was a major culprit.

All of this doesn’t make for a great endorsement of CARE as an investment, but there were a couple of factors which gave me some comfort in making a (big) investment. We’ll delve into these factors below after discussing the nature of the credit rating industry.

Characteristics of the Credit Rating Industry

Rating agencies don’t follow the typical cost-plus pricing strategy, where you charge a markup on the cost incurred to produce an item. They follow a value-based pricing strategy where the fee charged to the company issuing a bond (or taking a loan) is pegged to the amount of money being raised. A corporate can digest paying an initial rating fee of 10 bps of the issue amount because the rating allows them market access and potentially a much larger saving on their annual interest cost. If you browse the websites of the major Indian rating agencies the standard rates that you’ll see are an initial rating fee of 10 bps for bond ratings and 4 bps for bank loans. This is the one time fee that an agency charges when a company first comes to them with a rating assignment. Every subsequent year as long as the bond or the loan is still in effect, the company pays a surveillance fee that is roughly half the amount of the initial rating fee. While these are the stated rates, actual pricing on the ground has been much lower due to competitive pressures. Even after this subdued pricing and decline in revenues CARE was generating return on capital in excess of 50%. And globally as well rating agencies are known to generate these inordinate returns. If there’s one thing we know about capitalism it’s that seeing these returns lots of competition would come up. So why is the rating space an oligopoly all over the world?

This is a space which is heavily dependent on trust, i.e. trust that the symbols assigned by the agency actually mean something. There are trillions riding on the back of this trust. Any new agency can set up shop but it would find it tough to get past the first hurdle itself, i.e. getting a license from the regulator. Regulators are very wary of who they let in, as rating agencies act as gatekeepers to fundraising activities. If they get past this hurdle (and a few manage to do so), they face a bigger challenge which is acceptance of the market itself. By market I mean the investors like mutual funds, insurers, pension funds etc. And a new agency might find it easier to get an entry into the bank-loan rating business, where the banks are mainly reliant on credit ratings because of regulations (to comply with the Basel norms on risk-weighted assets) rather than for actual credit appraisal of the company, for which they would have full-fledged internal teams. Entry into bond ratings is much tougher as the typical investor here wouldn’t have the same scale or resources of a bank to perform an in-depth credit appraisal into hundreds of issuers. This is where a credit rating is truly needed and the reason why the fee for a bond rating is more than double the fee of a bank-loan rating. A stronger corporate would always want to get a rating from one of the established agencies as investors are willing to invest at a lower yield based on such ratings. This would only leave the cohort of financially weaker companies (or smaller companies which might want to save on the rating fee) who might become clients of the new agency. This dooms the new agency from its very inception, as its client base is much more likely to see higher levels of default, with a corresponding hit to the agency’s reputation. Therefore this is a space where the earliest mover which comes out with a reliable product and builds a clean track record over many years becomes impossible to shake out. The later entrants either are not able to build a strong reputation and they die out, or they remain fringe players. Very few over the years find a nice niche for themselves and are able to scale, in which case they become acquisition candidates.

After the 2008 Global Financial Crisis, there were plenty of inquiries in the West on the role played by credit rating agencies. One such report by the Competition Committee of the OECD provides excellent insights into this industry. I’m highlighting a passage from the report here (NRSRO is the regulatory term for a rating agency in the US):

Pursuant to the 2006 Act, the SEC has been required to admit any NRSRO applicant that can make an adequate showing of competence, and the SEC has in fact expanded the number of NRSROs to ten (with several applications pending that are likely to be successful). Still, the Big Three (Moody‟s, Standard & Poor‟s and Fitch Ratings) have remained dominant (with the new CRAs largely focusing on specialised market niches or rating foreign firms based in their own jurisdiction). This result suggests that the regulatory power assigned to the Big Three by the NRSRO system does not truly explain their market dominance. Even during the 1975-2006 period, a few new entrants were admitted by the SEC to the NRSRO club, but they were unable to compete successfully (and were acquired by the Big Three).

Uniquely, Fitch Ratings did become competitive with Moody‟s and S&P, but it had specialised in structured finance and thereby had acquired a competitive headstart over its rivals (Moody‟s was in fact slow to enter the structured finance field). Overall, this pattern suggests that there are important “first mover” advantages because reputational capital is hard to acquire and goes to the first firms in the field. If licensing power alone could explain the dominance of the Big Three, then the newer members of the SEC‟s “NRSRO Club” would have joined and shared in their oligopoly.

As an aside, I found a nice parallel of this same phenomenon while going through a con-call recently. This is a different industry but with very similar qualitative characteristics (International Gemological Institute India Ltd Q4 2025 call):

Q: Can any other agency take market share from us? I mean what is the entry barrier that stays our market position?

A: The most important factor here is trust. And trust is not something you can acquire in a small brief time. We have 50 years of legacy plus 50 years of expertise plus 50 years of expert gemologists. All in all the entry barrier is extremely high. There are today only 2 labs of repute. One is IGI, the other is GIA and then there are 10,000 other laboratories.

The above passages explain why S&P and Moody’s have been around for 100+ years and account for more than 80% share of outstanding ratings in the US. The Indian rating space has also witnessed a similar evolution, although it started much later. The earliest guys still account for almost the entire market. The Big 3 (CRISIL, ICRA and CARE) account for more than 75% of the market, and if we add in India Ratings & Research (subsidiary of Fitch) the share goes above 90%. Given all these qualities a true investment opportunity could only arise in a severe crisis, and this is exactly what CARE was facing. But before committing any capital a big question needed to be answered.

Was CARE’s reputation permanently impaired?

If the answer to this question was a ‘yes’, that would mean a constant loss in market share without any hope of recovery, and possibly some major regulatory action. Some temporary loss of market share of a few percentage points from ICRA and CARE to CRISIL was expected in a ‘flight to quality’ sort of move. I felt the answer was a ‘no’ with a very high probability. A couple of factors which gave me comfort were:

1.) Regulator’s thinking - CARE had a 25 year track record of successful ratings, and not as a fringe player but as the player with the second highest revenue share. And while this quantitative record is noteworthy it’s not a qualitative statement from an industry insider. There were numerous legal cases which these rating agencies were going through in the aftermath of the defaults, and one such case related to the ratings given by CARE to Reliance Communications NCDs. SEBI’s Adjudicating Officer found the company to be guilty and imposed the maximum penalty of Rs. 1 crore. CARE appealed to the SAT and its order (which came out in June 2021) was very interesting. I’m highlighting a passage from that order below (italics mine):

We find that the AO has failed to take into consideration Clause (c) of Section 15J of SEBI Act, namely, repetitive nature of the default. Admittedly, the appellant has been in the business since 1993 and as per the memo of appeal it is one of the largest credit rating agencies having a good reputation in the market which fact has not been disputed by the respondent. No evidence has come forward that the appellant was giving false rating in the past or had violated any provisions of the securities laws and its Regulations.

The above passage gave me a lot of comfort on the structural integrity of CARE’s franchise. SAT placed a lot of weight on the repetitive default clause and felt that since CARE was a first time offender it didn’t warrant the maximum penalty, and hence reduced the quantum to Rs. 10 lacs. SEBI appealed against this order to the Supreme Court but it was dismissed.

2.) Systemic issue - Globally we have seen periodic episodes in the credit markets where they go through some major upheavals. This happens about once in a decade or so where a lot of the players get sucked in one way or another. The Global Financial Crisis (2008) was an obvious example of this. This was a period where even the 100 year old credit rating agencies, with all their experience and knowledge, got caught up in the reality of market competition. This happened because Fitch made serious inroads into the share of S&P and Moody’s, especially in the structured finance products which were the cause of the crisis. Structured finance issuances were concentrated in the hands of 10-12 investment banks which were large and regular borrowers from the markets. This shifted bargaining power away from the rating agencies as compared to regular corporate bond issuances, where the issuers were smaller, numerous and came to the markets less often. Similar factors were seen in the Indian context as well. Competition had increased with new entrants such as Brickwork and Acuité gaining market share, albeit starting from a very low base. In terms of the defaulting entities, both IL&FS and DHFL were large and regular borrowers in the debt markets and their management had significant influence on the rating agencies, as became evident from the forensic audit conducted by Grant Thornton and other cases. The only agency which came out clean in this entire mess was CRISIL. SEBI conducted inquiries into the behaviour of all the agencies on their ratings of IL&FS NCDs. It levied a penalty of Rs 25 lacs each on CARE, ICRA and India Ratings in separate Adjudication Orders (all dated Dec 26, 2019). This amount was later enhanced to Rs. 1 crore for all 3 agencies on Sep 22, 2020. All 3 appealed against this SEBI order to the SAT which are still pending. Going through the forensic report and numerous legal cases where these 3 agencies had to face the same implications and penalties, it was clear that this was a systemic issue rather than something affecting just one agency.

The global experience shows that systemic credit crises rarely kill the incumbents in this industry. Post 2008 there was a push from the regulators in both US and Europe to lessen the reliance on credit ratings. In one such instance the SEC mandated that rating agencies be held liable as ‘experts’ for the ratings published in public bond offerings. The agencies responded by refusing to sign off on these documents (essentially going on strike) bringing the public debt markets to a grinding halt overnight until the regulator blinked. The regulators ultimately realised the power of the agencies and how entrenched they were in the system. This passage from the aforementioned OECD report is instructive:

The message here is that reform needs to be incremental, because ratings are too deeply embedded in the debt offering process to be simply eliminated by the stroke of a pen. Whether rating agencies will continue their “strike” if it would cost them issuer business is uncertain, but negligence-based liability could conceivably cause them to withdraw from some markets. Similar problems will arise if money market funds are told that they may not rely on NRSRO “investment grade” ratings. Worried that they may face personal liability for an investment that goes sour, the boards of such funds have already fiercely resisted any deregulation that would deny them the ability to rely on investment grade ratings, and politically they are a potent force. This does not mean that de-emphasis of credit ratings is wrong, but only that it will involve bruising political fights.

What’s interesting here is that the institutional investors themselves were much less concerned about this issue than the regulators. Perhaps they felt that if the market were to switch to an ‘internal rating’ based system en masse, the consequences would be far worse.

Conclusion

According to me, CARE had a solid business franchise whose growth was directly linked to the level of fundraising activity in the Indian economy. If a country has to grow it cannot come without growth in the bond markets or bank loans, which should roughly be around the level of nominal GDP growth. There was also plenty of evidence to show that the more remunerative part of the business, i.e. bond markets was an area of focus for the regulators so as not be a completely bank-dependant economy. The company had gone through a period of operating deleverage, so revenues had fallen but profits had fallen much more. So overall this was an opportunity where I could see three levers of growth:

1.) Volume growth - amount of issuances to increase both cyclically in the short term (5 year timescale) and structurally over the long term.

2.) Value growth - pricing would increase as competitive intensity rationalised post IL&FS. Also because of fee caps, the fee yield goes down as borrowing gets concentrated in the hands of banks and NBFC’s. This is because these large borrowers are able to negotiate fee caps where they don’t pay any fee if they exceed a certain amount of borrowing in a year. As and when the borrower base in the bond markets diversifies and includes smaller corporates, the fee yield increases.

3.) Operating leverage - while I didn’t believe that margins would go to the pre IL&FS highs as CARE was structurally going to be increasing salary levels in order to attract more qualified talent, there was still plenty of room for them to increase.

Selling at 15 times depressed earnings for a company able to generate in excess of 100% on deployed capital, which is probably one of the only companies I’ll find in my investing lifetime where I can say that this business might still be around a 100 years from now, I thought this was a solid bet.