Number of PE deals in India rose 60% over last 5 yrs: McKinsey's Akash Lal

In a Q&A, the Senior Partner at the Consultancy firm also says banks will need to increase productivity by 25%-30% to reach pre-Covid levels of profitability

The access to online information and ease of transactions has supported the rise in financialization of assets, says Akash Lal, Senior Partner, McKinsey & Company. In an interview with Ashley Coutinho, he says banks will need to increase productivity by 25-30 per cent to reach pre-Covid levels of profitability. Edited excerpts:

In 2020, India moved up to the ninth rank in McKinsey's Asian Capital Market Index. What factors are responsible for the improvement in the country's performance on the index?

We identified a few key trends that contributed to the improvement. First, private equity investments have quadrupled in the past five years, with the number of annual deals rising from 588 in 2016, to 917 in 2020.

Secondly, the Indian bond market, while underdeveloped compared to global peers, crossed $100 billion in 2020 primarily due to regulatory reform, improved demand-supply dynamics, economic growth, and the channeling of money from pension funds, insurance, and mutual funds.

The access to online information and ease of transactions has supported the rise in financialisation of assets and growth in mutual funds and equity markets. India has an opportunity to attract new capital, currently available in the form of savings and deposits within Indian households, by extending the reach of its capital markets to tier-2 and tier 3 cities.

Finally, in 2020, equity flows from foreign portfolio investors remained robust, with investments of $23.7 billion between December 2019 and December 2020 even as other emerging markets witnessed outflows. India remains a preferred choice for FPIs owing to the prospects of better economic growth in the coming months.

What are the steps that India ought to take to deepen its capital market?

As of 2019, Indians held 63 per cent of their personal financial assets in cash, deposits, and savings accounts, compared with 16 per cent in the US and 35 per cent in Europe. India should sustain the long-term growth of mutual funds by widening MF distribution, particularly in tier-2 and tier-3 cities. The role of private equity can be enhanced. PE firms headquartered in India are still in their nascency, and at their current growth rate, could grow to several times their size in the next decade. The country has to accelerate the rate of disinvestment in public sector companies, which have risen from $15 billion during 2004-2014 to $40 billion during 2014-2019. Expediting infrastructure financing, gold monetisation and shifting the focus to sustainable finance are some of the other means to deepen the capital market. Gold monetization could release up to $100 billion in liquidity, which could be used for long-tenor and affordable funding, such as infrastructure projects.

A McKinsey analysis earlier this year said Indian banks could withstand trillions in credit and revenue losses for the next few years. What is your assessment of the sector now?

The Indian banking sector has shown great resilience through the Covid-19 crisis, and has played a critical role in its response to the crisis, particularly through the credit guarantee schemes which have helped in keeping the SME sector afloat. The full impact of the crisis in terms of credit losses and the associated revenue losses, however, will play out over the next 12-18 months. Sustained low interest rates will also impact banks' net interest margins, which have been cushioned so far by the inflow of cheap deposits into the banking system.

Banks will need to increase productivity by 25-30 per cent to continue at pre-Covid levels of profitability. A number of leading banks and financial institutions are trying to achieve this through digitization and leveraging advanced analytics.

What are the key trends that you see playing out in the PE space?

India has been one of the largest recipients of PE capital with investments quadrupling in the past five years to $37 billion in 2020. Of this, about $10 billion has come in the form of venture capital investments. The number of ‘unicorns’ has more than tripled from 10 to 36 in this period, and India-focused dry powder remains healthy at $8 billion. All this indicates that capital is available for high-quality deals and can be a key driver for growth. Going forward, consumer tech, IT/ITES, and healthcare are expected to remain in focus, whereas BFSI could see a recovery given the prospects of economic growth.

The participation of retail investors has grown significantly during the pandemic. What do you make of this trend?

The increase of retail participation in equity markets is a global phenomenon, which has accelerated during the pandemic. What is interesting to note is that the number of retail investors participating through debt funds has also seen a surge. Mutual fund folios for debt funds rose to 5.4 million by March 2021 from 4.5 million at the beginning of the pandemic. The value of debt fund assets under management from retail clients surged to $57 billion from $48 billion in the same period.

How will digitization of gold help to deepen capital pools in the country?

India buys 900 tonnes of physical gold each year, of which 250 tonnes is gold bullion. If just 60 tonnes, or 25 per cent, of India’s annual bullion purchase was bought through e-gold platforms and Sovereign Gold Bonds, India could reduce its yearly gold import bill by $4 billion. The World Gold Council estimates that gold has a market size of $1,570 billion in India. However, market penetration of online purchases remains under 2 per cent of annual purchases, providing tremendous scope for digitization to deepen capital pools.

India should create a well-defined set of standards to accelerate the digitization of gold. Offering interest on gold purchased on an e-gold platform, or selling smaller fractions of gold, for example, could help increase market participation. The country could also look at establishing a world-class market infrastructure for the yellow metal by offering a gold vault facility, certified gold-melting operators and assessment/certification providers, a central clearing counterparty clearing to manage counterparty credit risks, and centers for physical gold delivery.

Could you tell us about the pace of ESG adoption in India?

India’s sustainability funding requirements to mitigate climate change could be higher than $2 trillion by 2030. For ESG investing to achieve critical mass in India, it is important to standardise ESG taxonomies and mandate public funds to enhance exposure to ESG securities. Companies should build awareness around ESG benefits, improve ESG performance tracking, simplify regulatory reporting and broaden the ambit of ESG investing to include smaller and mid-size companies.