What Is An Alternative Investment Fund?

Key Highlights

• An Alternative Investment Fund is an investment vehicle that collects funds from domestic and international investors and invests the corpus while adhering to a predetermined investment philosophy.

• AIFs mostly invest in illiquid and unlisted companies like startups, real estate, private equity funds, etc.

• AIFs fall into one of three categories: category I, category II, or category III AIFs.

• Individuals must invest a minimum of ₹1 crore in an AIF.

Overview Of Alternative Investment Funds

Alternative investment funds accumulate capital from knowledgeable private investors. The money raised is invested in line with the AIF's investing philosophy. AIFs are exempt from the mutual funds regulations of the Securities and Exchange Board of India (SEBI). Instead, Regulation 2 (1) (b) of the Regulation Act, 2012 of SEBI applies to AIFs in India. It allows for the establishment of AIFs as companies, limited liability partnerships (LLPs), corporate entities, or even trusts.

AIFs make investments in non-traditional assets. The Securities and Exchange Board of India divides AIFs into three major groups. They are Category I, Category II, and Category III AIFs. Depending on the wide definition of the category, each investment falls under a different category. Private equity, hedge funds, angel funds, and venture capital, are some prime examples.

AIFs have higher entry requirements and costs than traditional investments. Since the asset classes they invest in are quite rare, finding the valuation of AIFs might be challenging. AIFs lack liquidity since only a small number of investors may purchase them. Because the overall turnover of AIFs is less than with typical investments, the transaction costs are lower. AIFs do not disclose any fund-related information to the general public. AIFs also have fewer opportunities to showcase to the investors.

Factors to Consider Before investing in AIFs

Before diving into alternative investments, there are several critical factors to evaluate.

• Investment horizon: AIFs typically require a longer investment horizon due to their nature and structure. As an investor, you should assess your ability to commit funds for an extended period, often ranging from five to ten years.

• Risk tolerance: The risk profile of AIFs can vary significantly based on the underlying assets. Understanding your risk tolerance is crucial, as some AIFs may involve higher volatility and potential for loss compared to traditional investments.

• Fund manager expertise: The success of an AIF often hinges on the expertise of its fund manager. Evaluating the track record and experience of the fund management team is vital to ensure that your investment is in capable hands.

• Regulatory framework: Familiarity with AIF regulations is essential for compliance and understanding the operational aspects of the fund. Different categories of AIFs are subject to specific guidelines, and being informed about these can aid in making informed decisions.

Categories Of AIFs

According to the market regulator SEBI, AIFs fall under the following three major categories. They are further subdivided into subcategories, as shown below.

1. Funds In Category 1 AIFs

These alternative investment funds frequently make investments in start-ups, early-stage firms, social enterprises, small and medium-sized organisations, and infrastructure. They may also invest in industries or regions that the government or regulators deem to be desirable from a social or economic standpoint. The government offers tax incentives or other benefits to investors in these types of funds. They include the following.

Funds for venture capital: These funds invest largely in emerging companies with a strong potential for development and a need for capital. These funds must put two-thirds of the surplus funds into the equity shares of these firms in accordance with SEBI regulations. The remaining one-third may be used to purchase debt instruments, unlisted firm initial public offerings (IPOs), equity shares of any financially unsound listed company, etc.

SME Funds: As their name indicates, these funds invest in small and medium-sized businesses. These businesses may be unlisted, listed, or have applied for listing on the SME stock exchange. SEBI regulations require these funds to invest at least 75% of the surplus funds in these businesses.

Social venture funds: These funds make investments in profitable companies that also make a beneficial contribution to society by addressing different environmental and social issues. Affordable healthcare, sustainable energy, financial inclusion, and other topics are some of the themes. These funds must invest at least 75% of assets in them, in accordance with SEBI regulations.

Infrastructure Funds: These funds invest in companies that create infrastructure, such as rail, roads, ports, airports, and power. According to SEBI regulations, at least 75% of these funds' assets must be in unlisted companies. The remaining 25% may be put towards listed debt instruments of businesses engaged in the development, management, and holding of infrastructure projects.

Angel Funds: These funds are a particular subset of venture capital funds that invest in startups or very early-stage enterprises in exchange for an equity share, giving them the necessary resources to grow or develop. However, only angel investors may provide funding for these funds.

2. Funds In Category 2 AIFs

Funds invested in both debt and equity instruments fall under this category. The government does not grant any incentives for investments made for Category 2 AIFS.

Funds for private equity: Private equity funds invest in unlisted private enterprises. It is challenging for privately held enterprises to raise capital through the issuance of equity and debt instruments. The lock-in period for these funds typically lasts 4 to 7 years.

Debt Funds: Debt securities of unlisted companies make up the majority of this fund's holdings. These businesses often adhere to sound corporate governance principles and have significant room for expansion. They are a dangerous alternative for cautious investors because of their poor credit rating.

Funds of Funds: These funds focus on making investments in other alternative investment funds.

3. Funds In Category 3 AIFs

These funds follow advanced trading approaches to invest in listed or unlisted derivatives. The following funds fall within this category:

Private Investment in Public Equity Funds (PIEFs): These funds invest in publicly traded companies by purchasing their stock at a discount.

Hedge funds: They assemble cash from individuals and businesses to participate in the local and international debt and stock markets. To give its investors a better return, these schemes employ an aggressive investing approach.

Benefits Offered By AIFs

AIFs come with several AIF benefits that make them appealing to certain investors.

• Diversification: AIFs offer access to a broad spectrum of asset classes, which can help diversify an investment portfolio beyond traditional stocks and bonds, potentially reducing risk.

• Potential for higher returns: Due to their diverse nature and exposure to unique assets, AIFs hold the potential for higher returns compared to conventional investment vehicles.

• Customised investment strategies: AIFs often employ specialised strategies tailored to specific investment goals, providing investors like you with opportunities to participate in niche markets and unique ventures.

Drawbacks of AIFs

While AIFs offer unique advantages, they also come with certain challenges.

• Limited liquidity: AIFs typically have longer lock-in periods, making them less liquid than traditional investments. This lack of liquidity can be a drawback for investors needing quick access to their funds.

• Higher fees: Due to the complex nature of AIFs and the expertise required to manage them, they often come with higher management fees and costs compared to standard mutual funds.

• Regulatory complexity: Navigating the regulatory landscape for AIFs can be challenging, requiring investors to stay informed and compliant with evolving guidelines.

Key Requirements And Guidelines For Investing In AIFs

Indian residents, foreigners, and Non-Resident Indians (NRIs) are eligible to invest in AIFs. This broad eligibility criteria allows for a diverse investor base, promoting capital inflow from various sources. However, the high minimum investment threshold of ₹1 crore ensures that only high-net-worth individuals or institutional investors participate. This requirement is in place to protect retail investors from the higher risks associated with alternative investments.

For directors, staff members, and fund managers, the minimum annual salary requirement of Rs. 25 lakh is designed to ensure that those closely involved with the fund have a significant financial stake and are likely to have the necessary expertise to manage such investments.

Lock-in period

The typical three-year lock-in period for AIFs serves multiple purposes. It provides fund managers with a stable capital base to execute their investment strategies, which often involve illiquid assets or long-term investment horizons. This lock-in also aligns with the nature of many alternative investments, which may take time to realise returns.

Investor limits

The limit of 100 investors per plan is intended to keep the investor base manageable while still allowing for sufficient capital pooling. This cap helps maintain the exclusive nature of AIFs and allows for more personalised investor relations.

For angel funds, a subcategory of AIFs focusing on early-stage startups, the lower limit of 49 investors reflects the higher risk and more specialised nature of these investments. This smaller group size can facilitate more active involvement of investors in the startups they fund.

As AIFs are categorised into three types, it is crucial to know that each category has specific investment restrictions and regulatory requirements. For instance, Category I and II AIFs cannot engage in leverage except for meeting temporary funding requirements, while Category III AIFs can use more complex trading strategies including leverage.

How to Invest in AIFs?

Investing in AIFs involves three main steps.

• Research and selection: Begin by researching various AIF types and understanding their investment strategies, goals, and historical performance. This research will aid in selecting the right AIF that aligns with your investment objectives.

• Investment process: Once a suitable AIF is identified, the investment process typically involves completing an application form, providing necessary documentation, and meeting the minimum investment requirements.

• Ongoing monitoring: After investment, it's essential to regularly monitor the performance of the AIF and stay informed about any changes in the fund's strategy or management.

AIF Taxation

Understanding the tax implications of AIFs is just as crucial for effective financial planning.

• Tax treatment: The tax treatment of AIFs varies based on the category and underlying assets. Generally, income from AIFs is taxed at the fund level, while investors are taxed on distributions.

• Capital gains: The capital gains tax on AIFs depends on the holding period and the nature of the underlying assets, similar to traditional investments.

• Tax efficiency: Certain AIFs may offer tax efficiency by employing strategies that optimise tax liabilities, making it essential to understand the tax implications before investing.

Conclusion

AIFs are an appealing option for investors looking for high returns with a certain amount of risk. They are distinct investment avenues that privately pool funds. There are enough regulatory frameworks for alternative investment funds in India. Less exposure to market volatility and diversification are the key benefits they offer. However, one must have substantial funds to invest in AIFs. Moreover, accessing information regarding their investment plans is a bit difficult. So, before making an AIF investment, investors must fully understand the fund and obtain all the relevant information regarding it.