Alternative Investment Funds are a class of pooled-in investment vehicles, that raise money from institutions, family offices and HNIs including Indian, foreign or non-resident Indians with a minimum ticket size of Rs. 1 crore (exception applies under the Accredited Investors framework discussed in our earlier article). As the name suggests, they provide an alternative to traditional forms of investments like direct equity, mutual funds and bonds.
The privately pooled funds in AIFs are invested as per a defined investment policy in alternative asset classes such as venture capital, private equity, hedge funds, infrastructure funds etc. This means they provide long-term and high-risk capital to a diversified set of ventures at all stages of their evolution. The investee universe includes pre-revenue stage companies, early and late-stage ventures and growth companies that wish to scale their future operations.
Emergence of AIFs in India
The govt had been focusing on Venture Capital Funds (VCFs) since their inception in the late 1980s to promote the growth of particular sectors and early-stage companies. However, concessions given to VCFs were unable to produce the desired impact in promoting the emerging sectors and start-up companies due to uncertainties created by various regulations.
Therefore, in 2012, the SEBI introduced the SEBI (Alternative Investment Funds) Regulations, to recognise AIFs as a distinct asset class like Private Equities (PEs) and VCFs. The aim was to set up a new category of investments that will finance the socially and economically desirable sectors and ensure a long-term capital flow in India by attracting a different asset class of investors and putting fewer constraints on investments.
Regulation
As per the 2012 regulations, an AIF fund can be established or incorporated as a trust, a company, a limited liability partnership or a body corporate. However, most of the alternative investment funds are registered with SEBI as Trust in India.
The person who sets up the AIF fund is called the “Sponsor”, which refers to a promoter in the case of a company and a designated partner in the case of a limited liability partnership. In order to ensure “skin in the game”, AIF Regulations require the Sponsor to have a certain continuing interest in the AIF in an absolute amount or certain percentage of the corpus.
Each category of AIFs (other than angel fund) should have a corpus of at least Rs. 20 crore to begin operations. In the case of an angel fund, it should have a corpus of at least Rs. 10 crore.
To reiterate, alternative investment funds are a strictly privately pooled investment vehicle. Hence, it cannot raise funds by making an invitation or solicitation to the public.
Structure of AIFs
As per the classification made by SEBI, AIFs can be divided into three unique categories, which are defined as follows:
Category I
This category of AIFs invests in start-ups, early-stage ventures, social ventures, small and medium enterprises (SMEs), infrastructure, social ventures, or other sectors that are considered by government regulators as positive and beneficial either socially or economically. Hence, Cat I funds are expected to have spillover effects on the economy and the govt might consider giving them incentives or concessions for serving that purpose. Examples include venture capital funds, SME funds, social venture funds, infrastructure funds, etc.
It also includes Angel Funds, which are funds pooling investments from Angel investors. Angel investors can be a corporate body with a net worth of at least Rs. 10 crore; an individual owning tangible assets valued at least Rs. 2 crore excluding the value of his principal residence and having experience as a serial entrepreneur, senior management professional & early-stage venture investor; an AIF; or a registered VCF.
Category II
This category is created to offer a defensive investment alternative where diversified investment portfolios are built and managed by experienced fund managers to reduce the risk profile of investors. The debt funds that fall under this category invest in debt/debt securities of listed or unlisted investee companies as per the stated objectives of the fund. Examples include debt funds, private equity funds, real estate funds, distressed asset funds, fund of funds, etc.
Both Cat I and Cat II AIFs are required to be close-ended with a minimum fund life of 3 years. The Sponsor’s interest in each of these categories must be not less than 2.5% of the corpus or Rs. 5 crore, whichever is lesser. For Angel funds, such interest shall be not less than 2.5% of the corpus or Rs. 50 lakh, whichever is lesser.
Category III
Cat III AIFs apply complex trading strategies such as arbitrage, margin, futures and derivatives to generate returns. Hedge funds, which trade for short-term gains and private investment in public equity (PIPE) funds, which buy publicly traded stock at a below-market price, & other similar types of funds qualify to be registered as AIFs under this category.
Unlike Cat I and Cat II, these funds are allowed to undertake leverage or borrowing (which could be up to two times the fund corpus) in order to make investments in both unlisted and listed derivatives. They can be either close-ended or open-ended. As far as the Sponsor’s interest is concerned, it must be not less than 5% of the corpus or Rs. 10 crore, whichever is lesser.
In practice, there are two types of Cat III funds: Long-only funds and Long-short funds. In Long-only funds, fund managers follow a strategy of buying and holding stocks like an equity mutual fund with a thematic idea, with no alternative strategy involved. They account for the majority of Cat III funds and gained popularity compared to mutual funds due to lesser regulatory constraints.
Long-short funds are designed based on two types of asset allocation: Equity risk long-short and debt-risk long-short. The equity-risk long-short funds hold cash equities with a net exposure of 50%—100% and compete against large-cap equity funds. The debt-risk long-short funds hold debt papers with a net exposure of 5%—25% and compete against arbitrage or short-term debt funds.
Conclusion
Today AIFs are a faster-growing investment vehicle in India when compared to mutual funds. Thanks to a number of factors such as low susceptibility to volatility in the stock market, the ability to generate higher returns than stocks and mutual funds and diversification of risk compared to traditional asset classes.
It also provides a compelling option to investors looking to invest in private markets (such as private credit) under a regulatory framework. However, choosing a highly professional fund manager is extremely useful when investing in the space to ensure the stability and predictability of returns.
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