Alternate Investment Funds (AIFs): Types, Who Can Invest, Advantages

Alternative Investment Funds (AIF) are privately pooled investment vehicles that collect funds from investors and allot them in unconventional asset classes. The asset categories can include real estate, private equity, hedge funds, commodities, derivatives, and more. AIF investments behave differently than equity market investments and offer broader diversification options, making them more suitable for HNI investors seeking diversification beyond traditional investment options.

Alternative funds are a type of mutual fund through which you can invest in hedge funds, private equity, venture capital, and other alternate investment classes.In India, alternative funds are defined under SEBI Regulation of Alternative Investment Funds, 2012. The statutory body states AIF funds as privately pooled funds, either Indian or foreign, in the form of a trust, a company, or a Limited Liability Partnership (LLP) . Usually, alternative investment funds require substantial investments and are therefore marketed to HNI and institutional investors. Also read: How To Invest In An Alternative Investment Fund In India?

SEBI has broadly classified alternate investment funds into three categories.

Category 1:

Category 1 funds invest in SMEs, start-ups and economically viable new businesses with substantial growth potential. The different fund types that fall under this category are:

Venture Capital Funds (VCFs):

Venture capital funds invest in start-ups and entrepreneurial businesses with sharp growth prospects. VCFs adopt high-risk, high-return investment strategies to identify high-potential start-ups. HNI investors with high-risk tolerance typically invest in VCF funds.

Infrastructure funds:

These AIFs collect investor funds and distribute them to companies that invest in infrastructure projects. Examples of infrastructure projects can include the construction of airports, ports, railroads and so on.

Angel funds:

These funds raise capital from angel investors primarily to invest in start-up and new-age businesses that are not backed by VCFs. According to SEBI guidelines, the minimum investment requirement for angel funds is typically around ₹25 lakh.

Social venture funds:

These are a type of private equity investments that pool money towards businesses that have a social or environmental vision. Examples of such visions can include reducing the effects of greenhouse gases, leveraging wind and solar energy and so on.

Category 2:

Category 2 funds invest in private equities, debt and real estate funds. The different fund types that fall under this category are:

Private equity funds:

Private equity funds invest primarily in unlisted companies to overcome financial crunch. Usually, private equity funds come with a lock-in period that doesn’t allow investors to withdraw their investment capital prematurely.

Debt funds:

Like private equity funds, debt funds invest in debt securities of unlisted companies. Some advantages of investing in debt funds are its relatively limited capital requirements, stable returns, high liquidity and reasonable safety.

Fund of funds:

Fund of funds typically invest in other mutual funds or hedge funds and derive their value portfolio value from pooled investments. These asset classes can be registered as mutual funds, private equity funds, hedge funds, or investment trusts. FOFs are ideal for investors with limited capital and those looking for less exposure to market volatility.

Category 3:

These funds invest following complex investment strategies.

Private Investment in Public Equity Funds (PIPE):

PIPE funds allow institutional investors and accredited individuals to purchase shares of publicly traded companies at a value below the current market price. These are a form of private placement that is used by publicly traded companies to raise capital quickly due to day-to-day operations, expansion, or acquisitions.

Hedge funds:

Hedge fund managers invest in equity and debt securities in the domestic and international markets. Hedge fund managers implement aggressive investment strategies to generate higher returns for their investors.

Both Indian and foreign nationals can invest in AIFs. It should be noted that these funds typically cater to high-net-worth individuals (HNIs). Other criteria for investing in AIFs can be as follows:

• Those who can meet a minimum investment threshold of ₹1 crore.
• AIF Regulations dictate that AIF sponsors or managers must invest in the fund. For Category I/II AIFs, the investment required by fund managers is 2.5% of the corpus or ₹5 crore, whichever is less.
• Category III AIF require fund managers to invest 5% of the fund corpus or ₹10 crore, whichever is lower.
• Angel investment funds' sponsors or managers must invest 2.5% of the corpus or ₹50 lakhs, whichever is less. Additionally, they must disclose their investment to AIF investors, ensuring transparency.
• The number of maximum investors is restricted to 100 for most types of AIFs. For Angel funds, the maximum number of investors cannot exceed 49.

Also read: Who Can Invest in Alternative Investment Funds?

While investing in AIFs can offer several advantages, these are the key benefits.

Diversification:

AIFs allow diversification beyond the scopes of equities and bonds by allowing exposure to alternative asset classes and investment strategies.

Potential for higher returns:

AIF usually have higher return potential than some traditional asset classes. The large volume of pooled funds allows the fund managers more room to invest using aggressive strategies.

Low volatility:

AIFs invest in asset classes that are not directly related to the equity market and have volatility that is less than the equity market.

Risk mitigation:

Some funds, such as hedge funds, allow for better risk-adjusted returns as they use hedging techniques.

Alternative asset exposure:

These funds provide exposure to alternative asset classes like private equity and venture capital that are not commonly available to investors.

Tailored investment strategies:

AIFs offer exposure to a variety of asset classes, from private equity and real estate to distressed debt and venture capital, allowing investors to choose investment strategies that align with their personal goals.

Professional management:

Alternate investment funds are managed by experienced managers, who specialise in alternative investment strategies and aim to generate rapid returns.

Just like with any other investment, there are some caveats attached to investing in AIFs. Some of them are as follows:

Lack of transparency:

AIFs may not offer the same level of transparency as traditional mutual funds. Hence, it is imperative to do due diligence and read the investment documents carefully before investing.

Higher risk profile:

Fund managers may employ aggressive investment strategies for higher returns that expose your investment capital to high risk. You should access these funds only if you have a high-risk tolerance level.

Limited liquidity:

AIF funds usually come with a three-year lock-in, meaning investors may not be able to exit the investment prematurely.

Regulatory complexities:

The regulatory requirements in India are complex and subject to change. Investors should stay updated on the changing regulatory requirements while investing.

Higher fees:

AIF funds typically have higher fees than traditional mutual funds. These fees cover expenses related to management fees, performance fees, and other expenses. As a side note, higher fees can diminish your final returns.

Illiquid assets:

AIF investments may include illiquid assets such as private equity, venture capital, or real estate, which can be challenging for investors to sell in the secondary market.

Concentrated portfolio:

Some AIFs may have portfolio concentration on a particular asset, increasing the chances of losses if the asset class performs poorly.

Before 2011, VCF and private equity funds in India were a highly unregulated segment. SEBI brought them under its purview in 2011 and laid down several regulatory practices. These regulations prevent fund managers from adopting highly risky strategies and safeguard the interests of the investors.The formation of AIF is managed by the Alternative Investment Funds Regulations, 2012 of SEBI. Some of the regulatory requirements that AIF funds must adhere to are the following:

• The AIF regulation has stipulated that each AIF established in India to pool funds from investors must register with the SEBI. Unregulated funds should also register with the SEBI to remain operational.
• SEBI has further categorised alternative investments in India under categories 1, 2, and 3 based on their investment strategy, fund purpose, leverage, and complexities.
• Investments in AIF follow the valuation technique of assets. Section 23 of the Alternative Investment Funds Regulations, 2012 offers flexibility to AIFs to adopt a valuation technique that suits their requirement.
• SEBI has also implemented a ceiling on the amount of investment under each category of AIF.

AIFs offer distinct tax benefits, particularly in the Category I and II funds. Investments in these categories may be eligible for pass-through status, meaning that any income or gains generated by the AIF are not taxed at the fund level. Instead, these profits are passed through to the investors, who are then taxed based on their applicable income tax slab rates.Additionally, certain types of Category I AIFs, such as those focused on startups and SMEs, may benefit from specific tax incentives and exemptions under Indian tax laws.Meanwhile, Category III AIFs do not typically enjoy the same pass-through tax benefits as Category I and II funds. Instead, the taxation of Category III AIFs is subject to standard capital gains tax regulations in India. Short-term capital gains (STCG) are taxed at the applicable income tax slab rates, while long-term capital gains (LTCG) are taxed at a flat rate with indexation benefits. Also read: Understanding Mutual Fund Tax Implications on Redemptions

Alternative investment funds in India are gaining a lot of traction from Indian investors of late. Data shows that investment in AIF funds has grown 7 times in the last five years. According to SEBI data, the Indian AIF industry was valued at 8.34 lakh crore as of March 2023 and continues to show healthy growth prospects. However, if you are attracted to investing in AIF funds, conduct research and complete due diligence regarding the fund's category, financial goals, and risk tolerance level.