What are Alternative Investment Funds and Why are They Becoming Increasingly Popular?

May 10, 2019 | 1 month ago | Read Time: 4 minutes | By iKnowledge Team

Alternative Investments India

Only a few years ago, the only way to create financial assets in India was to put your money in conventional investment categories such as stocks, bonds and real estate. With the increasing tribe of high net-worth individuals in the country, there is a steady rise in the demand for non-conventional investment avenues such as Alternative Investment Funds (AIFs).

What are Alternative Investment Funds?

In essence, AIFs are a class of pooled-in vehicles for investing in real estate, private equity and hedge funds. While the regulations for AIFs were formulated just over six years ago by the Securities and Exchange Board of India (SEBI), they have evidently gained acceptance among India’s ultra-rich as strong investible platforms. In fact, the capital pumped in by AIFs rose to nearly Rs. 1.1 trillion in the Jan-Mar quarter of 2019, which is nearly 79% higher than it was in the same period a year ago. [1]

While AIFs are currently not covered by the current jurisdiction of any regulatory body in India, they have been described and classified in detail in Regulation 2 (1) (b) SEBI (Alternative Investment Funds) Regulation, 2012. As per the current definition, AIFs are privately held and managed pool of investment fund of either domestic or foreign origin, organised in the form of an LLP (limited liability partnership), corporate body, company or trust. For all intents and purposes, AIFs are seen as private investment funds, and therefore, are not available through IPOs (initial public offerings) or other forms of a public issue which are applicable to Collective Investment Schemes and Mutual Funds that are registered with SEBI.

Types of AIF

As per existing SEBI classification, these private investment funds have been divided into 3 unique categories – Category I, Category II and Category III, with the minimum qualifying corpus amount for these schemes being Rs. 20 Crores. The only exception to this rule is an ‘angel fund’, which is a subcategory of Category I AIFs, as they have lower qualifying criteria in terms of fund corpus at Rs. 10 crores. Let’s discuss them in a little more detail to gain a clear understanding of each category:

  1. Category I: Venture Capital Funds, Startup / Early stage funds, Infrastructure funds – These are those AIFs which are positive and beneficial to the Indian economy and enhance growth. Hence, these funds receive incentives or concessions by SEBI or the government of India. Such funds generally invest in start-ups or early-stage ventures, social ventures, SMEs, infrastructure or other sectors which are considered socially or economically important for the country.
  2. Category II: Private equity funds – Private equity (PE) funds, especially Real Estate PE funds, typically reduce the risk profile by offering diversified investment portfolios managed by experienced fund managers. Thus, it provides the dual benefit of a defensive investment alternative as well as a hedging mechanism by offering an alternative investment asset class.
  3. Category III: Hedge fundsCategory III AIFs are a unique class of privately pooled funds that employ a range of complicated trading strategies including but not limited to arbitrage, margin trading, futures and derivatives trading, etc. to generate returns. This category of AIF is also allowed to utilise leverage in order to make investments in both unlisted and listed derivatives as specified by SEBI (Alternative Investment Funds) Regulation, 2012. Leading examples under this alternative investment fund category include PIPE Funds and Hedge Funds.

Alternative investments continue to grow in popularity and are making their way into the portfolios of well-off individual investors. So, if you are one of them, you must understand the advantages and limitations of investing in Alternative Investment Funds in India. Alternative investments typically do not correlate to the stock market, which means they add diversification to a portfolio and help mitigate volatility. While, just like any other investment, the rate of return for AIFs is not guaranteed, there is potential for it to be higher than that of traditional investments through inflation hedging and robust diversification. However, alternative investments are more complex and have higher fees associated with them than traditional investment vehicles. Moreover, the majority of AIFs are invested in illiquid investments, making them difficult to exit and price on a regular basis. And as with any investment, the potential for a higher return also means higher risk.

Andhra Pradesh Urban Development Fund (APUDF), a state government-backed AIF aiming at high socio-economic impact while delivering sustainable returns to investors, is a very good example of alternative investment in India. APUDF is a SEBI registered Category-II AIF that is mandated to invest in companies or projects or urban local bodies or other urban development agencies operating in Andhra Pradesh. The strategic objective of APUDF is to build a scalable and sustainable investment framework, which can be leveraged to support socio-economic development while generating reasonable returns to its contributors by investing in commercially viable and bankable projects in the state.

As discussed above, AIFs in India are regulated by Regulation 2 (1) (b) SEBI (Alternative Investment Funds) Regulation, 2012. To set up an AIF, an investor needs to submit a required application form and a bank draft of Rs. 1 Lakh to SEBI. Thereafter, SEBI will evaluate the application and will notify about its success to the investor within 21 days. In case, the investor receives the letter from SEBI notifying that its application has been successful, it must prepare for paying a registration fee of Rs. 5 Lakh for getting the status of AIF in India. After getting the getting the certification of registration of AIF issued by SEBI, the AIF may approach the exchanges for listing by submitting a draft information/placement memorandum, an investment management agreement, a custodian agreement, a trust deed, memorandum & articles of association of the issuer and an undertaking from the CEO/ compliance officer that AIF is in compliance with Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 as amended and all the other applicable laws. In order to invest in an AIF, you need to submit your identity proof, pan card and proof of income.

Pros & Cons of AIF

Alternative investments are becoming more popular for investors. These non-traditional investments allow investors with access to assets not correlated to the stock market, offering diversification and potentially higher returns when compared to mutual funds, stocks and bonds. Alternative investment funds are complex and often higher risk than traditional investments to which most high net-worth individual investors are already accustomed. Even the Finance Minister Arun Jaitley, in his 2018 Union Budget speech, spoke about measures to improve and strengthen investments into AIFs — particularly venture capital funds and angel investors—sending out a signal that India is ready to look beyond the usual when it comes to investments.

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