Introduction to alternative investment funds

Alternative Investment Funds AIF differ from regular conventional investments (asset classes) like stocks, debt securities etc. Alternative Investment Fund is a privately pooled investment vehicle that collects money from sophisticated private investors.

AIFs include private equity, venture capital, hedge fund, and angel fund etc. Also, AIFs don’t come under the purview of Securities and Exchange Board of India SEBI mutual fund regulations. Investors who wish to diversify can choose Alternative Investment Funds to invest. All Indians, including NRIs, PIOs, and OCIs, are eligible to invest in AIFs. However, they will have to meet the eligibility criteria.

What are Alternative Investment Funds?

Alternative Investment Funds AIF pool money from sophisticated private investors. Funds collected are invested according to the investment policy of the AIF. Securities and Exchange Board of India‘s mutual fund regulations doesn’t govern AIFs. However, AIF in India has its regulation, Regulation 2 (1) (b) of the Regulation Act, 2012 of SEBI. An AIF in India can be established as a company, Limited Liability Partnership (LLP), corporate body, or trust.

AIFs invest in investments that are not traditional (for example, equities or fixed income). Securities and Exchange Board of India classifies AIFs under three broad categories. Namely, Category I AIF, Category I AIF and Category III AIF. Each of the categories has different investments as per the broad definition of the category. Some of them are private equity, venture capital, hedge fund, and angel fund etc.

The minimum investments and fees for AIFs are higher than conventional investments. It is difficult to value an AIF as the asset classes that they invest in are pretty rare. AIFs are illiquid as these investments are open only to limited investors. The transaction costs for AIFs are lower than traditional investments as the turnover is lower. AIFs don’t share any information relating to the fund publicly. Also, AIFs have less opportunity to advertise to potential investors.

What are the types of Alternative Investment Funds in India?

Securities and Exchange Board of India (SEBI) categorises Alternative Investment Funds into three broad categories. Investors can choose to register in any of the following three categories and subcategories thereof.

• Category I AIF:
  • Venture Capital Funds
  • Angel Funds
  • SME Funds
  • Social Venture Capital Funds
  • Infrastructure funds
• Category II AIF
  • Private Equity (PE) Funds
  • Real estate Funds
  • Funds for distressed assets
  • Debt Funds
  • Funds of Funds
• Category III AIF
  • Hedge Funds
  • Private Investment in Public Equity Funds (PIPE)

What are Category I AIFs?

Category I AIFs invest in startups or early-stage ventures or SMEs or social ventures or infrastructure or other sectors. The government or regulators consider these sectors as economically and socially desirable. Following are the subcategories under Category I AIF:

Venture Capital Funds

Venture capital funds primarily invest in startups and emerging businesses that have strong growth potential. Also, during the VCF launch, it specifies the sectors that the fund is targeting. Most importantly, venture capital is a kind of equity financing. In other words, VCFs provide funds to companies in exchange for an equity stake.

Additionally, venture capitalists also tend to participate in company operations. VCFs generate returns upon selling their stake in the companies. Also, angel funds are a subcategory of venture capital funds. Following are some of the key features of venture capital funds:

• They are close-ended funds and have a minimum tenure of three years. With the approval of the AIF unitholders, the tenure can be further extended to two years.
• With a minimum tradable lot of INR 1 crore, these can be listed on stock exchanges.
• Investment in a company cannot be more than 25%.
• The unit holder can invest in other subcategories of Category I AIF, but cannot invest in FoFs (Funds of Funds).
• VCFs cannot borrow funds directly or indirectly to run their business operations.

Angel Funds

Angel funds raise funds from angel investors. These funds comply with Chapter III-A of the AIF Regulations and make investments. Angel investors are persons who show interest in investing in angel funds and satisfy any one of the following conditions:

1. An individual investor with not less than INR 2 crore net tangible assets. The net tangible assets value excludes the value of their principal residence. And,
   • has early-stage investment experience, or
   • has experience as a serial entrepreneur, or
   • At least ten years of experience in a senior management professional role

Note:

Early-stage investment experience refers to prior experience in investing in emerging businesses or start-ups or early-stage ventures.

Serial Entrepreneur refers to a person who has experience in co-promoting or promoting more than one start-up venture.

2. A body corporate with a net worth of not less than INR 10 crore; or
3. An AIF registered under the regulations or a VCF.

Angel funds raise funds by issuing units to angel investors. Also, angel funds accept investments not less than INR 25 lakhs from an angel investor for a maximum period of three years.

SME (Small and Medium Enterprises) Funds

As the name suggests, SME funds invest in micro, small and medium enterprises that are listed or unlisted. These companies raise debt through NBFC. While SME funds provide equity financing for these companies. Following are some of the key features of SME Funds:

• Minimum investment of INR 1 Crore.
• Has a minimum lock-in period of three years. Additionally, an option to extend for two more years.
• To be classified as an SME AIF, a minimum investment of 75% has to be done. The investment has to be done in unlisted or proposed to be listed SME companies.

Additionally, SME funds generate returns when the company reports substantial growth or when the company gets listed. Also, when the fund delivers higher returns, say more than 8%, then the fund management team takes a share in the excess returns.

Social Venture Capital Funds

As the name suggests, social venture capital funds provide funding for businesses that positively impact lives. These businesses also offer reasonable returns to their investors. Moreover, these funds are most commonly known as impact funds. The fund manager of these funds analyses the social impact the business creates on society.

Following are some of the key features of Social Venture Capital Funds:

• Minimum investment of INR 1 crore.
• Lock-in period of three years, with an option to extend for two years.
• The fund has to invest a minimum of 75% of the assets in businesses that have a positive social impact.

Mostly, SVCFs do theme-based investing in India. For example, education, affordable healthcare, agriculture, and clean energy.

In addition to seed investment, social venture funds also provide technical and operational support to businesses. They also help in setting up the business, laying down compliance and governance procedures. Also, if necessary, they offer business connections and help in getting further funding.

Investors and the fund share the returns from the social venture fund. They follow the waterfall mechanism. As per this mechanism, firstly, the capital and hurdle rate is distributed among the investors. The hurdle rate is the minimum profit that is given. The excess returns are then distributed as per the terms in the scheme information document.

Infrastructure funds

Infrastructure funds primarily invest in firms that develop infrastructure projects. These funds raise capital from private investors. The infrastructure projects include railways, roads, water, municipal solid waste, and renewable energy. The Government of India offers incentives and concessions for investment in infrastructure funds.

Following are some of the key features of infrastructure funds:

• Closed-ended funds with a minimum lock-in of three years and an option to extend for two years.
• With a minimum tradable lot of INR 1 crore, these can be listed on stock exchanges.
• Investors can liquidate within one year after the fund tenure expiry.
• Investment in a company cannot be more than 25%.
• The unit holder can invest in other subcategories of Category I AIF, but cannot invest in FoFs (Funds of Funds).
• Infrastructure bonds are refrained from borrowing funds directly or indirectly to run their business operations.
• The fund allows only 1,000 investors per scheme.

What are Category II AIFs?

SEBI defines Category II AIFs as the funds that do not fall under  Category I and III and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements. 

Following are the investment restrictions for Category II AIFs:

• Close-ended schemes with a minimum lock-in period of three years.
• Minimum corpus under each scheme is INR 20 crores.
• Minimum investment from an investor is INR 1 crore. However, for the employee or director of AIF, it is INR 25 lakhs.
• Funds in Category II can invest only in units of other AIFs or in unlisted companies.
• Except for Funds of Funds, they can invest in units of other AIFs.
• These funds can borrow only to meet temporary requirements. Category II Funds can borrow money only for a period of 30 days. Also, borrowing cannot be done more than four times in a year. The amount borrowed cannot be more than 10% of its investible funds.
• Category II AIFs can engage in hedging.
• By getting into an agreement with the merchant banker, the funds can invest in unsubscribed portions of an IPO.
• SEBI exempts these funds from Insider Trading Regulations. This exemption is valid only for investments in SME exchange. However, there is a minimum holding requirement of one year for such securities.
• The funds can invest 25% of the investible funds on investee overseas. However, with an overall capping of USD 500 million.
• The funds under Category II AIF should obtain valuations by an independent valuer every six months.
• Category II AIFs accept joint investment. However, the investment value cannot be less than INR 1 crore. The join investment can be made by the following:
  • Investor and his or her spouse
  • An investor and his or her parent
  • Investor and his or her daughter or son

The Government of India doesn’t give any incentive or concession for investment in these funds.

Following are the subcategories under Category II AIFs:

Private Equity (PE) Funds

Private Equity funds primarily invest in unlisted private companies. These funds take ownership of the company for their investment. Since unlisted private companies cannot raise capital through equity or debt instruments, they usually opt for PE funds.

PE funds usually have a fixed investment horizon. The lock-in ranges between four years to seven years.

Debt Funds

Debt funds under the Category II AIFs primarily invest in debt or debt securities. These investments are made in listed or unlisted investee companies as per the objectives of the fund. Therefore, debt funds invest in companies with good corporate practice and growth potential but facing a capital crunch.

By the SEBI regulation, money pooled by debt funds cannot be used for giving loans.

Funds of Funds

As the name suggests, funds of funds invest in various alternative investment funds. Funds of funds follow an investment strategy of investing in other AIFs. These funds do not make their own investment portfolio.

Furthermore, funds of funds under AIFs cannot issue units of the fund to the public.

What are Category III AIFs?

Category III AIFs apply diverse trading strategies and leverage by investing in listed and unlisted derivatives. They use arbitrage, derivatives trading, futures and margin trading strategies. Category III funds can be both close-ended and open-ended funds. They are less regulated than conventional investments. Hence they do not need to publish their information regularly. Also, the Government of India doesn’t give any incentive or concession for investment in these funds.

Following are the subcategories under Category III AIFs:

Hedge Funds

Hedge funds invest in domestic and international markets by pooling investments from private investors. These funds use multiple trading and investment strategies to invest the funds collected.

They hold both long and short positions in regular securities. And also hold positions in listed and unlisted derivatives. Hedge funds are aggressively managed and use leverage strategies.

They borrow to invest and can currently borrow up to 200% of the fund size. Hedge funds are pretty expensive as the fund management team charge a fee of 2% of the investment and take up to 20% share in the profits as fees.

Hedge funds are subject to higher market volatility. Hence the returns and the risk tends to be higher than traditional investments.

Private Investment in Public Equity (PIPE)

A long only fund of the Category III of AIFs is PIPE. Here the fund managers buy shares of publicly traded companies at a discounted price. This helps businesses to infuse capital into the business. Also, the regulations for funding the business through PIPE are less than going for a secondary issue.

PIPE transactions help medium and small-sized businesses to fund their projects with ease. PIPE transactions need less administration and paperwork when compared to a secondary (public) issue.

Also, the time taken to fund an issue through PIPE is way lesser than a secondary issue. Hence companies prefer PIPE even though the capital inflow is less due to discounting of the share price.

Who should invest?

Resident Indian individuals, Non-Resident Indians (NRIs) and foreign nationals can invest in alternative investment funds.

Also, there is a cap on investment by each investor. The minimum investment permitted is INR 1 crore. However, for directors, employees and fund managers of the AIF, the minimum amount is INR 25 lakhs.

Additionally, the funds restrict the number of investors per scheme to 1,000. However, for Angel funds, it is 49.

Additionally, it is essential to know that AIFs have a minimum lock-in of three years. Category I and II are close-ended funds, while category III can be either close or open-ended.

Therefore, investors who are willing to diversify their investment portfolio by fulfilling all the above requirements can invest in alternative investment funds.

Who are angel investors?

Angel investors are persons who show interest in investing in angle funds and satisfy any one of the following conditions:

1. An individual investor with not less than INR 2 crore net tangible assets. The net tangible assets value excludes the value of their principal residence. And,
   • has early-stage investment experience, or
   • has experience as a serial entrepreneur, or
   • At least ten years of experience in a senior management professional role

Note:

Early-stage investment experience refers to prior experience in investing in emerging businesses or start-ups or early-stage ventures.

Serial Entrepreneur refers to a person who has experience in co-promoting or promoting more than one start-up venture.

2. A body corporate with a net worth of not less than INR 10 crore; or
3. An AIF registered under the regulations or a VCF.

Angel funds raise funds by issuing units to angel investors. Also, angel funds accept investments not less than INR 25 lakhs from an angel investor for a maximum period of three years.

What are the taxation rules for AIFs?

Alternative Investment Funds are privately pooled investment vehicles. They collect money from sophisticated private investors. Following are the taxation rules of AIFs for each category.

Category I and Category II are pass-through vehicles. The fund doesn’t have to pay any tax on its earnings. However, the investors have to pay the tax at their respective tax slabs. If the fund has any capital gains on stocks, then the investors have to pay 15% or 10% depending on the holding period.

Category III AIFs are taxable at the highest income tax slab level (42.7%) at the fund level. The returns given to investors are after deducting the tax.

Who is the Sponsor of the AIF?

Sponsor(s) is a person(s) who has established the AIF. In the case of a company, a promoter is the sponsor. And in case of a Limited Liability Partnership, a designated partner is the sponsor. To ensure the good interest of the sponsor or manager is aligned with that of the investors, few regulations have been set up.

The sponsor/manager will have a certain continuing interest in the AIF. This will not be in the form of a fee waiver. For Category I and II, the sponsor/manager will contribute an amount not less than 2.5% of the corpus or INR 5 Cr, whichever is lesser. For Category III, the contribution will be 5% of the corpus or INR 10 Cr, whichever is lower. Also, for angel investors, this amount will not be less than 2.5% of the corpus or INR 50 lakhs, whichever is lesser.

Who is eligible to invest in AIF?

Investors who wish to diversify can choose Alternative Investment Funds to invest. However, they have to be eligible for the same.

Resident Indian individuals, Non-Resident Indians (NRIs) and foreign nationals can invest in alternative investment funds.

Also, there is a cap on investment by each investor. The minimum investment permitted is INR 1 crore. For angel investors, the minimum investment is INR 25 lakhs. However, for directors, employees and fund managers of the AIF, the minimum amount is INR 25 lakhs.

Can an AIF raise any amount of funds from any investor?

AIFs can raise money privately from sophisticated investors with a minimum investment value of INR 1 Cr. The investors can be Indians, including NRIs, PIOs and OCIs. The investors should be willing to invest in unlisted and illiquid securities to absorb the underlying risk.

Angel investors have a minimum investment of INR 25 lakhs. Any employee(s) or directors of the AIF can invest in the AIF with a minimum investment of INR 25 lakhs.