Alternative Investment Funds (AIFs)- Categories and Benefits

You must have heard the news about celebrities having invested in certain early-stage businesses. Do you often wonder how new businesses, and start-ups, are funded? Where do HNIs invest other than popular investment options? Are there ways to invest directly in certain asset classes? The answer is Yes. There are investment vehicles known as Alternative Investment Funds that collect money privately and invest in alternative asset classes. AIFs are growing in popularity in India. Let’s learn more about AIFs in this article.

What is AIF?

What is an Alternative Investment Fund? These are privately managed funds that collect a pool of money typically from HNIs and institutions in large ticket sizes. They invest in alternative asset classes or unconventional investments e.g. private equity, real estate, derivatives, hedge funds, venture capital, commodities, etc. These investments can be in assets in India or overseas. 

AIFs are regulated by SEBI (Alternative Investment Funds) Regulations, 2012, and incorporated as a trust, company, Limited Liability Partnership, etc. 

Categories of AIFs

Alternative Investment Funds fall into three categories.

Category 1 AIFs

These AIFs invest in early-stage businesses, startups, SMEs, or social ventures that are considered beneficial to the economy or government. These can be further subcategorized into the following: 

1. Venture Capital Funds (VCF)

As the name suggests, Venture Capital Funds invest in early-stage businesses and startups in need of financial support poised to grow big in the future but also at the same time entail higher risks. VC funds invest with a vision to participate in the early steps of the growth ladder and make substantially large gains. These funds also benefit from government incentives and tax sops for supporting new companies.

2. Angel Funds:

Angel Funds a sub-category of Venture capital funds invests in very early-stage businesses, newly coined startups, and entrepreneurs with innovative ideas in need of seed capital to boost the business. Angel funds have a lower investment ticket compared to VC Funds. 

3. SME Funds: 

SME funds invest in small and medium enterprises in need of funds for expansion. These SMEs are selected on the basis of the company's past record, growth, viability, and economic relevance. 

4. Social Venture Funds: 

Social Venture funds invest in startups or social enterprises that work on socially relevant business ideas like environment, education, clean energy, recycling, etc, and also build profitable ventures around philanthropic initiatives. 

5. Infrastructure Funds: 

Infrastructure funds invest in large projects for building roads, bridges, railways, ports, airports, etc, and run on government contracts. These projects often receive tax and other benefits. Furthermore, Infrastructure funds are low in risk and offer stable returns over the long term.

Category II AIFs

This is a category of AIFs that do not fall under Category I and III and which do not undertake leverage or borrowing with the exception of meeting the day-to-day operational requirements and as permitted in the SEBI (Alternative Investment Funds) Regulations, 2012

1. Private Equity Funds:

PE funds invest in unlisted companies looking for capital infusion and struggling to raise money through debt or equity route. These Funds assist the firms in smoothly raising capital. Usually, PE funds have a lock-in period that allows the firms to grow and generate a return on capital. 

2. Debt Funds: 

Debt funds invest in debt instruments issued by unlisted companies and other entities. These companies find it difficult to raise debt due to their low credit history or low credit score but have a good track record in terms of financial performance and governance. Debt funds focus on earning interest income through investing in bonds, debentures, and other fixed-income instruments issued by these companies.

3. Fund of Funds: 

Fund of funds is a category that invests in other AIF funds, either of the same or different categories. They don’t invest in any company or venture directly, instead, offer a solution to diversify their investment to hedge the risk and add flavor of different segments for optimum growth without having to invest in each fund separately and incur higher cost and effort. 

Category III AIF

These are the types of AIFs that utilize diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. These use Alternative Investment Funds such as hedge funds or funds that trade with a view to making short-term returns or other open-ended funds. 

Private Investment In Public Equity (PIPE) Fund:

PIPE Funds invest in publicly listed companies. Usually, these are private placements or preferential allotments that save the long process of going via secondary markets. PIPE Funds invest in stocks available at a discounted price in distressed, cash-crunched, or undervalued companies. They aim to earn returns from the uptick in stocks over time. 

Hedge Funds

Hedge funds source funds from private investors and institutions with an aim to generate aggressive returns using complex strategies and techniques like short selling, leverage, arbitrage, derivatives, futures and options, etc to generate maximum returns. Hedge funds usually charge higher fees for sophisticated investment management.

Benefits of AIFs (Alternative Investment Funds)

High Growth: 

AIFs invest in off-beat and diverse investment options like startups, new businesses, and sectors that contribute to the economy and social capital. Being in the early stages of inception and growth, these investments hold the potential to turn into windfall gains and investors can add them as high-risk reward allocations in their portfolios. 

Variety and Diversification: 

AIFs invest in a broad spectrum of assets locally or internationally without specific restrictions on asset type, geography, strategy, or currency usually applicable to traditional investments. This offers the potential to diversify multiple assets and implement complex strategies for growth.

Stability:

For investors who seek diversification yet stable returns and lower risk, Debt funds, Infrastructure funds, and funds of funds offer a safer avenue. Popular investors utilize hedge funds to hedge their risks.

Niche Avenues:

AIFs invest in niche sectors like early-stage companies, infrastructure, socially beneficial ventures, etc. Investors looking for direct investment in startups or niche sectors invest through AIFs, which are not available through off-the-shelf investments.

Who can Invest in AIF?

An AIF may raise funds from any sophisticated investor whether Indian, foreign or non-resident Indians, who undertakes the risk of investing in primarily unlisted or illiquid securities.

However, AIF (other than angel funds) accepts an investment of a minimum investment value of one crore rupees from every investor. In the case of investors who are employees or directors of the AIF, the minimum value of investment shall be twenty-five lakh rupees.

The maximum number of investors in every scheme of the AIF is restricted to 1,000 (49 in the case of angel funds). Furthermore, most AIFs will come with a minimum lock-in period of 3 years

Alternative Investment Fund Examples

There are more than 1000 registered AIFs in India. some examples of AIF in India include Capital Trust, 100Unicorns, 108 Capital Venture Fund, 3FVentures, A91 Emerging Fund 1 LLP, etc. Visit the link here to check the list of registered AIFs with SEBI.

AIF Taxation

Category I and II AIF

For Category I or II AIF, any income (other than business income) has been given a pass-through status. This means investors are taxed on their share of income of the AIF in the same manner as if they had made the investments directly.

Business income is taxable at a maximum marginal rate in the hands of AIF and is exempt in the hands of investors.

AIF to withhold tax on income (other than business income) paid/credited to resident investors at 10% and rates in force for non-resident investors.

Category III AIF

Unlike Category I and Category II, there is no specific tax regime for Category III AIFs. The income earned by these AIFs is taxable depending upon the legal structure of the fund (i.e. trust, LLP, or company).

Conclusion

To summarise, AIFs are a niche investment option for experienced and high-net worth investors willing to take high risk in part of their investments for diversification into assets not available through the listed route and for higher return potential. AIFs invest in early-stage businesses, cash-strapped startups, entrepreneurial ventures, and economically and socially important businesses or projects backed by the government. AIFs also invest via debt route into these entities. 

However, it should be noted that this investment avenue is not meant for retail or small investors with limited capital or experience or low-risk appetite. Investors considering AIFs must conduct thorough due diligence and risk assessment before investing via AIFs. Visit SEBI’s page for FAQs.