Alternative Investment Funds (AIFs): Concepts, Categories and Benefits

Table of Contents

Introduction

Investments in AIFs (Alternative Investment Funds) have been on a rapidly growing path over the past decade. The trajectory has been quite strong in the past five years as well – much faster than the growth in mutual funds and other products.
In the last five years (September 2018-September 2023), AIF assets have grown at a compounded annual growth rate (CAGR) of 34.5 per cent.
This rate is more than the 15 per cent levels at which mutual fund assets have increased over the same period.
Category II AIFs garnered the maximum investment interest and account for nearly 82 per cent of the total commitments raised, a six-fold rise in just the past half-a-decade.

What are AIFs?

AIFs are privately pooled investments from Indian investors, and even NRIs and foreign nationals. These can invest in a variety of avenues and asset classes without restrictive mandates.
Investors who wish to opt for AIFs have to commit at least ₹1 crore, which is the minimum ticket size prescribed for such funds.
There are some AIFs that demand a much higher ticket size for entry and are thus more suited to the requirements of high net-worth individuals (HNIs), and Ultra HNIs.
Though there is a specific investment mandate, AIFs are not rigidly defined as is done with mutual funds.
- - Products are not standardised in the case of AIFs. The fund names can give a broad-brush indication of where the AIF invests.
  - There are both individual and institutional investors in these products.
AIFs can be both open and close-ended. Some schemes demand a lock-in for even five or more years to gain better returns and to avoid distress-selling due to the relatively illiquid nature of their assets’ markets in certain cases, such as real estate funds.
- - Open-ended funds offer flexibility of investing through lump-sum investments and Systematic Investment Plans (SIPs). Investors can make multiple purchases in the fund at their discretion.
  - Closed-ended funds permit investment solely during the New Fund Offer (NFO) period and do not accept investments through SIPs. NFO period meaning is the specific timeframe during which investors can subscribe to units of a newly launched mutual fund scheme at the initial offer.
High net-worth individuals (HNIs), NRIs and other wealthy individuals apart from institutions are investing heavily in AIFs. Many asset management companies (AMCs) that run mutual funds also have AIF products.

Categories of AIFs

Alternative investment funds come in three different categories.

Category 1 AIFs

Venture capital, social ventures, SMEs (small and medium enterprises), start-ups and infrastructure funds fall under this category.
Venture capital funds invest in new businesses with high growth potential. They take equity stakes in start-ups in their early or initial stages.
- - HNIs who wish to make substantial profits in such ventures during exit via IPOs or buyouts from other institutional investors, and with a high risk appetite, opt for such venture capital funds.
Then there are infrastructure funds that invest in airports, highways and power projects. They are expected to offer periodic and healthy dividends as the projects start turning out cash flows regularly.
Investors keen on socially conscious businesses or who want specific environmental or social outcomes can opt for funds that invest in social ventures.

Category 2 AIFs

The most popular category houses private equity funds, bond funds, real estate funds and fund of funds. These schemes do not have too many restrictive or narrow investment mandates, giving fund managers considerable flexibility. This category receives the maximum inflows, given its wider ambit.
Private equity funds invest in late or even mid-stage businesses in the unlisted space. They also invest in companies that seek to tap the IPO (initial public offering) market and wish to capitalise on the pre-IPO attraction early on.
Then there are real estate and credit opportunities funds that invest in a variety of debt and realty avenues to generate steady coupons and higher XIRR than normal bonds.
- - XIRR or Extended Internal Rate of Return is that single rate of return that provides the current value of the total investment when it is applied to each instalment in a systematic investment plan (SIP). XIRR is the actual returns on your investments.
Structured credit funds (fund developers not catered to by banks) for higher coupons and substantial cover (1.5-2X the underlying asset value) are also offered under the category.
Fund of funds invest in other AIFs across segments to make the most of different investment styles, domestically and overseas.

Category 3 AIFs

This category includes hedge funds, commodity funds and private investment in public equity (PIPE).
Hedge funds use complicated trading strategies, short-selling techniques and dabble with derivatives as well.
Commodity funds invest in gold, silver, oil and their derivatives.
Private investment in public equity funds are the AIFs that fall in this category. Such funds can invest in stocks, bonds, commodities or other asset classes and deploy any strategy without any specific restrictions.
Some of the strategies in the category III AIF in India are long-short and long-only, apart from debt and SME focused approaches.
Long-only funds invest in stocks with a medium to long-term view like the way mutual funds do.
The long-short strategy involves taking both long and short positions in the market with stocks or indices so that there is a certain market-neutral position taken to generate reasonable returns at low risk.

Key characteristics

AIFs come with a few inherent characteristics that make them ideal for HNIs.
First, there are no restrictive mandates on investing only in specific avenues, or in assigning of weightages to specific investments.
- - For example, mutual funds have restriction on maximum weightage that can be given to a stock or sector, choice of market capitalisation and so on. But AIFs have no such compulsions.
  - Therefore, an AIF fund manager can take concentrated or diffused exposures to various investment avenues in order to deliver the best returns.
Second, complex strategies, including the use of derivates for risk management, are all allowed via AIFs.
- - The Securities and Exchange Board of India (SEBI) permits mutual funds to use derivatives for hedging (a strategy that seeks to limit risk exposures in financial assets) purposes and for arbitrage strategies. In no case, a scheme shall write a call option without holding the underlying equity shares.
Third, there is the advantage of AIFs being able to offer bespoke (tailor-made investment) solutions that are geared to achieving all the wealth goals of HNIs.
Four, many AIF managers choose to have a closed structure for the schemes they manage. They restrict the flow of money into, and the outflow of money from the funds based on their own assessment of the markets, the dynamics of asset classes involved, thus improving their ability to deliver healthy risk-adjusted returns.
- - Given that some AIF assets may not be that liquid or may have long-term pay-offs, this flexibility in structure helps fund managers by not having to make distress sales during turbulent markets.
Five, since AIFs are locked for the long term, there are no short-term redemption pressures and requirements in terms of maintaining liquidity. There are limited short-term performance pressures as well.
Finally, these AIFs are run by professional managers with deep expertise, thus giving scope for building a well-diversified portfolio.

Thus, AIFs are reasonably convenient and transparent like mutual funds. However, they operate at different levels and cater to a very different set of investors and do not compete with retail-focused products such as mutual funds.

Taxation of AIFs

As with regular mutual funds, equity-driven AIFs are also reasonably tax-efficient in the way they are structured.
Since AIFs are pooled investment vehicles, there are different taxation rules depending on the category chosen.
For AIFs in categories I and II, a pass-through status is given for the investments. So, the gains or income (other than business income) distributed by the AIF to investors is taxable in the hands of investors and not the fund house or AMC.
In the case of category III AIFs, the pass-through structure is not allowed. Therefore, the income earned by the AIF will be taxed on the AIF itself.
Note: On the debt side, there is very little difference in taxation across fixed-income products. In the Finance Bill passed in 2023, debt funds and market-linked debentures were made fully taxable.
That is, the indexation benefit was taken away and all distinction of long and short-terms was done away with. All realized gains from such investments would be added to the overall income of an investor and taxed at the slab applicable.
For similar taxation, it would be wiser to look for higher returns on the debt side from AIFs for HNIs with a higher risk appetite.

Indexation Benefit

• It helps adjust the asset’s value as per the inflation level in the economy.

• It reduces investors’ tax burden by adjusting the acquisition cost as per inflation, thereby reducing taxation on gains.

• It promotes long-term investing, as investors can get indexation benefits.

Non-standardised fee structure

In terms of fee structure, AIF charges are quite different across players. AIF fee can be structured based on performance or asset size or any other factor.
Since charges and fees are not standardised by the market regulator SEBI, AIFs are free to charge what they deem fit. Most AIFs also charge a performance-related fee.

References:

Practice Questions for UPSC Mains

Topic: Economic Development ans Related Issues

Q . In light of India’s evolving financial landscape, critically analyze the role and regulatory framework of Alternative Investment Funds (AIFs) in fostering economic growth and addressing capital market needs. (Answer in 250 words)