Alternative Investment Funds: A Guide To Investing In India

Alternative Investment Funds (AIFs) are a special category of investment that differs from conventional investment instruments. They are privately pooled funds that collect money from sophisticated investors, both domestic and international, to invest in non-traditional asset classes. These funds are established in India and are regulated by the Securities and Exchange Board of India (SEBI).

AIFs can be a great way to diversify your portfolio and protect your investments from volatility. They are also an excellent source of passive income and can provide access to niche markets and sectors. However, they come with high risks, costs, and low liquidity.

To invest in AIFs in India, you need to meet certain eligibility criteria, including a minimum investment corpus of Rs.1 crore. In this article, we will discuss the different types of AIFs available in India, the benefits and risks of investing in them, and the steps to start investing.

Understanding the basics of Alternative Investment Funds (AIFs)

Alternative Investment Funds (AIFs) are a special category of investment that differs from conventional investment instruments. AIFs are privately pooled investment vehicles that collect funds from sophisticated investors, both domestic and international, with substantial investments required. These funds are established in India and are regulated by the Securities and Exchange Board of India (SEBI) under the 2012 AIF Regulations, which set out the eligibility criteria for investors.

AIFs can be formed as a company, Limited Liability Partnership (LLP), trust, or other forms, and they offer a wide range of investment strategies beyond traditional asset classes. They are not meant for the general public or retail investors due to their high risks, high costs, and low liquidity. Instead, they cater to high-net-worth individuals, institutional investors, and qualified investors with a higher risk appetite and longer investment horizons.

AIFs are typically classified into three categories based on their investment strategy and objectives:

Category I AIFs: These funds focus on start-ups, early-stage ventures, social ventures, SMEs, infrastructure, and other sectors with social or economic benefits. They receive government incentives and enjoy tax benefits. Examples include infrastructure funds, venture capital funds, and start-up funds.

Category II AIFs: This category includes funds such as private equity funds and debt funds that do not fall under Category I or III. They invest in a range of instruments without borrowing, except for day-to-day operations. Examples include private equity funds, real estate funds, and distressed asset funds.

Category III AIFs: These funds employ complex trading strategies, leveraging, and hedging to generate short-term returns. They have minimal regulation and do not receive tax benefits. Examples include hedge funds and private investment in public equity (PIPE) funds.

AIFs provide investors with access to a diverse array of investment opportunities, including venture capital, private equity, hedge funds, real estate, and infrastructure funds. They offer the potential for high returns, low volatility, and portfolio diversification. However, due to their focus on non-traditional assets and strategies, AIFs carry significant risks, including market volatility, liquidity constraints, operational risks, and regulatory changes.

To start investing in AIFs, investors must meet certain criteria, including a minimum corpus of funds, and provide proof of identity, income, and PAN card.

Exploring the types of AIFs

Alternative Investment Funds (AIFs) are a special category of investment that differs from conventional investment instruments. AIFs are privately pooled funds that are established in India to collect funds from investors. They are regulated by the Securities and Exchange Board of India (SEBI) and adhere to the SEBI (Alternative Investment Funds) Regulations of 2012.

SEBI has categorised AIFs into three categories based on their investment strategy, objectives, and regulations. These categories offer investors diverse avenues to explore, depending on their financial goals and risk appetite. Here is a detailed look at each category:

Category I AIFs:

This category includes funds that focus on India's economic growth and invest in sectors that are socially or economically beneficial. These funds receive incentives from the government. Category I AIFs primarily invest in:

• Start-ups and early-stage ventures with high growth potential
• Social ventures
• Small and medium enterprises (SMEs)
• Infrastructure projects, such as roads, bridges, airports, and power plants

Within Category I, there are Venture Capital Funds (VCFs) and Angel Funds. VCFs support new-age entrepreneurial firms with large financing requirements during their initial stages. Angel Funds, a sub-category of VCFs, focus on very early-stage start-ups, and the minimum investment by each angel investor is Rs. 25 lakh.

Category II AIFs:

Category II AIFs include funds that do not fall under Category I or III. These funds typically invest in a range of instruments without borrowing, except for day-to-day operations. This category includes:

• Private equity funds that invest in unlisted private companies, helping them raise capital
• Debt funds that invest in debt instruments or loans issued by companies or governments
• Real estate funds that allow investors to own fractional interests in commercial properties
• Funds for distressed assets

Category III AIFs:

These funds employ complex trading strategies, leveraging, and hedging to generate short-term returns. They are more flexible and dynamic in their investment approaches. Category III AIFs include:

• Hedge funds: These funds collect money from investors and invest in both domestic and international debt and equity markets. They adopt an aggressive investment strategy and are known for high fees.
• Private Investment in Public Equity (PIPE) funds: PIPE funds invest in publicly listed companies by buying shares at discounted prices through private placements.

Each category of AIF offers unique opportunities and carries its own set of risks and potential returns. Investors should carefully consider their financial goals, risk tolerance, and investment horizon before deciding which category of AIF aligns best with their investment strategy.

Analysing the benefits and risks of AIF investments

Alternative Investment Funds (AIFs) are a growing asset class in India, providing investors with access to a broader range of assets and investment strategies beyond traditional investments. AIFs are particularly attractive to those seeking diversification and higher returns. However, it is essential to carefully consider the benefits and risks before investing in AIFs.

Benefits of AIFs:

• High Return Potential: AIFs offer the potential for higher returns compared to conventional investment options due to their focus on high-growth areas and diverse investment strategies.
• Stability and Low Volatility: AIFs are not directly linked to the stock market, providing stability and lower volatility. This makes them suitable for risk-averse investors.
• Diversification: AIFs invest in a wide range of assets, including real estate, private equity, commodities, and distressed assets, reducing exposure to market volatility and offering a hedge against inflation.
• Access to Specialised Opportunities: AIFs provide access to investment opportunities typically unavailable to retail investors, such as startups and disruptive technologies.

Risks of AIFs:

• High Risk: AIFs carry higher risks due to their focus on non-traditional assets and complex strategies. These include market volatility, liquidity constraints, operational risks, and regulatory changes.
• High Costs: AIFs often have higher fees and expenses, including management and performance fees, which can impact overall returns.
• Low Liquidity: AIFs typically have lock-in periods, ranging from three to five years, restricting investors' access to their capital.
• Complex and Less Transparent: AIFs can be complex investment vehicles, making it challenging for less experienced investors to understand their structure and potential risks fully.
• Regulatory Changes: The regulatory environment for AIFs can change, impacting their operations and tax treatment, requiring investors to stay updated.
• High Minimum Investments: Some AIFs require significant minimum investments, limiting access to smaller investors.

In conclusion, AIFs offer attractive benefits, including higher return potential, diversification, and access to specialised opportunities. However, investors should carefully consider the risks, conduct thorough research, and seek advice from financial experts before investing in AIFs.

Knowing the eligibility criteria and investment process

To be eligible to invest in an Alternative Investment Fund (AIF) in India, you must meet the following criteria:

• Resident Indians, NRIs, and foreign nationals can invest in AIFs.
• The minimum investment corpus is Rs. 1 crore for investors, while the minimum investment amount for directors, employees, and fund managers is Rs. 25 lakh.
• AIFs typically have a minimum lock-in period of three years.
• Each AIF scheme can have a maximum of 1,000 investors, except for angel funds, which can have up to 49 investors.
• Investors must provide proof of income, PAN, and ID.

To start investing in AIFs, individuals must meet the criteria listed above and follow the necessary procedures, including submitting the required documentation and making the minimum investment amount. It is important to note that AIFs are not suitable for the general public or retail investors due to their high risks, high costs, and low liquidity. They are designed for high-net-worth individuals and accredited investors with the knowledge, experience, and financial capacity to invest in these alternative investment options.

Comparing AIFs with other investment options

Alternative Investment Funds (AIFs) are a special category of investment that differs from conventional investment instruments. They are privately pooled funds that collect money from investors to invest in non-traditional asset classes like real estate, commodities, and hedge funds. AIFs are not regulated by the Securities and Exchange Board of India (SEBI) under the conventional mutual funds or collective investment schemes.

AIFs offer a higher degree of flexibility than mutual funds as they invest in unlisted shares and also use shorting and leverage. They provide investors with the opportunity to diversify their portfolios and access niche markets, sectors, or opportunities that are otherwise difficult or costly to invest in.

AIFs vs Mutual Funds

AIFs offer better flexibility and diversity in non-conventional securities, while mutual funds offer live tracking and tuning of investments. AIFs typically require higher investment minimums and have lock-in periods, whereas mutual funds provide more liquidity. Both AIFs and mutual funds have a high risk-reward ratio, so investors can decide based on their investment goals, liquidity needs, tenure, and security preferences.

AIFs vs PMS (Portfolio Management Services)

PMS offers customised investment services that cater to an investor's risk appetite, return expectations, and time commitments. In PMS, each investor has a separate Demat account, and there is no pooling of funds. Investors can withdraw their capital at any time. In contrast, AIFs pool capital for their investment objective and generally have a lock-in period of 3 to 5 years. AIFs offer more flexibility and diversity in non-conventional securities, while PMS offers live tracking and tuning of investments. Again, both AIFs and PMS have a high risk-reward ratio, so investors can choose based on their specific needs.

AIFs vs Traditional Investments

AIFs offer a higher rate of return compared to traditional investments like cash, bonds, and stocks. They are riskier than mutual funds and cater to sophisticated investors like high-net-worth individuals (HNIs) with large amounts of capital to invest. AIFs provide excellent portfolio diversification and protection against volatility by investing in a wide array of assets beyond traditional asset classes.

In conclusion, AIFs are a viable option for investors seeking higher returns, portfolio diversification, and access to specialised investment strategies. However, they entail high risks, costs, and limited liquidity. Therefore, thorough research and consultation with financial experts are crucial before investing in AIFs.

Frequently asked questions