Alternative Investment Funds: India's Unique Investment Opportunity

Alternative Investment Funds (AIFs) are a type of investment fund in India. They are privately pooled investment vehicles that collect money from investors, both Indian and foreign, to invest in asset classes beyond traditional options like stocks, bonds, and cash. AIFs are an avenue for investors to generate superior returns by investing in private equity, real estate, hedge funds, and other alternative investments. With a minimum investment limit of ₹1 crore, AIFs are considered an option for high rollers and High Net Worth Individuals (HNIs). The Securities and Exchange Board of India (SEBI) regulates AIFs and categorises them into three categories based on their investment strategies and requirements.

Characteristics of Alternative Investment Funds in India

Alternative Investment Funds (AIF) in India: definition and structure

Alternative Investment Funds (AIFs) are a type of investment fund in India. AIFs are defined under Regulation 2(1)(b) of the SEBI (Alternative Investment Funds) Regulations, 2012. AIFs are privately pooled investment vehicles that collect funds from investors, including Indian and foreign investors, to invest in accordance with a defined investment policy. The funds are invested in asset classes other than bonds, stocks and cash, such as private equity, venture capital, hedge funds and managed funds.

AIFs are established or incorporated in India in the form of a Limited Liability Partnership (LLP), company, trust or body corporate. The majority of AIFs are registered as trusts due to the minimal regulatory framework governing trust structures, which allows management independence in formulating standards of governance.

AIFs are divided into three categories, based on their investment strategies and requirements:

Category I AIF

These funds invest in startups or early-stage ventures, social ventures, Small and Medium Enterprises (SMEs), infrastructure or other sectors deemed socially or economically desirable by the government or regulators. Examples include venture capital funds, SME funds, social venture funds, infrastructure funds and angel funds.

Category II AIF

This category includes funds that do not fall under Category I and III, and do not undertake borrowing or leverage other than for day-to-day operational requirements. Funds in this category include private equity funds, debt funds, real estate funds, funds for distressed assets and funds of funds.

Category III AIF

AIFs in this category employ complex or diverse trading strategies and may employ leverage through investment in listed or unlisted derivatives. Examples include hedge funds, funds that trade for short-term returns and other open-ended funds.

To register as an AIF, certain eligibility criteria must be met, including requirements for the applicant, manager and sponsor, as specified in the SEBI (Intermediaries) Regulations, 2008.in addition, there are minimum corpus and investment requirements.

Categories of AIFs and their investment strategies

Alternative Investment Funds (AIFs) are divided into three categories by the Securities and Exchange Board of India (SEBI) based on their investment strategies and requirements. Here is a detailed overview of each category:

Category I AIFs:

This category includes funds that primarily invest in startups, early-stage ventures, social ventures, Small and Medium Enterprises (SMEs), infrastructure, and other sectors deemed socially or economically desirable by the government or regulators. These funds aim to have a positive impact on the economy and receive incentives and concessions from the government or other regulators. Examples include Venture Capital Funds (VCFs), Angel Funds, SME Funds, Social Venture Funds, and Infrastructure Funds.

Category II AIFs:

Category II AIFs consist of funds that do not fall under Category I or Category III. They include Private Equity Funds, Debt Funds, Real Estate Funds, Funds for distressed assets, and Funds of Funds. These funds typically invest in a range of instruments without borrowing, except to cover day-to-day operations. They do not receive specific incentives or concessions from the government or other regulators.

Category III AIFs:

These funds employ complex or diverse trading strategies, including leveraging and hedging, to generate short-term returns. Category III AIFs may use leverage or debt for investment in listed or unlisted derivatives. Examples include Hedge Funds, Private Investment in Public Equity (PIPE) Funds, and other open-ended funds. These funds do not receive specific concessions or incentives from the government or other regulators.

Each category of AIF has specific investment conditions and strategies, with SEBI specifying additional requirements or criteria for certain funds. The choice of AIF category depends on the investor's financial goals, risk appetite, and investment strategy preferences.

Eligibility criteria for AIF registration

To start an Alternative Investment Fund (AIF) in India, applicants must obtain a certificate of fund registration from the Securities and Exchange Board of India (SEBI). Here is the eligibility criteria for AIF registration:

Allowed Business Activities

The Memorandum of Association (MoA) of a company, the Trust Deed of a Trust, or the Partnership deed of a Limited Liability Partnership (LLP) must allow AIF investment activities as permitted in the different categories of AIF.

Private Subscription

The applicant's founding documents (Memorandum of Association, Articles of Association, Trust Deed, or Partnership Deed) must prohibit public invitations to subscribe to its securities.

Legal Incorporation

Trusts must be registered under the Registration Act, 1908. LLPs must be incorporated and have their partnership deed filed with the Registrar under the LLP Act, 2008. A company must be registered under the Companies Act, 1956/2013.

Fit and Proper Criteria

The applicants, sponsors, and managers must be considered fit and proper people according to Schedule II of the SEBI (Intermediaries) Regulations, 2008.

Qualified Management

The AIF management team must have a minimum of 5-10 years of experience, with at least one key personnel having a minimum of five years of experience in relevant financial activities and holding relevant professional qualifications like CFA/CA. At least one member of the key investment team needs to have NISM Series-XIX-C: Alternative Investment Fund Managers Certification.

Infrastructure and Manpower

The manager or sponsor must have the necessary infrastructure and manpower to manage AIF activities effectively. The infrastructure includes a data storage server, file lock room, and a minimum office space of 500 square feet at the time of the application.

Clear Investment Plan

The applicant must clearly describe the investment objective, targeted investors, proposed corpus, investment style or strategy, and the proposed tenure of the fund or scheme at the time of registration.

Compliance requirements for AIFs

Compliance is a crucial aspect of alternative investment funds (AIFs) in India, ensuring adherence to regulatory requirements, protecting investor interests, and maintaining transparency in their operations. AIFs are required to comply with various elements, including registration, regulatory filings, investment restrictions, operational and governance compliance, investor disclosure and protection, custodian and trustee compliance, and anti-money laundering and know-your-customer (KYC) compliance.

The Securities and Exchange Board of India (SEBI) has laid down specific regulations and guidelines for AIF compliance. AIFs must submit periodic reports to SEBI regarding their activities, operations, and performance. These reports typically include information about the funds raised and invested under various schemes, details about the categories of investors, and compliance with applicable regulations. The specific format, frequency, and details required for these reports are outlined by SEBI through its regulations, circulars, or guidelines.

Category-specific Compliance Requirements:

The compliance requirements vary depending on the category of the AIF. While Category I AIFs focus on socially and economically desirable investments, Category II AIFs have more flexibility in investment strategies, and Category III AIFs employ complex trading strategies and have broader investment approaches. Here are the key compliance requirements for each category:

Category I AIFs:

• Registration with SEBI as an AIF.
• Minimum investment amount from investors.
• Compliance with SEBI regulations on investment objectives, conditions, and restrictions.
• Appointment of a custodian for the safekeeping of securities.
• Regular reporting to SEBI.
• Minimum corpus of INR 20 crore.

Category II AIFs:

• Registration with SEBI as an AIF.
• Compliance with SEBI regulations on investment objectives, conditions, and restrictions.
• Appointment of a custodian for the safekeeping of securities.
• Regular reporting to SEBI.
• Additional obligations specified by SEBI.
• Minimum corpus of INR 20 crore.

Category III AIFs:

• Registration and regulatory filings: Submission of the application form, offering memorandum, agreements, and other required documents to SEBI for registration. Periodic reports, disclosures, and notifications as specified by SEBI.
• Investment restrictions: Compliance with investment restrictions outlined by SEBI, including limits on leverage, concentration of investments, and investment in certain sectors or assets.
• Risk management and due diligence: Implementation of adequate risk assessment, risk mitigation, and due diligence processes. Effective monitoring and management of risks associated with complex trading strategies.
• Valuation and pricing: Establishment of appropriate policies and procedures for accurate and fair valuation of investments, aligning with SEBI guidelines and industry best practices.
• Reporting and disclosure: Submission of regular reports to SEBI, providing details of activities, investments, performance, and compliance. Periodic financial statements, performance reports, and other disclosures as per regulations.
• Code of conduct and investor protection: Adherence to the code of conduct prescribed by SEBI, including acting in the best interests of investors, maintaining confidentiality, avoiding conflicts of interest, and ensuring fair treatment of investors.

Additional Compliance Requirements:

• Performance Benchmarking: AIFs are required to conduct performance benchmarking to compare their performance with industry benchmarks and other investment avenues.
• Standardisation of Private Placement Memorandums (PPMs): AIFs must follow a detailed format for PPMs, which disclose all necessary information about the AIF to prospective investors.
• Annual Compliance Audit: AIFs must carry out an annual audit of their compliance with the terms of PPMs, either by internal or external auditors/legal professionals.
• Contribution Agreements: The terms of contribution or subscription agreements must align with the PPM and cannot go beyond what is stated in the PPM.
• Disclosure and Reporting: AIFs must make periodic disclosures to investors, including financial, risk management, operational, portfolio, and transactional information, as well as any material liabilities that arise during their tenure.
• Conflict of Interest: Sponsors and investment managers (IMs) must disclose any conflicts that arise or are likely to arise and formulate policies to identify, monitor, and mitigate future conflicts.
• Online Dispute Resolution: AIFs must provide an online dispute resolution process for efficient redressal of investor complaints.

Risks and challenges of investing in AIFs

Alternative Investment Funds (AIFs) in India offer investors access to a broader range of assets and investment strategies than traditional investments. However, investing in AIFs carries its own set of risks and challenges that investors should be aware of. Here are some of the key risks and challenges associated with investing in AIFs:

Risk Profile

AIFs typically carry higher risks than traditional investments such as stocks and bonds. They often invest in non-traditional and complex asset classes, such as private equity, venture capital, distressed assets, and hedge funds. These alternative assets can be more volatile and carry a higher risk of loss. Investors should carefully consider their risk tolerance and assess the risk profile of the specific AIF they are considering before investing.

Liquidity and Lock-in Periods

AIFs are typically illiquid investments with long lock-in periods, usually of at least three years. During this time, investors may not have easy access to their invested funds, which can be challenging if unexpected liquidity needs arise. It is important for investors to evaluate their investment horizon and liquidity needs before committing to these funds.

Complexity and Understanding

AIFs can be complex investment vehicles with unique structures, strategies, and regulatory requirements. Understanding how AIFs operate, their potential risks, and the applicable regulations can be challenging, especially for less experienced investors. It is crucial for investors to thoroughly research and understand the AIF and its investment strategy before making any investment decisions.

Regulatory Changes

The regulatory environment for AIFs can change over time, impacting their operations, tax treatment, and investor protections. Staying updated on regulatory changes is essential for investors to effectively manage their investments and make informed decisions. Regulatory changes may also affect the performance and value of the underlying assets in which AIFs invest.

High Minimum Investments

Many AIFs require significant minimum investments, such as INR 1 crore or more. These high minimum investment requirements may limit access to AIFs for smaller investors or those with lower risk tolerance. It is important for investors to carefully consider the financial commitment required and ensure it aligns with their investment goals and financial situation.

Performance Variability

The performance of AIFs can vary widely depending on the fund's investment strategy and the skill of the fund manager. It is essential for investors to thoroughly research the track record and historical performance of the AIF and its management team. Investors should also be aware that AIFs may use complex investment strategies that can be difficult to evaluate and compare with traditional investments.

Investor Suitability

AIFs are typically designed for sophisticated investors, such as high-net-worth individuals (HNIs) and institutional investors. They may not be suitable for retail investors or those with lower risk tolerance. Investors should carefully consider their financial situation, investment goals, and risk appetite before investing in AIFs. Seeking independent financial advice can help investors determine if AIFs are an appropriate addition to their investment portfolio.

In conclusion, while AIFs offer attractive benefits such as diversification and the potential for high returns, investors should carefully consider the associated risks and challenges. Understanding these risks and conducting thorough due diligence is crucial for making informed investment decisions and managing expectations.

Frequently asked questions