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August 2022

Alternative Investment Funds (AIF): What, Why & Where


Over the past decade, Alternative Investment Funds (AIF) have grown rapidly in popularity, on the heels of the 2008 financial crisis, as investors sought to diversify their portfolios reducing over-dependency on a single market or asset. Investors prefer AIFs as their listed equity portfolios are much more focused and tend to be more benchmark agnostic- not like mutual funds showing their immense diversity. These funds are particularly attractive to investors carrying more comfort with direct investments in publicly traded shares through a compliant structure. In addition to the benefit of diversity, AIFs also protect the investment against volatility of direct trading as an expert fund manager will be at the helm of affairs, also ensuring better risk adjusted returns. However, if you are new to investing, a better assessment of suitability of an AIF in your portfolio should be done by your Financial Advisor. The minimum commitment and lock in period towards an AIF can also be a gating criterion.

Defining an AIF

  • AIF investments are not traditional. They differ from regular funds like stocks, debts and securities. It is a privately funded pooled investment which collects money from private investors. AIFs have a variety of fund options such as private equity, venture capital, hedge fund, and angel fund etc. AIF’s don’t come under the purview of the SEBI mutual fund regulations. In India, an AIF can be set up as a company, Limited Liability Partnership (LLP), corporate body, or trust.
  • The minimum investment fees for AIF’s is generally higher than conventional investments. The minimum investment amount is set at 1 Crore.
  • They are categorized into three categories; Category I AIF, Category II AIF and Category III AIF. Each of the categories has different investment structures as per the broad definition of the category. As of 9thFebruary 2022, out of the total AIF 831 funds, 475 are in the Category II followed by 196 in Category I and 160 in Category III. Notably, Category II AIFs contribute 80% to the industry. (1)
  • The balance sheet of Alternate Investment Fund consists of two major groups of assets and liabilities. The first group consists of cash and investments in other companies. The second group consists of debt and liabilities for loans and leases. It currently has no public debt, but it is able to obtain loans from other private firms and the government. Its goal is to invest in businesses and help them expand, creating jobs and generating tax revenue for the government.
  • Alternative investment funds (AIFs), as a different class of assets, have become more popular in recent times amidst the rise in the number of wealthy individuals and their growing appetite for sophisticated financial instruments for investing. The total assets of AIFs surpassed ₹ 5-lakh crore mark for the first time recently. According to latest data of the Securities and Exchange Board of India, assets of AIFs have grown over 32 per cent year-on-year to ₹5.35-lakh crore at the end of September 2021. 

Category deep dive

  • Category I – Investment in startups or early-stage ventures or SMEs (Economically and socially desirable), typically Venture capital funds, Angel funds, SME Funds, Social Venture Capital funds, Infrastructure funds.
    • Venture Capital funds- Venture capital funds are private, for-profit investment entities that invest in small, early-stage companies. While VCs make it possible for promising startups to access much-needed capital, they take a substantial risk that their investments will not be successful.
    • Angel Funds- Angel funds essentially raise money only from angel investors. These are individuals with not less than 2crores net in tangible assets and have vast experience.
    • SME Funds- SME Funds, also known as Small and Medium Enterprise Funds, are defined as “managed investment vehicles for small and medium enterprises (SMEs) that are not eligible to access most retail and commercial banking products and services.”
    • Social Venture Capital Funds- Social venture capital funds provide funding for businesses that positively impact lives. These businesses also offer reasonable returns to their investors. These are also known as impact funds. The fund manager analyses the social impact on society.
    • Infrastructure Funds- Infrastructure funds are a portion of the federal government’s budget used to help states and local governments build and maintain their infrastructure. The federal government provides states and local governments with funds to use for infrastructure projects such as roads, bridges, airports, schools, and other public buildings. The federal government also provides funds to help states and local governments pay for their infrastructure costs. The federal government uses the interest earned on the funds to pay for other programs.

  • Category II – SEBI Defines this as AIF’s which don’t fit into the I and III Category and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements. This includes PE Funds, Real estate funds, Funds for distressed assets, Debt funds, Funds of Funds.
    • PE Funds- Private equity funds, also known as PE funds or buyout firms, are the largest and most well-known source of capital in the world. They are companies that buy controlling interests in other companies and use their resources to build and grow their portfolio companies. They are most often managed by a firm or a limited liability partnership. The average tenure of such funds often is 5-10 years.
    • Debt Funds- Registered under Category II, Debt fund is an Alternative Investment Fund (AIF) which invests primarily in debt or debt securities of listed or unlisted investment companies.
    • Since Alternative Investment Fund is a privately pooled investment, the amount contributed by the investors shall not be utilized for the purpose of giving loans.
    • Funds of Funds- Funds of funds are a relatively new investment category that have been gaining in popularity among investors. Funds of funds invest in other funds, which can range from small family offices to giant asset management firms. They provide a way for investors to diversify their portfolios without taking on the risk of investing directly in funds. They also offer the benefit of reducing bias, since the people managing the funds are not biased toward a particular industry or region, which can lead to better performance for investors.

  • Category III – These AIFs use diverse trading strategies by investing in listed and unlisted “derivatives”. They don’t need to publish their information regularly. They can be close-ended or open-ended. These are Hedge funds and PIPE.
    • Hedge Funds- Hedge funds are private investment funds which use a variety of complex financial strategies to generate returns. They specialize in trading a single asset class, such as stocks or bonds. Most hedge funds specialize in just one industry, such as technology, energy, or manufacturing.
    • PIPE Funds- It stands for Private Investment in Public Enterprise Funds. Here the fund managers buy stakes in public companies at a cheaper price. PIPE transactions provide easy funding to the projects of medium and small-sized businesses.

What drives interest in AIF’s

As stated earlier, a common attraction for investment through the vehicle of Alternative Investment Fund is diversification. An Alternative Investment Fund is made up of a portfolio of securities that are a mix of common and preferred stocks.

It offers following -

  1. Diversification – Helps with portfolio diversification. The AIF’s don’t have a dependency on the stock market. The substantial size of funds enables fund managers to tap into the broader investment universe.
  2. Low Volatility – AIFS are less volatile than stocks given their divarication to market ups and downs.
  3. Higher Returns – Most AIFS give much better returns than regular investments aimed at achieving long-term capital appreciation. Through the tool of AIF, investors can be exposed to alternate securities providing higher return as compared to traditional investment instruments.

The assets in Alternative Investment Funds (AIF) touched Rs 6.41 trillion at the end of the January-March 2022 quarter, a growth of 5.2 per cent over the previous quarter, reveals Securities and Exchange Board of India (SEBI). The assets have grown over 42 % in the last year. The industry as a whole has grown more than 7 times in the last.

  • Category 1 - 19% Growth. 65000 crore of assets are tagged to this category
  • Category 2 - 40% Growth since 2016. 80% of the total assets marked in AIFs are in this category, i.e 4.95 lakh crore
  • Category 3 - 36% growth. 63699 crore of assets are under this category

The main reason an Alternative Investment Fund has submitted good returns is to the credit of it being a diversified portfolio outperforming a typical diversified portfolio on a risk-adjusted basis over the long term. According to SEBI, the Cumulative net figures as at the end of March 31, 2022 shows that the total investments made was, "2,84,058.64 Cr”. Out of which, it was extremely diversified amongst the categories showing; Category 1: 23,798.02 Cr, Category 2: 1,99,451.62 Cr and Category 3: 60,809.00 Cr.

The rise of UHNIs and keenness of investors in diversification had led to introduction of newer investment instruments including but not limited to AIFs. It is crucial to understand the structure of the product, its restrictions, options and considerations, and their applicability on an investor’s portfolio before choosing to include the AIF in the portfolio.

Author:

Vir Manepally
Intern, Wealth
Client Associates, Bangalore

Under the guidance of:

Pradeep Sangunni
Director, Wealth
Client Associates, Bangalore
Reach at: pradeep@clientassociates.com
Shashank Gautam
VP, Investment Research & Advisory
Client Associates, Gurgaon
Reach at: shashankgautam@clientassociates.com