Alternative Investment Funds

Everything you need to know before making the choice to invest in Alternative Investment Funds.
What are Alternative Investment Funds (AIFs)
4 mins
26-April-2024

Alternative Investment Funds, or AIFs, are a growing asset class in India. Defined as privately pooled investment vehicles, AIFs collect funds from sophisticated investors, both domestic and international. These funds operate under a clearly defined investment strategy, aiming to generate returns for their investors.

This article explores the benefits they offer, how they function, and the different types of AIFs available. Whether you are a seasoned investor or just starting out, understanding AIFs can provide valuable insights into alternative investment opportunities.

What is an Alternative Investment Fund

Alternative Investment Funds (AIFs) are a category of investment vehicles that are not regulated by the Securities and Exchange Board of India (SEBI) under the conventional mutual funds or collective investment schemes. They invest in assets or strategies that are different from the traditional ones such as stocks, bonds, or cash.

Investors in AIFs typically include high-net-worth individuals, institutions, and family offices. While they carry higher risk due to complex strategies, AIFs also provide opportunities for capital appreciation and exposure to non-traditional asset classes.

Benefits of investing in AIFs

  1. High return potential
    AIFs can offer high return potential for investors who are willing to take more risks and have a longer investment horizon. AIFs can invest in assets or strategies that have high growth potential but also high risk, such as start-ups, private equity, hedge funds, etc. They can generate returns from multiple sources, such as capital appreciation, dividends, interest, fees, etc.
  2. Low volatility
    AIFs can offer low volatility for investors who are looking for stability and consistency in their returns. They can invest in assets or strategies that have low correlation with the market movements, such as infrastructure, debt, fund of funds, etc. AIFs can also hedge their risks by using derivatives, leverage, short-selling, or other techniques.
  3. Diversification
    AIFs can invest in a variety of assets or strategies that have different characteristics, performance, and risk profiles, such as venture capital, social venture, PIPE, etc. They can also invest across different geographies, currencies, and markets, which can reduce the impact of local or regional factors.
     

Despite the significant benefits of AIFs listed above, investors should note that they involve high risks, high costs, and low liquidity. Hence, those interested in these funds should do their own research and seek advice from a qualified professional first.

Types of alternative investment funds (AIFs)

SEBI has classified AIFs into three categories based on their investment objectives, strategies, and regulations. They are designated as follows:

  1. Venture capital funds (VCF)
    VCFs are funds that invest in start-ups or early-stage companies that have high growth potential but also high risk. They are typically registered as Category I AIFs, which enjoy certain tax benefits and incentives from the government.
  2. Angel funds
    Angel funds are a sub-category of VCFs that invest in very early-stage start-ups or entrepreneurs who have innovative ideas but lack funds or experience. These funds are also registered as Category I AIFs and have a lower minimum investment requirement than VCFs.
  3. Infrastructure funds
    Infrastructure funds are funds that invest in projects or assets related to infrastructure development such as roads, bridges, airports, power plants, etc. They aim to generate stable and long-term income from these assets, which are often backed by government contracts or policies. Infrastructure funds are also registered as Category I AIFs and can avail tax benefits and exemptions.
  4. Social venture funds
    Social venture funds are funds that invest in social enterprises or businesses that have a positive social or environmental impact along with financial returns. These funds are also registered as Category I AIFs and can claim tax deductions for their investments.
  5. Private equity funds
    Private equity funds are funds that invest in private or unlisted companies that have established business models and strong growth prospects. Such funds may exit their investments by selling them to other investors, listing them on stock exchanges, or merging them with other companies. Private equity funds are typically registered as Category II AIFs, which are subject to less regulation than Category I AIFs but do not enjoy any tax benefits or incentives.Read more about What is a private equity fund?
  6. Debt funds
    Debt funds are funds that invest in debt instruments or loans issued by companies, governments, or other entities. Debt funds aim to earn interest income and capital appreciation from these instruments, which may have different maturity, credit quality, and risk profiles. Debt funds may also lend money to companies or projects that need funds but cannot access the traditional sources of finance. Debt funds are also registered as Category II AIFs and must follow certain leverage and diversification norms.
  7. Fund of funds
    Fund of funds are funds that invest in other funds, either within the same category or across different categories of AIFs. Fund of funds offer investors a way to diversify their portfolio, access different strategies and managers, and reduce the cost and hassle of investing in multiple funds. Fund of funds are registered as either Category I, II, or III AIFs depending on the nature and composition of their underlying funds.Read more about, What is a fund of funds?
  8. Private investment in public equity fund (PIPE)
    PIPE fund is a fund that invests in publicly listed companies by buying their shares at a discounted price through a private placement or a preferential allotment. PIPE fund aims to benefit from the potential upside of these companies, which may be undervalued, distressed, or in need of capital. PIPE fund is registered as a Category II AIF and must comply with certain disclosure and lock-in requirements.
  9. Hedge funds
    Hedge funds are funds that employ complex and sophisticated strategies to generate high returns irrespective of the market conditions. Hedge funds may use derivatives, leverage, short-selling, arbitrage, or other techniques to exploit market inefficiencies, anomalies, or trends. Hedge funds are registered as Category III AIFs, which are subject to the least regulation but also do not get any tax benefits or incentives.

Why invest in AIFs?

AIFs can offer investors several advantages over the conventional investment options, such as:

  • Accessing niche markets, sectors, or opportunities that are otherwise difficult or costly to invest in.
  • Providing diversification, risk management, and higher returns potential for investors who are willing to take more risks and have a longer investment horizon.
  • Having more flexibility, innovation, and customisation, which can suit different investor preferences and needs.
  • Having more transparency, accountability, and governance in their operations, as they are regulated by SEBI and have to follow certain reporting and disclosure norms.

Who can invest in an AIF?

AIFs are not meant for the general public or retail investors, as they involve high risks, high costs, and low liquidity. AIFs are suitable for high-net-worth investors who have the knowledge, experience, and financial capacity to invest in them.

Alternative Investment Fund (AIF) Taxation

Alternative Investment Funds (AIFs) are unique investment vehicles that go beyond traditional options like fixed deposits and stocks. They cater to sophisticated investors, including high-net-worth individuals (HNIs). Here is how AIF taxation works:

1. Category I and Category II AIFs:

2. Category III AIFs:

  • These may use advanced trading strategies.
  • Taxed at the maximum marginal rate of 42.7%.

Conclusion

Alternative Investment Funds (AIFs) present a diverse array of investment opportunities, ranging from venture capital to hedge funds, offering potential for high returns, low volatility, and portfolio diversification. While catering to sophisticated investors, AIFs entail high risks, costs, and limited liquidity. Thus, thorough research and consultation with financial experts are imperative for individuals considering AIF investments. Despite their complexities, AIFs remain an attractive avenue for those seeking exposure to non-traditional asset classes and niche investment strategies, contributing to a dynamic and multifaceted investment landscape in the ever-evolving global financial markets.

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Frequently Asked Questions

How to invest in alternative investment funds in India?

To invest in AIFs, you need to be an accredited investor with a minimum net worth of Rs. 2 crore or an annual income of Rs. 50 lakh. You also need to meet the minimum investment amount of Rs. 1 crore for each AIF scheme.

How to start an alternative investment fund?

To start an AIF, you need to apply to SEBI and comply with their regulations and guidelines for AIFs.

How is AIF different from mutual funds?

AIF offers better flexibility and diversity in non-conventional securities while mutual funds offer live tracking and tuning of your investments. Both have a high risk-reward ratio, so investors can decide based on their investment goals, liquidity, tenure, and security preferences.

What is the difference between PMS and AIF?

PMS and AIF are both pooled investment vehicles. However, PMS allows investors to have separate Demat accounts and own the underlying assets, while AIF pools the funds and issues units to investors.

What is an alternative investment fund (AIF)?

An AIF is a private pool of funds from sophisticated investors that invests in assets beyond traditional stocks and bonds, following a defined strategy.

Is an AIF better than a mutual fund?

AIFs are not inherently better than mutual funds. They cater to different risk profiles and investment goals. AIFs offer more flexibility but typically require higher investment minimums.

How many types of AIFs are there?

There are various AIF categories like venture capital, private equity, hedge funds, real estate, and infrastructure funds.

What are the benefits of AIFs?

AIFs offer potential for higher returns, greater investment flexibility, and access to a wider range of assets compared to MFs.

What is the criteria for investing in AIFs?

AIFs typically have minimum investment requirements and target sophisticated investors with a high-risk tolerance.

Is AIF tax free?

No, AIFs are not entirely tax-free. The taxation structure depends on the AIF type and investment strategy.

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