Alternative Investment Funds are a class of pooled-in investment vehicles, which raise money from institutions and high-net-worth individuals, including Indian, foreign or non-resident Indians with a minimum ticket size of Rs.1 crore. As the name suggests, they provide an alternative to traditional forms of investments like direct equity, mutual funds, and bonds.
The privately pooled funds in AIFs are invested as per a defined investment policy in alternative asset classes such as venture capital, private equity, hedge funds, infrastructure funds, etc. This means they provide long-term and high-risk capital to a diversified set of ventures at all stages of their evolution. The investee universe includes pre-revenue stage companies, early and late-stage ventures, and growth companies that wish to scale their future operations.
Today AIFs are a faster-growing investment vehicle in India when compared to mutual funds. Thanks to a number of factors such as low susceptibility to volatility in the stock market, the ability to generate higher returns than stocks and mutual funds, diversification of risk from traditional asset classes, etc. However, their emergence in India was driven by some fundamental factors.
Emergence of AIFs in India
The govt had been focusing on Venture Capital Funds (VCFs) since their inception in the late-1980s to promote the growth of particular sectors and early-stage companies. However, concessions given to VCFs were unable to produce the desired impact in promoting the emerging sectors and start-up companies due to uncertainties created by various regulations.
Therefore, in 2012, the Securities and Exchange Board of India introduced the SEBI (Alternative Investment Funds) Regulations, to recognise AIFs as a distinct asset class like Private Equities (PEs) and VCFs. The aim was to set up a new category of investments that will finance the socially and economically desirable sectors and ensure a long-term capital flow in India by attracting a different asset class of investors and putting lesser constraints on investments.
As per the 2012 regulations, an AIF fund can be established or incorporated as a trust, a company, a limited liability partnership, or a body corporate. However, most of the alternative investment funds are registered with SEBI as Trust in India.
The person who sets up the AIF fund is called the “Sponsor”, which refers to a promoter in case of a company and designated partner in case of a limited liability partnership. In order to ensure “skin in the game”, AIF Regulations require the Sponsor to have a certain continuing interest in the AIF in an absolute amount or certain percentage of the corpus.
To reiterate, alternative investment funds is a strictly privately pooled investment vehicle. Hence, it cannot raise funds by making an invitation or solicitation to the public.
Structure of AIFs
As per classification made by SEBI, AIFs can be divided into three unique categories, which are defined as follows –
This category of AIFs invests in start-ups, early-stage ventures, social ventures, small and medium enterprises (SMEs), infrastructure, social ventures, or other sectors which are considered by government regulators as positive and beneficial either socially or economically. Hence, Cat I funds are expected to have spillover effects on the economy and the govt might consider giving them incentives or concessions for serving that purpose.
It also includes Angel Funds, which are funds pooling investments from Angel investors. Angel investors can be a corporate body with a net worth of at least Rs. 10 crores; an individual owning tangible assets valued at least Rs 2 crores excluding the value of his principal residence and having experience as a serial entrepreneur, senior management professional & early-stage venture investor; an AIF; or a registered VCF.
This category of AIFs includes debt funds and private equity funds. The category is created to offer a defensive investment alternative where diversified investment portfolios are built and managed by experienced fund managers to reduce the risk profile of investors. The debt funds that fall under this category invest in debt/debt securities of listed or unlisted investee companies as per the stated objectives of the fund.
Both Cat I and Cat II AIFs are required to be close-ended with a minimum fund life of 3 years. The Sponsor’s interest in each of these categories must be not less than 2.5% of the corpus or Rs. 5 crores, whichever is lesser. For Angel funds, such interest shall be not less than 2.5% of the corpus or Rs. 50 lakhs, whichever is lesser.
Cat III AIFs apply complex trading strategies such as arbitrage, margin, futures, and derivatives to generate returns. Hedge funds, which trade for short-term gains, and Private investment in public equity (PIPE) funds, which buy publicly traded stock at a below-market price, & other similar types of funds qualify to be registered as AIFs under this category.
Unlike Cat I and Cat II, these funds are allowed to undertake leverage or borrowing (which could be up to two times the fund corpus) in order to make investments in both unlisted and listed derivatives. They can be either be close-ended or open-ended. As far as the Sponsor’s interest is concerned, it must be not less than 5% of the corpus or Rs. 10 crores, whichever is lesser.
In practice, there are two types of Cat III funds: Long-only funds and Long-short funds. In Long-only funds, fund managers follow a strategy of buying and holding stocks like an equity mutual fund with a thematic idea, with no alternative strategy involved. They account for the majority of Cat III funds and gained popularity compared to mutual funds due to lesser regulatory constraints.
Long-short funds are designed based on two types of asset allocation: Equity risk long-short and Debt-risk long-short. The Equity-risk long-short funds hold cash equities with a net exposure of 50%—100% and compete against large-cap equity funds. The Debt-risk long-short funds hold debt papers with a net exposure of 5%—25% and compete against arbitrage or short-term debt funds.
The growth of India’s alternative investment funds industry has been phenomenal over the past few years. The industry’s commitments raised, which denotes the amount clients are willing to invest in AIFs, clocked a 5-year CAGR of ~50% to ~INR 7 lakh crores as of Jun 2022. However, the mutual fund industry, which sits with an average AUM of ~INR 41 lakh crores (as on Dec 2022), achieved an AUM of the same level over four decades in mid-2009, after the first scheme (US-64 by UTI) was launched in 1964.
Over the last five years, the growth in the AIF industry has been super steady without any dent even at the onset of Covid-19 unlike mutual funds.
Within the AIF segment, Category II constitutes more than 80% of industry commitments. As of Jun 2022, Cat II commitments jumped ~44% y-o-y to ~INR 5.6 lakh crores. Among other categories, Cat I commitments rose ~27% to ~INR 58,000 crores and Cat III commitments grew ~47% to ~INR 74,500 crores as of June 2022.
What are the catalysts for growth?
The major factor that is driving the growth in alternative investment funds is their low correlation to public markets. Hence, high net-worth individuals (HNIs) and family offices are increasingly preferring AIFs over other asset classes like traditional equity and bonds.
Economic uncertainties led by Covid, and geo-political tensions have added a lot of volatility to the market, higher valuations in the listed space have been a major concern, while inflation hedging is a must. Given these issues, alternative investment funds fit well into the criteria with higher risk-adjusted returns.
Among other factors that led AIFs to gain traction include the regulatory mandate to ensure sponsors’ “skin in the game” as mentioned in Part I. The investments in the funds are managed by a team of seasoned finance professionals and a competent investment committee with the ability to underwrite risk and ensure consistently higher returns.
The robust growth in Cat II AIFs is attributed to their ability to provide a diversified investment portfolio, mitigating the risk profile of investors. Foreign Portfolio Investors (FPIs) have been increasingly taking the AIF route to make debt investments as stringent RBI rules for debt investments by offshore investors do not apply to the route. For instance, as per 2020 circular by RBI, short-term investments by an FPI were limited to 30% of total investment in corporate bonds. Credit AIFs are able to provide flexibility to offshore investors to participate in private debt issuances and generate additional alpha through strategic asset allocation.
What advantages do AIFs gain over other vehicles to capture the Performing Credit opportunity?
When we spoke about the asymmetry in the debt market, we mentioned huge opportunities in the Performing Credit space comprising of issuers largely in the unlisted universe. Alternative investment funds seem to be perfectly fit the criteria in addressing the space.
In 2020, the Securities and Exchange Board of India (SEBI) issued new norms in a circular that placed several limitations for debt investments by mutual funds. It has restricted mutual funds from investing in unlisted debt instruments such as the unlisted commercial papers (CPs), which are short-term debt securities issued by corporates for up to one year. It has allowed mutual funds to invest in unlisted non-convertible debentures (NCDs), used for raising long-term capital, provided the instruments have a simple structure and the exposure to them does not exceed 10% of the scheme’s portfolio. The circular also reduced the exposure to unrated debt from 25% to only 5% of the net assets of a mutual fund scheme.
In contrast, debt AIFs, under Cat II, are allowed to invest in both listed and unlisted investee companies. They are also not subject to restrictions such as sectoral exposure caps or sticking to one class of investments.
Due to the absence of small/retail investors in the space, liberal regulations for AIFs help them stand apart from other vehicles like mutual funds to capture the Performing Credit opportunity.
(Note: The article has been updated to reflect the latest available data for AIF and MF.)
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