All about alternative investment funds or AIFs; how to invest in them

Kavya Balaji   /   January 14, 2021

A mutual fund collects money from various investors to invest in stocks, fixed-income investments, gold and so on. Alternate Investment Funds (AIFs) pool money to invest in other funds such as venture capital, hedge funds, etc. So, while mutual funds are for the simple investor, AIFs are for experienced investors who have already invested in various markets and are looking to diversify their portfolio while earning higher returns. In simple words, an AIF refers to an investment that differs from traditional investment avenues such as shares, debt securities, etc.

As per the guidelines of the Securities Exchange Board of India (SEBI), “AIF means any fund established or incorporated in India which is a privately pooled investment vehicle which collects funds from sophisticated investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors”. 

AIF is described under Regulation 2(1)(b) of the Regulation Act, 2012 of SEBI. AIF can be established in the form of a trust, company, a corporate body or a Limited Liability Partnership (LLP). Most of the AIFs registered with SEBI are in trust form.

What are the different kinds of AIFs?

According to SEBI, AIFs are classified into three broad categories that are Category I, category II and category III. 

Category I 

AIFs that invest in start-ups, Small and Medium Enterprises (SMEs) and new businesses that have high growth potential will fall under category I.  These are funds that are considered socially and economically viable by the government. These will be businesses that help the economy do well and hence, the government will promote and incentivise investments in these businesses. These will include venture capital funds, SME Funds, social venture funds, infrastructure funds, etc.

Venture Capital Funds pool money from investors to make equity investments in ventures. They invest in multiple start-ups and focus on early-stage investment. The share of the business will be given to each investor as per their investment. Venture Capital Fundsinvest in start-ups with an innovative business model and require funding to establish or expand their business.  Bank loans and capital markets are often unviable for these businesses and Venture Capital becomes the most convenient solution for their financing needs.

Infrastructure Funds invest for the development of public assets such as road and rail infrastructure, airports, communication assets etc. Since the infrastructure sector has high barriers to entry and relatively low competition, profits can be made from investing in the sector. Investors receive capital gains and dividend income from infrastructure funds. If the Infrastructure Fund invests in socially viable projects, the government may provide tax benefits on such investments.

Social Venture Funds typically invest in companies that have a strong social responsibility. These companies focus on making profits by avoiding negative impacts and making a positive impact on the environment. Social Venture Funds solve environmental as well as social issues simultaneously. 

Category II

AIFs under this category invest in funds that put their money in various equity securities and debt securities. All funds that are not classified by SEBI under category I and III will come under category II. Note that the government doesn’t provide incentive or concession on investments in these funds. Funds under this category include Private Equity, Debt Fund etc.

Private Equity Funds invest in unlisted private companies. Since these companies can’t rely on the capital markets, they find that Private Equity Funds are a good option. These funds typically have a fixed investment horizon that is about 4 to 7 years.  They are usually managed by a firm or a limited liability partnership. There are Private equity real estate funds that invest money in various real estate properties. 

Debt Funds primarily invest in debt securities of listed as well as unlisted companies. These funds typically invest in companies that have high growth potential, good corporate practices and can provide good yields in the long run.

Fund of Funds is a combination of various AIFs. These funds invest in a portfolio of other AIFs rather than having a portfolio of their own. Note that these Fund of Funds under AIFs cannot issue units to the public, unlike Fund of Funds under mutual funds.

Category III

AIFs that are looking for short term returns fall under this category. These AIFs employ diverse or complex trading strategies. They may use leverage including investments in listed or unlisted derivatives. Since there is no long term investment made, the government doesn’t provide any specific incentive or concession on these funds. Funds under this category include hedge funds, private investments, etc. 

Hedge Funds pool money from institutional investors to invest in domestic as well as international markets. These funds use arbitrage and aggressively manage their investment portfolio. These funds are less regulated when compared to mutual funds and other investment vehicles. Note that since these are short term investments, Hedge Funds charge more. They could take more than 20% of the profits earned as a fee.

Private Investment in Public Equity Funds are privately managed pools of privately sourced funds. These are funds that have been earmarked for public equity investments. In simple words, these are funds that buy shares of publicly traded shares at a discounted price. 

How are AIFs taxed?

Funds under Category I and Category II do not have to pay any tax on their earnings. However, the investors will need to pay tax as per their tax brackets. Category III AIFs are taxable under the highest income bracket. The returns will be provided to investors after deducting taxes.

Who can invest in AIFs?

Resident Indians, Non-Resident Indians (NRIs) and foreign nationals can invest in AIFs.

Note that there is a cap on investment for each investor. The minimum investment is Rs. 1 crore. However, for angel investors, the minimum investment is Rs. 25 lakhs. Even for fund managers, directors and employees of the AIF, the minimum investment is Rs. 25 lakhs. 

Generally, high net worth individuals (HNIs) and institutions invest in AIFs because it requires high investment amounts, unlike mutual funds. 

Looking to invest in AIFs? can help you. Click here to learn more.  

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