What are AIFs?

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.

In recent years, Alternative Investment Funds (AIFs) have gained significant traction in India's investment landscape. Offering diversification beyond traditional avenues like stocks and bonds, AIFs have attracted both institutional and individual investors seeking higher returns and exposure to alternative asset classes. Regulated by the Securities and Exchange Board of India (SEBI), AIFs are classified into three categories, each with distinct characteristics and investment strategies. Let's delve into each category to understand their nuances and potential benefits.

Category I: Mainstream AIFs

Category I AIFs comprise investment strategies that focus on venture capital, infrastructure, or small and medium enterprises (SMEs). These funds typically invest in startups, early-stage companies, or infrastructure projects, aiming for long-term capital appreciation. The objective is to foster entrepreneurship, support economic growth, and contribute to infrastructure development in the country. It also includes Angel Funds, 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.

Key Features:

Investment Focus: Category I AIFs prioritize investments in sectors crucial for economic development, such as technology, renewable energy, healthcare, and infrastructure.

Long-Term Perspective: These funds have a longer investment horizon, often spanning several years, to realize capital gains as the invested companies mature or infrastructure projects become operational.

Category II: Private Equity Funds

Category II AIFs encompass a broad spectrum of investment strategies beyond Category I, including real estate, distressed assets, and mezzanine financing. These funds cater to sophisticated investors seeking higher risk-adjusted returns and portfolio diversification beyond traditional equity and debt instruments.

Key Features:

Flexibility: Category II AIFs enjoy more flexibility in investment strategies compared to Category I, enabling them to explore a wider range of opportunities across sectors and asset classes.

Risk-Return Profile: Investments in Category II AIFs involve higher risk due to exposure to less liquid and more volatile asset classes. However, they also offer the potential for higher returns, especially in specialized areas like distressed assets or real estate.

Active Management: Fund managers play a crucial role in identifying and capitalizing on investment opportunities, often employing active management strategies to enhance returns and mitigate risks.

Category III: Hedge Funds

Category III AIFs encompass funds employing diverse trading strategies, including leverage, derivatives, and short-selling, to generate absolute returns irrespective of market conditions. These funds cater to sophisticated investors seeking capital appreciation through active trading and risk management. However, hedge funds are expensive as fund managers can charge an asset management fee of 2% or more. They can also levy 20% of the returns generated as their fees.

Key Features:

Dynamic Strategies: Category III AIFs employ dynamic trading strategies to exploit market inefficiencies, volatility, and arbitrage opportunities across various asset classes, including equities, commodities, currencies, and derivatives.

Risk Management: Despite their aggressive investment approach, Category III AIFs implement robust risk management practices to protect investor capital and navigate market turbulence effectively.

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 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.

A Regulatory & Governance POV:

Where are we heading?

Recent years have seen the growth of the start-up culture in India, with government data showing the total number of recognized start-ups in the country at more than 1,12,000 as on October 3, 2023. This will further boost the investment opportunities available to AIFs and strengthen the segment.

AIFs provide a vital source of capital to start-ups or established companies, depending on the fund strategy, and offer diversification opportunities to investors as alphas decline for traditional asset classes.

As per SEBI, there are as many as 1,096 AIFs registered as on March 31, 2023. Of these, 157 and 235 AIFs have been registered with SEBI in fiscals 2022 and 2023, respectively, which is ~36% of the total number of AIF registrations. About two-thirds of the total AIFs have been registered in the past five years. Moreover, about 58% of the AIFs have been registered as Category II AIFs as of March 31, 2023.

In barely a decade, AIF has become one of the key segments in private markets in India. It has been growing at a steady pace, with a total commitment of Rs 8,338 billion as on March 31, 2023. The segment is expected to remain one of the fastest growing managed products categories over the next few years as more and more high net worth individuals (HNIs) and ultra-HNIs seek out differentiated products that give them an option to generate better returns on their investments.