Alternative Investment Funds: Types, Risk, Investment, Taxation, Who should Invest

What are Alternative Investment Funds (AIFs)?

Alternative Investment Funds (AIFs) are funds incorporated in India which operate as an investment vehicle that privately pools funds from the affluent investors for the purpose of generating returns by following a defined investment strategy. Alternative Investment Funds are defined under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations 2 (1) (b), 2012 set up by the SEBI. These funds can be instituted in the form of a company, corporation, trust, or even Limited Liability Partnership (LLP).

Alternative Investment Funds include pooled investment vehicles like private equity, hedge funds, venture capital, real estate funds, PIPEs, and others. Investments in these assets are suitable for sophisticated investors having large capital & high-risk preferences.

As per the latest data available, currently Rs. 1.4 lakh crores of investments have been made by AIFs in India.

Different Types of Alternative Investment Funds (AIFs):

Securities and Exchange Board of India (SEBI) have classified Alternative Investment Funds (AIFs) into three types which are mentioned below:

1. Category 1 

Those Alternative Investment Funds (AIFs) that invest in ventures being in their initial or beginning stage, social ventures, small and medium enterprises also called SMEs, infrastructure, or other sectors that are considered potentially advantageous in social and economic aspects by government or regulators. The funded ventures are expected to generate economic benefits for the country including generating employment, innovative offerings & promoting economic growth. 

Category 1 comprises different funds such as:

  • Infrastructure Fund 

Infrastructure funds are those funds that invest in companies that are either directly or indirectly involved in infrastructure development related projects in the nation. Corporates involved in industries such as power, metals, estate, etc. come under the infrastructure sector.

  • Venture Capital Fund (VCF)

Venture Capital Funds are those funds that provide funding to the start-ups in their initial stage to help them expand their business. The funded start-ups carry high potential of growth and the investors can expect to earn good returns over time on their share of investments. 

  • Angel Fund

Angel funds are those funds in which the investors facilitate by providing funding in exchange for receiving an equity position in the company. The angel fund makes investments in startups or businesses in their early stage and generally requires its investors to have prior experience as an investor, entrepreneur, or as a senior management professional which will help in providing guidance to the funded start-ups. These funds are a sub-category of the Venture Capital funds in the Category-1 AIF.

These funds are considered a kind of equity funding.

  • Social Venture Fund (SVF)

Social Venture Funds are those funds in which social venture capitalists or groups facilitate funding in ventures that have the potential to become a social boon as an enterprise. The Social Venture Funds promote investments in ventures or businesses that aim to operate their activities in a socially responsible manner i.e without harming the environment or social values. These funds want to generate returns for their investors by investing in companies incorporating the best practices of corporate governance, protecting the environment & deploying advanced technologies.

2. Category 2

These Alternative Investment Funds (AIFs) do not undertake leverage or borrowings other than to achieve operative objectives on a daily basis and as allowed by regulations set by the SEBI for the AIF Category 2. This category includes different types of funds, such as:

  • Private Equity (PE) Funds

Private Equity Funds (PE Funds) are those funds that make investments in unlisted companies which can’t use other sources of funding. The investors in these funds are generally called limited partners and are given a share in the invested companies in proportion to their investments. Investments in these funds are directly made into different private companies to diversify investments.

  • Real Estate Funds 

Real Estate Funds are funds that invest in securities issued by corporations or companies that further invest in projects in the real estate sector.

  • Debt Funds

Debt funds are those funds that invest in debt or debt-related securities issued by the unlisted or listed companies for the purpose of generating returns as per the investment objective of the AIF. Debt funds are also called fixed-income funds.

  • Fund of Funds

Fund of Funds is the Alternative Investment Funds that follow the investment strategy of holding a diversified portfolio of other investment funds rather than directly making investments in investment instruments or securities.

3. Category 3

These Alternative Investment Funds (AIFs) are funds that deploy different complex investment strategies to generate returns for the investors. These funds may also use leverage to make investments in listed and unlisted equity or other derivative products. These AIFs include different funds such as:

  • Hedge Funds

Hedge Funds are those funds that are built as limited liability partnerships. These funds deploy complex investment strategies including using technical analysis, algorithmic trading, derivative trading, etc. for the purposes of making investment-related decisions. As the name implies "hedge", these funds aim to protect downside risks through their exposures in related instruments available in the market. 

  • PIPE Funds

Private Investment in Public Equity Funds (PIPE) are those funds that involve private investments made by investment organizations, mutual funds, and other investors into publicly-traded equities. These funds invest in equity stocks of corporations or companies at a discounted price of the current value in the market. PIPE funds are of different types such as traditional, structured, etc.

Investment in Alternative Investment Funds

Investments in AIFs are suitable for high net worth investors because of the higher minimum ticket size for investments. The investments can be made by Indian residents, NRIs, & Foreign Investors as well.

AIFs other than Angel Funds have a criteria of a minimum investment size of Rs.1 crores as per SEBI rules. For angel funds, the minimum investment size is Rs.25 lacs.

Risks Involved in AIFs

The risks in AIFs vary across different funds within categories. However, the risks involved in investments in Category -3 AIF Funds is generally higher than others because of their ability to take leverage for making further investments. Also, Investments in AIFs overall carry higher risks than the other market instruments like stocks, mutual funds,etc. as these funds take positions or provide funding in unlisted ventures as well.

A proper research on the available AIFs in their respective categories could be conducted to choose the one for making investments which is handling money really well and so the risks could be reduced because of their wise investment decisions.

Taxation of Alternative Investment Funds

Under the Finance Act 2015, the category-1 & 2 of the Alternative Investment Funds (AIFs) have been granted special pass-through tax status under section 115UB of the Income Tax Act of India, 1961. This means that incomes or gains received by AIFs gets taxed in the hands of investors in AIFs in a way that assuming investments have been made directly by the investors and so, the tax would need to be paid by the investors at the slab rates applicable to them. 

However, the Category-3 AIF which includes investment in hedge funds, PIPEs, etc. has still not been given pass-through status by the Indian tax law which leads to higher taxes on these investments. The taxes on these investments need to be paid at the fund level and is not passed on to the investors. The effective taxation rate for AIF Category-3 comes out to be around 42.7% including the highest tax slab rate of 30%, a surcharge of 37.5% on the tax, and applicable cess rates.

Who should invest in Alternative Investment Funds?

Investments in AIFs are somewhat different than the other traditional investments available in the market due to their basic characteristics. Their very high risk nature coupled with a higher minimum investment requirements makes it only suitable for High Net-worth Investors(HNIs). Also, these investments are suitable for sophisticated investors who have an understanding of the markets & similar investments and the risks associated with such investments.

Frequently Asked Questions (FAQs)

1. Are AIFs open-ended?
AIFs under Category 3 do have a choice to be open ended in nature.

2. What is the corpus of the AIF?
'Corpus' is the complete amount of funds committed by investors to the AIFs through a written contract or any document.

3. Can AIF launch schemes?
Yes, AIF can launch schemes under certain terms.

4. How many categories do AIF have?
AIFs have been classified into three sub-categories.

5. Is Real estate fund an AIF?
Yes, Real estate funds come under category 2 in AIF.

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