A much unconventional investment, such as stocks, bonds, or cash, is often categorized as an alternative investment. These are privately pooled funds that invest in venture capital, private equity, hedge funds, infrastructure, and other types of investments that form public equities or debt securities. Because of their complexity, lack of liquidity, and limited rules, the majority of alternative investment assets are owned by institutional investors or accredited, high-net-worth individuals. There are approximately 700 AIFs now, with over Rs 4 trillion in assets under management, representing a 15 times increase since 2015. For international investors anticipating double-digit returns, India has the mushrooming background of the favoured investment destination. During the first nine months of FY 2020-21, India received the biggest ever FDI influx of about $70 billion due to the adoption of investment vehicles AIF as a financial instrument.
What is an Alternative Investment Fund?
Alternative Investment Funds defined by Regulation 2(b) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 as any fund created or incorporated in India in the form of a trust, a company, a limited liability partnership, or a body corporate which;
- is a privately pooled investment vehicle that collects funds from Indian and overseas investors and invests them according to a defined investment policy for the benefit of its investors; and
- are not covered under the SEBI (Mutual Funds) Regulations, 1996, SEBI (Collective Investment Schemes) Regulations, 1999, or any other Board regulations governing fund management operations.
The following investments are exempted from the purview of Alternative Investment Funds; namely, they are;
- According to the Companies Act of 1956, family trusts established for the benefit of “relatives”;
- ESOP Trusts established in accordance with the Securities and Exchange Board of India (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999, or as approved by the Companies Act, 1956;
- Employee welfare trusts, or gratuity trusts, are trusts established for the benefit of employees;
- Holding companies, as defined by Section 4 of the Companies Act of 1956;
- Other special purpose vehicles not established by fund managers, including securitization trusts which are governed by a separate regulatory framework;
- Funds maintained by a securitization or reconstruction firm that has been registered with the Reserve Bank of India under Section 3 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002;
- Any other pool of funds in India that is directly regulated by another authority;
Categorization of Alternative Investment Funds
Securities Exchange Board of India has classified Alternative Investment Funds (AIF) broadly into 3 categories as;
- Category I
These are the AIFs that are helpful to the Indian economy and help to boost growth. As a result, SEBI or the Indian government provides incentives or concessions to these funds. These funds often invest in start-ups, early-stage businesses, social initiatives, SMEs, infrastructure, and other areas that are deemed socially or economically vital for the country. Because these initiatives have a multiplier effect on the economy in terms of growth and job generation, the government encourages and incentivizes investment in them. These funds have provided a lifeline for already successful businesses in need of funding.
Some comprehensive classification of Category I funds are;
- Venture Capital Funds
A venture capital fund is a form of investment fund that makes investments in early-stage startup firms with high return potential but significant risk. A venture capital firm manages the fund, and the investors are often institutions or high-net-worth individuals. VCFs aggregate money from investors who wish to engage in companies as equity partners. They invest in a variety of companies based on their company characteristics, asset size, and product development stage.
- Social Venture Fund
Social venture capital funds support firms that have a beneficial impact on people while still providing acceptable returns to investors. Because the fund manager is obliged to analyze the social value generated by the firms, they are frequently referred to as impact funds. Financial inclusion, affordable healthcare, renewable energy, education, and agriculture are among the topics that social venture capital firms in India invest in. These funds provide money to early-stage start-ups in this industry. They give initial funding as well as operational and technical assistance to help start-ups establish their businesses and establish governance and compliance systems. A social venture capital fund must invest at least 75% of its assets in firms that have a beneficial impact on society, according to SEBI guidelines.
- Angel Funds
Angel funds invest in startups and early-stage enterprises, providing cash to help them grow. Angel investment is far riskier than debt funding since, unlike a loan, invested cash is not required to be repaid if the firm fails. Angel funds must accept an investment of not less than Rs. 25 lakh from an angel investor for a period of up to three years.
These requirements apply to an AIF or a VCF registered under the SEBI (Venture Capital Funds) Regulations, 1996.
- CATEGORY II
All funds that aren’t classified as category I or III by SEBI are classified as category II. Funds that invest in private equity – PE funds, particularly Real Estate PE funds usually decrease risk by providing diverse investment portfolios managed by competent fund managers. By offering an alternate investment asset class, it provides the dual advantage of a defensive investment option as well as a hedging tool. The government offers no incentives or concessions for investing in these funds.
Some types of Category II funds are;
- Private Equity Fund
A private equity fund is a type of collective investment scheme that invests in a variety of equities and debt securities. They’re often run by a corporation or a limited liability partnership. Such funds’ duration (investment horizon) might range from 5 to 10 years, with the option of an annual extension. The most distinguishing characteristic of private equity funds is that the money pooled for fund investment is not traded on the stock exchange and is not available for subscription to the public. PE funds invest in private companies that are not publicly traded and take a stake in them. Because unlisted private enterprises are unable to raise cash through the issuing of equity or debt instruments, they turn to PE funds for help.
- Debt Fund
The debt market is made up of a variety of instruments that make it easier to purchase and sell loans in exchange for interest. Many investors with a lower risk tolerance prefer debt instruments because they are considered to be less dangerous than equity investments. Treasury bills, corporate bonds, commercial papers, government securities, and a variety of other money market instruments are among the securities that debt funds invest in. The term “fixed-income securities” refers to financial products that have a predetermined maturity date and interest rate that the buyer can earn at that time.
- CATEGORY III
Category III AIFs are a special type of privately pooled fund that generates profits using a variety of complex trading methods such as arbitrage, margin trading, futures, and derivatives trading, etc. To attain their aim of short-term wealth appreciation, they use a variety of complicated and diversified trading methods. The government does not offer any special incentives or concessions for investing in these Category III funds.
- Hedge Funds
Hedge funds are private investment partnerships and capital pools that employ a variety of proprietary methods and invest in or trade complicated products such as listed and unlisted derivatives. Hedge Funds are not required to register with a securities authority and are exempt from reporting obligations, such as the periodic disclosure of NAVs. High-net-worth individuals (HNIs) and families, endowments, and pension funds, insurance firms, and banks are all common hedge fund investors. These funds operate as either private investment partnerships or offshore investment companies. They are, nevertheless, more expensive than other financial investment tools. Hedge funds typically charge a 2% asset management fee and retain 20% of earnings gained as a fee.
- Private Investment in Public Equity Fund
The sale of common shares to private interest groups is known as private investment in public equity (PIPE). Common shares are usually listed on the main stock exchange and are available for purchase by ordinary investors with a low capitalization. This allows the investor to purchase an interest in the company, while the company selling the stake benefits from the capital infusion.
The tenure of a Category I fund and a Category II fund which shall be close-ended shall be set at the time of application, and such fund or schemes shall have a minimum tenure of three years.
Alternative Investment Funds in Category III may be open-ended or closed-ended.
The close-ended Alternative Investment Fund’s tenure can be extended for up to two years with the consent of two-thirds of the unitholders by the value of their investment in the Alternative Investment Fund. In the absence of unitholder permission, the Alternative Investment Fund will entirely liquidate within one year of the fund’s initial or extended tenure expiring.
Pros of Alternative Investment Funds
- When compared to mutual funds, stocks, and bonds, these non-traditional investments give investors access to assets that are not tied to the stock market, providing diversification and perhaps higher returns.
- Alternative investments are not linked to financial market investments; rather, they diversify a portfolio to reduce volatility. Any market-related stock is volatile, and due to inflation, hedging, and portfolio diversification, its rate of return is predicted to be higher than traditional investments.
Cons of Alternative Investment Funds
- Alternative investments are typically private rather than public, and they are generally illiquid, which means they can be difficult to exit and the funds would be constricted for an extended period of time.
- Alternative investments are frequently sophisticated products that necessitate additional due diligence. Institutional and high-net-worth investors were the only ones who could invest in alternative investments earlier due to the ramifications.
Valuation of AIFs
With Category I and II AIFs, the valuation must be done at least once every six months or once a year, with at least 75% of the investors’ consent. There is a time lag between the unit holder’s promise to invest and the investment’s drawdown, which could result in a change in the portfolio firms’ valuation and, as a result, a change in the AIF’s valuation. If the AIF units are transferred inter se, they have to be sold at the Fair Market Value, which necessitates a new valuation. This raises the frequency of AIF valuations and violates the AIF requirements. Because of the high threshold for the frequency of AIF valuation, there may be delays in closure as well as increased investment costs, preventing legitimate enterprises from raising capital.
Tax Implications of AIFs
For tax purposes, funds designated as Category I or Category II are given pass-through status. This means that any profit or loss generated by these funds’ investments is allowed in the hands of the unitholder as if the investments were made directly by the unitholder. This means that there is no tax imposed on the fund level. If the fund invests in a startup and subsequently sells it for a profit, the profit incurred would be taxable.
If the fund’s income contains business income, that money is not allowed to be passed through to unitholders, and the fund must pay tax on it. The tax rate is determined by the legal form of the fund: a company pays 25% + surcharge (as of 2020 and subject to turnover limits), an LLP pays 30% + surcharge, and trust is taxed at the highest marginal rate based on income slabs.
Pass-through status has not been granted to Category III funds. As a result, a CAT III fund’s whole revenue will be taxed at the fund level. The tax rate is determined by the legal form of the fund (corporation, limited liability partnership, trust, etc.). The tax rules governing trusts are more complicated than those governing companies or limited liability partnerships.
AIFs in India
In India, AIFs are not permitted to issue public invites to subscribe to their securities. They’re held as privately pooled investment entities, and they can only raise money through private placements. By September 2020, AIFs had raised roughly USD 27.0 billion, representing a 74.4 percent CAGR from 2014 to 2020. During this time, investment commitments totaled USD 55.5 billion (65.5 percent CAGR), and AIF investments in alternative assets totaled USD 22.7 billion (75.2 percent CAGR).
During economic downturns, cyclical difficulty in equity and bond markets has encouraged investors to seek out new assets to invest in, such as alternative classes, resulting in a rise in alternative investment adoption. AIF funds are generally subject to higher volatility, liquidity, and credit risks than traditional securities investments, which may deter investors. Investors, on the other hand, have access to a variety of products with high liquidity and low volatility. In 2021, India has already seen a record number of 12 startups achieve unicorn status. More startups are preparing for their initial public offerings (IPOs). These are all solid evidence that the Indian market is maturing and expanding with mushrooming growth.
The Alternative Investment Fund Regulations are a positive step forward since they bring transparency to the issue of regulating private pools of cash acquired locally for deployment by various types of investment funds. It will aid in the monitoring of unregulated funds, as well as the generation of fresh capital and the protection of investors. SEBI published a discussion paper on Performance Benchmarking for AIFs and Standardization of PPMs on December 04, 2019, to further bring changes in the AIF space. SEBI welcomed views from the public and other stakeholders. SEBI formalized regulations in this regard after receiving a public response on the abovementioned consultation paper and deliberations in the Alternative Investment Policy Advisory Committee (AIPAC). In February 2020, SEBI issued a circular that formalized the framework for AIF performance benchmarking. SEBI has also implemented guidelines for uniformity of PPM and audit requirements for AIFs through the circular, with few exceptions. SEBI has taken another step toward improving the AIF regulatory ecology, which is constantly changing.
This article is authored by Aathira Pillai a 5th year BLS LLB student of Dr. D. Y. Patil College of Law.
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