Features of Alternative Investment Funds (AIFs) and it's category I, II, III

Diversification across asset classes and investment products is a key to wealth maximization and risk mitigation. With the development of the financial markets and economic revival investors are looking for sophisticated products with innovative themes which promises higher returns. One such product garnering investors’ attention is alternative investment funds (AIFs). Besides, with the outbreak of the coronavirus outbreak, preference for the insurance cum investment product like Unit Linked Insurance Plans (ULIPs) which has the ability to give dual benefit of market linked returns and safeguard against financial uncertainties is also gaining prominence. This article highlights the features and significance of both these products in the portfolio.

Alternative investment funds (AIFs)

Latest statistics from the capital market regulator Securities and Exchange Board of India (SEBI) shows cumulative net investments made by AIFs at the end of June 2021 stood at Rs 2.17 lakh crore compared to Rs 1.59 lakh crore in June 2020. The commitments and funds raised by AIFs have increased 26% and 29%, respectively, compared to a year ago period. India has total of 750 AIFs registered with SEBI. Changes in the structure and guidelines, more clarity on the tax aspect are some of the key reasons of the investors’ interest in this product. AIF 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. As per the SEBI guidelines, AIFs are classified into three types:

• Category I - AIFs invest in start-up or early-stage ventures or social ventures or SMEs or infrastructure or other sectors or areas which the government or regulators consider as socially or economically desirable and shall include venture capital funds (including angel funds), SME Funds, social venture funds and infrastructure funds. Angel funds raises money from by way of issue of units to angel investors and comply with Chapter III-A of the AIF Regulations and make investments.
• Category II - AIFs consists of various types of funds such as real estate funds, private equity funds (PE funds), funds for distressed assets, etc. AIFs which do not fall in Category I and III and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements are the category II AIFs.
• Category III - AIFs includes hedge funds, Private Investment in Public Equity (PIPE) funds. These funds employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives.

Other features are:

• Category I and II AIFs are required to be close ended have a minimum tenure of three years. Category III AIFs may be open ended or close ended.
• The minimum ticket size for investing in AIFs is currently Rs 1 crore. In case of investors who are employees or directors of the AIF or employees or directors of the Manager, the minimum value of investment is Rs 25 lakhs
• Resident Indian individuals, Non-Resident Indians (NRIs) and foreign nationals can invest in alternative investment funds.
• Scheme of AIFs should have 1000 investors while an angel fund restricted to 49 investors.
• Taxation rules varies across different categories of the AIFs and bit complex. While Category I and II are the pass-through vehicle which means that the income or loss (other than business income) generated by the fund will be taxed at the hand of the investor and not by the fund business. In event of investment in these two funds the taxation depends on the holding period and according short term and long-term capital gains tax is applicable. And category III is not the pass-through vehicle and charged at the fund level. AIF is usually taxed as business income, although there can also be a capital gains component. Hence, the tax paid is, typically, at the highest tax slab, including surcharge of 42.7%, and is deducted before the returns are paid out. This can be huge burden for investor. Seeking a professional help to understand the tax implications is crucial before investing.

While investing in AIFs can be interesting alternative for the HNIs, the investment is highly risky and much more complex than the traditional investment avenues. Analysis of the risk factors such as credit risk, counterparty risk and operational risk is very important as AIFs are not linked directly to market but involves in investing in startups, early-stage ventures etc. Evaluating the theme, nature of the investment, objective, cost involved and the tax implications is must.