Alternative Investment Funds: Meaning, Benefits & Types

Introduction

Alternative Investment Funds (AIFs) are unique privately pooled investment vehicles. The funds have a clearly defined investment policy and collect investments from sophisticated investors, Indian or foreign. These investments differ significantly from traditional investment options like mutual funds, stocks, or PPFs.

These funds require a substantial minimum investment and are generally opted for by HNIs (High Net Worth Individuals) or financial institutions. While these funds have a high entry barrier, they offer the possibility for exponential returns, even though they come at higher risks.

But what are AIFs? Are they SEBI regulated? Let’s answer these questions and review the various AIF types and their benefits.

What is an Alternative Investment Fund?

Alternative investment funds can be established as limited liability partnerships (LLP), companies, or trusts. Generally, a majority of AIFs in India operate as trusts. These funds are not included under the SEBI (Mutual Funds) Regulations of 1996 or the SEBI (Collective Investment Schemes) Regulations of 1999.

AIFs are regulated by SEBI (Securities and Exchange Board of India) as per the SEBI (Alternative Investment Funds) Regulations of 2012. These funds invest in alternative asset classes such as real estate, private equity, hedge funds, derivatives, and venture capital.

Benefits of investing in AIFs

AIF funds offer several benefits to investors. From having low volatility to providing an opportunity for higher returns to investors, let’s look at some of the top benefits of AIFs.

• Low Volatility: AIFs are not directly linked to the money markets. This is why, if you’re looking for stable and consistent returns, AIF investment can be a good tool. These funds invest in assets and strategies that have a minimal correlation to money market performance, like infrastructure projects or funds of funds. These funds also use techniques like short selling and derivatives to hedge their investment risks.
• Diversification: Alternative investment funds invest in various asset classes across different geographical locations, financial markets, and currencies. This allows investors to avail of broad market access while also ensuring that the impact of local and regional factors has minimal impact on their investments.
• Potential for High Returns: To ensure investors can get the best possible returns on their investments, AIFs invest in assets with high growth potential, like start-up companies or hedge funds. However, these high-growth investment opportunities also come at a high risk. To offer maximum returns to investors, AIFs also generate returns from other sources, like dividends, fees, interest, and capital appreciation.

Types of Alternative Investment Funds (AIFs)

SEBI registers AIFs in three categories, each with sub-categories. Let’s examine the different AIF categories.

Category I AIF

These AIFs invest specifically in startups, SMEs, and other early-stage ventures considered economically and socially desirable by the government or other regulators. Funds in these categories can be further subdivided into infrastructure, venture capital, social venture, and SME funds.

• Infrastructure Funds: These funds invest in major government infrastructure projects like railways, airports, and bridges.
• SME Funds: SME funds invest in small and medium-sized businesses with a thorough track record of growth and profitability.
• Venture Capital Funds: Venture Capital Funds invest in startups and early-stage ventures with high growth potential.
• Social Venture Funds: These funds invest in companies that work towards sustainability, clean energy, and other advancements that positively impact society. The chosen companies are considered based on their profitability and business track record. 

Category II AIF

Category II AIFs are interesting as they are classified only as funds that do not fall into either the first or third category of AIFs. As per the SEBI guidelines, these funds should also not undertake borrowings or leverage other than to fund operational costs. Examples of these funds include debt, private equity, and fund of funds. 

• Debt Funds: These funds invest in debt securities like bonds and debentures of unlisted companies. The strategy followed by these funds is to invest in fixed income securities.
• Private Equity Funds: Private equity funds invest in unlisted companies and help them raise capital.
• Fund of Funds: These funds do not invest directly in securities or debt instruments. They invest in the portfolios of other AIFs.

Category III AIF

Category III AIFs employ complex investment strategies and may even employ leverage or debt in listed or unlisted derivatives. Examples of these funds include hedge and PIPE (Private Investment in Public Equities) funds. 

• Hedge Fund: These funds use various complex investment strategies, such as short selling, arbitrage, and margin trading, to generate maximal returns for their investors.
• Private Investment in Public Equities: These AIFs invest in the equities of listed companies, especially when their share prices have dropped and they’re looking to raise capital. This allows the AIFs to purchase the equities at a discounted value.

Why to invest in AIFs?

While sorting through various mutual funds to invest in, there are actually several reasons why sophisticated and experienced investors can choose to invest in AIFs; these include:

• Access to niche markets and investment sectors
• Higher return opportunities for investors able to manage high-risk investments on a long investment horizon
• Ability to invest directly in infrastructure projects and social venture funds

Who Can Invest in an AIF?

Unlike other mutual funds and investment instruments, not everyone can invest in AIF meaning there are predefined guidelines regarding an investor's net worth and annual income before they can invest in these funds. Here is a list of who can invest in AIFs.

• Indian nationals, foreign nationals, and non-resident Indians are allowed to invest in AIFs
• Joint investors can invest in AIFs. The investor can jointly invest with their spouse, parent, or child.