What are Alternative Investment Funds (AIF) – Features, Benefits and Taxation
Alternative investment fund (AIF) is a Fund of Fund that privately pools in funds from investors and invests in unconventional investments like private equity, hedge funds, angel funds, venture capital, etc.
Earlier, Indian investors only invested in conventional instruments like bonds, stocks, securities, etc. But the rise of high-net-worth individuals and venture capital investments led to the introduction of AIF.
If you are looking to move away from traditional investment avenues, Alternative Investment Funds are a great option. Know the types, features, benefits and taxability of AIF before you invest. Read on!
What is an Alternative Investment Fund?
AIFs offer alternative investment options to traditional instruments like stocks or debts. It is a type of fund of funds that invests in real estate, commodities, derivatives, private equity, etc.
As alternative investment funds require massive investment, mostly high-net-worth individuals or big companies invest in them. Furthermore, they do not fall under the ambit of the Securities and Exchange Board of India’s (SEBI) mutual fund regulations.
However, AIFs are defined under Regulation 2(1)(b) of SEBI’s Regulation Act of 2012. The regulations state that:
- Only a company, corporate body, trust or Limited Liability Partnership (LLP) can establish an AIF.
- These schemes cannot invest in funds that fall under the purview of SEBI’s mutual fund regulations.
- AIFs have to act as a privately pooled investment vehicle that invests the money of Indian or foreign investors for their benefit as per a defined investment strategy.
What Does Not Fall under Alternative Investment Fund?
Here is a list of investments that does not fall under Alternative Investment Fund:
- Family trust set up to benefit relatives.
- Employee welfare trust or gratuity trust set up to benefit employees.
- Holding companies that buy and own shares of other companies.
- Employee Stock Ownership Plan or ESOP trust.
- Other special purpose investment vehicles that fall under a specific regulatory framework.
- Any pool of funds that falls under the purview of a particular regulator in India.
Types of Alternative Investment Fund
According to the Securities and Exchange Board of India, there are three broad categories of AIFS:
1. Category I
These mainly invest in start-ups, small and medium enterprises, social ventures, or other sectors that the government considers economically and socially desirable. The government supports and gives incentives to investors for such projects as they have a positive multiplier effect on the economy.
Funds under this category aid businesses that show massive growth potential. These funds are as follows:
- Venture capital funds
- SME funds
- Angel funds
- Infrastructure funds
- Social venture capital funds
2. Category II
As per SEBI regulations, those funds that do not fall under Category I and III are part of this category. Furthermore, those schemes that do not undertake leveraging or borrowing other than to meet daily operational requirements are also a part of Category II.
Funds under this category mainly invest in various equity and debt instruments. Thus, they do not receive any incentives from the government. The subcategories are given below:
- Private equity funds
- Debt funds
- Funds of funds
- Real estate funds
- Funds for distressed assets
3. Category III
The funds under this category have the objective of providing short-term returns to unit-holders. To achieve this goal, they use various complex trading techniques like arbitrage, margin trading, derivatives trading, etc. Furthermore, to make short-term capital gains, these funds invest in listed and unlisted derivatives.
Unlike other traditional investment options, these do not face enormous regulations. However, like Category II, these funds also receive no incentives from the government or any other regulator. The subcategories are as follows:
- Hedge funds
- Private investment in public equity funds
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Features of Alternative Investment Fund
- Eligibility – To invest in alternative investment funds, an investor needs to have an investible surplus of more than Rs. 5 crore. These investors can be Indian residents, NRIs, Persons of Indian Origin (PIO) or Overseas Citizens of India (OCI). The Union Budget of 2018 also allowed foreign investment in AIFs.
- Minimum Investment – AIFs cater to high-net-worth individuals and companies as they need massive investments. In the case of angel funds, the minimum investment amount is Rs. 25 lakh. Meanwhile, investors need to invest a minimum of Rs. 1 crore for other AIFs. However, an employee, fund manager or director of an AIF can invest a minimum of Rs. 25 lakh.
For Category I and II, an AIF sponsor must contribute at least 2.5% of the fund corpus or Rs. 5 crore (whichever is lower) towards initial capital investment. In the case of Category III, the contribution increases to 5% of the corpus or Rs. 10 crore.
- Number of Investors – Each AIF scheme has a minimum corpus of Rs. 20 crore (Rs. 10 crore for angel funds). Along with that, there is also a cap on the number of investors each scheme can have. Most schemes cannot have more than 1000 investors, whereas angel funds can cater to a maximum of 49 investors.
- Investment Horizon – With alternative investment funds, you can choose between close and open-ended funds. Category I and II are close-ended funds with a minimum subscription tenure of three years. Meanwhile, Category III provides an option of being close or open-ended. Thus, if you want to end the subscription at any time, you can opt for open-ended funds in Category III.
3 Benefits of Investing in Alternative Investment Fund
If you are able to meet the eligibility requirements of investing in AIFs, you can enjoy the following benefits:
- Portfolio Diversification: The primary benefit of AIFs is that it offers unique asset allocation and diversification of portfolio. The number of asset classes available for investment is more than most of the other investment vehicles, and their performance is uncorrelated to the stock market. Thus, there is more flexibility for fund managers while building a portfolio.
- Hedge Against Volatility: As noted above, the investments undertaken in an AIF are unrelated or less related to the stock market. Thus, their returns do not fluctuate owing to the ups and downs in the broader market. Furthermore, as AIFs do not allocate funds to investments that trade publicly, unit-holders do not have to tolerate share price fluctuations. So, if you are looking to stabilise your portfolio, AIFs are one of the best investment opportunities.
- Reasonable Returns: As AIFs tap into a broader investment universe, they can offer high returns. Due to their investment strategy, these funds are a better source of passive income compared to many traditional instruments like debentures or bonds. Furthermore, due to minimal dependency on the stock market, the chances of return fluctuations are also less.
Taxability of Alternative Investment Fund
AIFs attract many high net worth individuals in India with their tax benefits. Category I, and after the Finance Act of 2015, Category II enjoy a pass-through status. It means that the AIF does not have to pay any tax on the earnings of these two categories.
However, the income of these investors or unit-holders will be subject to tax based on their respective tax slabs. If the fund invests in equity instruments, then investors pay a capital gain tax of 15% (short term investment) or 10% (long term investment).
Meanwhile, Category III is taxable at the fund level and enjoys no pass-through status. It faces the highest rate of income tax, i.e. 42.7%. The unit-holders receive their returns after the deduction of this tax.
Final Word
Alternative investment funds bring a unique risk and investment profile that help high-net-worth individuals to make long-term bets. However, investing in unconventional financial instruments comes with its own challenges and regulations. So, inspect the features and types of AIFs before deciding to invest in Alternative Investment Funds.
FAQs
Ans: The main difference between portfolio management services and alternative investment funds lies in their portfolio. PMS have a tailor-made portfolio that invests in fixed income instruments and asks for a minimum investment of Rs. 50 lakh. Meanwhile, AIF act as a pooled investment vehicle that invests in non-traditional instruments and has a minimum investment value of Rs. 1 crore. Nonetheless, both cater to high-net-worth individuals.
Ans: In financial terms, corpus refers to the total amount of money that investors commit to putting in a scheme. This commitment is via a written contract or a similar document. In the case of AIFs, the fund must have a minimum overall investment of Rs. 20 crore or Rs. 10 crore for angel funds.
Ans: A sponsor is a person or group of people who establish an alternative investment fund. In a company, the promoter acts as a sponsor, and for a Limited Liability Partnership, this role is played by a partner.
Ans: The objective of AIFs is to benefit the high-net-worth unit-holders only. So, they cannot raise funds from the public by inviting them to buy their securities. They can only raise funds through private placements.
Ans: These are a type of venture capital funds that pool in capital from angel investors to invest in start-ups. Angel investors need to have net tangible assets worth Rs. 2 crore. Furthermore, to bring in some business management knowledge, these investors need to be in a senior management post for at least ten years.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
