Alternative Investment Funds (AIF’s) are investment funds that are targeted at more sophisticated & wealthy investors (require a minimum investment of Rs. 1 cr). These funds offer wealthy investors an ability to invest their money in more sophisticated investment products, whose risk-reward can differ materially from traditional mutual funds.
AIF’s are broadly categorized into 3 different types
Cat 1 AIF
- Invest in early-stage ventures, start-ups, social ventures, SMEs, infrastructure and other sectors considered by the government as socially desirable
- Typical Funds: SME Funds, Venture Capital Funds, Infrastructure Funds, Social Venture
Cat 2 AIF
- AIF’s that do not fall under Cat 1 or 3
- Typical funds: Real Estate, Private Equity, Debt Funds
Cat 3 AIF
- AIF’s that employ complex or diverse trading strategies, employ leverage, invest in derivatives or listed equities
- Typical funds: Listed Equities, Long-short,
- Can be both close-ended or open-ended
Suitability of AIF's for Investors
AIF’s are more complex investment vehicles, and the suitability of an AIF for an investor is highly dependent on the type of AIF and the unique requirements of the individual investor.
We provide below some of the main pros & cons of different types of some of the major AIF fund categories:
Start-up Funds (Angel/Venture)
- Higher Potential Returns driven by the potential for exponential growth in start-ups
- Thriving digital start-up ecosystem in India
- Close-ended structures: not liquid & timing of return of capital is uncertain
- Lack of transparency: especially around valuations. True returns are only known once fully exited, returns in between are subject to highly subjective valuations
Private Equity (Traditional PE/Late-Stage/Pre-IPO)
- Lower risk than start-up funds, as investments are made in more established companies with more clearly defined exit stategies
- Thriving digital start-up ecosystem in India, with a strong appetite for digital IPOs
- Close-ended structures: not liquid & timing of return of capital is uncertain
- Lack of transparency: especially around valuations. True returns are only known once fully exited, returns in between are subject to highly subjective valuations
- Valuations, especially in the digital pre-IPO stage, tend to be very expensive and returns are dependent on a hot IPO market for these deals sustatining
Real Estate Equity Funds
- Professional Management of Real-estate investments. Helps remove substantial operational and structural risks.
- Allows investors to invest in a diversified pool of RE assets (compared to the typical concentrated direct approach)
- Despite professional management, Real Estate investments in India continue to be subject to various regulatory, operational, execution & market risks
- Close ended structures: not liquid & timing of return of capital is uncertain
Debt AIF's
- Higher yields available than traditional bank FD's or Debt MF's
- Certain AIF's have multiple classes, that protect investors of lower-risk classes from the risk of a few defaults
- Risk of capital loss in case of defaults (especially in more sector concentrated strategies)
- Close ended structures: not liquid. There is typically some indicative schedule of capital repayments
Long-Short AIF's
- Allow the Fund Managers to generate returns in both bullish & bearish market conditions
- Diversification benefits, since returns are not linked to market returns
- Range of options in terms of risk-reward, driven by the extent of flexibility in gross & net long & short exposure levels
- Relatively new segment in India: limited set of Investment Teams with proven track records in such strategies
- The specific nature of the fund (in terms of how exposures change across market conditions) is often not very clear
Listed Equity AIF's
- Easier to understand risk-reward (closer to the traditional MF & PMS strategies)
- Fund Manager stability in the case of FM-sponsored AIFs
- More sophisticated equity investment strategies available
- Operational ease compared to PMS (simpler documentation, taxed at the fund level)
- Lower levels of differentiation (especially in cases where manager runs a similar PMS strategy)
- Risks of MMT tax in case of highly traded strategies
AIF Taxation
Cat 1 & 2 AIF
- Non-business income: pass-through status. Non-business income is taxed in the hands of the investor, as if this investments had been made directly by the investor.
- Business Income: Taxed at the AIF level, based on the structure of the AIF (25% company, 30% LLP, maximum marginal rate or 41.1% in case of a trust)
Cat 3 AIF
- Taxed at the fund Level
- Taxation depends on the type of income & the structure of the AIF.
- Taxation based on type of Income
- ST Capital Gains (Equity): 20%
- LT Capital Gains (Equity): 12.5%
- Business Income/Dividends/non-Equity ST gains: based on AIF structure. 25% company, 30% LLP, 41.1% Trust
Note
- Tax rates indicated are pre-cess and based on FY21 Budget
- Nuances & complexities in Cat-3 Taxation
- Nature of Investments: investments have to be categorised as held for trading or investments. Gains arising from the trading book are considered as business income (and not capital gains)
- Trust Structure: If the fund is structured as an indeterminate/discretionary trust, fund pay tax based on MMT (41.1%). If the fund is structured as a determinate/specific trust, fund pays tax at the rate applicable to each beneficiary based on his share of income.
- Applicability of MMT on Capital Gains: An income tax circular has clarified that gains from investments held in the investment book are subject to Capital Gains tax (and not MMT). While this has been clarified, there is still some gray areas around the risk of a tax-official insisting on applicability of MMT (based on the general tax treatment of indeterminate trusts).
AIF FAQ's
An AIF can be structured as either a private limited company, an LLP or a trust.
An AIF is established by a Sponsor, who is mandated to maintain a certain continuing interest in the AIF in the form of the sponsors contribution. The sponsors contribution is the lower of 2.5% of AUM or Rs. 5 cr (Cat 1 & 2) or 5% of AUM or Rs. 10 cr (Cat 3).
The typical minimum investment required for an AIF is Rs. 1 cr. There are however certain exceptions to this minimum for Accredited Investors, Directors/Employees/FM of AIF (25 lakhs) and Angel Investors (25 lakhs).
AIF’s are open for investments for Resident Indians, NRI’s and foreign nationals as well.
Joint investments in AIF’s are allowed, but subject to certain specific criteria:
- Only 2 joint investors allowed (not more than 2)
- Joint investors have to be from the immediate family (the investor’s spouse, parents or children)