What Are Alternative Investment Funds? Benefits of AIF

What Are Alternative Investment Funds?

6 mins read

by Angel One

Alternative Investment Funds (AIFs) provide investors with exposure to private equity, hedge funds, venture capital, and other alternative assets. Categorised into three types, AIFs offer diversification and high-return potential.

Investing is no longer limited to traditional options like stocks, bonds, or mutual funds. Alternative Investment Funds (AIFs) have emerged as a popular choice for investors looking to diversify their portfolios and explore unique investment opportunities. These funds offer exposure to non-traditional asset classes such as private equity, real estate, hedge funds, and venture capital. This article explores the concept of AIFs, their types, benefits, and how they function in the financial landscape.

Understanding Alternative Investment Funds

Alternative Investment Funds (AIFs) refer to privately pooled investment funds that operate outside the traditional financial market regulations. In India, AIFs are defined under Regulation 2(1)(b) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012. These funds can be structured as trusts, companies, Limited Liability Partnerships (LLPs), or other legal entities and attract investments from high-net-worth individuals (HNIs) and institutional investors.

Categories of Alternative Investment Funds

The Securities and Exchange Board of India (SEBI) classifies AIFs into three categories based on their investment strategies and objectives:

Category I AIFs

These funds primarily invest in start-ups, small and medium enterprises (SMEs), and other sectors that the government considers socially and economically viable. They include:

Venture Capital Funds (VCFs): These funds provide capital to early-stage start-ups and small businesses with high growth potential. VCFs help innovative businesses scale up while offering investors high-return potential in exchange for higher risks.
Angel Funds: These funds invest in start-ups at their nascent stages, where traditional venture capital firms may not be interested. Angel investors typically have business experience and mentor start-ups while providing capital.
Infrastructure Funds: These funds invest in infrastructure projects such as highways, railways, ports, and power plants. The objective is to boost infrastructure development while generating long-term returns for investors.
Social Venture Funds: These funds support businesses with social and environmental objectives. Investors not only seek financial returns but also focus on making a positive social impact through their investments.

Category II AIFs

This category includes private equity and debt funds that do not receive government incentives. These funds focus on investing in established businesses and include:

Private Equity Funds: These funds invest in privately held companies, providing capital for expansion, buyouts, or restructuring. Investors typically commit their capital for several years, expecting significant returns upon exit.
Debt Funds: These funds primarily invest in debt securities issued by private companies. They cater to firms with strong growth potential but limited access to traditional credit channels.
Fund of Funds: Instead of directly investing in companies, these funds allocate capital across various AIFs, providing investors with diversification and access to multiple investment strategies within a single fund.

Category III AIFs

These funds engage in complex trading strategies with the objective of generating high returns. They include:

Hedge Funds: These funds pool capital from accredited investors and use complex strategies to achieve high returns. Hedge funds invest in multiple asset classes and often take both long and short positions in the market.
Private Investment in Public Equity (PIPE) Funds: These funds invest in publicly traded companies by acquiring discounted shares. PIPE investments offer companies a faster way to raise capital while allowing investors to benefit from market price appreciation.

Tenure and Listing of AIFs

Category I and II AIFs are close-ended, with a minimum tenure of 3 years.
Category III AIFs may be open-ended or close-ended.
Investors can extend the tenure of a close-ended AIF by up to 2 years with the approval of two-thirds of unit holders.
Close-ended AIFs may be listed on stock exchanges, but listing is voluntary and requires a minimum tradable lot of ₹1 crore.

Example of Alternative Investments

Consider an investor who diversifies their portfolio by allocating funds to different alternative investments:

They invest in a private equity fund that buys shares in a fast-growing technology company.
They purchase commercial real estate to generate rental income.
They buy gold as a hedge against market volatility.

Over time, the tech company expands, the real estate appreciates in value, and gold retains its worth during economic downturns. This combination enhances the investor’s overall portfolio performance.

Who Can Invest in an AIF?

AIF investments are typically suitable for investors with a high risk appetite and significant capital. The eligibility criteria include:

Resident Indians, Non-Resident Indians (NRIs), and foreign nationals can invest.
The minimum investment amount is ₹1 crore for most investors, while directors, employees, and fund managers can invest with a minimum of ₹25 lakh.
AIFs come with a minimum lock-in period of 3 years.
The number of investors per scheme is capped at 1,000, except for angel funds, which allow up to 49 investors.

Benefits of Investing in AIFs

Higher return potential: AIFs offer higher returns compared to traditional investment options due to their exposure to high-growth sectors and unique investment strategies.
Diversification: Investing in alternative funds reduces portfolio risk by spreading investments across multiple asset classes.
Lower market volatility: Alternative mutual funds are not directly tied to stock market fluctuations, making them a more stable investment option.
Access to exclusive opportunities: AIF investment provides exposure to niche markets like private equity, hedge funds, and venture capital that are not accessible to retail investors.

Risks Associated with Alternative Investment Funds

Illiquidity: Most AIF investments require a long-term commitment and may not be easily liquidated.
High entry cost: The substantial minimum investment requirement makes AIFs accessible only to HNIs and institutional investors.
Regulatory risks: Alternative investment fund managers must comply with SEBI regulations, which may change over time, affecting fund operations.
Market risks: Some AIFs, especially hedge funds, engage in aggressive strategies that may lead to significant losses.

How to Invest in AIFs

Assess investment goals: Determine risk appetite and financial objectives before investing.
Choose a category: Select an AIF category that aligns with investment preferences and risk tolerance.
Select a fund manager: Research and choose experienced alternative investment fund managers with a strong track record.
Understand fund structure: Review the investment strategy, tenure, and fee structure before committing funds.
Regulatory compliance: Ensure the AIF is registered with SEBI and complies with legal requirements.

Conclusion

Alternative Investment Funds provide a compelling option for investors seeking diversification and higher returns beyond traditional investment avenues. While they come with risks, the potential for superior returns and access to exclusive investment opportunities make them attractive to HNIs and institutional investors. Before investing in an AIF fund, investors should conduct thorough research, consult financial experts, and choose a fund that aligns with their financial goals.