Evolution of India’s Alternative Investment Fund (AIF) Landscape

In this era of constant change, the investment options landscape is undergoing an unprecedented upheaval. With their complex investing techniques and captivating tales of risk and reward, Alternative investing Funds (AIFs) have developed significantly.

In addition to providing new opportunities for capital deployment and wealth development, alternative investment funds in India allow investors to diversify their portfolios beyond conventional assets like stocks and bonds.

Growth of Alternative Investment Fund in India

The venture capital (VC) funding scope was first limited by the Venture Capital Guidelines, which the Indian government issued on November 25, 1988, and are credited with initiating the development of alternative investments in India.

By announcing an all-new set of guidelines for the venture capital sector known as the SEBI (Venture Capital Fund) Regulations, 1996, SEBI expanded the scope of venture capital by including all forms of private capital investment in unregistered firms under the institutional investment purview. The K.B. Chandrasekhar Committee’s 2000 recommendations were subsequently followed by revising the SEBI regulations and tax benefits granted to VCFs at the fund level.

Many venture and private equity funds were formed primarily with off-shore funding during the development phase that followed in 2003, with the establishment of a robust domestic financing system and the fantastic rise of corporate India. Domestic companies like UTI, ICICI, and others became significant participants in private equity.

The Progression of AIF Continues

From a business standpoint, the Indian industry moved towards sectoral consolidation starting in 2001. A surge in private equity investment occurred in India due to this corporate growth push, a hospitable system to investors, and favourable economic conditions. Warburg Pincus’ USD 292 million acquisition of Bharti Televentures Ltd. was India’s first notable private equity deal. This investment also led to a profitable exit approach by the fund when Bharti went public following its IPO in 2002.

Although private equity was initially mostly limited to the IT industry, by the end of 2007, the sectoral bias mainly had disappeared, and private capital was expanding to several other sectors. Furthermore, the Indian market witnessed the rise of buyout deals led by firms like Actis, KKR, and Blackstone, among others, who obtained a majority stake in closely held and listed companies. The 2006 KKR acquisition of Flextronics Ltd. was a landmark deal.

The market remained restrained by the 2008 Global Financial Crisis until 2012, when growth began to speed up dramatically, primarily due to the SEBI (Alternative Investment Funds) Guidelines. However, 2011 through 2019 might be referred to as the time of consolidation and change, when some of the more established funds left and others strengthened their position. The transition from a VC and PE business into the AIF industry was also signalled during this era.

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Evolution of Hedge Funds

The first hedge fund, A.W. Jones & Co., founded by Alfred Winslow Jones, is credited with coining the phrase “hedge funds” in 1949. Any investment fund that maximized investors’ profits through leverage, short sales, and incentive fees was called a “Hedge Fund.” With time, hedge funds started to add new financial instruments into their portfolios of investments to broaden them, including currencies, exchange-traded futures agreements, commodities futures and options, fixed-income securities, and convertible securities.

In the 1990s, the Indian capital markets expanded significantly. The asset management industry in India began to take shape in the private sector with the publication of the SEBI (Mutual Funds) Regulations and the laws and regulations regulating Portfolio Managers.

Foreign investors invested significant sums of money through funds-of-funds and hedge funds established in offshore countries. These monies are either placed directly in the Indian stock market or via offshore derivative instruments (ODIs) against Indian stocks that are underlying and released by foreign institutional investors (FIIs).

The Eurekahedge India Long Short Equities Hedge Fund Index consists of 15 constituent funds that are equally weighted. The index aimed to give investors who only make investments in India a broad indication of how well underpinning hedge fund executives perform. Starting in December 1999, the index has a base weight of 100. India has consistently produced returns despite a decline in the index’s value during the 2008 Global Financial Crisis.

Nevertheless, India did not have any hedge funds. Due to the lack of regulations governing establishing and marketing hedge funds in India, overseas hedge groups could not sell their offerings to Indian investors nationwide.

Hedge funds’ marketing choices to Indian investors were restricted, given the absence of a distinct regulatory framework and additional FEMA regulations. Hedge funds have a brief window till 2012 to register as FIIs with further protections under the SEBI (Foreign Institutional Investors) Regulations. as per the SEBI (Security and Exchange Board of India) Regulations, 2012. Hedge funds are categorized under “Category III AIF,” which employs various intricate and varied investing techniques similar to those used by hedge funds worldwide.

Know about the Trends after 2012

The following is a summary of the significant developments that emerged after 2012:

• From primarily focused on venture capital and private equity, the business has developed into a fully-fledged alternative investment sector that includes multiple alternative portfolio management funds, UHNIs, and family offices. For instance, the infrastructure and real estate sectors are two prime examples. AIF Regulations-registered hedge funds, whether domestic or foreign, are another option. • 
• In Asia Pacific, private equity activity and inflows reached record levels despite global events like the US-China trade war and Brexit. India saw the highest growth in these areas in 20171 and 2018.
• Domestic money has seen a noticeable rise in assisting the AIF business during this era. The ultra-rich Indian billionaires have a keen interest in the AIF business. To serve the extremely rich Indian investor population, several new fund companies and investment managers established or introduced new AIFs.
• Government measures were adopted to offer tax benefits to startups. As a result, privately held equity and venture capital markets have received a much-needed boost. A steady stream of capital from domestic and foreign investors, including financial institutions, insurance organizations, foundations, sovereign wealth funds, pension funds, insurance companies, family offices, and high-net-worth individuals, has been ensured.
• The identification of fresh potential for alternative investments, such as pre-IPO financings, resolution of debt refinancing with banks, special situations like stressed asset auctions under the Insolvency and Bankruptcy Code 2016,  real estate debt financings, M&A financings and co-investments,  infrastructure debt, mezzanine funding,  and equity funds, and so forth, contributed to the growth of the domestic AIF market.
• One significant development during this period was the creation of AIF schemes that concentrated on the listed market space. These funds are similar to hedge funds in that they trade the equity, debt, and derivatives markets long-shortly. A few of them additionally concentrate on unique circumstances, including rights offers, buybacks, delistings, open offers made by the Takeover Code, merger arbitrage, and hedging. Several venture and real estate debt funds concentrating on particular AIF investing categories have also surfaced.
• The SEBI (Mutual Funds) Regulations’ rationalization of the Total Expense Ratio (TER) levied by equity-oriented mutual fund investments has incentivized mutual fund managers to divest and establish their vehicles as Alternative investing Funds (AIFs) in India, hence affording them more freedom in their investing strategies. Under the terms of the AIF structure, AIF managers can impose Performance-based Fees on the “Additional Return” that the fund generates over the “Reference Hurdle Rate.” This cost is paid annually alongside administration fees, which are assessed at a set rate by the manager.
• Every AIF registered with SEBI is closely observed by the Risk Management Framework and Operational Guidelines, including the prudential standards and relevant leverage limitations that are periodically stated.
• The domestic Category III AIF market expanded by discovering innovative alternative investment possibilities, such as gaining exposure to exchange-traded commodities futures and commodity options agreements.
• Thanks to the rise of e-commerce and digital technology start-ups that offer cutting-edge technologies in a wide range of service delivery and frontier areas like fintech, electronic payment systems, machine learning, the Internet of Things, Data Analytics, Cloud Computing, etc., AIFs now have many fresh possibilities. These start-ups have also been essential in pulling large capital from offshore and sovereign wealth funds.

 

What are the Types of AIFs?

The term “Alternative Investment Fund” (AIF) refers to an investment instrument that comprises essentially a privately pooled investment vehicle, according to the SEBI (Alternative Investment Funds) Regulations 2012 (AIF Regulations), which currently govern such activity. Nevertheless, the definition stipulates that only a “privately pooled” organization with assets collected within India or outside for a stated investment strategy is regarded as an AIF due to the variety of investment funds available in the market.

The phrase “privately pooled” indicates that a few investors are pooling the money instead of the entire public. These private investors come from groups like institutions and high net-worth individuals (HNIs), who can appreciate the subtleties of taking on more risk and intricate investment plans. However, this definition expressly excludes the following categories:

Any fund that, by SEBI laws, qualifies as a mutual fund or collective investment program.

Family trusts, employee benefit plans such as ESOPs, holding corporations, securitization-related special purpose vehicles, and other similar arrangements.

Funds governed by other regulators or established under RBI norms, such as securitization corporations. It should be highlighted that the excluded funds are those governed by different authorities like the RBI, IRDAI, PFRDA, or IFSCA or the private assets of a corporation, enterprise, or family.

Depending on their investing approach and the kinds of assets they manage, alternative investment funds (AIFs) can take many forms. A Sponsor or trustee (if an AIF is in trust form) may register the following kinds of funds as AIFs by the SEBI (AIF) Regulations, 2012:

Venture Capital

Venture Capital Funds (VCFs) are alternative investment funds (AIFs) that invest mainly in unlisted investments of start-ups, arising or early-stage entrepreneurial undertakings that focus on new technology, products, services, business models, or IP-based ventures. These funds may also include angel funds.

As used herein, “start-up” refers to a private limited company or limited liability partnership that satisfies the requirements for establishment as laid out by the Department of Promotion of Industry and Internal Trade (DPIIT), Ministry of Commerce and Industry, Government of India, as per notification no. G.S.R. 127(E) dated February 19, 2019, or any other periodically issued policy of the Central Government. A domestic firm that does not trade on a recognized stock market at the time of investment is called a “venture capital undertaking.”

Venture capital refers to the initial phase of institutional funding for nascent or early-stage companies, typically occurring following the successful completion of angel fund fundraising by the respective entities. It works best for asset-light companies focusing heavily on digital media programs, technology, and proprietary rights. Businesses see corporate fundraising as a healthy option.

Angel Fund

A subset of Category I AIF Venture cash Fund known as “angel fund” is defined as such because it raises cash from angel investors and makes investments by SEBI (AIF) Regulations.

Anybody interested in investing in an angel fund and meeting one of the requirements listed below is considered an angel investor. Specifically, this person must be an individual investor with tangible net assets of at least INR 2 crore, excluding the value of their primary property.

It has early-stage investment experience, which is the ability to invest in start-up, emerging, or early-stage businesses, or has previously worked as a seasoned entrepreneur, having spearheaded or assisted in the launch of many start-up businesses, possesses at least ten years of experience as a senior management professional, a company having a minimum net value of INR 10 crore either a fund of venture capital established under the former SEBI (Venture Capital Funds) Regulations 1996 or an AIF registered under the SEBI (AIF) Regulations.

Private Equity Fund

A fund that predominantly invests in equity, equity-linked securities, or partnership interests of investee firms following the fund’s declared aim is referred to as a private equity fund (AIF).

The primary function of a private equity fund is to invest in equity. However, unlike venture capital funds, which prioritize early-stage investments, private equity investments mainly finance later stages of business ventures that are developing a business model and require scaling up for additional expansion.

Debt Fund

Under the Fund’s declared objectives, a debt fund is an AIF that principally invests in debt investments of published or unpublished investee firms or securitized financial instruments.

Due to their illiquidity and frequent non-ownership by traditional investors, many private debt instruments are considered alternative investments. Even publicly traded corporations offer debt instruments through private placement, such as bonds and non-convertible debentures (NCDs), that are not accessible through conventional investment channels.

Since they provide funding for advanced-stage venture capital via mezzanine financing—debt financing with potential equity upside, such as warrants connected to the loan—some venture financing firms also refer to themselves as “venture debt funds. Several pure venture debt funds offer debt financing to high-growth start-ups that have already received venture equity funding at a rate more significant than the market rate.

In addition to financing senior debt, several private debt funds also provide “leveraged loans,” which are used to finance businesses having significant levels of subordinate debt on their financial statements.

Infrastructure Fund

An infrastructure fund is an AIF that predominantly invests in partnership interests, unlisted securities, listed debt, securitized debt instruments, or special purpose vehicles that are involved in or were established with infrastructure projects’ operation, development, or holding.

Using AIFs for debt or equity funding for infrastructure in India is a relatively new development. The leading investors in this market are Sovereign Wealth Funds, Multilateral Funds, and Thematic AIFs because of the sector’s high illiquidity, lengthy project execution gestation risk, and lengthy debt amortization period.

SME Fund

An alternative investment fund (AIF) known as a Small and Medium Enterprise (SME) Fund is one that predominantly engages in unlisted assets of SMEs (small and medium-sized enterprises) or in securities of SMEs that are listed or scheduled to be listed on a SMEs exchange or SME sector of an exchange.

Within this context, the term “SME” refers to a Small and Medium Enterprise and will carry the same definition as specified by the Micro, Small and Medium Enterprises Development Act 2006, subject to periodic amendments. SME enterprises can list and trade on distinct segments of the BSE and NSE. The qualifications and compliance specifications for the exchange above are more lenient than the primary board listing requirements.

Hedge Fund

Hedge funds are investment vehicles that, regardless of the state of the market, use intricate and sophisticated procedures to produce large returns. They can use derivatives, leverage, short sales, arbitrage, and other strategies to exploit market ineffectiveness, deviations, or trends. Hedge funds are classified as Category III AIFs, meaning they are the least regulated but do not receive any financial benefits or tax breaks.

Social Impact Fund

An AIF, also known as a “social impact fund,” meets the fund’s social performance standards and is predominantly invested in securities, units, partnership interests, or shares of social projects or companies.

“Social Ventures” are businesses established to advance social welfare, address social issues, or offer social advantages. These might consist of:

• Public Charitable Trusts that are Charity Commissioner-registered
• Societies that are registered to support science, literature, the arts, or charity
• Section 8 company, established by the 2013 Companies Act’s regulations
• Microlending Establishments

Special Situations Fund

SEBI has now classified Category I AIFs, or distressed debt funds, to include Special Situations Funds (SSF) as a subcategory. Under the IBC 2016, SSFs can participate in debt settlements to obtain loans or equity. They can also purchase distressed loans and secured payments provided by property reconstruction firms and finance businesses that default with banks and NBFCs for a minimum of ninety days.

Corporate Debt Market Development Fund

The Corporate Debt Market Development Fund is a 15-year-term, closed-ended AIF established as a trust. Asset Management Companies get units of a Corporate Debt Market Development Fund. Such a fund aims to buy corporate debt securities through debt-focused mutual fund schemes when the market is disrupted, as SEBI determines. Such debt-focused mutual fund plans need to make sure that:

• Securities issued by corporations must be listed and rated as investment-grade.
• These securities’ residual maturity as of the acquisition date cannot exceed five years.
• These assets have no risk of default or negative credit news or opinions.
• According to SEBI guidelines, the fund will invest in low-risk, liquid debt securities without market disruption.

What are the Categories of Alternative Investment Funds (AIFs)?

According to the SEBI (AIF) Regulations, all the previously discussed fund types fall into one of three categories concerning licensing and other administrative criteria. Below is a list of these categories.

• Category I AIF: Investing in start-ups or early-stage businesses, social ventures, SMEs, infrastructure, or other sectors or areas deemed socially or economically desirable by the government or regulators is known as Category I AIF.

This category includes venture capital funds, SME funds, social venture funds, special situation funds, infrastructure funds, and other AIFs that may occasionally be specified under the Regulations. This category also includes additional funds deemed economically advantageous and that get unique incentives from the government or other regulatory bodies.

• Category II AIF: AIFs in Category II do not come under Categories I or III and do not borrow or use leverage for purposes other than meeting their daily operating needs or as the regulations allow. For this reason, AIFs like debt or private equity funds that do not get any special treatment or incentives from the government or another regulator fall under this category.
• Category III AIF: AIFs falling under Category III use various intricate trading techniques and may use leverage by investing in listed and unlisted derivatives. AIFs fall under this category. Examples of AIFs include hedge funds, funds that trade to generate short-term profits and other open-ended funds for which the government or another regulator provides no additional incentives or exemptions.
• Specified AIF-SEBI added the fourth type of AIF, designated AIF: The Corporate Debt Market Development Fund mentioned before falls under this category. SEBI may occasionally create new categories under Regulation 19.

Considerations Before Investing in AIFs

Before investing in alternative investment funds (AIF) in India, there are a few extra considerations. Here is a summary of a couple of them:

Investing Objectives

Investors should evaluate the investment objective of the Alternate Investment Fund India to ensure that it aligns with their investment goals and risk tolerance.

Track Record

Investors may evaluate the AIF’s track record by examining its historical performance. This information may also help investors assess the fund’s risk-adjusted returns and regularity of returns.

Team Management

The AIF team selects investments and manages fund assets. Investors should consider the team’s track record and qualifications before investing.

Fees and Expenses

AIFs often charge performance and management fees. Investors should think about the costs charged by the AIF and how they impact returns.

Liquidity

Investors may not sell their shares immediately since AIFs are frequently illiquid assets. Before investing, investors should consider their investment horizon and evaluate the liquidity of the AIF.

Evaluate the risk

AIFs have a higher risk than traditional investments. Before investing, investors should consider their tolerance for danger and the AIF’s risk assessment.

Regulatory Structure

Before investing in an alternative investment fund, investors must assess the regulatory framework governing it and confirm that it conforms with all applicable legal requirements.

Options for Exit

Investors ought to evaluate their choices and consider the lock-in term of the Alternate Investment Fund.

What are the Key Advantages of AIFs?

A few benefits of buying AIFs are as follows:

• High Potential Return: AIFs usually have a higher expected return than other financial choices. The substantial sum pooled gives fund managers plenty of room to create flexible strategies to maximize profits.
• Diversification: These funds add much-needed diversity to an investing portfolio. They could offer stability when the economy is struggling, or the market is erratic.
• Volatility: AIFs are not impacted by changes in the stock market, in contrast to equities or mutual fund investments, which tend to be more volatile because of their connection to the stock market.

Conclusion

Venture capital and hedge funds are among the many investment options offered by Alternative Investment Funds (AIFs), which have the potential to provide high returns, low volatility, and portfolio diversity. AIFs have significant risks, high expenses, and restricted liquidity, even though they cater to sophisticated investors. For those considering investing in AIFs, careful study and advice from financial professionals are essential.

 AlFs remain a desirable option for investors seeking exposure to non-traditional asset classes and specialized investment strategies despite their complexity, adding to the rich and varied investing landscape in the constantly changing global financial markets.

Step into the future of investing with India’s dynamic AIF market! Visit our website Corpbiz to elevate your portfolio and seize cutting-edge opportunities in alternative assets.

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