Alternative Investment Funds, or AIFs as they are popularly called, are preferred by HNI investors looking to invest their money in unconventional avenues, suitable to their investment strategies.
The minimum investment required to opt for the AIF scheme is Rs.1 crore which makes the scheme exclusive for sophisticated investors having alternative investment strategies.
AIFs are considered alternatives to stocks and mutual funds and, given the nature that these investments work, a defined investment strategy is necessary before investing in them.
Given the large ticket size, any ambiguity in your investment strategy means considerably compromised returns. You wouldn’t want that, would you?
So, let’s have a quick look at the concept of AIFs and how you can define your investment strategy when investing in an AIF scheme.
What are AIFs?
Regulated under Regulation 2 (1) (b) of the Regulation Act, 2012 of SEBI (Securities Exchange Board of India), AIF is a specialized investment fund.
The fund pools money from different investors and then invests the pool in different investment avenues based on the investment strategy of the AIF.
Moreover, there are three different categories of AIF funds. Knowledge of these categories is important as you can choose the category that you want to invest in and every category has a different investment strategy. So, let’s have a look at the categories of AIF in details –
Category I AIF
Category AIF invests primarily in start-ups, businesses that are in their nascent stages, infrastructure, social ventures or SMEs. Category I AIFs are close-ended in nature with specific minimum maturity tenure.
So, if you invest in this category, your investments would be tied-up over the lock-in period.
Category II AIF
Category II AIF is one that does not belong to Category I or Category II. These funds include debt funds, private equity (PE) funds, funds of funds, funds for distressed assets, real estate funds, etc.
These funds are also close-ended in nature with a specific maturity date thereby tying in your investments for a specific period.
Category III AIF
Category III AIFs invest in unlisted or listed derivatives. Common examples of Category III AIFs include PIPE (Private Investment in Public Equity) funds and hedge funds.
These AIFs can be offered either as close-ended schemes or open-ended schemes. So, if you invest in open-ended funds, you can get easy liquidity if you want to redeem your investments at your discretion.
On the other hand, if you choose the close-ended schemes available under this category, your investments would be tied-up for a specific lock-in period.
Furthermore, AIFs have some salient features that help you in defining and customising your investment strategy.
Here are top reasons why investors are opting for alternative investments
These features are as follows –
Customisable in nature
AIFs are customisable as per the needs of their investors. The structure of an AIF can be designed keeping in mind the investment needs of its investors.
Since AIFs have a limited number of investors (maximum 1000), the investment strategy of the AIF can either lean towards a specific sector or theme or it can be diversified across different asset classes.
The flexibility of funding
AIFs is open to investors of all nationalities. Thus, Indians, NRIs and even foreign nationals can invest in an AIF scheme provided they bring in the minimum investment amount to invest in the chosen fund.
This flexibility in funding attracts HNIs from all walks of life making AIFs a specialized investment tool.
Large corpus for investment
As mentioned earlier, AIFs have a minimum ticket size of Rs.1 crore. Thus, investors contribute substantial amounts towards AIF schemes creating a large corpus.
The returns earned from such large investments are also considerable and the large accumulated corpus becomes more effective in achieving the investment objective of the scheme.
Now that you know what AIFs are, the different types of categories that they fall into and their salient features, defining your AIF strategies would be easier. So, let’s get to the task of how to define your AIF investment strategy effectively so that you can make the most of your investments.
Here’s a step by step process on how to invest in alternative investment in India
How to define AIF strategies?
Tod define your AIF investment strategy, you should keep in mind certain important aspects of the scheme.
These aspects are as follows –
Alternative Investment Funds (AIF) are definitely exclusive and not for every investor
Exclusivity is the driving factor behind investors picking AIF schemes. With a high ceiling on the minimum investment, AIFs are not accessible by investors with limited capital.
AIFs also allow exposure to investment avenues that common investors cannot avail of. For example, pre-IPO private equity of businesses, hedge funds, venture capital, SME investments, etc. can be sourced only through AIFs.
So, if you are looking to invest in different avenues, separate from the commonly available mutual funds, stocks, gold or real estate, you can opt for AIFs and get exposure to different types of assets that are not commonly available for investment through traditional investment platforms.
Alternative Investment Funds (AIFs) are high-risk and high-return products
Before you set out to invest in AIFs, remember that AIFs are risky. They invest in different types of assets (as mentioned earlier) that are prone to volatility and other types of risks. Moreover, Category III Funds borrow to invest and are, therefore, highly risky.
If you have a healthy risk appetite and don’t mind exposing your investment to a variety of market risks, you can choose AIFs. The risk that you take would be compensated through the potential of high returns that the scheme has.
But remember, if the underlying assets underperform or hit a rough patch, the losses would be considerable. Patience is the key strategy when investing in AIFs and taking high risks on your investments.
Assessment of Alternative Investment Funds (AIF) schemes is tricky
You can try and assess the performance of an AIF scheme through its past returns. However, if the investment strategy of the scheme has changed, past performances would not be relevant.
Moreover, being exclusive types of funds, AIFs lack peer-to-peer comparison. One AIF fund might be an exclusive fund in its segment making a comparison of its returns difficult.
Though AIF funds are benchmarked as per SEBI’s mandate, you can only compare the performance of the scheme against the benchmark category average. Comparing across peer funds becomes difficult given the mixed investment objectives of AIFs.
Thus, you need to have a strong and keen investment acumen to understand and judge the performance of the AIF scheme and to choose the most suitable scheme for yourself.
Alternative Investment Funds (AIFs) incur high costs
When it comes to the cost structure of the AIF scheme, it is on the higher side. This is because there is no regulation on the maximum charge that AIFs can exact. AIF fund managers are therefore free to charge a fee from investors.
Usually, the fee involves two components, a flat management fee and profit-sharing. The management fee is expressed as a percentage of the AIF investment and remains fixed. Profit-sharing, on the other hand, involves splitting returns with the fund manager.
The idea behind this is since the fund managers have identified and managed the investments to generate returns, a part of the returns should belong to them. In fact, under many AIFs, there is no management fee, only profit sharing.
So, if there is a profit-sharing of 15% and you earn a return of Rs.10 lakhs in the first year, you would have to pay Rs.1.5 lakhs to the fund manager while the remaining Rs.8.5 lakhs would be yours.
Even if the fund generates lower than the previous return, profit sharing would be applicable if you have earned any returns.
For example, in the above example, if there is a return of 10% in the next year, though you have lost 5% in returns compared to the first year, 15% of the returns earned would be paid to the fund manager.
The concept of ‘high water mark’
To avoid double performance fee, there is a concept of ‘high water mark’ under most AIF scheme. Under this concept, profit-sharing would be applicable only if the fund consistently performs well every year.
Let’s understand with an example –
Say, you invest Rs.1 crore and, in the first year, the fund yields a 15% return increasing the corpus to Rs.1.15 crores. In the first year, therefore, you would be sharing the profit with the fund manager.
In the second year, the corpus falls to Rs.1.10 crores. In this case, since the corpus fell, no profit-sharing would be applicable. Now, in the third year, the corpus regains its original growth and grows to Rs.1.15 crores.
Again, there would be no profit-sharing because the profit on the initial growth of 15% was already shared. In future years, if the fund crosses Rs.1.15 crore mark, then profit-sharing would be applicable.
There are lock-in periods in Alternative Investment Funds
Another factor that you need to check is the lock-in period applicable under the scheme. Category I and II funds are close-ended schemes. Their lock-in periods usually go up to 7 years.
Category III funds, however, have both the open-ended and close-ended options, with close-ended funds having lower lock-in periods of 3 years or 3.5 years and above.
So, when investing in AIFs, remember that if you choose Categories I and II, your funds would be tied. If you are looking for liquid investment opportunities or if you have a short-term investment horizon, opt for Category III funds.
Taxation of Alternative Investment Funds (AIFs) need to be considered
AIFs are taxed differently compared to other traditional investment avenues. The tax treatment of your investment would depend on which Category AIF you invested in.
In the case of Category I and II AIFs, the AIF fund itself does not pay any tax on the returns generated. The returns are credited to you and you need to pay income tax on such returns as per your tax slab rates.
Moreover, even if the fund retains a part of the return and reinvests it in the portfolio, your tax liability would be calculated on the gross returns generated and not on the returns that you have received.
For example, if the fund earns a return of Rs.10 lakhs and pays you Rs.8 lakhs while retaining Rs.2 lakhs in the fund itself, your tax liability would be calculated on Rs.10 lakhs. Since you fall in the highest tax slab, you lose a major part of the return in taxation.
If the AIF invests in stocks and you earn a return from such investments, taxation would be computed based on your holding period. Long term capital gains tax would be charged on returns exceeding Rs.1 lakh @10% while short term gains would be taxed @15%.
In the case of Category III AIF, the fund itself pays tax on the returns earned. The returns generated by the AIF are considered to be business income and they are taxed at the highest tax slab rate.
Thus, a tax of 42.7% is deducted from the returns earned. The returns are, then, paid out to investors. Even though you have a lower tax bracket of 30%, the returns attract a higher rate of tax.
You should, therefore, consider these aspects when defining your AIF investment strategies. Only if you understand these aspects of AIF investments, are willing to take risks and share your profits, you should invest in AIF.
AIF is a specialized and sophisticated investment avenue. Your investments should also be specialized, sophisticated, well-thought-of and fool-proof. If you are confused about choosing the right AIF, don’t worry.
Koppr is here to help. Let Koppr’s fund managers help you choose the right AIF as per your investment preferences.
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