Alternative investment funds (AIFs), as a distinct asset class, are gaining more prominence in recent times amid rise in the number of wealthy individuals and their growing appetite for sophisticated financial instruments for investing.

The total assets of AIFs surpassed ₹ 5-lakh crore mark for the first time recently. According to latest data of the Securities and Exchange Board of India, assets of AIFs have grown over 32 per cent year-on-year to ₹5.35-lakh crore at the end of September 2021. The total AIF assets stood at ₹4.05-lakh crore as of September 2020 and ₹3.17-lakh crore in September 2019.

“While traditional investment avenues such as fixed deposits, shares, and bonds are effective tools for wealth generation, savvy investors are increasingly turning to AIFs to generate additional alpha. Higher projected returns, low correlation with traditional asset classes, which allows for portfolio diversification, and recent clarity on AIF structures, standards, and taxation have all contributed to a recent increase in AIF allocations,” said Sabyasachi Mukherjee, Head Investment, Fisdom Private Wealth.

R Pallavarajan, Founder & Director, PMS Bazaar, said that investor appetite for enhanced returns, diversification of portfolio beyond traditional equity and debt asset classes and growing product awareness are some of the factors pushing the growth of this alternative investment product.

“AIFs offer a plethora of structures, varieties and products. For instance, some clients want to invest in start-up ecosystems but don’t have an expertise in that space while some are interested to invest in venture capital or private equity (PE) funds. AIFs allows them to do that because for every client need there is a product. Hence, we see a lot of interest in this space,” Pallavarajan added.

According to a latest PMS Bazaar report, assets under management (AUM) of AIFs are expected to grow six-fold to reach ₹30-lakh crore in the next 10 years, growing at a compounded annual growth rate (CAGR) of 20 per cent.

Structured similar to mutual funds, AIF is a privately pooled investment vehicle that collects money from sophisticated private investors, both from India and overseas, for investing with a defined investment policy. It has a minimum investment limit of ₹1 crore.

Three categories

As per SEBI guidelines, AIFs are classified into three categories. Category I AIF includes Venture Capital Funds, Angel Funds, SME Funds, Social Venture Capital Funds and Infrastructure Funds. Category II AIF covers Private Equity (PE) Funds, Real Estate Funds, Funds for distressed assets, Debt Funds and Funds of Funds. Category III AIF are those trading with a view to making short-term returns and include hedge funds and PIPE Funds.

On a category-wise basis, Category II AIF accounts for 80 per cent of the total assets at ₹4.28-lakh crore followed by Category II (₹57,953 crore) and Category I (₹48,394 crore).

“Category II offers a plethora of products. There will be real-estate products, long short products, debt funds but with a different product offering. For example, there are funds which focus on providing debt funding to start-ups with a fixed return and so on,” PMS Bazaar’s Pallavarajan said.

He also added that Category II AIFs have been gaining traction in recent years as some asset managers invest in companies at pre-IPO stage, thereby gaining handsome returns for the investors post their listing.

“We expect investors to seek out AIFs investing strategies that follow non-traditional patterns, such as long short strategies, pre-IPO, and structuring products, to further diversify their opportunity set as volatility in domestic equities rises and valuations appear stretched, while fixed income investments continue to provide low returns,” Fisdom’s Mukherjee said.

Despite its recent traction, AIFs are still considered to be meant for sophisticated investors. Mukherjee feels that complex strategies, Illiquidity (most AIFs have a strict lock-in period), difficult ways of valuing the underlying assets, and higher taxation are some of the significant challenges that the AIF business is facing.

Product awareness

Pallavarajan says lack of awareness about the product itself is another challenge but added that it has been improving in recent times.

“There are more than 700 AIFs in the country but clients are aware of only 30-40 of them. There are variety of products still waiting to be discovered by investors,” Pallavarajan said, adding that “However, AIFs cannot be as public as a mutual fund or PMS because it’s a private product and SEBI has clearly mandated that if someone needs to put money into AIFs, they need to thoroughly grow through a private placement memorandum.”