Alternative investment funds: Designed exclusively for the wealthy

Much of the spotlight on the rise in Indian equity markets in the post-Covid era has centred around retail investors in general, and mutual funds as vehicles for counterbalancing the might of foreign portfolio investors in particular. The Indian mutual fund industry crossed the ₹50-lakh crore mark in December 2023.

At another level, sophisticated and affluent Indians are now pushing the boundaries with a different class of investment.

When financial major Goldman Sachs recently released a report stating that there would be 10 crore affluent Indians by 2027 from six crore currently, there seems to be a rub-off on the avenues chosen for investments by the high net-worth individuals (HNIs), too.

Investments in AIFs (Alternative Investment Funds) have been on a rapidly growing path over the past decade. The trajectory has been quite strong in the past five years as well – much faster than the growth in mutual funds and other products.

Data from market regulator SEBI (Securities and Exchange Board of India) indicates that the total commitments raised by AIFs across all three categories as of September 2023 was over ₹9.54-lakh crore.

In the last five years (September 2018-September 2023), AIF assets have grown at a compounded annual growth rate (CAGR) of 34.5 per cent. This rate is more than the 15 per cent levels at which mutual fund assets have increased over the same period. CRISIL Research expects the industry to grow at 27-29 per cent till FY2027.

Category II AIFs garnered the maximum investment interest and account for nearly 82 per cent of the total commitments raised, a six-fold rise in just the past half-a-decade.

It is clear that HNIs, NRIs and other wealthy individuals apart from institutions are investing heavily in AIFs. Many asset management companies (AMCs) that run mutual funds — ICICI Prudential, Axis, Nippon Life, Aditya Birla Sun Life — also have AIF products. Abakkus Asset Manager, White Oak Capital, Alchemy Capital and Aequitas Equity are some other prominent players. SEBI regulates these entities.

But what are these AIFs essentially? How are the three AIF categories different from each other? What is the minimum ticket size, the fees levied and how are these investments taxed?

Read on for more clarity on how AIFs are designed to cater to the needs of HNIs.

How alternatives are structured

Alternative investment funds come in three different categories. Though there is a specific investment mandate, AIFs are not rigidly defined as is done with mutual funds. Products are not standardised in the case of alternatives. The fund names can give a broad-brush indication of where the AIF invests. There are both individual and institutional investors in these products.

These AIFs are privately pooled investments from Indian investors and even NRIs. These can invest in a variety of avenues and asset classes without restrictive mandates.

Investors who wish to opt for AIFs have to commit at least ₹1 crore, which is the minimum ticket size prescribed for such funds. There are some AIFs that demand a much higher ticket size for entry and are thus more suited to the requirements of HNIs and Ultra HNIs.

AIFs can be both open and close-ended. Some schemes demand a lock-in for even five or more years to gain better returns and to avoid distress-selling due to the relatively illiquid nature of their assets’ markets in certain cases, such as real estate funds. Indian citizens, NRIs and even foreign nationals can invest in these schemes.

Three categories

Here’s how each of the three categories stacks up and the different funds under each type.

Category 1: Venture capital, social ventures, SME, start-ups and infrastructure funds fall under this category. Venture capital funds invest in new businesses with high growth potential. They take equity stakes in start-ups in their early or initial stages. HNIs who wish to make substantial profits in such ventures during exit via IPOs or buyouts from other institutional investors, and with a high risk appetite, opt for such venture capital funds.

Then there are infrastructure funds that invest in airports, highways and power projects. They are expected to offer periodic and healthy dividends as the projects start turning out cash flows regularly.

Investors keen on socially conscious businesses or who want specific environmental or social outcomes can opt for funds that invest in social ventures.

In some cases, the government may offer concessions for infrastructure project funding and those catering to SMEs (small and medium enterprises).

Category 2: The most popular category houses private equity funds, bond funds, real estate funds and fund of funds. These schemes do not have too many restrictive or narrow investment mandates, giving fund managers considerable flexibility. This category receives the maximum inflows, given its wider ambit.

Private equity funds invest in late or even mid-stage businesses in the unlisted space. They also invest in companies that seek to tap the IPO (initial public offering) market and wish to capitalise on the pre-IPO attraction early on.

Then there are real estate and credit opportunities funds that invest in a variety of debt and realty avenues to generate steady coupons and higher XIRR than normal bonds. Structured credit funds (fund developers not catered to by banks) for higher coupons and substantial cover (1.5-2X the underlying asset value) are also offered under the category.

Fund of funds invest in other AIFs across segments to make the most of different investment styles, domestically and overseas.

Category 3: This category includes hedge funds, commodity funds and private investment in public equity (PIPE). Hedge funds use complicated trading strategies, short-selling techniques and dabble with derivatives as well.

Commodity funds invest in gold, silver, oil and their derivatives.  

Private investment in public equity funds are the AIFs that fall in this category. Such funds can invest in stocks, bonds, commodities or other asset classes and deploy any strategy without any specific restrictions.

Some of the strategies in the category III AIF in India are long-short and long-only, apart from debt and SME focused approaches.

Long-only funds invest in stocks with a medium to long-term view like the way mutual funds do. The long-short strategy involves taking both long and short positions in the market with stocks or indices so that there is a certain market-neutral position taken to generate reasonable returns at low risk.

Key characteristics

Apart from the avenues themselves, AIFs also come with a few inherent characteristics that make them ideal for HNIs.

First, there are no restrictive mandates on investing only in specific avenues, or in assigning of weightages to specific investments. For example, mutual funds have restriction on maximum weightage that can be given to a stock or sector, choice of market capitalisation and so on. But AIFs have no such compulsions. Therefore, an AIF fund manager can take concentrated or diffused exposures to various investment avenues in order to deliver the best returns.

Second, complex strategies, including the use of derivates for risk management, are all allowed via AIFs.

Third, there is the advantage of AIFs being able to offer bespoke or tailor-made investment solutions that are geared to achieving all the wealth goals of HNIs. Curated products and AIF structures that fit the requirements of HNIs are easily accommodated.

Four, many AIF managers choose to have a closed structure for the schemes they manage. They restrict the flow of money into, and the outflow of money from the funds based on their own assessment of the markets, the dynamics of asset classes involved, thus improving their ability to deliver healthy risk-adjusted returns. Given that some AIF assets may not be that liquid or may have long-term pay-offs, this flexibility in structure helps fund managers by not having to make distress sales during turbulent markets.

Five, since AIFs are locked for the long term, there are no short-term redemption pressures and requirements in terms of maintaining liquidity. There are limited short-term performance pressures as well.

Finally, these AIFs are run by professional managers with deep expertise, thus giving scope for building a well-diversified portfolio.

How taxation works

As with regular mutual funds, equity-driven AIFs are also reasonably tax-efficient in the way they are structured.

Since AIFs are pooled investment vehicles, there are different taxation rules depending on the category chosen.

For AIFs in categories I and II, a pass-through status is given for the investments. So, the gains or income (other than business income) distributed by the AIF to investors is taxable in the hands of investors and not the fund house or AMC. If the investments are in listed shares, long-term capital gains — made on a holding period of more than one year — are taxed at the rate of 10 per cent.

Long-term gains from unlisted shares are taxed at 20 per cent with indexation benefit. .Any business income distributed is taxed in the hands of the AIF itself. Surcharges and cess will also be applicable.

In the case of category III AIFs, the pass-through structure is not allowed. Therefore, the income earned by the AIF will be taxed on the AIF itself. Long-term capital gains are taxed at 10 per cent, plus applicable surcharges and cess. Business income and dividends are taxed at the maximum applicable slab rate.

On the debt side, there is very little difference in taxation across fixed-income products. In the Finance Bill passed in 2023, debt funds and market-linked debentures were made fully taxable. That is, the indexation benefit was taken away and all distinction of long and short-terms was done away with. All realized gains from such investments would be added to the overall income of an investor and taxed at the slab applicable. For similar taxation, it would be wiser to look for higher returns on the debt side from AIFs for HNIs with a higher risk appetite.

Non-standardised fee structure

In terms of fee structure, AIF charges are quite different across players. AIF fee can be structured based on performance or asset size or any other factor.

Since charges and fees are not standardised by the market regulator SEBI, AIFs are free to charge what they deem fit.

Since it is only with category III AIFs that charges or fees are easily available in public domain, given that many HNIs invest in it, much of the illustration pertains to that category.

Very few AIFs charge a flat fee. Usually, there is a base fee charged that is in the range of 2-3 per cent.

Most AIFs also charge a performance-related fee.

These funds set a hurdle or a threshold rate for performance. So, a hurdle return rate (usually 10-12 per cent) is fixed. If the fund manages to deliver returns higher than the hurdle rate, the performance fee kicks in. The performance fee or profit sharing can be quite steep. Some AIFs charge a significant 10-15 per cent on the returns in excess of the threshold or hurdle rate.

For example, if the hurdle rate is 12 per cent and a fund charges 10 per cent performance fees and manages 15 per cent returns, then the 10 per cent fee will apply on the excess 3 percentage points returns (15 per cent-12 per cent). This is in addition to the fixed fee.

The fixed fee is usually charged on a daily basis, while the profit sharing or performance fee is levied on an annual review basis.

Investors thus have to understand the payoffs well when they opt for AIFs and get a sense of post-expenses returns.

Where AIFs fit for HNIs

AIFs are reasonably convenient and transparent like mutual funds and can offer sophisticated strategies of portfolio management services (PMS), thus making for a healthy mix to optimise returns.

For an HNI with who has already done enough and more asset allocation for goals with the common financial products — mutual funds, bonds, direct stocks, deposits and the like — creating generational wealth could be a goal worth aspiring for. That’s where AIFs can fit the bill as HNIs usually have a better level of financial understanding and wealth creation than regular retail investors.

They can then consider allocating a part of their large surplus to AIFs in pursuit of superior returns with the attendant risks. Not that wealth can’t be generated just with mutual funds. But AIFs operate at different levels and cater to a very different set of investors and do not compete with retail-focused products such as mutual funds.

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