Impact of AIFs on capital markets and financial stability

Swetha Dhinesh

06 Jun, 2023

A few years ago, investing in traditional investment categories like shares, bonds, real estate, FDs, etc., was the only method to accumulate financial assets in India. There is an increasing demand for unconventional investment options due to the country’s rising high-net-worth population. Due to this, our capital market and financial stability have been impacted by the AIFs.

Alternative Investment Funds (“AIF”) are a particular category of unconventional investment options. AIF is a fund that investors can use to make investments and profit from them. AIFs are a fund that assembles capital from knowledgeable private investors. Alternative investment funds are a realistic option for savvy investors who want to diversify their holdings. 

Regulating Authority

The funds raised will be invested in accordance with the AIF’s investment strategy. AIFs are not subject to the mutual fund regulations of the SEBI. The SEBI (AIF) Regulations 2012 (the “AIF Regulations”), however, were introduced in 2012 by the Securities and Exchange Board of India (“SEBI”) to recognise AIFs. In India, an AIF may be incorporated as a trust, company, Limited Liability Partnership (LLP), or body corporate.

A consultation paper on the proposed revision to the SEBI (Alternative Investment Funds) Regulations, 2012¹, was published by the (SEBI) Securities Exchange Board of India on May 18, 2023. This Consultation Paper’s goal is to improve the Alternative Investment Funds (AIF) governance structure.

Alternative Investment Fund

Alternative Investment Fund is a privately pooled investment vehicle that gathers assets from affluent people to invest for the benefit of their investment in accordance with a set investment policy.

A fund founded or incorporated in the form of a company, body corporate, trust, or LLP, which is a privately pooled investment vehicle, is defined as an AIF under Regulation 2(1)(b) of the AIF Regulations. It receives money from investors to invest for the benefit of investors in accordance with a set investment policy. 

Benefits of AIFs

People continuously consider the advantages of AIFs and other funds when investing in a fund. Let us understand the advantages of AIFs:

• Dissociated from the stock market – Every investor active in the stock market for the long term has undoubtedly experienced huge wins and losses. Anyone who has retired or is close to retiring has experienced the pain of seeing their portfolio fall frequently and substantially. Diversifying their portfolios is one of the main reasons investors look for Alternative Investment Fund.

Many investors have discovered private alternatives to diversify their portfolios and hedge against volatility. As a result, if the stock market falls, they will have a hedge of protection, and their total investment portfolio will be unaffected. Even in a stable economy, the stock market is notoriously unstable, and alternatives are mostly immune to the public markets’ volatility.

• Lack of Volatility – Zero volatility share prices in conventional investments fluctuate for a variety of reasons and are unrelated to an actual asset. AIFs have no connection to the stock market because they are not publicly listed. Therefore, their returns are unaffected by market ups and downs. They are carried out through private placements, shielding unitholders from share market volatility. AIF is one of the best investment choices to create a steady portfolio.

• Be aware of the tax advantages – Alternative investments can provide large tax benefits. You keep more of your profit because of the structure of many alternative investments. In many private alternative investments, you should be a member of the fund or syndicate, and the tax advantages are transferred straight to you.

The two most significant tax advantages are long-term capital gains treatment and pass-through depreciation. Many real estate funds or syndications cut their taxable income by deducting depreciation expenditure (a non-cash item) from net income. The depreciation and depletion tax treatment for oil and gas assets is highly favourable.

• High Income – It might be challenging to generate income from public investments like bonds, dividends, etc., Due to the instability of the public markets, there is a greater danger of a poor yield. Even with AIFs, not all assets have high cash flows, but they typically produce a return on investment every month or every three months. Some also produce significant income of 8 to 10% each year. Additionally, a lot of funds are set up so that investors receive payment first.

• Proper Regulation – The SEBI (AIF) regulation, 2012, is a distinct set of rules that apply to properly regulated AIF. AIFs are only open t sophisticated investors who satisfy certain requirements. AIFs must also meet requirements such as minimum investment, investment limits, and other regulatory and transparency requirements.

• Flexibility – The most adaptable type of investment vehicle is an AIF. They are more adaptable in their investment plans and invest in a variety of assets. AIFs can modify their investments in reaction to changes in the market. For investors, this results in higher returns.

Impact of AIF on Capital Market and Financial Stability

Different perspectives are there in impacting the capital market and financial stability in alternative investment funds. Below are some important points that impact the capital market and financial stability:

• Market Liquidity: By acting as an additional source of cash and investment activity, AIFs can help to increase market liquidity. They invest in various assets, some of which may not have as much liquidity as publicly listed securities, such as real estate, private equity and venture capital. AIF can, however, increase the liquidity of some market segments, particularly in alternative asset classes.

• Capital Formation: AIFs contribute to capital formation by luring investment capital and directing it towards different industries. The expansion of enterprises, the creation of new infrastructure, and other investment opportunities can all benefit from this money inflow. AIFs, like venture capital funds and private equity, can offer long-term support to businesses that find it challenging to acquire conventional funding sources. It may help the economy grow and bring employment opportunities.

• Risk Diversification: AIFs give investors access to non-traditional asset classes and alternative investment techniques that are not normally offered by standard investment vehicles. Investors can lessen their exposure to conventional market risks and improve risk-adjusted returns by diversifying their portfolios with alternative assets. By distributing risk across various assets and asset types, this risk diversification can help maintain the financial system’s general stability.

• Potential Systemic Risk: The development and connectivity of AIFs may bring about systemic risks. Similar investment approaches or concentrated holdings in certain assets by a sizable number of AIFs have the potential to increase market volatility and create systemic hazards. To ensure that such vulnerabilities are found and fixed as soon as possible, regulators must continuously monitor the risks and actions related to AIFs.

• Regulatory oversight: To preserve financial stability and investor safety, regulators are essential in regulating AIFs. AIF may be subject to regulatory frameworks that mandate registration, disclosure, risk management principles, and reporting requirements. The stability of the capital markets is maintained, and possible risks associated with AIFs are reduced due to effective regulation and oversight.

Conclusion

It is crucial, and it should be remembered, that the effect of alternative investment funds on capital markets and financial stability can change depending on the particulars of each fund, the regulatory landscape, and the market environment. In order to strike a balance between fostering market expansion and preserving financial stability, regulatory authorities and policymakers continuously evaluate the possible risks and benefits associated with AIFs.

Read our Article: Benefits of Investing in AIF (Alternative Investment Funds)

1. https://www.sebi.gov.in/legal/regulations/apr-2017/sebi-alternative-investment-funds-regulations-2012-last-amended-on-march-6-2017-_34694.html