Types of AIFs (Alternate Investment Funds) in India

Ankita Tiwari

06 Apr, 2023

Alternate Investment Funds (AIFs) are non-conventional investments as they collect money from private investors and invest in private equity, venture capital, hedge fund, angel fund, etc. The funds so collected by AIFs are invested as per the prescribed investment policy. AIFs are governed under a separate regulation namely the Securities Exchange Board of India (Alternate Investment Fund) Regulation, 2012 (hereinafter referred to as “SEBI (AIF) Regulation, 2012^[1]“). To operate as an AIF, it has to be registered under the SEBI (AIF) Regulation, 2012. This Regulation provides for three types of AIFs namely Category I, Category II, and Category III. An investor can choose to register under any one category depending upon its investment objective. Let’s understand each type of AIF in detail:

Types of AIFs

1. Category I AIF
   Investors who intend to invest in unlisted and private space of start-ups, early-stage ventures, SMEs, social ventures, infrastructure or socially and economically viable sector register as Category I AIFs. Following are the various types of AIFs under Category I:
   • Venture Capital Funds
     Venture Capital Fund (VCF) is a kind of equity financing where funds are provided to companies in exchange for an equity stake. VCFs generally invest in start-ups, new businesses that have growth potential. Venture Capitalists also participate in company operations. VCFs are closed-ended funds having a lock-in period of 3 (three) years which can be extended for 2 (two) years.
   • Angel Funds
     Angel Funds are funds that are raised from angel investors. Chapter III-A which was inserted by way of the 2013 amendment in the SEBI (AIF) Regulations, 2012 deals with Angel Funds. Angel funds are raised by the issue of units to angel investors. To invest in Angel funds, the investor has to qualify for any one of the following conditions:
     • An individual investor should not have less than Rs. 2 crore net tangible assets excluding the value of the principal residence. In addition, the individual investor must have early-stage investment experience or experience as a serial entrepreneur or at least 10 (ten) years of experience in a senior management professional role.
     • A body corporate should have a net worth of not less than Rs. 10 crores.
     • It must be registered as an AIF under the SEBI (AIF) Regulations, 2012, or as a venture capital fund registered under the SEBI (Venture Capital Funds) Regulations, 1996.
   • Small and Medium Enterprises (SME) Funds
     SME Funds invest in small to medium enterprises whether listed or unlisted. These funds raise debt from NBFCs to provide equity financing to companies. To be classified as an SME Fund, a minimum investment of 75% has to be made in unlisted or proposed to be listed SME companies. A minimum of Rs. 1 crore is invested with a lock-in period of 3 (three) years extendable for further 2 (two) years. When the SME company reports substantial growth or when it gets listed, the SME funds generate returns. If the returns are greater than 8% then the fund management team gets a share in excess return.
   • Social Venture Capital Funds or Impact Funds
   • These funds invest in companies that focus on bringing positive change in society or companies which are involved in solving social and environmental issues. The investors get reasonable returns from these businesses. The investors and fund share return from the social venture fund by following the waterfall mechanism. The waterfall mechanism provides that the capital and hurdle rate (minimum profit that is given) are distributed among the investors then the excess return is distributed as per the terms of the scheme.
   • Infrastructure Funds
     Infrastructure funds are funds primarily invested in infrastructural projects such as railways, roadways, airways, renewable energy, etc. The Government of India offers incentives and concessions to investors investing in such funds. Investors who are confident about infrastructural development should invest their money in these funds.
2. Category II AIF
   SEBI (AIF) Regulations, 2012 defines this type of AIF as funds that neither fall under Category I nor Category II and which do not undertake leverage or borrowings other than to meet the operational requirements. No incentives or concessions are provided by the Government of India to these AIFs. The types of AIFs under Category II are as follows:
   • Private Equity (PE) Funds
     PF funds are primarily invested in unlisted private companies and take ownership of the company. They are generally invested in the mid-stage of a business. Unlisted private companies usually raise capital through PE funds as they cannot do it through equity or debt instruments. PE funds usually come with a lock-in period of 4 (four) to 7 (seven) years.
   • Debt Funds
     These funds are primarily invested in debt or debt securities of listed or unlisted companies. Debt funds are invested in companies facing capital shortages but have good growth potential. Funds pooled for the purpose of debt funds cannot be used to give loans. It has a low credit rating which makes it a high-risk option for investors.
   • Funds of Funds
     Funds of Funds are used to invest in various types of AIFs by following an investment strategy. They do not have their investment portfolio so they invest in different AIFs.
3. Category III AIF
   Category III AIFs are invested in listed as well as unlisted derivatives by applying diverse trading strategies. Funds under this Category can be close-ended as well as open-ended. Strategies such as arbitrage, derivatives trading, and future and margin trading are used to invest in this category of AIF. The investment is done across large, medium and small capital businesses and is the largest category from the seller’s and buyer’s perspective due to the highest number of funds as well as the highest number of investors. The various types of AIFs under this category are as follows:
   • Hedge Funds
     Under this type of AIF, investments from private investors are pooled and invested in domestic as well as international debt and equity market by using various trading and investment strategies. The return and the risk tend to be higher in hedge funds as they are subject to high market volatility. This type of AIF is expensive for investors as the fund manager charges an asset management fee at the rate of 2% or more. In addition to this, they also consider a return in excess of 20% as their fee.
   • Private Investment in Public Equity
     Under this type of AIF, the shares of publicly traded companies are bought at a discounted price. This type of AIF helps infuse capital into businesses especially small to medium-sized enterprises. The benefit of this type of AIF is that the funds can be raised easily due to lesser regulations as compared to a secondary issue.

Conclusion

AIFs are the preferred investment option, especially for High Net Worth Individuals who desire to receive a high return with lesser risk as compared to other investment options. Based on the investment objectives, an investor can do thorough market research on the types of AIFs and decide in which type of AIF, he should finally invest. 

Also Read: Categories of Alternative Investment Funds