Alternative Investment Funds
A CNBC article noted, "With the Stock market bland and the bond market bubbling, investors may have to search elsewhere in the months ahead for return." The investors who are tired of the stock markets wrench and their volatility and who have been continuously looking out for innovative investment options, Alternative Investments come conveniently for them. During the past decade, investors have been just walking away from the stock market, attempting to venture into alternative investments. The reasons behind such a bold step are that the results for long term investors from the stock market are not encouraging, and the rewards are not in proportion to their patience and risk tolerance. Considering the past ten years, S & P 500 has been over only by 10 percent or more, approximating 1 percent per year. The term "Alternative Investments" is a broad term and can be defined as an investment product, other than traditional products like bonds, shares or cash. Liang (2003) defined Alternative Investments as complex investment strategies that create returns in excess from the returns, which are typically available with traditional investments. Alternative investments vary from traditional investments considering the use of a wide range of techniques and instruments, low correlation with traditional asset classes, and dynamic trading strategies. Liang proceeds to state that many institutional investors like investment banks, insurance companies as well as the private endowments like university endowments are flocking to the alternative investment funds due to its lack of regulatory oversight, demands from both wealthy and institutional investors and other special features.
In India, Alternative Investment Funds (AIFs) are defined in Regulation 2(1)(b) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012. It refers to any privately pooled investment fund, whether from an Indian or foreign or Non-Resident Indian Investor, incorporated or established in the form of a company or a trust or a Limited Liability Partnership (LLP) or a body corporate which is neither presently covered by any regulation of the Securities and Exchange Board of India (SEBI) governing fund management like, the Regulations governing Mutual Fund Regulations, 1996 or Collective Investment Scheme Regulations, 1999, and any other regulations of the SEBI to regulate fund management activities, nor coming under the direct regulation of any other specific regulators in India like the Insurance Regulatory and Development Authority (IRDA), Pension Fund Regulatory & Development Authority (PFRDA), Reserve Bank of India (RBI). Therefore, in India, AIFs are defined as private funds which are otherwise not falling under the jurisdiction of any regulatory agency in India except SEBI. AIFs include Hedge Funds, Venture Capital Fund, Private Equity Funds, SME Fund, Equity-linked instruments, Social Venture Fund, Debt Funds, Infrastructure Funds, Commodity Funds, etc. AIFs primarily exclude Mutual Funds, Collective Investment Schemes, Family Trusts (set up for the benefits of relatives under the Companies Act 1956), Employee Welfare Trusts or Gratuity Trusts, Employee Stock Option Scheme or Employee Stock Purchase Schemes, 'holding companies' falling under the definition of Section 4 of the Companies Act 1956, other specific purpose vehicles that are not established by fund managers including securitization trusts regulated as per a specific regulatory framework, and funds managed by a securitization company or reconstruction company that is registered with the RBI as per Section 3 of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 and it also excludes any such fund which is directly regulated by any other regulator in India. SEBI issued the AIF Regulations to create a structure where a regulatory framework is available for all shades of investment vehicles or private pool of capital so as to channelize and better regulate the funds where institutions or High Net-worth Individuals invest. The necessity for the framework arises to help detect any fraud, unfair trade practices and minimize conflicts of interest through disclosures, incentive structures, reporting requirements and legal agreements.
Considering AIFs' impact on the economy and the regulatory regime, the concerned exposure, risk as well as their impact on the economy in other aspects, they are categorized into three categories:
- Category I AIF is the AIF with positive spillover effects on the economy, for which certain concessions or incentives might be considered by the Government of India or SEBI. Such funds generally invest in a start-up or early-stage ventures or social ventures or SMEs or infrastructure or other sectors which as per the government or regulators is economically or socially desirable. They shall not be permitted to engage in any leverage except to meet a temporary funding requirement for not more than thirty days, not more than four occasions per year and not more than 10 percent of the corpus, for instance, Venture Capital Funds, SME Funds, Social Venture Funds and Infrastructure Funds. Fund of Category I AIFs may invest in units of Category I AIFs of the same sub-category provided that they only invest in such units and not be investing in units of other Fund.
- Category II AIF is the AIF for which no certain concessions or incentives are given and do not fall under Category I and Category III. Same as specified for Category I AIFs, Category II AIFs are also not permitted to engage in any leverage, except to meet a temporary funding requirement for not more than thirty days, not more than four occasions per year and not more than ten percent of the corpus, for example, Private Equity or Debt Fund for which no specific concessions or incentives are given by the Government of India or any other Regulator. Fund of Category II AIFs may invest in units of Category I or Category II AIFs, provided that they only invest in such units and not be investing in units of other Fund.
- Category III AIF is a fund that has some potential negative externality in specific situations and which undertakes leverage to a great extent. These funds intend to make short term returns or such funds which are open-ended or close-ended and receive no certain concessions or incentives from the Government of India or any other Regulator for instance Hedge Funds which employ a diverse or complex trading strategy and invest and trade in securities of listed or unlisted investee companies having diverse risks or complex products including listed and unlisted derivatives. Category III AIFs may engage in borrow or leverage or subject to consent from the investors in the fund and subject to a maximum limit, as may be specified by the SEBI provided that such funds disclose complete information concerning the overall level of leverage employed, the level of leverage arising from the borrowing of cash, from the position held in derivatives or in any complex product and information regarding the main source of leverage in their fund to the SEBI and to the investors periodically, as may be specified by the SEBI. These funds are allowed to invest in Category I and III AIFs, provided they only invest in such units and shall not invest in units of other Fund. Category III AIFs shall be regulated through issuance of directions regarding areas such as operational standards, the conduct of business rules, prudential requirements, restrictions on redemption and conflict of interest as may be specified by the SEBI.
Investment Restrictions and Conditions for AIFs
All AIFs shall state the investment purpose, strategy and methodology in its placement memorandum to the investors and raise funds by way of issue of units from any investor whether an Indian, foreign or non-resident Indian. Consent of two-third of unit holders by value of their investment in AIF is required for any material alteration to the fund strategy.
AIFs raise funds through private placement and cannot accept an investment of value less than INR 1 Crore, provided that in case the investor is an employee or director of the AIF or employee or director of the manager, the minimum value of an investment is INR 25 lakh. Any scheme of the fund is not permitted to have more than 1000 investors, and each scheme must have a corpus of minimum INR 20 Crore. The manager or sponsor of the AIF should have a continuing interest in the AIF of minimum 2.5 percent of the corpus or INR 5 Crore, whichever is lower. This continuing interest should be in the form of investment in the AIF. It cannot be through any waiver of management fees, provided that in case of Category III AIF, the continuing interest should be a minimum of 5 percent of the corpus or INR 10 Crore, whichever is lower. The manager or sponsor shall disclose their investment in the AIF to the investors of the AIFs in all Categories. Under Category I and II the AIFs are close-ended, and schemes launched by such funds should have a tenure of minimum three years and extension of the tenure of the close-ended AIF may be allowed for a maximum of two years subject to the approval of two-thirds of the unitholders by the value of their investment in the AIF. AIFs of Category I and II are not permitted to invest more than 25 percent of the investible funds in one Investee Company while it is 10 percent for Category III AIFs, and Category III AIFs can be open or close-ended. In case of absence of consent of the unitholders, the AIF shall fully liquidate within a period of one year following the expiration of the fund tenure or extended tenure. AIFs can invest in associates in which the sponsor or manager holds interest, either individually or collectively, more than fifteen percent of its paid-up equity share capital or partnership interest, with the approval of 75 percent of investors by the value of their investment in the AIF. An un-invested portion of the corpus may be invested in liquid mutual funds or bank deposits or other liquid assets of higher quality such as, but not limited to, Treasury bills, Commercial Papers, Certificates of Deposits till deployment of funds as per the investment objective. Units of close-ended AIFs can be listed on a stock exchange after the final close of the fund or scheme subject to a minimum tradable lot of INR 1 Crore. Co-investment in an investee company by a manager/sponsor cannot be on more favorable terms than those terms offered to the particular AIF by the investee company.
Reporting norms to SEBI are on a:
- quarterly basis for Category I, II AIFs and Category III AIFs which do not employ leverage;
- monthly basis for Category III AIFs which employ leverage.
Benchmarking of Performance
In February 2020, SEBI issued the guidelines for benchmarking of the performance of AIFs in order to streamline disclosure standards and helping the investors to assess scheme performance. The agreement between the AIFs and benchmarking agencies shall cover the manner of data reporting, certain data that must be reported, and terms of confidentiality. Performance benchmarking shall be done on a half-yearly basis as on 30 September and 31 March of each year. Performance benchmarking enhances transparency among AIF investors aiding in their ability to compare performance across similar strategy schemes possessing the same vintage and thereby assess the relative performance of the management team while considering making investments.
A template for Private Placement Memorandum (PPM) has been introduced to ensure minimum disclosure to prospective investors. To further ensure compliance with the terms of PPM, it will be mandatory for AIFs to carry out an annual audit by an internal or external auditor or legal professional. Angel funds, as well as AIFs/schemes in which each investor commits to a minimum capital of INR 70 crore or USD 10 million, are exempted from the requirement of PPM and audit.
As of 30 September 2019, investments made in AIFs have risen to INR 1.25 trillion, with 65 percent of the assets coming from Category II Funds. In December quarter 2019, investments by AIFs rose to over INR 1.4 lakh crore.
India, as a nation has witnessed several investment schemes in varying shades of grey. The AIF Regulations are a facilitator as they bring transparency regarding the issue of regulation of capital that is raised locally for deployment by various types of investment funds. It will help to monitor the unregulated funds, encourage the formation of new capital and investor protection. AIF’s comprehensive Regulations surely bring greater clarity to the market and the investors. Its comprehensive nature brings different investment entities under the watchdog that were hitherto unregulated by the SEBI.