Only a few years ago, the only way to create financial assets in India was to put our money in conventional investment categories such as stocks, bonds, real estate, FD’s, etc. With the increasing tribe of high net-worth individuals in the country, there is a steady rise in the demand for non-conventional investment avenues such as Alternative Investment Funds (AIFs).
The need for Alternative Investment Funds (“AIFs”) in India was boosted with the surge in venture capital investments. However, caught in the confusion of many regulations, the Venture Capital Fund (“VCF”) vehicle came to be used by many other funds such as private equity (“PE”), private investment in public equity, real estate, etc., thereby making it difficult to give targeted concessions to VCFs to promote startup or early-stage companies.
It is in this background that in 2012 the Securities and Exchange Board of India (“SEBI”) introduced the SEBI (Alternative Investment Funds) Regulations, 2012 (the “AIF Regulations”) and to recognize AIFs, such as PEs and VCFs, as a distinct asset class apart from promoter holdings, creditors and public investors.
What is an Alternative Investment Fund (AIF)?
*“Alternative Investment Fund or AIF means any fund established or incorporated in India which is a privately pooled investment vehicle which collects funds from sophisticated investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors.
AIF does not include funds covered under the SEBI (Mutual Funds) Regulations, 1996, SEBI (Collective Investment Schemes) Regulations, 1999, or any other regulations of the Board to regulate fund management activities. Further, certain exemptions from registration are provided under the AIF Regulations to family trusts set up for the benefit of relatives as defined under Companies Act, 1956, employee welfare trusts or gratuity trusts set up for the benefit of employees, ‘holding companies’ within the meaning of Section 4 of the Companies Act, 1956 etc. [Ref. Regulation 2(1)(b)]”
Any privately pooled investment vehicle, established or incorporated in India, in the form of a trust or a company or a limited liability partnership (“LLP”) or a body corporate, not covered under any other SEBI or sectoral regulations. Such privately pooled investment vehicle may collect funds from investors, whether Indian or foreign, for investing such funds in accordance with defined investment policies
Specific exclusions include family trusts, employee stock option trusts, employee welfare trusts or gratuity trusts, holding companies, special purpose vehicles not established by fund managers and regulated under a specific regulatory framework (eg. securitization trusts), and funds managed by registered securitisation or reconstruction companies.
Source of definition: SEBI AIF Regulations 2012
Apart from the registration and compliance requirements under the AIF Regulations, each AIF also needs to be compliant with the applicable statutes, depending upon the chosen structure of trust, LLP, or a company. Apart from these, there are also filing and audit requirements for a company and an LLP. As such, a trust is a more favoured structure amongst the existing AIFs in India, since the regulatory framework governing trust structures is minimal and allows the management independence with respect to formulating its own standards of governance.
Different Categories of AIF
As per the existing SEBI classification, these private investment funds have been divided into 3 unique categories – Category I, Category II, and Category III, with the minimum qualifying corpus amount for these schemes being Rs. 20 Crores. The only exception to this rule is an ‘angel fund’, which is a subcategory of Category I AIFs, as they have lower qualifying criteria in terms of fund corpus at Rs. 10 crores. Let’s discuss them in a little more detail to gain a clear understanding of each category:
Category – I
Funds that invest in StartUps, Small and Medium Enterprises (SMEs), and new businesses which have high growth potential and are considered socially and economically viable, are part of this category. The government promotes and incentivizes investment in these projects as they have a multiplier effect on the economy in terms of growth and job creation. These funds have been a lifeline to already thriving startups starving for capital.
Category I comprises the following funds:
Venture Capital Fund (VCF)
Venture Capital Funds invests in StartUps that have high growth potential but facing an investment crunch in the initial phase and need funding to establish or expand their business. Since it is difficult for new businesses and entrepreneurs to raise funding through the capital markets Venture Capital Funds become the most sought-after solution for their financing needs.
VCFs pool in money from investors who want to make equity investments in ventures. They invest in multiple startups, depending on their business profiles, assets’ size, and phase of product development. Unlike mutual funds or hedge funds, venture capital funds focus on early-stage investment. Each investor gets a share of the business the VCF has invested in proportional to their respective investment.
High Net Worth Investors (HNIs) who seek high risk-high return investments options prefer to invest in VCFs. After the inclusion of VCFs in AIFs, HNIs from abroad are also able to invest in VCFs and contribute to the growth of the economy.
Infrastructure Funds (IF)
The fund invests in the development of public assets such as road and rail infrastructure, airports, communication assets, etc. Investors who are bullish on the infra development in the coming times can invest in the fund since the infrastructure sector has high barriers to entry and relatively low competition.
Returns from investing in Infrastructure Fund can be a combination of capital growth and dividend income. When an Infrastructure Fund invests in socially desirable/viable projects, the government may also extend tax benefits on such investments.
This fund is a type of Venture Capital fund where fund managers pool money from numerous “angel” investors and invest in budding startups for their development. As and when the new businesses become lucrative, investors get the dividends.
In the case of Angel Funds, units are issued to the angel investors. An “angel investor” refers to an individual who wants to invest in an angel fund and brings in business management experience, thus guiding the startup in the right direction. These investors typically invest in firms that are generally not funded by established venture capital funds because of their growth uncertainty.
Social Venture Fund
Socially responsible investing has led to the emergence of Social Venture Fund (SVF) that typically invests in companies that have a strong social conscience and aim to bring a real change in society.
These companies focus on making profits and solve environmental as well as social issues simultaneously. Even though it is a kind of philanthropic investment, one can still expect returns because the firms would still make profits.
Social Venture Fund generally invests in projects based out of developing countries as they have great potential for growth as well as social change. Such investments also bring the best managerial practices, technology, and vast experience to the table which makes it a win-win deal for all stakeholders including investors, enterprises, and society.
Funds investing in various equity securities and debt securities come under this category. All those funds that are not described under category I and III by SEBI, fall under category II. No incentive or concession is given by the government on investment in these funds.
Category II comprises the following funds:
Private Equity (PE) Fund
PE funds basically invest in unlisted private companies and take a share of their ownership. Since unlisted private companies can not tap capital through the issuance of equity or debt instrument, they look out for PE funds.
Further, these companies present their investors with a diversified portfolio of equities which essentially, lowers the risk to the investor. A PE fund typically has a fixed investment horizon ranging from 4 to 7 years. After 7 years, the firm expects that it would be able to exit the investment with a good amount of profit.
This fund primarily invests in debt instruments of listed as well as unlisted companies.
Companies that have low credit scores generally release high yield debt securities accompanies with high risk. So companies with high growth potential, good corporate practices but facing capital crunch can be a good investment option for debt fund investors.
As per the SEBI Regulations, the amount invested in Debt Fund cannot be utilised for the purpose of giving loans, as Alternative Investment Fund is a privately pooled investment vehicle.
Fund of Funds
As the name suggests, this fund is a combination of various Alternative Investment Funds. The investment strategy of the fund is to invest in a portfolio of other AIFs rather than making its own portfolio or deciding what specific sector to invest in. However, it should be kept in mind that Fund of Funds under AIFs cannot issue units of fund publicly, unlike Fund of Funds under Mutual Funds.
Funds that aim at short-term returns fall under this category. They employ various complex and diverse trading strategies to achieve their goal of short-term capital appreciation. There is no specific incentive or concession given by the government on investment in these funds as well.
Category III comprises the following funds:
A hedge fund pools capital from institutional and accredited investors and invests in domestic as well as international markets to generate high returns. They take up leverage to a great extent and have aggressive management of their investment portfolio. Hedge funds are relatively less regulated as compared to their counterparts such as mutual funds and other investment vehicles.
However, they are expensive relative to other financial investment instruments. Hedge Funds generally charge 2% as the asset management fee and take up 20% of the profits earned as a fee.
Private Investment in Public Equity Fund (PIPE)
It is a privately managed pool of privately sourced funds earmarked for public equity investments. Private investment in public equity refers to buying shares of publicly traded stock at a discounted price. This enables the investor to purchase a stake in the company, while the company selling the stake receives capital infusion to grow its business.
Alternative investments continue to grow in popularity and are making their way into the portfolios of well-off individual investors. So, if you are one of them, you must understand the advantages and limitations of investing in Alternative Investment Funds in India. Alternative investments typically do not correlate to the stock market, which means they add diversification to a portfolio and help mitigate volatility. While, just like any other investment, the rate of return for AIFs is not guaranteed, there is potential for it to be higher than that of traditional investments through inflation hedging and robust diversification. However, alternative investments are more complex and have higher fees associated with them than traditional investment vehicles. Moreover, the majority of AIFs are invested in illiquid investments, making them difficult to exit and price on a regular basis. And as with any investment, the potential for a higher return also means higher risk.
What is an Angel Fund?
Angle Funds are funds where the money is pooled in by investors termed as ‘Angels’. This pooled amount is then invested into startups in sizable amounts, this provides the investors better negotiating powers.
In India, Angel Funds are covered under the umbrella of Category I of Alternative Investment Funds which are regulated by Securities Exchange Board of India (Alternative Investment Funds) Regulations, 2012. Under Category I Angel Funds are summed up with venture capital funds, SME funds, social impact funds, etc.
Who is an Angel Investor?
Angel investors are experienced and well-established investors who have an insight into the industry. In the general course of business, normal venture equity funds or equity funds are not interested in committing their funds to start-ups and businesses in their formative stages. This is because there is no surety or track record regarding the returns from such startups. In such situations, Angel Investors play a key role as they undertake such startups with their funds as well as trust.
These angel investors can be individuals or companies with high net worth. While venture capital funds focused on investing in later stages of business, angel investor provides the much-needed support in the initial stages of the business.
Legal Definition of Angel Investor
Legally Angel Funds are regulated by AIF Regulations. As per these regulations, Angel funds Investors will be an investor willing to invest in Angel Funds and can be any of the following:
1) Any INDIVIDUAL whose has net tangible assets is not less than 2 Crore rupees. This will not include the value of his principal They are required to have any one of the following features:
Early stage investment experience, this refers to prior experience in investing in start-up or emerging or early-stage ventures, this refers to any person who has earlier promoted or co-promoted more than one such ventures or
Experience as a serial entrepreneur or
The individual is a senior management professional and has experience of minimum 10 years.
2) Any BODY CORPORATE, which has a minimum net worth of 10 Crore rupees.
3) Any AIF registered under Securities Exchange Board of India (Alternative Investment Funds) Regulations, 2012 or any Venture Capital Fund registered under Securities Exchange Board of India (Venture Capital Funds) Regulations, 1999.
How is an Angel Fund different from other AIFs?
Following are the points of difference between the two categories:
Corpus: Angel funds form a part of Category I AIF where the corpus requirement is Rs. 10 Crore. On the other hand, Category II and II AIF are required to have a corpus of Rs. 20 Crores.
The minimum investment limit for a single investor is set at Rs. 25 lakhs for Angel Funds unlike other AIFs where this limit is set at Rs. 1 Crore Rupees
The Sponsor/ Manager is required to have a continuing interest in the Angle Funds will be lower of the two; 2.5% of corpus or Rs. 50 lakhs. However, in the case of other AIFs, this requirement is way higher.
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