Setting up of an Alternate Investment Fund in India

An Alternate Investment Fund (AIF) is a unique investment vehicle formed with privately pooled investments either by Indian or Foreign High Net Worth Individuals (HNIs), Financial Institution and Wealthy Family Offices. These funds are not meant for retail investors like mutual funds. They work on a dynamic and clear strategy to generate higher returns for their investors. They are specialized funds involving high risk and low liquidity catering to only the people who have the financial acumen to understand them.

The purpose for the formation of these funds is to provide accessibility to investing in niche asset classes apart from the traditional ones (like stock, bonds etc.) which might be illiquid and costly but have the potential to generate higher returns compared to the markets. They provide the investors with an option to diversify their portfolios and mitigate their risks. These funds must ensure complete transparency in their operations as they are regulated by SEBI to protect the interest of the investors.

Types of AIFs in India

Based on the AIFs investment objectives and strategies, SEBI has classified them in three categories:

Category I AIF

These are the funds which typically invest in startups, early-stage companies, SMEs or companies focused on social impact or sectors classified as economically beneficial by the government. They also enjoy government incentives and concessions.

• Venture Capital Funds: These are the fund that typically invest in high growth-high risk early-stage startup companies
• Infrastructure Funds: These funds invest in long-term infrastructure projects like roads, railways, bridges and airports. They are backed by the government and have an aim to generate long term stable income.
• Social Impact Funds: These funds are focused on ventures having a positive social impact, being ESG considerate while generating high returns.
• SME Funds: They invest in small and medium enterprises which have reflected a great historical performance and have the potential to expand in future.

Note: A new type of fund known as Special Situation Funds has been introduced by SEBI to improve the working of banks as they will focus takeover of NPAs.

Category II AIF

These funds typically invest in unlisted companies either as debt or equity. They usually invest for a fixed duration and don’t enjoy any benefits like category I AIF.

• Private Equity Funds: They invest in unlisted companies and try to acquire a large stake, as the companies are unlisted and face difficulties raising capital.
• Debt Funds: These funds invest in unlisted companies through bonds, debentures and other fixed income instruments.
• Fund of Funds: Rather than being a specialized AIF, they tend to invest in multiple AIF. Instead of investing in a stock or bond, they invest in portfolio of companies.
• Real Estate Funds and Distressed Funds are also a part of category II.

Category III AIF

These types of funds invest in listed and unlisted derivatives and may use leverage for that as well. They also deploy complex strategies to achieve the required return.

• Private Investment in Public Equity Fund (PIPE): These funds invest in companies listed on the stock exchange. When the company is in the need to raise capital due to distress or illiquidity at a discounted price, they invest in them through private place in the value of potential upside.
• Hedge Fund: The main aim of the fund is to generate high returns irrespective of the market situation. To achieve high returns, they deploy complex strategies. A few of the strategies are arbitrage, short selling, use of derivatives and many more.

Establishment of AIF

As mentioned under the regulations and guidelines of SEBI, all AIFs can be established or incorporated in the form of a trust, company or as a body corporate or even a limited liability partnership. However, most of the AIF registered with SEBI, are registered as a trust.

Prerequisites for registration of AIF Fund

• The documents such as Memorandum of Association (MOA) or any deed shall have mentioned in them the clauses allowing them to carry out the venture as an AIF.
• The charter document should have clauses mentioned in them stating that invitation to the public to subscribe to its securities is prohibited.
• At least one member of the main founding team who will be a key fund manager should have been accredited with a certificate of passing the NISM Series-XIX-C which is the AIF Managers certification exam.
• Necessary infrastructure and manpower should be fulfilled before commencing the operations.
• The objectives of investment, the strategy of investment, the potential targets and the duration must be clearly disclosed by the applicant.
• The minimum corpus of an Alternate Investment Fund should be INR 20 crores.
• The minimum investment made by any investor to the fund can’t be below INR 1 crore.
• Any employee or the fund manager should make a minimum investment of INR 25 Lakhs
• There cannot be more than 1000 investors in an AIF.
• The listing of units of AIF can be done on stock exchange only once the fund has been finally closed, with the minimum tradable lots of INR 1 crore.

Registration Fees

• Category I: INR 5,00,000 is the fees and INR 2,00,000 is the fees for the Angel Funds.
• Category II: INR 10,00,000 is the stipulated fee for registration.
• Category III: INR 15,00,000 has been stated as the required fee.

Managers Contribution

The contribution of the manager should be the lower of:

• Category I: > 2.5% of the corpus of the fund or > INR 5 crore, > INR 2 crore (for angel funds).
• Category II: > 2.5% of the corpus of the fund or > INR 5 crore.
• Category III: > 5% of the corpus of the fund or > INR 10 crore.

Minimum Corpus

For all the three categories the minimum corpus required is INR 20 crores and INR 5 crores for Angel Funds

Permitted Investment in listed securities

• Category I: Different limits have been permitted for different categories of securities.
• Category II: <50% of the total fund can be invested in listed securities
• Category III: Up to 100% of the total fund is permitted to be invested in listed securities.

Period of Investment

• Category I: The investment period ranges from a minimum of 3 years to a maximum of 10 years.
• Category II: The investment period ranges from 2 to 5 years.
• Category III: The investment period ranges from 1 to 10 years.

Use of Leverage

• No leverage is permitted for Category I & Category II
• Category III: High exposure to leverage is permitted.

Investment by banks and insurance companies

• It is permitted for Category I & Category II with a restriction of 10% in Angel Funds.
• Category III: It is not permitted for them.

Type of Fund

• Category I & Category II are closed end funds.
• Category III: It can be either closed end funds or open-end funds.

Guide to setting up an AIF in India

AIFs has become quite popular in India as a source to diversify the portfolio. Now the small investors have also had access to invest in the AIFs through mutual funds.

1. Application to SEBI through Form A, along with a cover letter

The process of registration starts with an application made to SEBI through the filling of Form A in the stated format which needs to be properly filled, numbered, duly signed and stamped. The usual time taken by the SEBI for the registration is 21 days but could be longer as well depending on how well compliance the application was made.

A cover letter needs to be attached with the main purpose to inform SEBI:

• If the AIF has been already registered as a VC and if it is then all the details regarding the registration must be provided.
• It needs to be mentioned if the AIF activities have already been taking place before the registration and if yes, all details need to be provided.

2. Preparing a Bank draft payable to SEBI

Along with the Form A for application, a bank draft of INR 1,00,000/- needs to be made in favor of SEBI as the application fee.

3. Application will be evaluated by SEBI

Once it is checked that the application has been made as per the compliances then SEBI will evaluate and scrutinize the complete application ensuring proper adherence to rules and regulations. Once SEBI is completely satisfied with the application they will approve the application.

4. Registration fees payment to SEBI

Once the AIF receives the letter from SEBI stating that ‘the application has been successful’, the AIF must prepare themselves to pay the registration fees as per their designated category. Also, if an AIF has already been registered as a VC, they don’t have to pay the complete registration fees but a reduced payment of INR 1,00,000/- needs to be made instead. Once SEBI confirms the registration fees have been received then ‘Certificate of Enrolment’ is issued to the AIF.

5. SEBI ensures AIF’s compliance with its rules and regulations.

After receiving the ‘Certificate of Enrolment’ it is important for the AIF to make sure to comply with all the rules and regulations stated by SEBI. The SEBI will continue to update about any changes made through the issue of circulars to the AIF and they must act on it. Also, any changes made by AIF to the original data provided to SEBI must be informed to SEBI within a specified frame of time.

Alternate Investment Funds in India

In recent times, AIFs has gained much traction in India by consistently generating higher returns compared to the traditional method. As a result, they have received more than USD 119 billion in commitments.

AIFs have come a long way, over a decade ago, the majority investments were made by the foreign investors but eyeing the investment opportunities presented, and the returns generate by AIFs, it has gained much attraction from the domestic investors and as of now 80-90% of funding is made by them. The AIF industry is growing at a rapid rate and aims to become as big as the mutual fund industry. The AIF industry has offered the investors opportunities to invest in specialized assets which further can have more niche segments within them.

The rise of AIF industry can possibly be explained by the rise of domestic pool of investments mainly driven by contributions from Tier II and Tier III cities. With all that said there are still some challenges which need to be addressed for continuous development of the industry.

The maximum number of AIFs are deployed in real estate followed by IT, financial services and pharmaceuticals sectors. These sectors normally have relaxed sectoral norms while accounting for around 46% of total deployment of funds by AIFs as of the end of March 2023.

On 19th September 2024 amendments have been made to the valuation framework of the AIFs which are listed and highly traded on the stock exchange, they will be valued as per the same guidelines of mutual funds, this decision has been taken in interests of the public to simplify the process. Also, SEBI mentioned that the decision on valuation framework of AIFs which are unlisted, non-traded or thinly traded will be provided by 31st March 2025.

Foreign Investors Perspective over AIFs in India

Historically, the AIF sector has been dominated by the investments made by foreign investments. The norms mentioned under the Foreign Exchange Management rules state the criteria to classify the investments made by AFIs are ‘indirect foreign investments’ or not. The norms mentioned are as follows:

• The investment manager who is controlling the AIF, so if the manager is foreign national, it will be considered under the ‘indirect foreign investments’.
• Category III AIF’s having any foreign capital should only make investments in the sectors which are permitted under the FDI policy but to what extent investments will be made was not mentioned.

This became one of the major reasons for dominance of FDI into the AIFs as they found a way to invest in sectors beyond the mentioned limit through establishing AIFs. On observing these scenarios, on April 26, 2024, SEBI has made amendments to the policies to stop the exploitation of these policies. New policies have capped the investments made by AIFs having a certain level of foreign capital. The new policies can be a way cannibalizing the FDI inflows into Indian AIFs. The government and the regulatory bodies need to strike a balance for the growth of the country.

Conclusion

Setting up an Alternative Investment Fund (AIF) in India offers investors a way to access alternative asset classes and potentially higher returns, involving higher risks as well. The alternate investment sector is on the track for a rapid expansion as the popularity of AIFs is growing amongst both the domestic and foreign investors. However, to fully realize its potential, continued regulatory refinement and investor education will play a major role. As these factors evolve in the Indian market, AIFs will play an increasingly important role in portfolio diversification and wealth generation.