What are Alternative Investment and how do they work?

Introduction:

An Alternative Investment Fund (AIF) in India is a privately pooled investment vehicle that is incorporated or registered as a trust or company. This legal entity, not falling under the purview of the company, LLP, SEBI, or other sector regulations, can raise funds from both Indian and foreign investors. These funds are then invested according to established investment guidelines.

Alternative investment assets encompass a wide range of investments that do not fall under traditional asset classes like cash, stocks, or bonds. Examples of alternative investments include private equity real estate, private equity infrastructure funds, secondary funds, and private debt funds.

It's important to note that AIFs do not cover funds regulated by the SEBI (Mutual Fund) Regulations of 1996 and the SEBI (Collective Investment Scheme) Regulations of 1999. Additionally, under the AIF Regulations, family trusts created for the benefit of "relatives" as defined in the Companies Act are exempt from registration requirements.

Purposes of investing in alternative investments:

Before the rise of the venture capital-private equity (VCPE) industry in India, entrepreneurs primarily relied on private placements, public offerings, and bank lending/financial institutions for business expansion and financing needs. To address the gap between the capital needs of rapidly growing companies and traditional financing sources like banks and IPOs, the Venture Capital Fund Regulation (VCF) was introduced by SEBI in 1996.

The introduction of VCF aimed to provide a structured framework for venture capital funds to operate in India, facilitating investments in high-growth potential companies. This regulatory framework helped foster the growth of the VCPE industry in the country, enabling entrepreneurs to access funding beyond traditional avenues.

By incorporating alternative investments like venture capital and private equity into traditional investment portfolios, investors can effectively reduce overall portfolio volatility. This diversification strategy not only helps in spreading risk but also enhances the potential for higher returns. Alternative investments typically exhibit lower correlation with traditional asset classes such as stocks and bonds, offering a way to further diversify and potentially enhance portfolio performance.

Categories of AIFs

Category I AIFs

·         Category I AIFs focus on investments in start-up or early-stage businesses, social ventures, SMEs, infrastructure, and other sectors deemed appropriate by government or regulatory bodies. These funds are considered beneficial on a social or economic level and are designed to support small and medium-sized enterprises, social ventures, and infrastructure projects. Category I AIFs do not typically use leverage except for limited temporary financing needs and primarily invest in unlisted securities of investee companies.

Category II AIFs

·         Category II AIFs encompass funds that do not fall under Category I or Category III. These funds, such as private equity funds and debt funds, invest in a diverse range of assets that may not fit the criteria of Category I or involve complex trading strategies. Private equity funds primarily invest in equity instruments of investee firms, while debt funds focus on debt securities of listed or unlisted companies. Category II AIFs do not use leverage extensively except for operational requirements as permitted by regulations.

Category III AIFs

·         Category III AIFs engage in sophisticated trading techniques and may utilize leverage, including investments in derivatives. Hedge funds are a common example of Category III AIFs known for their flexibility in trading strategies and risk management approaches. These funds require approval from investors to use leverage and must adhere to SEBI-set limits. Category III AIFs cater to investors seeking exposure to alternative strategies beyond traditional investments, with a focus on generating short-term profits through diversified trading methods while complying with regulatory guidelines.

Benefits of Alternative Investments

Risk reduction through diversified investment is a key objective of alternative investing. These investments aim to mitigate risk by diversifying across various asset classes that are not closely correlated with traditional assets like public equities and bonds. By including alternative investments in a portfolio, investors can effectively reduce overall risk exposure.

Another primary goal of alternative investments is to enhance the expected returns of a portfolio by acquiring assets that offer attractive risk-adjusted returns, known as alpha. Alternative investments like hedge funds and private equity provide opportunities to potentially increase the risk-adjusted returns of a diversified portfolio through alpha generation.

Additionally, alternative investments often come with direct tax benefits. Investors can benefit from structures that allow for more profit retention. For instance, in many private alternative investments, investors become fund or syndication partners, enabling them to receive tax incentives directly.

Two significant tax benefits include future depreciation processing and long-term capital gains. Real estate funds and syndicates, for example, can deduct depreciation from their net income, reducing taxable income. Similarly, investments in sectors like oil and gas can benefit from favorable depreciation and tax treatment, enhancing the overall tax efficiency of these alternative investments.

Cons of Alternative Investments

Illiquidity

·         One significant drawback of alternative investments is their illiquidity. These investments are often private and unpredictable, leading to high volatility. Consequently, they can be challenging to sell quickly for cash when needed, as the assets lack the liquidity of more traditional investments like stocks or bonds.

Overall Complexity

·         Alternative investment funds are known for their complexity compared to traditional investment options. Investing in alternatives requires a higher level of due diligence and understanding. Potential investors must conduct thorough research to grasp the intricacies, risks, and potential consequences associated with these investments before committing capital.

Unregulated Nature

·         A key concern with alternative investments is their lack of regulation. Unlike traditional investments that are subject to regulatory oversight and reporting requirements, alternative investments operate in a less regulated environment. This lack of oversight can expose investors to higher levels of risk, especially in cases where the provider of the assets or investments faces financial difficulties or insolvency.

Valuation Difficulty

·         Valuing alternative investments can be challenging, leading to pricing opacity and reduced transparency. The lack of standardized valuation methods can make it difficult for investors to accurately assess the true worth of their alternative holdings. Despite these challenges, alternative investments continue to gain popularity among investors due to their unique characteristics and potential for diversification in a portfolio.

Conclusion:

In conclusion, the rising popularity of Alternative Investment Funds (AIFs) in India underscores the potential for diversification and enhanced returns when integrated thoughtfully into investment portfolios. To sustain and further boost the growth of AIFs in India, it is imperative for regulatory authorities to align with industry standards by adopting global best practices. This entails fostering on-shore fund management capabilities, facilitating access to domestic capital pools through strategic sectoral interventions, and implementing regulatory measures that promote investor confidence and market integrity. By embracing these initiatives, India can nurture a conducive environment for the continued evolution and success of the AIF industry, unlocking new avenues for investment growth and financial innovation in the country.