According to SEBI, AIF means any fund established or incorporated in India in the form of a trust or a company, LLP or a body corporate. AIFs are privately pooled investment vehicles which collect funds from investors (Indian or foreign) and invest according to a defined investment policy.
Alternative investments are more than just simply going long on stocks, bonds or cash. To put it simply, they are alternatives to investing in equities, bonds or cash. However, the term ‘alternative’ should not be construed to imply that alternatives are necessarily uncommon or relatively recent additions to the investment universe. AIFs invest in real estate and commodities, which are arguably two of the oldest asset classes.
The only difference is that they adopt non-traditional approach to investing by using special vehicles such as PE funds, hedge funds etc. Such funds give fund managers more flexibility while investing. AIFs are also characterized by high fees, use of leverage, restrictions on redemption, etc.
Categories of AIFs
SEBI has categorized AIF into three categories:
- Category I
- Any AIF having a spillover effect on economy falls in this category
- Government or other regulatory bodies provide incentives or concessions for this category
- Such funds include SME funds, venture capital funds, infra funds, etc.
- The fund should be closed end in structure
- These funds are not allowed to engage in leverage
- Category II
- These funds have no specific incentive or concession given by government or any other regulatory body.
- The fund should be closed end in structure
- Fund managers are not allowed to engage in leverage.
- Such funds include private equity funds, debt funds and funds of funds
- Category III
- It includes funds which aim to generate short term returns.
- Includes funds which employs diverse or complex trading strategies and use leverage by investing in listed or unlisted derivatives.
- These funds can be open end or closed end in structure.
- Such funds are regulated through issuance of directions regarding areas such as operational standards, conduct of business rules, prudential requirements and restrictions on redemption, conflict of interest which are specified by SEBI.
Basic terminology to remember:
- Hurdle Rate: - It is the “line is the sand” which helps the company to decide whether or not they should pursue the project or charge the client an incentive fee. Ex: If hurdle rate is 10%, the project should be accepted only if the returns generated on the same is above 10%. Client/Investor will be charged an incentive fee only if returns generated by the fund manager is above 10%.
- Leveraged buyouts: - It a leveraged transaction in which firms acquire or buyout other public or private establishments with significant part of the purchase price financed through debt.
- High water mark: It is the peak in value of investments. It is used to compensate the fund managers so that they don’t not get paid for poor performing funds.
In the next series of tutorials we will cover different types of AIFs, how they operate, their returns, etc.