December 5, 2021

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What aspects must be considered while making an investment in an Alternative Investment Fund

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This article is written by Brijesh Devi, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho. The article has been edited by Tanmaya Sharma (Associate, LawSikho) and Smriti Katiyar (Associate, LawSikho).

Table of Contents

Individual investors have minimal say in portfolio compositions in most traditional investment vehicles, which have universal investment patterns. People can invest in a variety of different investment options. Common investments are divided into two types: equity-oriented investments, which are market-linked and add to a company’s equity capital, and debt-oriented investments, which are not market-linked and invest in fixed-return instruments. There are capital risks associated with equity-oriented investments, but they are outweighed by the potential for higher returns when compared to debt-oriented investments.

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In debt-oriented investments, on the other hand, the risk of losing the capital invested is theoretically absent, but the chance of earning a higher return than the predetermined rate of return is also absent. 

A financial asset that does not fall into one of the traditional investment categories is known as an alternative investment. Stocks, bonds, and cash are all common types of alternative investments. Private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts are also examples of alternative investments. Real estate is frequently referred to as an “alternative investment.”

Alternative Investment Fund or AIF means any fund established or incorporated in India which is a privately pooled investment vehicle that collects funds from sophisticated investors, whether Indian or foreign, for investment, following 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.

An alternative investment is a financial asset that does not fall into one of the conventional equity/income/cash categories. Private equity or venture capital, hedge funds, real property, commodities, and tangible assets are all examples of alternative investments. Most alternative investments have fewer regulations from the SEC and tend to be somewhat illiquid. While traditionally aimed at institutional or accredited investors, alternative investments have become feasible to retail investors via alt funds, ETFs, and mutual funds.

Because of their complexity, lack of regulation, and high risk, most alternative investment assets are owned by institutional investors or accredited, high-net-worth individuals. 

All Alternative Investment Funds have to state their investment strategy, investment purpose, and investment methodology in their placement memorandum to the investors. Any material alteration to the fund strategy has to be made with the consent of at least two-thirds of unit holders by value of their investment in the Alternative Investment Fund. Alternative Investment Funds have to raise funds through private placement by the issue of information memorandum or placement memorandum, by whatever name called. Extension of the tenure of the close-ended Alternative Investment Fund may be permitted up to 2 years subject to the approval of two-thirds of the unitholders by the value of their investment in the Alternative Investment Fund. In the absence of consent of unitholders, the Alternative Investment Fund has to fully liquidate within 1 year following the expiration of the fund tenure or extended tenure.

Category III Alternative Investment Fund cannot invest more than 10% of the investable funds in one investee company. Alternative Investment Fund cannot invest in associates except with the approval of 75% of investors by the value of their investment in the Alternative Investment Fund.

Applicants can seek registration as an AIF in one of the following categories as may be applicable.

Category I AIF

Category I AIFs invest in early-stage initiatives, start-ups, social ventures, Small and Medium Enterprises (SMEs), infrastructure, or other sectors/areas deemed socially or economically acceptable by the government or regulators. SME funds, venture capital funds, infrastructure funds, social venture funds, and other such AIFs are included in Category I AIF investments. AIFs fall under this category since they are expected to generate beneficial economic spillover effects. This category includes funds for which the SEBI, the Government of India (GOI), or other Indian regulators may consider granting incentives or concessions.

Category II AIF

Category II AIFs are those that do not come under Category I or III and do not borrow or leverage for anything other than day-to-day operational needs, as defined by the SEBI (Alternative Investment Funds) Regulations, 2012. This category of AIF covers debt or private equity funds that do not get any special incentives or concessions from the government of India or any other regulator. Real estate funds, private equity funds (PE funds), distressed asset funds, and other types of funds are all classified as Category II AIFs.

Category III AIF

Category III AIFs are those that use complex or diverse trading methods and leverage, as well as investments in listed or unlisted derivatives. This category includes open-ended AIFs such as hedge funds or funds that trade for short-term returns, as well as other similar funds that get no specific concessions or incentives from the GOI or any other regulator.

Before making an investment in AIF’s it is advised to consider the following points:

Legal and regulatory framework

Do any special regimes or provisions apply to specific types of alternative investment funds? Under the AIF Regulations, an AIF can seek registration in either Category I, Category II, or Category III. Category I: The stated objective is to provide certain benefits to Category I AIFs, which include AIFs that invest in: start-ups or early-stage ventures; social ventures or small and medium-sized enterprises; infrastructure; or such other sectors as the government considers are socially and/or economically desirable. In case of breach of the AIF Regulations and/or the FEMA Regulations, both SEBI and the Reserve Bank of India have the powers to take action against the AIF, the manager of the AIF, and the sponsor of the AIF, and their respective promoters. SEBI has wide powers under the SEBI Act and AIF Regulations, including the power to conduct inspections, searches, and seizures, to impose penalties, and to issue other orders, such as an order barring an errant person from accessing the capital markets. Specifically, about AIFs, SEBI has signed bilateral MoUs with securities market regulators of 27 member states of the European Union/European Economic Area concerning consultation, cooperation, and the exchange of information relating to the supervision of managers of AIFs.

Authorization and permissions

Is the AIF authorized or licensed in your jurisdiction? As per the AIF Regulations, no entity or person shall act as an AIF without obtaining a certificate of registration from the Securities and Exchange Board of India. To obtain this registration, the AIF must file the necessary declarations and the requisite application with SEBI. If the AIF is to be set up as a trust, the indenture of trust must be duly created under the Trusts Act and registered under the Registration Act, 1908.  Its AIF manager and sponsor must fulfil the ‘fit and proper criteria; either the AIF manager or the sponsor must have the necessary infrastructure and manpower to effectively discharge their obligations and duties towards the functioning of the applicant AIF; the key investment team of the AIF manager of the applicant AIF should have adequate experience in advising or managing the pools of capital and possess the relevant professional qualifications as prescribed in the AIF Regulations. They must also simultaneously pay the non-refundable application and registration fees as specified in the Second Schedule of the AIF Regulations.

Marketing considerations

Under the AIF Regulations, AIFs can be marketed only through private placement by the issuance of an information memorandum. Units of an AIF can be listed on stock exchanges only after the final close of the AIF or its scheme, and subject to a minimum tradable lot of INR 10 million. There are no specific authorization requirements for the marketing of an AIF; however, the AIF Regulations are evolving and the Securities and Exchange Board of India is seeking industry feedback on regulating the fees of brokers and placement agents of AIFs, as well as imposing a standardized private placement memorandum format for new AIFs and schemes.

Indian entities such as banks, insurance companies, and pension funds are subject to the restrictions prescribed by their sectoral regulators concerning investment in AIF units; hence their investments must comply with these regulations over and above compliance with the AIF Regulations. The marketing materials for AIFs must satisfy the requirements as specified in the AIF Regulations. Further, the AIF Regulations prescribe that the AIF cannot have more than 1,000 investors and each investor must make a minimum commitment of INR 10 million or INR 2.5 million in the case of employees of the sponsor or AIF manager.

Only sophisticated investors can invest in an AIF since each investor must make a minimum commitment of INR 10 million in an AIF.

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Investment process

At least two-thirds of their investible funds must be invested in unlisted equity shares or equity-linked instruments of a venture capital undertaking or in companies listed or proposed to be listed on a small and medium-sized enterprise (SME) exchange; and

Not more than one-third of their investible funds must be invested in:

  • The initial public offering of a venture capital undertaking proposed to be listed;
  • Debt instruments of a venture capital undertaking; preferential allotment of equity or equity-linked instruments of a listed company; 
  • Equity or equity-linked instruments of a financially weak company – that is, a company whose accumulated losses had eroded more than 50% of its net worth as at the beginning of the previous financial year; or 
  • Special purpose vehicles which are created by the fund to facilitate investment following the AIF Regulations. In terms of investment restrictions, a general diversification restriction is imposed whereby Category I and Category II AIFs can invest only the maximum of 25% of their ‘investible funds’ in a single portfolio company; and 
  • Category III AIFs are further restricted investing a maximum of 10% of their investible funds in single portfolio investment. 

At least 75% of their investible funds must be invested in unlisted securities or partnership interests of venture capital undertakings, or investee companies or special purpose vehicles which are engaged in or formed to operate, develop, or hold infrastructure projects. At least 75% of their investible funds must be invested in unlisted securities or partnership interests of venture capital undertakings or investee companies which are SMEs, or in companies listed on an SME exchange.

Tax considerations

The Indian Income Tax Act, 1961 has accorded tax pass-through status to Category I and II AIFs incorporated in India as a trust, limited liability partnership, body corporate, or company.

Category III AIFs: While Category I and II AIFs have been conferred with tax pass-through status, Category III AIFs are not afforded such tax relief under the Income Tax Act.

Under the Income Tax Act, where the beneficiaries are identifiable with their shares being determinate, the trustee of the trust is taxed, as a ‘representative assessee’, such taxes as would be recoverable only from the investors it represents, as if the income arising out of investments made directly by the investors. Managers and advisers are not governed by any separate tax regime and are taxed under the same provisions as apply to other resident entities.

The profits distributed by an LLP to its partners are taxed only in the hands of the LLP, as part of its income, and the partners of the LLP need not pay any additional tax on receipt of such profits. India has incorporated into law, in its entirety, the internationally accepted reporting standard under the Common Reporting Standard, and has also signed an inter-governmental agreement with the United States for the implementation of Foreign Account Tax Compliance Act rules. Concerning cross-border funds, the typical strategy adopted is to set up the offshore pooling vehicle in a tax-favourable jurisdiction that has better tax implications for capital gains or lower withholding tax.

According to the most recent data available with market regulator SEBI, AIFs made a total net investment of Rs. 2 lakh crores at the end of March 2021, compared to Rs. 1.53 lakh crore at the end of the previous fiscal. AIFs are divided into three categories according to the SEBI criterion. Venture capital funds, angel funds, SME funds, social venture capital funds, and infrastructure funds are all included in Category I AIF. Private equity (PE) funds, real estate funds, distressed asset funds, debt funds, and funds of funds are all included under Category II AIF. Hedge funds and PIPE funds are examples of Category III AIFs, which trade to create short-term profits. There are over 750 AIFs registered with the market regulator SEBI. Many alternative investments provide significantly greater returns relative to traditional investments. Also, the availability of a wide range of alternative investments makes them a viable option despite the investor’s risk tolerance or perceptions of the market.

Investing in AIF’s requires a lot of consideration. 


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