January 28, 2022

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Alternative investment and how it works

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This article is written by Sourabh Kumar Singh, pursuing a Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho

This article has been published by Shoronya Banerjee.

An alternative investment is a privately pooled investment vehicle, incorporated or registered in the form of a trust or company in India. A legal entity not covered by a company or limited liability partnership (‘’LLP’’) or SEBI or other sector regulations can raise funds from Indian or foreign investors and then invest those funds under the established investment guidelines.

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Alternative investment assets, in the broadest sense, are assets that are not part of a traditional asset class like cash, stocks, or bonds that are familiar to ordinary investors. As a result, alternatives include private equity real estate and private equity infrastructure funds, as well as secondary funds and private debt funds.

The AIF excludes funds governed by the SEBI (Mutual Fund) Regulations of 1996 and the SEBI (Collective Investment Scheme) Regulations of 1999. Under the AIF Regulations, family trusts established for the benefit of “relatives” as defined under the Companies Act are exempt from registration.

Before the emergence of the venture capital-private equity (VCPE) industry in India, with many multinational corporations, entrepreneurs have relied heavily on private placements, public offerings, and bank lending/FI for business expansion, financing, project finance, etc. In 1996 Venture Capital Fund Regulation (VCF) was introduced by SEBI to bridge the gap between the capital requirements of fast-growing companies and financing from traditional sources such as banks, IPOs, and financial institutions.

Incorporating alternative investments into traditional portfolios helps investors reduce overall volatility, where portfolio diversification increases at the same time, is usually less correlated with the market traditional investment movements such as stocks and bonds.

Risk reduction through diversified investment

The main target of alternative investing is mitigating risk through diversified investment. One of the differentiators of most alternative investments is the lack of relation with major traditional asset classes for public equities and bonds financial assets. Portfolios with various alternative investments reduce the risk.

Improved returns with alpha

The second primary goal of alternative investments is to increase the expected return on the portfolio by acquiring alternative assets that provide reasonable alpha expectations i.e., excellent risk-adjusted returns. Alternative investments have been shown to offer opportunities such as hedge funds and private equity. This allows one to increase the risk-adjusted returns of a well-diversified portfolio through alpha.

Direct tax benefits 

Alternative investments also offer attractive tax benefits. With many alternative investments, the structure gives you more of your profit. For many private alternative investments, you become a fund or syndication partner, so tax incentives are passed directly to you. 

The two main tax benefits are the processing of future depreciation and long-term capital gains. Many real estate funds and syndicates deduct depreciation (non-cash costs) from their net income, which reduces their taxable income. Investing in oil and gas is subject to very favourable depreciation/recovery tax treatment.

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Illiquidity

Alternative investments are usually private and unpredictable, so they are very volatile. Because of this, they tend to be very illiquid and assets cannot be easily sold in cash as needed.

Overall complexity

Alternative investment funds are generally more complex than traditional investment funds. A higher level of due diligence is needed. Therefore, before considering investing in these alternative investments, you need to conduct a survey and understand the potential risks and consequences associated with the investment.

Unregulated 

A concern for alternative investments is the lack of regulation. These types of investments are unregulated and are not subject to reporting requirements. If the company that provides the assets or investments goes bankrupt, you too can lose your money.   

Valuation difficulty

Alternative investments tend to be difficult to value, which reduces the difficulty of raising prices and the transparency of prices. So, we can say that alternative investments have their strengths and weaknesses, but they seem to be becoming more and more popular with investors these days.

Private equity, venture capital, real estate, infrastructure, private debt, and hedge funds make up India’s alternative assets business, which is valued at $43 billion in assets under management. The alternative assets business in India is a modest but expanding space, with 221 private capital fund managers and 46 hedge fund managers based in the nation.

The bulk of institutional investors in India (60 percent) invest in at least one alternative asset class. The most popular asset types among Indian investors are private equity and venture capital (63 percent) and infrastructure (62 percent).

More than $103 billion in venture capital and private equity was invested in Indian enterprises between 2001 and 2015. More than 3,100 enterprises were invested in across 12 major sectors, including those essential to the country’s development. The businesses ranged in size from start-ups to established mid-sized businesses. A large amount of these investments has been made in the form of foreign direct investment.

While the hedge fund sector is well-established in places like North America and Europe, the Indian market is still in its infancy, with only 16 investors allocating to the asset class in the first half of 2017. Despite its modest size this is more than twice as many as in 2013 and demonstrates how investors are increasingly appreciating the importance of hedge funds are included in their portfolios to attain their investing goals. Over the years, India’s policy on foreign direct investment (FDI) in real estate has been gradually liberalized.

In recent years, the number of institutional real estate investors in India has increased: as of August 2017, 49 institutional investors frequently allocate to the asset class, up from 34 in August 2013. The number of India-based private real estate funds in the market is at an all-time high, with 29 funds seeking $4.9 billion in capital commitments as of August 2017.

This is much greater than the $1.0 billion aim set just five years ago in August 2012, indicating that fund managers believe the industry in India has room to develop.

Category I 

Category I AIFs are funded with investment strategies that include start-up or early-stage businesses, social ventures, SMEs, infrastructure, and other industries or areas that the government or regulators deem appropriate.

Considered desirable on a social or economic level.

SEBI introduced ‘Venture’ capital funds in September 2013.

As a subsection of the venture capital fund subcategory, investment funds:

  • Small and medium-sized business funding.
  • Funds for social ventures.
  • Infrastructure investment funds.
  • Category I AIFs do not borrow directly or indirectly or exercise leverage except to obtain temporary financing that needs more than thirty days or four times a year and no more than 10% investable capital.

These funds will largely invest in unlisted securities of investee companies, as well as securities of SMEs that are listed or intended to be listed on an SME exchange or SME division of an exchange.

Venture capital

These funds will largely invest in unlisted stocks of start-ups, emerging or early-stage venture capital firms specialising in new goods, services, technology, or intellectual property rights-related activities, or a new business strategy.

Small and medium enterprises (‘’SME’’) funds

These funds will largely invest in unlisted securities of investee companies, as well as securities of SMEs that are listed or intended to be listed on an SME exchange or SME division of an exchange.

Category II

Category II AIFs are funds that do not fit into either the Category I or Category III categories. Other than to fulfil day-to-day operating needs and as authorized by the AIF Regulations, these funds do not use leverage or borrow.

Private equity funds

PE funds will invest largely in investee firms’ shares or equity-linked instruments, as well as partnership interests.

Debt funds

These funds will invest largely in debt or debt securities of listed or unlisted investee corporations.

Category III

AIFs in Category III use complicated or diversified trading techniques and may use leverage, such as through investments in listed or unlisted derivatives. Category III AIFs may use leverage or borrow, but only with the approval of the fund’s investors and up to a maximum amount set by SEBI. Hedge funds or funds that trade intending to make short-term profits, as well as other open-ended funds for whom the government of India or any other regulator provides no special incentives or exemptions, are classified as Category III AIFs.

Hedge funds

Hedge funds are probably the most well-known type of alternative investing. While hedge funds are frequently associated with specific fee structures or levels of risk-taking, we define a hedge fund as a privately organized investment vehicle that takes advantage of its less regulated nature to generate investment opportunities that are significantly different from those offered by traditional investment vehicles, which are subject to regulations such as those limiting their use of derivatives and leverage.

Investment process

At least two-thirds of their investible funds must be invested in venture capital undertakings’ unlisted equity shares or equity-linked instruments, or in firms that are listed or scheduled to be listed on a small and medium-sized company (SME) exchange; and

A maximum of one-third of their investable capital must be put into:

  • The projected listing of a venture capital firm’s initial public offering;
  • A venture capital undertaking’s debt instruments; a listed company’s preferential allotment of equity or equity-linked instruments; 
  • A financially weak company’s equity or equity-linked instruments – that is, a company whose accumulated losses had eroded more than 50% of its net worth as of the beginning of the previous financial year; 
  • or Special purpose vehicles created by the fund to facilitate investment following the AIF Regulations. A broad diversification limitation is enforced in terms of investment restrictions, with Category I and II securities being prohibited.
  • AIFs in Category III are also limited to investing no more than 10% of their investable capital in a single portfolio investment.
  • At least 75% of its investible funds must be invested in unlisted stocks or venture capital partnership interests, as well as investee firms or special purpose vehicles involved informed to operate, construct, or hold infrastructure projects. At least 75% of their investible funds must be invested in unlisted stocks or partnership interests of venture capital firms or SMEs, or listed companies on an SME exchange.

There is no doubt that the popularity of the AIF is growing in India, and that diversification and return enhancement may be accomplished if carefully studied and added to the portfolio. For the continued growth of AIFs in India, authorities must accept the industry expectations of implementing overall global best practices, supporting on-shore fund management, and unlocking domestic capital pools through sectoral and regulatory intervention, among other things.


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