In order to understand the Alternative Fund scenario (AIF) in India, we first need a clear understanding of what Alternative Investment Funds are. An AIF is  any financial asset that does not fall under regular investments categories, like debts, equities etc. Any funds that are established in India, and are privately pooled investments that collect their funds from high profile investors (national or international), with the purpose of investing the money in accordance with certain guidelines or policies can be classified as an AIF. Any privately held equity, a hedge fund, and even real estate can be considered to be a form of alternative investment.

Since an investment in AIFs is generally manifold higher than an investment in a regular Mutual Fund, they are mostly invested in by High Net work Individual (HNIs). The Stock Exchange Board of India (SEBI) has categorised AIFs into three broad categories, and understanding them should give us a better understanding of the Alternative Funds scenario in the country presently.

AIF scenario in the country

Since its inception in 2012, AIFs in India have seen unprecedented growth and investments in them have steadily gained a lot of traction, with the number of investors increasing year on year. Furthermore, hedging strategies are allowed to be incorporated into Alternative Funds, unlike mutual funds, where there is no scope for implementing similar strategies.

As of 2017, AIFs were regarded as the second most active sector in India. The reason for this high spur of activity within the industry was because of the Indian Government’s allocation of Rs 20,000 Crores to the National Infrastructure Investment Fund. By September of 2020, AIFs managed to raise investments worth a whopping figure of nearly $27 Billion, with a 74.4% compund annual growth rate (CAGR) between the years 2014-20.

However, in India, AIFs are not allowed to invite public investors for subscribing to their securities. Instead, they are privately pooled and raise funds specifically using private investment vehicles only. The minimum corpus for an AIF stands at a high $2.7 million, and the same for an angel fund corpus is at $1.4 million.

In it’s current state, AIFs can be broadly categorised into three sections, which also showcase their market size.

Category I AIF

Category I AIFs are funds that operate with the strategy of investing in a startup or venture in an early stage. SMEs or social ventures, which the government considers to be desirable by the society, are a part of category I AIFs. 

Category I AIFs generally tend to have a positive spillover effect on the economy of the country, due to which SEBI, and the Indian Government, along with other regulators sometimes consider providing concessions and incentives to these AIFs. 

Under the regulatory framework, Category I AIFs may be sub-categorised into venture capital funds, infrastructure funds, social venture funds and so on.

Category II AIF

Alternative Investment Funds that have a motive of investing in multiple securities, that comprise both equity and debt, can be put under Category II AIFs. These funds cannot be put under Category I or Category III by SEBI and other regulators, and are not given any particular concession or incentives by the Government for investing in these funds. However, Category II AIFs are the largest component of the Indian AIF industry, and alone makes up for nearly 77% of the same. Close ended funds like private equity funds, debt funds and fund of funds can be considered to be Category II AIFs.

Category III AIF

This category of Alternative Investment Funds undertake complex strategies and diverse trading methods to get short term returns on their capital. These can be open ended as well as close ended funds, which have the option of making an investment in both listed and unlisted derivatives. Unlike conventional investments, they are less regulated and hence do not have the requirement of publishing their information on a regular basis. However, like Category II AIFs, the AIFs in Category III are also exempt from all forms of incentives and concessions from the government and other authorities. Hedge funds can be said to be an example of a category III AIF.

While AIFs raise funds from high profile private investors, there are taxation rules that apply to these funds. Category I and II AIFs are exempt from taxes, and the fund itself does not have to bear taxes based on its earnings. However, the investors, on the other hand have to pay taxes based on their respective tax slabs. Investors have to pay a tax ranging from 10% to 15% based on the holding period, provided there has been capital gained from the stocks.

The Category III AIFs fall under the highest tax slab at the fund level, with the rate standing at 42.7%. The investors are given their returns post the deduction of relevant taxes.