Alternative Investment Funds (AIF)
Among the many ways of investing resources, one is through
Pooled Investments or Funds. Pooled funds combine resources of multiple
individuals, and such a combined portfolio is used to make one large
investment. These funds drastically reduce the cost of investments, and give
access to large scale opportunities with high returns.
Alternative Investment Funds, defined under Regulation 2(b)
of the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF
Regulations), are a type of privately pooled funds, which combine the
resources of sophisticated Indian and foreign investors, and consequently,
invest this combined portfolio as per a defined investment policy made for the
benefit of the investors.
These funds must be established in India as a company,
trust, limited liability partnership or any body corporate. The definition
under the AIF Regulations also makes a point to include all those funds which
are not covered under the Regulations governing Mutual Funds and Collective
Investment schemes, but also excludes specific funds such as family and ESOP
trusts, holding companies, etc. It also specifically excludes all those funds
which are regulated by any other sectoral regulator in India.
Categorization of AIFs
AIFs in India are classified into 3 different categories,
mainly according to the spill-over effect the different kinds of investments
have on the economy, as well as the regulatory regime.
The categories of Alternative Investment Funds and the basis of their classification are explained as follows:
·
Category I AIFs
This category includes
funds whose investment generally has a positive effect on the economy. These
include investments made in start-ups, SMEs, infrastructure projects, and other
areas which are considered as socio-economically desirable by the Government.
Since the Government
considers them to be desirable for the country’s socio-economic infrastructure,
these funds are characterised by many incentives, unlike the other 2
categories. These include easier compliances, such as a lower minimum sponsor
continuing, annual furnishing of reports to investors, and quarterly reports to
SEBI, instead of the quarterly reports for investors and monthly reports to
SEBI for category III. Further incentives
include the allowability of foreign investment for a fund registered with SEBI,
unlike other categories which are not allowed to do so. Tax incentives are also
given to Category I AIFs.
Since these funds are
provided with many incentives, they are also subject to certain regulatory
requirements. For instance, the minimum tenure for this category of funds is 3
years, as opposed to a non-prescription of such a tenure for Category III
funds. Category I funds cannot undertake hedging and are also always
close-ended.
·
Category II AIFs
This is like a residuary
category, and includes those funds which are not included in any of the other
two categories. These funds, like Category I funds do not employ leveraging,
i.e., borrowing to invest. They are permitted to borrow only for carrying out
their day-to-day operations.
Since these funds do not, per se, have a negative impact on the socio-economic infrastructure of the country, they are allowed many of the same, less stringent compliances as Category I funds, but are not allowed tax incentives and are also not permitted to accept foreign investment, except when the fund is set up as a company and FDI rules apply.
·
Category III AIFs
These funds employ complex
strategies for trading and investment in unlisted and listed derivative
securities. These funds invest in hedge funds, open ended funds and other funds
with short term returns. They are even allowed to invest in category I and
category II funds.
These funds are considered
to have negative socio-economic impacts, mostly because they employ leveraging
on a large scale. As a result, they are not allowed any incentives, and are
also subject to higher levels of compliances. For example, the minimum sponsor
continuing is much higher, the amount allowed to be invested in a single
company is much lesser than that in the other categories, and reports are to be
filed with the SEBI and investors much more frequently.
As seen here, the major factor taken into consideration for
the classification of funds into different categories is the effect the funds’
investments have on the regulatory and economic regime of the country. It is
important to classify these funds according to this criterion, as it makes
easier to identify which funds should be given incentives and allowed less
stringent compliances and which ones should be subject to more stringent
regulations. This classification encourages the growth of SMEs and start-ups,
which are the main drivers of innovation and economic growth in the nation. It
acts as a platform to encourage investment in these sectors instead of focusing
only on large corporations, through various incentives. This is also in line
with the Government’s objectives to encourage entrepreneurship and investment
in the country, adding more importance to such a system of categorization.
Investment Restrictions for AIFs
General Restrictions under Regulation 15 of the AIF
Regulations
Generally, all categories of AIFs are subject to a
diversification restriction, meaning that the maximum amount they can invest in
a single company is prescribed. Category I and Category II AIFs cannot invest
more than 25% in a single company, while Category III AIFs cannot invest more
than 10% in a single company.
These diversification restrictions are important in order to
control the activities of an AIF, and ensure that they do not indulge in the
practices of hostile takeovers and other unfair means of investing. This is especially
important as AIFs can aggregate a huge amount of funds from wealthy individuals
and persons. The even stricter requirements for Category III AIFs are put in
place to keep a check on the amount they borrow as a part of their investment
strategies, and ensure that there is no negative spill-over effect on the
economy.
Apart from the diversification restriction, AIFs cannot
invest in associates without the approval of 75% of its members. Further, the
uninvested corpus is also mandated to be invested in liquid assets like liquid
mutual funds, bank deposits, etc.
The reason behind this is to ensure that funds are not
stagnated and keep flowing to ensure the growth of the securities market, as
well as the economy. If AIFs keep investing in associates, or stagnate
uninvested resources, they may slow down the growth and development of the
securities market, and consequently the economy, as the funds available to
invest in the securities market will be substantially reduced.
Specific Restrictions
Apart from the general diversification restrictions, each
category and even sub-category of AIFs are subject to certain specific
restrictions. These are as follows:
·
Category I AIFs (Restrictions under
Regulation 16 of the AIF Regulations)
o
Venture Capital Funds (VC Funds): These
funds must have a minimum of two-thirds of their resources invested in equity
instruments of a Venture Capital Undertaking (VC Undertaking), unlisted
companies or those listed on the SME Exchange. Apart from this, a maximum of
one-thirds of their investible resources must be invested in:
§
IPO of a VC Fund proposed to be listed.
§
Debt securities of a VC Undertaking.
§
Preferential shares of a listed company.
§
Equity instruments of a company whose net worth
has reduced by more than 50% due to losses, recorded at the beginning of the
previous financial year.
§
SPVs created for the purpose of investing the
funds of the AIF.
o
SME Funds: A minimum of 75% of the
investible resources must be SMEs whether listed on the SME Exchange or not,
unlisted securities and/or partnership interests in VC undertakings.
o
Social Venture Funds: A minimum of 75% of
investible resources to be invested in securities and interests of social
venture enterprises.
o
Infrastructure Funds: A minimum of 75% of
investible resources to be invested in interests and securities of VC
Undertakings, and enterprises involved in infrastructure projects.
The AIFs under Category I
are meant to have significant positive impact on the economy of the country.
They encourage entrepreneurship, the growth of small and medium enterprises and
the development of infrastructure that is very important for the growth of the
economy. As stated before, the Government encourages these activities by
providing certain incentives and relaxations to such AIFs. However, in order to
ensure that these incentives are not misused by people looking to earn high
profits under the garb of economic development, certain investment restrictions
and guidelines are put in place. They prescribe certain minimum and maximum
thresholds for investments, in order to ensure that the funds invest their
major resources into activities that actually contribute to economic
development and the goals of the Government, thereby justifying the various
incentives and relaxations provided to them.
·
Category II AIFs (Restrictions under
Regulation 17 of the AIF Regulations)
The only major investment
restriction applicable is that a minimum of 50% of their investible resources
must be invested in unlisted companies.
The reason for this is
that since an AIF pools the resources of several wealthy persons, it has the
capability of creating a very large corpus of funds. Such a large corpus, when
invested into the listed Securities Market can create havoc for individual
investors, which can lead to their exit. Since SEBI’s main objective is to
develop and grow a healthy and fair securities market, allowing AIFs to freely
trade listed securities may be contrary to the same.
Further, Category II AIFs
are not given any specific incentives or concessions, as they generally invest
in areas such as real estate, private equity, etc., which may not have as
positive an impact on the economy as Category I funds do. This is why, they are
not subject to as many investment conditions and restrictions as category I
funds.
·
Category III AIFs (Restrictions under
Regulation 18 of the AIF Regulations)
Unlike Category I and
Category II AIFs, no specific threshold limits are prescribed for investment of
funds under this Category. They are permitted to invest in securities of both
listed and unlisted companies, as well as derivatives and even units of funds
of other categories. They are allowed to invest in hedge funds as well. However,
since these funds employ leveraging as a part of their investment strategy,
they must disclose details of such borrowings to the SEBI periodically.
These funds, as stated before,
are touted to have a negative external impact on the economic regime, largely
due their leveraging strategies, which may involve huge amounts of borrowing
and debt. A stringent diversification requirement, as explained before is
important to control the amount of funds leveraged, as well as to ensure that
hostile takeovers do no happen as a result of these borrowings. These funds are
also subject to very strict and stringent compliances, so that a check can be
kept on mainly their borrowing activities, and to ensure that there is no
negative impact on the securities market or the economy as a whole.
Conclusion
Alternative Investment Funds are used to create channels of
investment by pooling the resources of wealthy persons, and investing this
corpus as a whole, which results in very low costs of investment and even
higher returns.
Alternative Investment Funds are also, for the most part,
seen as drivers of economic growth and development in the country. However, to
prevent the misuse of these channels of investment, by way of setting them up
only to get access to certain incentives and concessions, many investment conditions
and restrictions are put in place in order to ensure that they do not hamper
the growth and development of the securities markets and even the economy as a
whole.
These restrictions and conditions put in place by SEBI
ensure that AIFs do not have a negative economic impact on the country and
instead, drive the growth of businesses, infrastructure and entrepreneurship in
the country.
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