A case for Alternative Investment Funds

In the last few years, the market dynamics have changed. This has been a common thread across the geographies. The stock indices have remained skewed and concentrated as few players occupied larger share. The pareto principle started to play out in the stock markets, and it was turning increasingly difficult to outperform through diversified portfolios. The traditional approach of mutual fund (MF) could only take one so far while the challenges continued to remain for working professionals to directly invest in equities.

The risk mitigation guidelines in the MF allocations could create a dent for aggressive investors looking to make outsized contributions. The restriction of allocation into a particular stock beyond a percentage of the fund could turn counterproductive. Also, as the fund size increases it turned out to be difficult to navigate the allocations as the structure meant to protect the smaller sized investors. There's nothing wrong in the MF approach, it's just won't alone suffice the need of such individuals with larger capacity to take risks and/or contributions.

This is where alternate category of funds makes a solid case. These include products like Portfolio Management Services (PMS) and Alternative Investment Funds (AIF). These products are regulated by the Securities Exchange Board of India (Sebi), but have a higher threshold of investment contribution. The minimum contribution to the PMS product has been in recent years increased to Rs50 lakh from Rs25 lakh and the minimum investment in AIF is at Rs1 crore.

In the past, these products particularly, PMS was abused by the manufacturers and distributors alike. A managed portfolio started at as low as Rs 5 lakh about a decade back and slowly moved to Rs 10 lakh and then to the current structure. Also, a tighter leash was enforced on the risk profiling of the clients and the management fees. The structure also has been refined and with greater regulatory overview on the distribution.

Sebi in its note on AIFs defines, any fund established or incorporated in India which is privately pooled investment vehicle which collects funds from 'sophisticated investors', whether Indian or foreign, for investing in accordance with a defined investment policy for the benefit of its investors. AIF doesn't include funds covered under the Sebi (MF) Regulations, 1996, SEBI (Collective Investment Schemes) Regulations, 1999, or any other regulations of the board to regulate fund management activities. Further, certain exemptions from registrations are provided under the AIF Regulations to family trusts set up for the benefit of 'relatives' as defined under the Companies Act, 1956, employee welfare trusts or gratuity trusts set up for the benefit of the employees, 'holding companies' within the meaning of Section 4 of the Companies Act 1956, etc.

AIFs are classified in three categories. Category I AIF has Venture Capital Funds (Incl Angel Funds), SME Funds, Social Venture Funds and Infrastructure Funds. Category (Cat) III funds employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. Various types of funds such as Hedge Funds, Private Investment in Public Equity (PIPE) Funds, etc., are registered as Cat II AIFs. The AIFs which don't fall in Cat I and III and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements and as permitted in the SEBI (Alternative Investment Funds) Regulations, 2012 are categorized as Cat II AIFs.

No scheme of an AIF (other than Angel Fund) shall have more than 1000 investors and in the case of Angel Fund, no scheme shall have more than forty-nine angel investors. However, an AIF can't make invitation to the public at large to subscribe its units and can raise funds only from the 'sophisticated' investors through private placement. Also, as per the circular dated 29th July '13, the leverage of a Cat III fund shall not exceed two times the NAV of the fund.

Sebi has also constituted a centralized grievance redress system called SEBI Complaint Redress System (SCORES) on its website where investors can lodge their complaints against AIFs. Further in terms of the AIF regulations, the manager or sponsor of the AIF is required to lay down procedure for resolution of disputes between the investors, AIF, manager or sponsor through arbitration or any such mechanism as mutually decided between the investors and the AIF.

Each of the AIF has a defined philosophy and investors could take advantage of their positioning through the evolving prospects in the environment. The relatively freedom to operate the allocations makes them attractive to pursue various opportunities in the market, either listed or unlisted. This, however, brings the risk associated and hence the vintage of the investor is also seen at the time of application to these funds to be qualified as sophisticated.

(The author is a co-founder of Wealocity, a wealth management firm and could be reached at [email protected])