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Home / IAS Preparation / Alternative Investment Funds AIF

Alternative Investment Funds (AIFs): Features, Categories & More | UPSC Notes

Last Updated on Sep 07, 2024
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Alternative Investment Funds (AIFs) are a distinct investment category, differing from traditional investment instruments, and typically involve a privately pooled fund. Typically, institutions and High Net Worth Individuals (HNIs) opt for AIFs due to the substantial investment amounts involved. These funds operate in accordance with the SEBI (Alternative Investment Funds) Regulations, 2012. AIFs can take various legal forms, such as a company, Limited Liability Partnership (LLP), trust, and others.

In this article on Alternative Investment Funds UPSC, let us look at Alternative Investment Funds Meaning, their types, benefits, drawbacks and the AIF set up by the Indian Government for the UPSC IAS Exam.

GS Paper

General Studies Paper III

Topics for UPSC Prelims

Investments, SEBI, Mutual Funds

Topics for UPSC Mains

Economic Impact, Role in Start-up Ecosystem, Regulatory Challenges

What is Alternative Investment Fund?

An AIF, Alternative Investment Fund is a privately pooled or collective investment fund incorporated in India. It piles up assets from Indian or global investors for investing in line with a specified investment policy for the well-being of its investors. The investment in AIF differs from traditional investment avenues such as stocks, debt securities, etc. Alternative Investment Funds invest in venture capital, private equity, hedge funds, etc.

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Categories of Alternative Investment Funds India

The Securities and Exchange Board of India (SEBI) classifies Alternative Investment Funds into three categories.

Category-1 AIFs

The funds are invested in start-ups, small and medium enterprises and other business entities that are new and are considered to have high growth potential with social and economical feasibility. Investments in this category are encouraged by the government as they benefit the economy by raising the output and creating employment. Funds under this category are as follows:

Infrastructure Funds

These are funds that are invested in the growth of public assets like road and rail infrastructure, airports, communication, etc. since the sector has low competition owing to the high entry barriers.

Venture Capital Funds 

These funds invest in startups that have high potential to grow but have an investment shortage in the initial phase and are in need of funds for business expansion.

Angel Funds

 This is a Venture Capital type fund where the money is pooled from a number of “angel” investors and invested in the development of startups. Investors get their dividends when the new firms become lucrative.

Social Venture Funds 

These funds invest in firms that have a social conscience and work to bring an impact to society. These entities aim to make gains and, at the same time, solve social issues.

Category-2 AIFs

The funds under this category are invested in equities and debt securities. Funds that aren’t categorized under category 1 or 3 also fall under this category. The government does not give any tax exemption or concession for investments in this category. Funds under this category are as follows:

Fund of Funds

The fund is a combination of multiple AIFs. The approach of the fund is to invest in a portfolio of other AIFs instead of making its own portfolio or concluding the sector to invest in.

Debt Funds 

This fund basically invests in debt securities of businesses that are both listed as well as unlisted. According to the SEBI Alternative Investment Funds Regulations 2012, Debt Fund investments cannot be used for providing loans.

Private Equity Funds

These funds primarily invest in private firms that are unlisted, taking a share of their ownership.

Category-3 AIFs

The funds in Category 3 offer investment returns in a short span of time. To achieve the objective of getting returns in a short span, these funds utilize various complex trading approaches. The government doesn’t give any concession for investments in these funds. Funds under this category are as follows:

Hedge Funds

Hedge funds pile up capital from certified investors and invest in national as well as global markets to produce high returns. They are less regulated when compared to mutual funds and other investments.

Private Investment in Public Equity Funds

Private investments in public equity mean purchasing the shares of a stock that are traded publicly at a discounted rate.

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Tenure and Listing of AIFs

AIF schemes launched under Category I & II must be close-ended, with the tenure determined at the time of application, and lasting a minimum of three years. Category III Alternative Investment Funds (AIFs) can be either open-ended or close-ended.

  • The tenure of close-ended AIFs may be extended by up to two years with the approval of two-thirds of unit holders by the value of their investments. 
  • If unit holders do not consent, the AIF must fully liquidate within one year after the fund's original or extended tenure expires. 
  • Units of close-ended AIFs may be listed on a stock exchange, with a minimum tradable lot of one crore rupees. 
  • Listing is allowed only after the final close of the fund or scheme, and it is entirely voluntary.

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Major Characteristics of Alternative Investment Funds

Alternative Investment Funds (AIFs) use various strategies, such as hedge funds and private equity, to diversify portfolios, often operating with lower regulatory oversight and higher minimum investments. These funds typically have lower liquidity and a risk profile aimed at higher returns.

  • Alternative investment funds often entail higher fees and minimum investment requirements compared to retail-oriented mutual funds and ETFs.
  • Despite higher fees, alternative investments generally come with lower transaction costs, contributing to their appeal to certain investors.
  • Obtaining accurate and verifiable financial data for alternative assets can be challenging due to their unique nature and less standardized reporting.
  • Alternative investments are typically less liquid than traditional securities, posing challenges in valuing certain assets that may be thinly traded.
  • Alternative investment funds encompass a wide range of asset classes, including private equity, hedge funds, real estate, commodities, and infrastructure, providing diversification opportunities.
  • Alternative investments often exhibit different risk and return profiles compared to traditional investments, offering investors the potential for enhanced returns along with increased risk.
  • Alternative investment funds operate within specific regulatory frameworks, and their structures may vary based on jurisdiction and local regulations.

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Advantages of Alternative Investment Funds (AIF)

AIFs provide diversification and the potential for higher returns, utilizing professional management and flexible strategies. They may also offer a hedge against inflation through investments in real assets like real estate and commodities.

  • The performance of Alternative Investment Funds does not depend upon the ups and downs or the functioning of the stock market. Hence, AIFs aid in reducing the instability associated with conventional investments.
  • Alternative investments also offer compelling benefits of the tax.
  • AIFs contribute to the diversification in the market techniques and types of investment.
  • Investing in AIFs allows the direct holding or ownership of the property, thus helping the investors in the mortgage.
  • Alternative Investment Funds act as a source of secondary earnings.
  • AIFs may be handled as passive investments as, most of the time, they don’t need active management, and teams can be used to look after them.

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Disadvantages of Alternative Investment Funds (AIF)

AIFs often come with high fees, low liquidity, and regulatory risks. They require a high level of understanding due to their complexity and carry a substantial risk of loss with their high-risk investment strategies.

  • Alternative investment funds need investors to be certified or accredited, i.e. an investor having a high net worth.
  • These funds require a huge initial investment.
  • AIFs are not affordable and accessible for investors of small-scale businesses.
  • Carrying out comprehensive research and analysis before an investment in AIF is needed, as AIFs are very complex.
  • Liquidity is one of the major drawbacks of AIFs as there exists a very long period of about 3-10 years before one can fetch the initial gain.

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Key Takeaways for UPSC Aspirants

  • Definition and Categorization: AIFs pool the investment in tangible assets, derivatives, and other non-traditional investments. According to SEBI, categorization of AIFs include: Category I- typically venture capital funds, social venture funds, SME funds, and infrastructure funds; Category II-private equity funds, debt funds, etc.; and Category III-hedge funds.
  • Regulation: Regulated under the SEBI (Alternative Investment Funds) Regulations, 2012. They are required to adhere to specified prescriptions in terms of type of fund, disclosure, size of the fund, and manner of investment.
  • Investment Strategy: Follow high-risk, high-return strategy, such as leveraged buyout, venture capital, distressed assets, real estate, and commodities.
  • Investor Eligibility: Typically target accredited and high net-worth individuals because entry thresholds in most cases are minimum investments of INR 1 crore.
  • Liquidity and Lock-up Periods: The investment in AIF mostly demands longer capital commitment with limited early liquidation possibility, hence less liquid.
  • Fee Structure: Generally higher management fees, often 1-2%, and performance fees, around 20% of the profits, than for traditional mutual funds.
  • Economic Impact: These funds have a very important role in the economy, giving long-term capital to projects concerning infrastructure and to startups and small and medium-sized enterprises; this will again boost economic growth.

We hope all your doubts regarding the Alternative Investment Funds (AIF) would have been addressed. Testbook provides comprehensive study material for various competitive examinations. Succeed in your UPSC preparations with the Testbook App!

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Alternative Investment Funds (AIF) FAQs

Alternative investment funds (AIFs) are privately pooled investment vehicles that collect funds from investors and invest in various asset classes such as private equity, hedge funds, real estate, infrastructure, and venture capital.

Alternative investments are investment options beyond traditional investments like stocks, bonds, and cash. They include assets such as real estate, commodities, private equity, hedge funds, and infrastructure projects.

As per the Securities and Exchange Board of India (SEBI) regulations, there are three categories of AIFs in India: Category I, Category II, and Category III. Each category has different investment strategies and regulatory requirements.

The choice between AIFs and mutual funds depends on an individual's investment objectives, risk appetite, and preferences. AIFs typically offer more flexibility and investment options but may carry higher risks compared to mutual funds.

AIFs are not tax-free. The tax treatment of AIFs depends on various factors, including the category of AIF, the type of income generated, and the investor's tax status. Consultation with a tax advisor is recommended for accurate information.

The safety of investments in AIFs depends on factors such as the investment strategy, the expertise of the fund manager, and the underlying assets. AIFs may involve higher risks compared to traditional investment options.
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