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Sebi classifies AIFs under three broad categories

The net cumulative investments made by AIFs (Alternative Investment Funds) at the end of March 2021 stood at a record Rs 2,00,483.50 crore surging almost 31% from Rs 1,53,403 crore in March 2020. With interest rates at record lows and clarity on taxation is making sophisticated investors primarily high networth individuals (HNIs) and ultra-high networth individuals (UHNIs) look towards AIFs and an investment opportunity.

Even the commitments raised by such funds rose by 22% from Rs 3,69,988 crore in March 2020 to Rs 4,51,216.01 crore as of March 2021. Likewise, funds mobilized by AIFs also grew by 23% to Rs 2,30,014.65 at the end of the financial year 2021.

What are AIFs?

Unlike regular conventional investments (asset classes) like stocks, debt securities etc. Alternative Investment Fund is a privately pooled investment vehicle that collects money from sophisticated private investors. Funds collected are invested according to the investment policy of the AIF. Securities and Exchange Board of India‘s (Sebi) mutual fund regulations doesn’t govern AIFs. However, AIF in India has its regulation, Regulation 2 (1) (b) of the Regulation Act, 2012 of Sebi. An AIF in India can be established as a company, Limited Liability Partnership (LLP), corporate body, or trust. AIFs invest in investments that are not traditional (for example, equities or fixed income).

Sebi classifies AIFs under three broad categories. Namely, Category I AIF, Category II AIF and Category III AIF. Each of the categories has different investments as per the broad definition of the category. Some of them are private equity, venture capital, hedge fund, and angel fund etc.

Category I AIFs

Category I AIFs invest in startups or early-stage ventures or SMEs or social ventures or infrastructure or other sectors. The government or regulators consider these sectors as economically and socially desirable. These are further divided into subcategories such as Venture Capital funds, Angel funds, SME funds, Social Venture Capital funds and Infrastructure funds.

Category II AIFs

According to Sebi Category II AIFs as the funds that do not fall under  Category I and III and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements. These primarily include Private Equity funds, Debt funds and Funds of funds.

This is the most preferred category among sophisticated investors as almost 70% or Rs 1,40,113.93 crore of the net cumulative investment Rs 2,00,483.50 crore is invested in either Private Equity funds, Debt funds or Funds of funds.

Category III AIFs

This primarily refers to those funds that deploy diverse trading strategies and leverage by investing in listed and unlisted derivatives. They use arbitrage, derivatives trading, futures and margin trading strategies. Category III funds can be both close-ended and open-ended funds. They are less regulated than conventional investments. Hence they do not need to publish their information regularly. Also, the Government of India doesn’t give any incentive or concession for investment in these funds.

They mainly consist of Hedge funds and Private Investment in Public Equity (PIPE) in which fund managers buy shares of publicly traded companies at a discounted price.

Eligibility criteria

Since these are complex products to understand and cater to sophisticated investors one needs to fulfil the eligibility criteria to invest.

An investor can be Indian, Non-Resident Indians (NRIs) and foreign national.

Also, there is a cap on investment by each investor. The minimum investment permitted is Rs 1 crore. However, for directors, employees and fund managers of the AIF, the minimum amount is Rs 25 lakhs. Minimum investment by each investor should be Rs 1 Crore, or Rs 25 Lakhs (in case of employees/directors/fund manager of AIF or angel investors), as applicable.

Additionally, the funds restrict the number of investors per scheme to 1,000. However, for Angel funds, it is 49. Furthermore, AIFs have a minimum lock-in of three years. Category I and II are close-ended funds, while category III can be either close or open-ended.

Taxation

The Category I and Category II AIFs are pass-through vehicles. Which means the fund doesn’t have to pay any tax on its earnings. But, the investors have to pay the tax at their respective tax slabs. If the fund has any capital gains on stocks, then the investors have to pay 15% or 10% depending on the holding period.

On the other hand, Category III AIFs are taxable at the highest income tax slab level at the fund level. The returns given to investors are after deducting the tax.