What is AIF? Characteristics, Types, Taxation, Benefits, and Risks Explained

In the world of finance, investment products are increasing at a very high speed because investors are continuously looking for different investment opportunities that will fetch them higher returns.

So, in today’s blog, we will introduce you to a new-age investment product gaining popularity among the elite class of investors.

Overview

Alternative Investment Funds (AIF) are designed to cater to the needs of Ultra High Net Worth Individuals. These types of funds pool money from investors and invest them into different non-traditional asset classes. The asset classes include private equity, venture capital, real estate, hedge funds, commodities, etc. These investment funds carry a higher risk than any other asset class.

Characteristics

1.  Diversification – These funds invest the pool amount into different asset classes that are not correlated with the market.

2.  High Risk – The AIF funds possess a risk higher than any other investment product.

3.  Liquidity – The AIF funds provide lower liquidity as most of them have a lock-in period.

4.  U-HNI Client – The product caters to investors with a higher risk-taking capacity and high net worth, known as Ultra High Net-Worth Individuals. 

5.   Fee Structure – The fee charged by AIFs is much more than traditional AMCs. 

Minimum Investment

The minimum investment stated by SEBI to invest in an AIF is 1 crore.

Note – Investors who are employees or directors of the AIF can invest with a minimum value of twenty five lakh rupees.

Types of AIF

Based on the investment product and risk, the AIF is categorized into 3 categories –

Category 1 AIF 

Funds collected in this category are invested in small and medium-sized businesses (SMEs), social initiatives, startups, and industries backed by government or regulatory support.

The funds included in this category are-

1.  Venture Fund and Angel Fund– New-age startups, which require funding in their initial stage, approach a venture capital fund for capital infusion and in exchange, VC firms take up a sizeable portion of the company’s equity.

Angel fund is a sub-category of Venture Fund. Angel funds can accept investment from angel investors for a maximum period of 5 years, and the investment amount should not be less than 25 lakhs. The risks associated with investing in these funds are very high.

2.  SME Funds – These funds’ investments go to small and medium enterprises that offer good value propositions.

3.  Social Venture Fund – Social venture funds invest in companies that positively impact society and have an environmentally friendly approach.

4.  Infrastructure Fund – These funds are invested in infrastructure companies involved in constructing railways, roadways, ports, etc.

Category 2 AIF

The funds that do not fall under category 1 or 3 of AIF fall under this category. They only take loans to meet their daily operational expenses as permitted by SEBI. Some of the Category 2 funds are mentioned below:

1.  Private Equity Fund – The investment under this category is made into unlisted companies, which generally face difficulty in raising capital. These funds generally come with a lock-in period.

2.  Debt Fund – These funds invest in listed and unlisted companies through debt such as bonds, debentures, etc.

3.   Funds of Funds – This category of AIF invests in the portfolio of other investment funds, as they do not invest directly in stocks and bonds. Hence, they invest in other AIFs.

Category 3 AIF

This category of AIF uses complex trading strategies and sometimes leverages its position to invest in listed or unlisted securities. Some of the funds that fall under this category are:

1.  Private Investment in Public Equity Fund (PIPE) – Under this category, the fund invests in listed companies but through private mode or without going through the secondary market. Investments are generally made at a discount on the share price.

2.  Hedge Funds – Hedge funds pool funds from investors and invest them in domestic and international markets, employing complex trading strategies like short selling, arbitrage, futures, and margin trading to maximize returns.

Eligibility to Invest in AIF 

Indian residents, NRI, and foreign citizens are eligible to invest in AIF. Joint holders are also eligible to invest in this product.

Category-Wise Contribution

Category of AIF	Commitments Raised	Funds Raised	Investments Made
Category I	73,601	39,407	43,486
Category II	8,83,216	3,08,472	2,67,911
Category III	1,28,058	81,676	88,256

The graph mentions the significantly higher contribution made by Category 2 AIFs. 

Taxation of AIF

The taxation in AIF depends on the category in which you are investing.

Categories 1 and 2

These categories are given a pass-through status under the Income Tax Act of 2015. Pass-through status means that the income earned under these funds will be taxable in the hands of investors. The taxability in the hands of investors is as follows –

1.  Long-Term Capital Gain – Taxed at 10%, and unlisted securities will be taxed at 20% with an indexation benefit.

2.  Short-Term Capital Gain – The short-term gain will be taxed at the rate of 15%.

3.  Dividend and Interest Income – Taxed as per the income tax slab.

Category 3  

Gains generated under this category will be taxed in the hands of funds as Income Tax does not give them pass-through status.

1.  Long-Term Capital Gain – Taxed at the rate of 10%.

2.   Short-Term Capital Gain – Taxed at the rate of 15%.

3.  Dividend and Interest Income – Taxed at a flat rate of 30%.

Benefits of investing in AIF

1.  Investment made in AIF can potentially earn higher returns than other investment options.

2.  Diversification techniques are employed while investing and this minimises the overall portfolio risk.

3.  These funds are typically not directly related to the market, so they are not prone to extreme volatility.

Risks of investing in AIF

1.  The funds may invest in assets that might possess liquidity risk and they cannot be sold easily and converted into cash.

2.  The trading strategies used are complex. The fund manager’s incompetence in using such complex strategies can potentially lead to losses.

3.  Your capital invested into startups, whether in the form of a loan or equity, needs proper monitoring. If the startups are not able to perform then it can lead to a loss in your portfolio.

Conclusion

Ultra-net-worth individuals aware of the risks associated with investing in AIFs can find AIFs to be a lucrative investment option. Investing in AIFs involves high risks due to the allocation of funds into unlisted shares and the execution of complex trading strategies.

Hence, if one wants to invest in this for higher returns then they should consider their risk profile before making any investment decision.

Frequently Asked Questions (FAQs)

Q1. Is there any lock-in period in AIF?

Ans. Yes, there are a few categories of AIF that come with a lock-in period.

Q2. Is AIF better than Mutual Funds?
Ans. Choosing between AIF or mutual funds lies at the investor’s discretion because both products have pros and cons. While AIFs are suitable for investors who can take risks for higher returns, mutual funds are ideal for investors who don’t want extra returns and can take moderate risks.

Q3. Who regulates AIF in India?
Ans. Securities and Exchange Board of India (SEBI) regulates AIFs under the Alternative Investment Fund Regulations 2012.

Q4. How many AIFs are there in India?
Ans. As of 9^th March 2024, there are a total of 1276 AIFs in India.

Q5. What is the minimum investment amount in AIF?
Ans. The minimum investment amount in AIF is 1 crore.