An AIF is a privately pooled investment vehicle with a minimum investment amount requirement of ₹1 crore (it is ₹25 lakh for a venture capital fund) that provides access to unconventional asset classes such as private equity, pre-IPO funds, hedge funds or simple funds claiming to have higher alpha-generating capabilities. These funds come under the purview of the Securities and Exchange Board of India’s (Sebi) AIF regulations.
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What the sharpest growth in risky AIFs means
Around 56% of the 881 AIFs, as of March 2022, were registered with Sebi in the last four years, as per Crisil. “Awareness about the AIF investment product has increased manifold in the last few years. One big driver for that was the Franklin Templeton’s debt fund crisis (when the AMC shut down a few debt funds in 2020 due to sudden redemption pressure), which resulted in credit becoming part of the AIF territory. The second big contributor has been the low-interest rate regime across the globe, which resulted in funds channelling to alternates in search of higher yield," said Vineet Sukumar, founder and managing director at Vivriti Group.
The phenomenal growth in the AIF industry, which is accessible only to high-net-worth individuals (HNIs) and ultra-high-net-worth individuals (UHNIs) with a minimum ticket size of ₹1 crore in most cases, brings into question if it is an indicator of growing income inequality in the country.
To put this in perspective, the retail investors’ favourite, the mutual fund industry, grew by about 16% CAGR in the said period.
Of course, the low base of the AIF industry makes the growth figures look optically elevated. The assets under management (AUM) of mutual funds and the AIF industry stood at ₹38.4 trillion and ₹6.4 trillion, respectively, as of FY 22 (see table).
Category II AIF space attracted significant interest with a lion’s share of capital allocated to this segment that includes private equity funds, real estate funds and debt funds. This category is said to offer the maximum level of customization and innovation in the alternates space that HNIs and UHNIs have been looking for.
For the uninitiated, an AIF comes in three different categories. Category I funds invest in startups or early-stage ventures. Category III funds such as hedge funds employ diverse or complex trading strategies for investment in listed or unlisted securities/derivatives. These funds are permitted to take leverage (borrowing) subject to specific conditions. Category II is a residual category that doesn’t fit Category I or III.
The growing credit requirement from the mid and small-cap companies and the drying up of financing from NBFCs (Non-banking financing companies) also leads to the faster growth of private credit funds within Category II funds. “AIFs lending to the unmet credit needs of mid and small-size companies and making money available for long-term is helping the structural rise of the AUM in the private credit space of AIFs," said Vikas M Sachdeva, managing director of Sundaram Alternates.
Delivered results?
Investors’ willingness to take higher risks with startups and unlisted equity space, resulted in these funds forming a significant portion of assets under management of AIFs.
As per the Crisil AIF Benchmarks research, venture capital funds (Category I) outperformed the public market index—S&P BSE 500 TRI—most times with an average outperformance by a good 20 percentage points in a three to five-year period as of FY21. The performance of unlisted equity funds (Cat II), is mixed, with near zero to nominal outperformance - for the risk it takes - compared to the market. The long-only equity AIFs in Category III couldn’t prove their outperformance during the same period, which brings into question the higher fee and lower tax efficiency these categories of funds come with.
Note that AIF benchmarking in India is still in its nascent stage and due to the diverse nature of investment themes that each AIF adopts, there is a possibility of combining not-like-to-like funds while taking a category average.
Also, most of the AIFs, as per Crisil, are yet to complete their life cycle and distribute a large portion of their portfolio. The attractiveness of the AIF space can be assessed only in the coming few years when many AIFs will be moving towards the end of their life cycle.
Jiju Vidyadharan and Piyush Gupta from Crisil, who authored the new report on investment industry, said, “The ability of fund managers to make timely exits from their portfolio companies at favourable valuations will be a key factor that will decide the experience that an AIF investor will have."
Income inequality?
Saurabh Mukherjea, founder, of Marcellus Investment Managers believes that the growth in the stock market/AIF space is in part a manifestation of the polarization of the Indian economy around a couple of efficient companies in every sector.
“As corporate profitability polarizes every year with 7-8 lakh small businesses shutting down, the formalization of the economy and consolidation in the market share in the hands of a few companies in every sector accelerates. This results in both income and wealth inequality in our country," added Mukherjea.
He, however, believes that India is following a fairly classical economic cycle. “Economic development across the world, including other Asian economies, typically all the way up to $10,000 per capita income tends to be associated with growing inequality. India is on its journey to the $10,000 mark and thus, we are living through income inequality," he added.
Nikhil Kamath, co-founder of Zerodha and True Beacon that has both PMS and AIF funds under its umbrella, says, “Any suggestion that India’s booming AIF sector has been precipitated by growing income inequality would be a mischaracterization of India’s socio-economic and financial landscape. As an emerging economy with a nascent financial sector, growth in Indian AIFs reveals augmented appetite and capacity among middle-class citizens to become participants in their country’s economy due to regulatory relaxation. Aside from a growing middle-class investor base, AIF sector growth also reveals a demand from its wealthiest citizens—most of whom were already involved in financial markets—to take advantage of these more sophisticated investment strategies now available to them. Although wealth inequality is a real and growing problem in India, AIF sector growth should be regarded not as being indicative of the problem, but as part of the solution."
Other experts, too, think that the growing AIF industry may not be an indication of income inequality. They believe it is a reflection of the middle class upgrading to the upper middle class due to economic progress but not at the cost of the low-income group.
“Let alone income inequality, many of the third and fourth generation members of family business are investors in the venture capital space of AIF. That’s an entrepreneurial wealth that is creating further employment in the economy resulting in economic progress," said Munish Randev, founder & CEO, Cervin Family Office & Advisors.
The road ahead
The AIF space is expected to grow at a healthy pace in the coming years as well with various initiatives from the industry and the regulator such as digital onboarding, AIF benchmarking and the introduction of an accredited investor framework.
Based on the 2022 survey of the Indian Association of Alternative Investment Funds (IAAIF), investors are willing to increase their allocation to alternates in the coming years by about 5-10 percentage points in the overall portfolio.
The industry players wish for certain amends in the current ecosystem to see further traction in the AIF space. The accredited investor framework comes with a host of benefits that include flexibility to participate in AIF with an investment amount lesser than the mandated minimum amount of ₹1 crore. “This concept is well thought-out, but the current framework is very onerous. This can genuinely deepen the market if it is executed well," added Sukumar.
Apoorva Vora, founder & CEO, Finolutions LLP in the IAAIF Survey 2022 pointed out that AIFs have become a very generic term. “You may have an AIF with the objective of being at-par or slightly better than a liquid fund versus an aggressive AIF dealing with distressed assets. Unfortunately, both are classified as AIFs. To the end investor, this may be challenging to decipher. First and foremost, industry leaders should start talking about the classification of AIFs based on risk and asset class. It will help in bringing more investor confidence and aid wealth managers as well."
Besides, the survey also highlights that 100% of the respondents wished for rationalisation of taxation of category III AIF. Currently, Category I and Category II AIF have tax pass-through status for Indian income-tax purposes. That means, investors are taxed on income arising from investments made by the AIF as if the investments were made directly by them. For Category III AIFs, tax is generally paid at the fund level depending on the legal structure of the AIF.
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