Alternative investments are catching up, though they need high risk appetite. It is little wonder that investors, especially high net worth individuals (HNIs), are seeking alternative investments. An alternative asset class is something beyond the traditional ones (stocks and bonds) and includes Structured Products such as private equity (PE), investing in unlisted firms and start-ups, and real estate funds. AIFs are privately-pooled investment funds which collect funds from investors, whether Indian or foreign, for investing with a defined investment policy for the benefit of the investors. Alternate Investment Funds (AIFs) are governed by the SEBI (Alternate Investment Fund) Regulations, 2012. Investments in AIFs have grown to Rs 1.4 trillion (Rs. 1.4 lakh cr.). As a consequence of high & exotic earning potential, asset managers in India have been able to attract investments from top quality investors like sovereign wealth funds, pension funds, university endowment funds etc. into these AIFs in India.
Minimum ticket size for investment should be Rs 1 crore.
AIFs come in 3 varieties, according to SEBI categorization.
1. The first type (category I AIFs) consists of venture capital, SME, infrastructure and social venture funds.
2. The second type (category II AIFs) invests in any type of asset class such as equity or debt, but does not leverage or borrow money to invest in stocks or other risky assets.
3. The third type (category III AIFs) can indulge in leverage or short selling to generate returns.
Category I and II AIFs are closed-end funds with a time horizon of at least 7 years, in most cases. Category III AIFs can be open-ended or closed-end. The time horizon of closed-end category III AIFs can be as short as three-and-a-half years.
Risk factors in investing in AIFs
Mis-selling: In their quest for higher commissions, which have been rationalized for mutual funds, more and more distributors have sharpened their sales pitch for alternative investment funds (AIFs). The complexity and the high commissions make AIFs prone to Mis-selling. A key factor in the sales pitch is the exclusivity of the product given its minimum ticket size (typically, Rs.1 crore).
Complex structure and fine prints in the agreement could be tricky.
One common risk associated with structured products is a relative lack of liquidity that comes with the highly customized nature of the investment.
Another risk associated with structured products is the issuer's credit quality
Taxation & resultant Cash flow issues-Investor pays the tax from his other funds as AIF withholds gain till end of tenure.
High risk in volatile market conditions particularly during economic down turn as NPAs shoots up resulting in possibilities of loss of capital.
How come AIFs more complex than mutual funds: AIFs give an option of investing in different asset classes that the investor may not have, directly or through mutual funds. Asset classes like venture capital, private equity pre-IPO, private credit and hedge funds can only be accessed through AIFs. Smaller-sized listed equity strategies may also allow the fund manager more flexibility to generate alpha compared to the popular mutual funds which have grown large over time, Alpha is the outperformance of a fund compared to its benchmark index. There are certain things you should keep in mind before investing in AIFs, especially if you are new to the product. Understand that AIFs are different from MFs in all these aspects.
Strategy: Understand the nature of the AIF you are investing in. This includes finding out which category (I, II or III) it falls under. For instance, category III AIFs can borrow to invest, which makes them riskier.
While selecting an AIF, you should first look at its theme or investment objective. For instance, an AIF investing in real estate debt will have a different type of risk-reward outlook compared to an AIF following a long-short strategy (which tries to benefit from both rise and fall in stock prices).
One way to evaluate the strategy is to look at past performance, but there are some limitations on this aspect. Typically, the AIF provider will give you past returns on it’s own performance.
Fees/Costs: AIFs typically charge a fixed as well as variable fee based on the performance & a portion of this is paid to distributors as commission.
Costs: It’s important to know the costs involved. There is no regulatory limit on costs in AIFs unlike the limits on total expense ratio (TER) in mutual funds.
Complex profit sharing arrangements are also common. You may have to pay a 2% management fee on the total value of your AIF investment every year and a 20% share in the profits that the AIF generates. Some AIFs may not take any management fee and only charge a profit share.
However, there are further nuances to tackle: What if an AIF delivers 20% returns in the first year, -20% (negative returns) in the 2nd year and 8% in the third year? In this case you would have paid the manager a profit share in the first and third years, even though the actual net asset value (NAV) of the fund will be lower than the value it hit in the first year because of the second-year loss.
Some funds have a concept known as “high water mark" in place to avoid such double payment of performance fees. A high water mark means that if a fund declines after hitting a high, fees cannot be charged until the previous high (high watermark) is crossed. For example, assume that a fund goes from ₹100 crore to Rs.110 crore in year one and you pay a performance fee of 20% on the gain of Rs.10 crore, which is Rs.2 crore. If the fund declines to Rs.105 crore in year 2, you pay no performance fee since there is no gain. Further, if it rises back to Rs.110 crore in year 3, you pay no performance fee despite the gain because it touched the high watermark of Rs.110 crore in year one.
Taxation: AIFs are not as tax-efficient as mutual funds. Also, the taxation rules of the three categories of AIFs are different.
Category I and II AIFs are pass-through vehicles. In other words, the fund does not pay any tax but the investor pays the taxes on the earnings of the fund. However, this tax becomes due even if the fund has not paid out cash to investors creating cash flow problem temporarily.
Hence, if the fund has received interest income of Rs.5 lakh, but has distributed only Rs.3 lakh to investors (retaining the balance to invest in its portfolio), then you will have to pay tax at your slab rate on the entire Rs.5 lakh. Similarly, if the fund has realized capital gains on stocks, you will be liable to pay tax on those gains at 15% or 10%, depending on the holding period, even if you haven’t received the gains.
Though mutual funds are also pass-through vehicles, you pay tax only when you redeem them units.
Category III AIFs are not considered pass-through vehicles. As a result, the fund has to pay tax when the AIF realises its gains or gets other income such as interest. The income of a category III AIF is usually taxed as business income, although there can also be a capital gains component. As a result, the tax paid is, typically, at the highest tax slab, including surcharge of 42.7%, and is deducted before the returns are paid out. This high deduction can lead to higher tax than the investor’s own tax bracket.
What Are Structured Products: Structured products are pre-packaged investments that normally include assets linked to interest plus one or more derivatives. They are generally tied to an index or basket of securities, and are designed to facilitate highly customized risk-return objectives. This is accomplished by taking a traditional security such as a conventional investment-grade bond and replacing the usual payment features—periodic coupons and final principal—with non-traditional payoffs derived from the performance of one or more underlying assets rather than the issuer's own cash flow.
Gravitating towards the exotic: If only we had a rupee for every time the allure of exotic investments did in an HNI investor! The wealthier one gets, the more they seem to want to move away from good old vanilla products like stocks, bonds, fixed deposits and mutual funds and gravitate towards fancier products like structures, real estate funds, private equity funds, art funds, film funds and what not. As history tells us, this is a very questionable move, as a lot of these glossy new investment products end up bombing and leaving gaping holes in investor portfolios. Their large entry ticket sizes only add to their allurement, and associated capital risk.
Investment banks were very innovative in creating financial structured products. Because these novel and exotic financial products were so complex, the markets, but the motive for the private sector investment banks was greed and profit. Structured products are pre-packaged investments that normally include assets linked to interest plus one or more derivatives. They are generally tied to an index or basket of securities, and are designed to facilitate highly customized risk-return objectives.
Financialisation of real estate: Investors currently are clearly showing an aversion to investing directly in residential projects. Instead, we see their preference leaning towards investing in the asset class, via non-convertible debentures issued by reputed developers, and through credit-based AIF funds. Investments made in CAT II alternate investment funds. With downturn hitting real estate, many of these investments are stuck with a possibility of loss of capital.
Merely having Rs.1 crore to invest should not be a reason for you to invest in AIFs as they are highly risky products meant only for sophisticated investors. Even sophisticated investors should evaluate AIFs carefully and carry out due diligence before investing in Exotic Products. However, you cannot avoid this option of investing because it generates much higher returns than the bench mark and hence part of your resources can be allocated to such risky options. You have to evaluate risks and rewards and read the fine print and do not get mis led in selling by highly sophisticated Investment Professionals.