AIF - Quick Revision Notes
• What are Alternative Investments?
o Asset classes outside traditional stocks/bonds/cash. Include hedge funds, private equity
(PE), venture capital, real estate, commodities, collectibles (art, etc.). Require specialized
analysis and often held in private structures.
o Differ from traditional investments in asset types (often illiquid, private) and vehicle
structure (partnerships, trusts). Managers commonly use leverage, derivatives, short
selling, and invest in illiquid assets.
o Higher fees than mutual funds (e.g. 2% management + 20% performance fee); return
streams usually have low correlation with public markets (good for diversification).
• Characteristics of Alternatives:
o Illiquid: Difficult to exit quickly (lock-up periods, no active secondary market).
o Specialized Management: Niche strategies requiring expertise (e.g. distressed debt
specialists).
o Less Regulated & Transparent: Fewer disclosure requirements, often private offerings.
Investors may get limited info on holdings.
o Limited Historical Data: Performance and risk metrics are hard to estimate (short
histories, survivorship bias). Unique legal/tax considerations as many are structured as
LLPs/Trusts.
• Major Types of Alternative Investments:
o Hedge Funds: Pooled funds for sophisticated strategies. Use long/short positions,
derivatives, leverage. Aim for absolute returns (not benchmarked). Not necessarily
hedging; can be opportunistic. Often open-ended with periodic liquidity for investors
(quarterly/annual), but initial lock-ups common.
o Private Equity (Incl. Venture Capital): Funds investing in private companies or
buyouts of public companies. LBO funds use debt to acquire companies (bulk of PE
capital). Venture Capital funds back startups/early-stage firms (smaller portion of PE).
PE funds are typically closed-end ~10-year funds, exiting via IPOs or sales.
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o Real Estate: Investment in physical properties (residential, commercial) or property-
backed loans. Can be through direct ownership, REITs, mortgage funds, property
development funds, etc.. Returns from rental income + appreciation. Illiquid but
provides inflation hedge and diversification.
o Commodities: Exposure to physical goods like gold, oil, agriculture. Achieved via
holding the commodity, futures contracts, or shares of commodity-producing
companies. Investors often use commodity index funds or ETFs; commodity futures are
common to track indexes. Commodities often zig when stocks zag (e.g. oil prices might
rise in late cycle).
o Collectibles/Other: Tangible collectibles (art, wine, classic cars, rare coins) and
intangible assets (patents, song royalties) as investments. Highly specialized markets;
value depends on rarity and collector demand. Useful for diversification but very illiquid
and require expert knowledge.
• How to Invest in Alternatives:
o Fund Investing: Contribute money to a fund (hedge fund, PE fund, etc.) which then
makes investments for you. Pros: professional management, instant diversification, low
effort. Cons: high fees (management & performance), lack of control, potential lock-ups.
Suitable for most institutions/HNWIs not wanting direct management.
o Co-Investing: Invest alongside a fund in specific deals. Usually offered to large LPs of
a PE/VC fund. Pros: no extra fees on co-invest, chance to put more money into attractive
deals, learn from GPs. Cons: offered deals might be ones the fund can’t take fully
(possible adverse selection); requires quick decision and deep pockets; still less control
than sourcing your own deal.
o Direct Investing: Directly buying stakes in companies, properties, etc. Pros: full control
over asset, tailored portfolio, no fund fees. Cons: demands expertise, deal flow access,
due diligence capability; high risk concentration; very illiquid positions. Only very
large investors (or specialized family offices) do sizable direct deals (e.g. a pension fund
directly buying infrastructure assets).
• Portfolio Benefits:
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o Diversification: Alternatives often have low correlation to stocks/bonds, thus adding
them can lower overall portfolio volatility. E.g., adding real estate or gold can buffer a
stock-heavy portfolio during equity downturns.
o Improved Risk-Return (Efficient Frontier): By expanding the investable universe,
alternatives can achieve higher returns for the same risk or lower risk for the same
returns. The efficient frontier shifts outward with alternatives. Example: A mix of stocks,
bonds and alts (like hedge funds, RE) might yield better Sharpe ratio than stocks and
bonds alone.
o Higher Return Potential: Alternatives tap into illiquidity premia and inefficiencies.
Skilled managers can exploit mispricings (e.g., buy undervalued private firms) and use
strategies (shorting, leverage) not available in traditional funds, aiming for alpha. Many
alternatives target absolute returns above public market averages (though not
guaranteed).
o Risk Hedging & Inflation Protection: Certain alts hedge specific risks: Commodities and
real assets hedge inflation (their values rise with price levels). Some hedge fund strategies
can profit in bear markets or volatility spikes (tail risk funds, global macro). This can
reduce drawdowns and concentration risk in a portfolio.
• Cautions and Risks:
o Survivorship Bias: Historical returns of alts may be overstated because only successful
funds report long-term results; failed funds drop out and aren’t counted, skewing
indices upward.
o Backfill Bias: When new funds join an index/database, they add their past performance
all at once (and usually only successful funds bother to join), which artificially inflates
average returns. Conclusion: past performance for alternatives may look better than
reality – use caution when interpreting data.
o High Fees: Alternatives charge hefty fees (2% management + 20% carry typical). These
fees can erode returns. Investors must be confident in a manager’s skill to justify fees.
o Complexity: Strategies can be very complex (derivatives, multi-asset trades). Requires
thorough due diligence to understand what you’re investing in. Also, evaluating fund
manager skill is harder due to shorter track records and opaque strategies.
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o Transparency: You often get limited information. Hedge funds might not disclose
positions; PE funds report only quarterly NAV. Lack of transparency makes it hard to
monitor risks. You must trust the manager.
o Illiquidity: Many alternative investments lock your capital for years (PE/VC funds ~10
years, real estate funds ~7 years) or have infrequent redemption windows (hedge funds
might quarterly, with notice). In a crisis, redemptions may be suspended. So only
allocate capital you won’t need short-term.
o Regulatory Risk: Regulations can change. E.g., government might change tax benefits
for a certain alternative (like removing pass-through status) or impose new rules
(registration, leverage limits). This could affect returns or operations.
• History & Global Context:
o Post-World War II era saw initial alt investing (first hedge fund in 1949; early VC in 50s).
o Key US regulatory changes enabled growth: 1958 SBIC Act (boost to VC); 1978 ERISA
rule change (pension funds allowed in privates); 1981 tax cuts on capital gains (made
equity investing more attractive). These opened floodgates of institutional capital into
alternatives.
o Financial innovation: tools like Black-Scholes (1973) for options and Gaussian Copula
(2000) for credit derivatives expanded what hedge funds and structured product
investors could do. Coupled with tech advances (fast computing, electronic markets),
this led to the rapid growth of complex hedge fund strategies and large-scale derivative
markets.
o Alternative AUM Growth: From the 1990s to 2020s, global alternative assets under
management grew exponentially. Institutions raised allocations for diversification (e.g.,
Yale endowment ~75% in alts, global pensions ~23% in alts). By 2025, estimates put global
PE AUM ~$5+ trillion, hedge funds ~$4 trillion, real assets and private debt each in the
trillions. Alts are now mainstream for big investors.
o Major events: Some high-profile failures (e.g., LTCM hedge fund collapse in 1998, some
PE-backed firms failing) taught lessons but also demonstrated systemic impact potential
– leading to more oversight. The 2008 crisis saw many alts suffer, but post-crisis low
yields drove even more money into alts (seeking higher returns).
• AIFs in India (Regulatory Framework):
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o Launched in 2012 via SEBI’s Alternative Investment Funds Regulations. Before that, only
VCFs and MFs were regulated; PE/hedge funds lacked a clear regime. AIF regulations
repealed the old 1996 VCF rules and brought all private funds under one umbrella
(except separate Foreign VCF regs).
o AIF Definition: Privately pooled investment vehicle (trust/company/LLP) raising
money from investors (Indian or foreign) for investing per a defined policy. Broad types
covered: PE Funds, VC Funds, Hedge Funds (called strategy funds), Angel Funds,
Social/Infra/SME Funds, etc.. Essentially, any non-public fund not regulated elsewhere
is an AIF. Must register with SEBI and cannot publicly solicit investments.
o AIF Categories:
▪ Category I: Funds with “positive impact” (govt-desired sectors). Includes VCFs,
Angel Funds, Social Venture, Infrastructure, SME funds. Given incentives (e.g.,
tax pass-through). No leverage allowed except temporary bridging. Close-ended,
≥3-year tenure.
▪ Category II: General private funds – PE, debt, real estate funds etc. No special
incentives, but also no extra restrictions beyond baseline. Can’t leverage except
interim financing. Close-ended, ≥3-year term. Forms the largest share of AIF
money (PE/VC).
▪ Category III: Hedge funds and other trading funds. Can be open-ended. Allowed
higher leverage with SEBI oversight. Often employ complex strategies
(derivatives, arbitrage). No pass-through tax (taxed at fund level). Subject to
stricter risk controls. No govt incentives.
o Angel Fund (Cat I – VCF subcategory): Special rules for startup investing. Angel
investors must be wealthy/experienced (net worth ≥ ₹2 Cr for individuals). Min fund
size ₹10 Cr, min investor commitment ₹25L (over up to 3 years). Max 200 investors per
scheme. Invest only in startups that meet criteria (small, not part of large groups).
Investment per startup ₹25L–₹5Cr, ≥1 year lock-in. Angel fund sponsor must contribute
≥2.5% (up to ₹50L). Can’t list units or invest abroad.
o Key AIF Rules:
▪ Min Investment: ₹1 Cr per investor (to ensure only sophisticated participants).
(₹25L for fund managers’ own employees).
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▪ Sponsor Commitment: Sponsors/Managers invest ≥2.5% of corpus or ₹5Cr (Cat I/II),
5% or ₹10Cr (Cat III) as skin in the game. Aligns interests; cannot be via fee
waiver.
▪ Diversification: Max 25% of fund in one investee for Cat I/II, 10% for Cat III to
avoid over-concentration.
▪ Max Investors: 1000 investors per scheme (keeps fundraising private).
▪ Close-ended tenure: Category I & II funds are closed-end (min 3 years, extendable
2 years with investor approval). Close-ended AIF units can be listed on exchange
(but ₹1Cr lot size) to provide some liquidity.
▪ Leverage: Category I & II cannot leverage (other than temporary loans for
operational needs). Category III can leverage with disclosure/limits.
▪ Private Placement Only: AIFs raise money privately; they issue a detailed PPM
(Private Placement Memorandum) to potential investors, filed with SEBI. No ads
or public solicitation.
▪ Reporting: AIFs must report regularly to SEBI and investors on financials,
portfolio, risk, etc. Must audit annually and provide valuation reports.
▪ Custodian: Mandatory for any AIF ≥ ₹500Cr corpus, and for all Cat III funds.
Ensures proper safekeeping of assets.
▪ Regulatory Oversight: SEBI can inspect AIFs; any change in control of
manager/sponsor needs SEBI approval. Strict rules to manage conflicts of interest
and ensure transparency to investors (disclosure of fees, litigation, etc.).
• Industry Size & Trends (India):
o Tremendous growth since 2012. As of Dec 2024, Total AIF commitments ~₹13 trillion
(₹13,05,179 Cr) across all categories. Majority in Cat II (~₹10 trillion, ~77%) for
PE/VC/debt funds. Cat III ~₹2.17 Tn (hedge funds), Cat I ~₹0.85 Tn (VC, social, infra).
These numbers reflect a robust alternative assets market in India.
o Venture Capital Boom: Many new VC funds (Category I AIFs) launched to fuel India’s
startup ecosystem (especially after 2014). Angel funds are more prevalent, and there’s
government backing via fund-of-funds.
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o Private Equity & Credit: Category II funds raised huge capital for infrastructure, real
estate, corporate credit (distressed asset funds via Insolvency and Bankruptcy Code
opportunities), and traditional PE in tech, consumer, etc. Indian PE/VC investment hit
record highs in recent years, indicating healthy deployment of these AIFs.
o Hedge Funds: Domestic hedge funds (Cat III) are emerging, often run by seasoned
traders or ex-global fund managers. Many set up in GIFT City (with USD-denominated
funds) to attract offshore money with tax breaks. Strategies include long-short equity,
arbitrage, quant/statistical arbitrage, etc.
o Accredited Investor framework: Introduced to possibly allow smaller ticket
investments if investors are certified sophisticated. This may broaden the investor base
for AIFs in the future (e.g., allowing ₹25L minimum for accredited investors in certain
funds).
o Performance: It varies – top-quartile PE/VC funds in India have delivered strong returns
(IRRs >20% in some cases), whereas average returns moderate. Hedge funds in India
often aim for ~10-15% annual returns with lower volatility than equities. Data is limited
due to short history, but signs are positive with successful exits giving confidence.
o Future outlook: With India’s economic growth, AIFs will likely play an even bigger role
in funding innovation, infrastructure, and offering investors avenues beyond public
markets. Regulators are balancing investor protection with market development by
gradually refining norms (recent consultation papers on PPM disclosures, performance
benchmarking for AIFs, etc., to improve transparency and comparability).
