Foundation — Evolution of AIFs in India, the definition and exclusions, and Category I

A community kitchen pools contributions from many households and feeds whoever comes. Three kinds of cooking pot look similar and are not the same thing.

The household's own pot, cooking only for that family. The office canteen, cooking only for employees. And the hospital kitchen, which is a kitchen but answers to the health inspector rather than the community board.

That is exactly the shape of the AIF exclusions, and the workbook supplies the summarising sentence: the exclusions are EITHER PRIVATE FUNDS OF A COMPANY, BUSINESS OR A FAMILY OR THOSE THAT ARE REGULATED BY OTHER REGULATORS such as RBI or IRDAI or PFRDA or IFSCA.

The first exclusion is different from the other two and is worth separating. Any fund which is a MUTUAL FUND or a COLLECTIVE INVESTMENT SCHEME as per SEBI regulations is excluded — not because it is private or foreign-regulated, but because it is pooled from the general public at large, which is the opposite of privately pooled.

The second covers private arrangements: family trusts, ESOP or other employee benefit trusts, holding companies, SPVs set up for securitisation or other such purposes. A holding company pools nothing from outsiders; an ESOP trust serves only employees.

The third covers other regulators: funds set up under RBI regulations such as securitisation companies or under the purview of any other regulator.

So an examination question that describes a fund should be tested on three questions: is it pooled from the general public? Is it a private arrangement of one family or business? Is it already regulated by someone else? If the answer to all three is no, and it is privately pooled for a defined investment policy, it is an AIF.

At a government office there are three counters. One has a shorter queue and a helpful officer, because the applicants there are doing something the government wants done. One is the ordinary counter. One is for complicated cases and is watched closely.

That is the logic of the three AIF categories, and it is a logic of policy, not of asset class.

Category I is the favoured counter. It invests in start-ups, early-stage ventures, social ventures, SMEs, infrastructure OR OTHER SECTORS OR AREAS WHICH THE GOVERNMENT OR REGULATORS CONSIDER AS SOCIALLY OR ECONOMICALLY DESIRABLE — and the workbook adds that other funds that are considered economically beneficial AND ARE PROVIDED SPECIAL INCENTIVES by the government or any regulator are also considered as part of this Category.

Category II is the ordinary counter, and its definition is purely residual. It is an AIF that DOES NOT FALL IN CATEGORY I AND CATEGORY III and which DOES NOT UNDERTAKE LEVERAGE OR BORROWING other than as permitted. The workbook explains the policy point directly: private equity funds and debt funds go here for which NO SPECIFIC INCENTIVES OR CONCESSIONS ARE GIVEN by the government or any other regulator.

Category III is the complicated counter. It employs DIVERSE OR COMPLEX TRADING STRATEGIES AND MAY EMPLOY LEVERAGE, including through investment in listed or unlisted derivatives — hedge funds, funds which trade with a view to make SHORT-TERM RETURNS, and open-ended funds, again with no specific incentives or concessions.

The examinable insight is that the same underlying asset can sit in different categories. A fund lending to infrastructure is Category I; a fund lending to an ordinary company is Category II. What differs is not the asset but whether the state wants that lending to happen.

A company takes money three times as it grows, and each cheque comes from a different kind of person.

The first cheque is small, early and personal. It comes from an ANGEL FUND, which the workbook defines as a sub-category of Category I AIF that RAISES FUNDS FROM ACCREDITED INVESTORS. An angel investor is an accredited investor OR key management personnel of an angel fund or its Manager. The constraint is examinable: angel funds need to invest a minimum of INR 10 LAKH and not more than INR 25 CRORE in a particular investee company.

The second cheque is the first institutional one. The workbook is precise: venture capital can be termed as THE FIRST STAGE OF INSTITUTIONAL FINANCING in an early-stage company or start-up, GENERALLY AFTER THE ANGEL FUNDS ARE SUCCESSFULLY RAISED. A VCF invests primarily in UNLISTED SECURITIES of start-ups, emerging or early-stage venture capital undertakings, and is mostly applicable to ASSET LIGHT BUSINESSES that are intensive in TECHNOLOGY, INTELLECTUAL PROPERTY OR DIGITAL MEDIA APPLICATIONS.

The third cheque is large and comes later. A PRIVATE EQUITY FUND invests primarily in EQUITY OR EQUITY LINKED INSTRUMENTS OR PARTNERSHIP INTERESTS of investee companies, and unlike VCFs, PE funds are mostly involved in LATER STAGE FINANCING in business entities that have ESTABLISHED A BUSINESS MODEL AND NEED TO BE SCALED UP.

And the difference in the two definitions is deliberate — the workbook explains it. VCFs may invest in SECURITIES generally — equity, debt, preference capital or other convertible securities — because the definition uses the word SECURITIES to provide LATITUDE TO STRUCTURE THE INVESTMENTS APPROPRIATELY. PE funds must invest in EQUITY or EQUITY LINKED instruments, because being later-stage investors, Private Equity Funds are IN A BETTER POSITION TO TAKE EQUITY RISKS in investee companies.

Early money needs flexible instruments; later money can afford to be plain equity. That single sentence explains the whole difference.

A caterer serving one hundred guests may put any number of dishes on the menu, but no single dish may take more than a quarter of the kitchen's ingredients. A second caterer, running a more experimental menu, is held to a tenth.

Those are the AIF concentration limits, and getting them the right way round is worth marks.

Category I and Category II: the maximum investment in a particular investee company CANNOT EXCEED 25% OF THE INVESTIBLE FUNDS of the AIF scheme.

Category III: the maximum investment in a particular investee company CANNOT EXCEED 10% OF THE INVESTIBLE FUNDS of the AIF scheme.

The tighter limit applies to the riskier category, which is the logic to remember if the numbers slip.

There is also a minimum investment by investors, and it is not a concentration limit at all — investors in Category I have to invest a minimum of INR 1 CRORE, with a footnote that this is NOT APPLICABLE TO ANGEL FUNDS AND LARGE VALUE FUNDS FOR ACCREDITED INVESTORS.

And angel funds carry their own pair of numbers, which candidates confuse with the Rs 1 crore: angel funds need to invest a MINIMUM OF INR 10 LAKH AND NOT MORE THAN INR 25 CRORE in a particular investee company. That is a limit on what the fund puts into one company — not on what an investor puts into the fund.

A building installs a large water tank connected to hydrants on every floor. In normal months it does nothing at all. It exists for the one day when something is burning.

The Corporate Debt Market Development Fund is built on exactly that principle, and the workbook describes both states.

In a crisis: its purpose is to PURCHASE CORPORATE DEBT SECURITIES FROM DEBT-ORIENTED MUTUAL FUND SCHEMES DURING PERIODS OF MARKET DISLOCATION AS MAY BE DECIDED BY SEBI. It is, in the workbook's words, a BACKSTOP FACILITY DURING TIMES OF MARKET STRESS.

In ordinary weather: during such periods when there is NO MARKET DISLOCATION, the fund will invest in LIQUID AND LOW-RISK DEBT INSTRUMENTS, in a manner specified by SEBI.

The problem it solves is a genuine one. When a debt market freezes, mutual fund schemes facing redemptions must sell bonds into a market with no buyers — and forced selling at any price drives the market down further, causing more redemptions. A standing buyer breaks that loop.

Its structure follows from the purpose, and every element is examinable. CLOSE-ENDED, so the money cannot leave when it is most needed. Formed as a TRUST. A 15-YEAR TENURE from the date of its first closing, because a backstop must be there for a long time. And units are issued to ASSET MANAGEMENT COMPANIES AND SPECIFIED DEBT-ORIENTED SCHEMES OF MUTUAL FUNDS — the beneficiaries fund it themselves, which is what makes it an industry facility rather than a public subsidy.

And the three purchase conditions ensure it rescues liquidity and not credit: the securities must be LISTED and INVESTMENT GRADE, with residual maturity NOT EXCEEDING FIVE YEARS, and with NO MATERIAL POSSIBILITY OF DEFAULT OR ADVERSE CREDIT NEWS OR VIEWS. It buys good bonds that nobody will bid for — not bad bonds that nobody should want.

A boat moving up a river is doing two things at once. The tide is carrying it, and the rower is rowing. Someone watching from the bank sees only one movement, but the two contributions are entirely different in kind.

The tide is BETA. The workbook defines it as the measure of SYSTEMATIC RISK, which is the change in the returns earned by the fund portfolio ON ACCOUNT OF A CHANGE IN THE RETURNS ON A BROAD-BASED INDEX. And the consequence: higher the Beta for the fund portfolio, THE MORE VOLATILE is the fund portfolio as compared to the market return.

The rowing is ALPHA, and the workbook gives it two connotations — both examinable.

First, alpha as compensation for unsystematic risk. It is the excess return expected from assuming UNSYSTEMATIC RISK which is associated with investing in alternative investments that may differ from traditional investments DUE TO ILLIQUIDITY, LOWER CREDIT QUALITY OR OTHER DISTINGUISHING FACTORS. In this sense alpha is the difference between the observed return of an asset and the observed return of its market benchmark, AFTER ADJUSTING FOR RISK DIFFERENCES.

Second, alpha as skill. It represents an EXPECTED SUPERIOR PROFIT DUE TO THE USE OF SKILL OF THE FUND MANAGER in the selection and allocation of investments. The workbook illustrates it: a portfolio invested in index stocks will have a beta associated with the index and the returns would be equal to market returns; but if investments are picked carefully using investment strategies and the portfolio beats the market, the excess returns or the alpha is attributable to the SUPERIOR SKILL of the fund manager. This type of risk taking is referred sometimes as ALTERNATIVE BETA.

And the workbook gives a worked figure worth quoting: if a private equity fund has a track record to offer an alpha of 3%-5% over benchmark returns from the capital market, it means that due to the active fund management skills being deployed, the fund is expected to CONSISTENTLY OUTPERFORM competitively priced assets of similar risk by an average of 3%-5% PER YEAR.

Before signing a rental agreement a careful tenant reads four things: what the flat actually is, how long the lease runs, who the landlord is, and how to get out.

The workbook prescribes exactly the same discipline before investing in an AIF, and names four crucial clauses of the Private Placement Memorandum.

"INVESTMENT OBJECTIVE AND STRATEGY" — which elaborates on the TARGETED SECURITIES, INVESTMENT STYLE, SECTORS, GEOGRAPHIC FOCUS, and such other factors. This is what the fund actually is.

"TERM OF THE FUND/SCHEME" — which states the FUND STRUCTURE, TERM of the fund or scheme, WHETHER OPEN OR CLOSED, FINAL CLOSING DATE and APPLICABLE EXTENSION PERIODS. This is how long the money is committed, and the extension periods are the part investors most often miss.

"MANAGER" — which states the PRIOR EXPERIENCE OF THE FUND MANAGER(S) RESPONSIBLE TO TAKE INVESTMENT DECISIONS for the Fund. Note what is being disclosed: not the firm's record but the experience of the individuals who will actually decide.

"REDEMPTION" — which states the period during which investors can redeem their money back, and also provides information about the LOCK-IN PERIOD and the REDEMPTION FEES, OR EXIT LOAD to be paid in case of EARLY REDEMPTIONS.

The four clauses map onto the four questions any alternative investor must answer: what am I buying, for how long, decided by whom, and how do I get out. And in an asset class whose essential characteristic is illiquidity, the fourth is the one that repays the most careful reading.

Water accumulates behind a dam. When a channel opens, it does not trickle — it moves, and it moves towards the lowest ground available.

The workbook describes both halves of that picture for Indian alternatives.

The water above the dam is global. The LACK OF GROWTH IN DEVELOPED ECONOMIES coupled with QUANTITATIVE EASING by the central banks over the past decade has created a situation of EXCESS CAPITAL GENERATION in these countries. This excess capital FOUND ITS WAY INTO EMERGING HIGH GROWTH MARKETS wherein INDIA STANDS AS ONE OF THE PREFERRED INVESTMENT DESTINATIONS IN THE WORLD.

The channel is regulatory. The regulatory impetus to the AIF industry's growth has been provided with the INTRODUCTION OF THE AIF REGULATIONS BY SEBI IN 2012, which provided the necessary framework which MADE ALTERNATIVE INVESTMENTS SPACE REGULATED FOR THE PARTICIPANTS.

And the state did more than open the channel; it primed the pump. A FUND OF FUNDS OF INR 10,000 CRORE FOR START-UPS was established under DPIIT, MANAGED BY SIDBI, UNDER CATEGORY I AND II AIFs, investing in SEBI registered AIFs which, in turn, would invest in start-ups — acting as an ENABLER TO ATTRACT PRIVATE CAPITAL in the form of EQUITY, QUASI-EQUITY, SOFT LOANS AND OTHER RISK CAPITAL. The NATIONAL INFRASTRUCTURE INVESTMENT FUND (NIIF) was set up in 2015 AS A CATEGORY II AIF to invest in infrastructure and strategic assets. And in 2025 an additional fund of INR 10,000 CRORE was announced for emerging technologies, artificial intelligence and machine learning.

On the domestic side the supply of opportunities grew too — start-ups in services and technology-enabled models, clean technologies and renewables, a realty sector thriving on URBAN MIGRATION, infrastructure, and after the INSOLVENCY AND BANKRUPTCY CODE IN 2016, A NEW SPACE FOR SPECIAL SITUATION FUNDS.

Capital seeking growth, a framework to receive it, and a pipeline of opportunities. The industry did not appear because alternatives became fashionable; it appeared because all three arrived within a few years of each other.