How Category III AIFs Try to Make Money

How Category III AIFs Try to Make Money

10.1 The starting point

Category III AIFs have been primarily investing in equities and derivatives contracts, with equities or equity indices as the underlying asset.

A Category III AIF is a pooled investment vehicle that collects capital to invest over a long term. It may take leverage, short positions and derivative positions to generate absolute returns over the medium and long term. So these funds generally do not invest for intra-day trading. The workbook does add that speculative investments in equities may be made if the manager can predict short-term profit generation.

Where is the strategy written down? The manager sets out the target sector, basis for selecting investments, time horizon and risk-return profile in the Investment Strategy, which is disclosed in the PPM. And a point worth remembering: by making capital commitments, the investor indirectly consents to the stated strategy.

Two words you need first

• Long position — you buy. You gain if the price rises.
• Short position — you sell (or sell futures, or buy a put option). You gain if the price falls.

Every strategy in this chapter is a different mix of these two.

10.1.1 Equity-market strategies

Long-only

• Takes only long ("buy") positions in selected stocks.
• Aims at absolute returns over the medium to long term, with a strong emphasis on capital preservation.
• Stocks are picked with a top-down or bottom-up fundamental approach, looking for predictable, scalable and quality business models — studying dividend pay-outs, return on capital employed and other parameters.
• A prudent manager may hedge against a market fall by taking an opposite (sell) position — a short futures position or buying a put option — on the stock or an index with similar characteristics.
• Even with hedges, a long-only strategy may be volatile and risky during economic downturns.

In the workbook's example, the most suitable hedge is to buy a put option on the NIFTY50 or S&P BSE SENSEX (or a combination) and keep rolling the contracts forward. The workbook says options can be more efficient than futures for hedging.

Long-short (the "130/30" fund)

• Identifies over-priced and under-priced stocks against the manager's fair valuation, using fundamental analysis plus macro-economic factors, industry factors and government reforms.
• Buys under-priced stocks, sells over-priced stocks.
• Often called a 130/30 fund (or 120/20): 130% long, 30% short, as a percentage of investable funds, so net market exposure is 100%.
• Short positions are usually taken through options and futures.
• Unlike long-only, the manager can short even at the time of investing. This gives more flexibility and can create a natural hedge against market risk — if the longs and shorts are in stocks with similar characteristics or the same industry.
• Excessive leverage and short positions can increase volatility, so SEBI restricts the leverage taken by long-short funds.

Market-neutral

• Like long-short, it buys under-priced and sells over-priced stocks.
• The difference: the fund keeps net "zero" or "neutral" exposure to a sector, industry or market-cap segment — equal long and short amounts.
• So the beta (systematic risk) of the fund is zero or close to zero.
• The manager has low flexibility — every trade must keep portfolio beta near zero.
• Uses fundamental analysis or quantitative algorithms.

The one-line distinction the exam likes: market-neutral funds use longs and shorts to minimise systematic risk; long-short funds use longs and shorts to exploit undervalued and overvalued opportunities.

And the warning: a zero beta does not ensure the strategy is not volatile or risky in downturns. Leverage and concentrated positions still add risk, and individual stocks still carry unsystematic risk.

Directional and short-bias

• A directional strategy takes a net long or net short position, based on the manager's call on the direction of the overall market. It is the opposite of market-neutral — it does not aim for beta near zero.
• Short-bias is a type of directional strategy: it takes both longs and shorts but keeps a net short exposure. It benefits when the market falls.
• A dedicated-long directional strategy takes exclusively long positions.
• Directional and short-bias strategies may be volatile during major upturns as well as downturns, depending on net exposure.

10.1.2 Global macro

• Takes long and short positions across asset classes — currencies, fixed income, equities, commodities, real assets and interest rate derivatives — across markets and geographies.
• Picks positions based on macro-economic trends, not company-by-company fundamentals. Large players use advanced algorithms with quantitative and discretionary inputs.
• Helps diversify across asset classes and manage the total risk of the portfolio.
• Within it, the fund may apply long-only, market-neutral, directional or long-short approaches. The workbook's example: long Indian corporate debt, short the Euro, long US T-bills, and market-neutral in crude — subject to regulatory guidelines.

10.1.3 Convertible arbitrage

A convertible security (convertible debt or convertible preference share — a hybrid security) lets the holder convert into equity shares at a pre-determined date and conversion ratio. Until then, the holder earns coupons.

The strategy: go long the convertible and short the same company's equity shares at the same time.

• If the share price falls — the short position gains, and the fund keeps earning coupons.
• If the share price rises — the fund converts, sells the shares at market value, and this compensates for the loss on the short.

The idea: convertibles are sometimes priced inefficiently relative to the company's shares, and the pricing depends on the conversion ratio.

Note the workbook's two statements side by side. It first says the strategy is pursued "to earn a riskless profit, independent of stock price movements." It then says convertible arbitrage is difficult to implement and can be riskier, especially at times of changing macro-economic factors and unpredictable events. Hold both: the aim is a riskless profit; the reality carries risk.

10.1.4 Event-driven strategies

These take positions in one target company because of a significant corporate event — debt restructuring, mergers, acquisitions, spin-offs or a change in management. They may take long and short positions in equities or fixed income. The primary indicator is a material corporate event.

Activist strategy

• The fund makes a significant investment in an investee company to benefit from a material corporate event — such as a change in management, filing for bankruptcy, or shutting a business segment — that may have pushed the price down.
• If the manager believes it can profit by improving operational efficiency, it invests enough to participate in management.
• Activist funds take a private equity approach and a long-term orientation. The workbook says this is also referred to as a Special Situations Strategy — for example, taking a stake in a company undergoing NCLT proceedings that is likely to be acquired by a big company in the same industry.
• Activist funds have less diversified portfolios and illiquid investments.

Concentration limits (as given in this chapter):

Because activism needs big cheques, Large Value Funds are most suitable, and activist strategy in India is still nascent. Given these limits, Indian Category III AIFs can typically take substantial stakes only in small-cap or mid-cap companies, which carry high failure risk.

Stewardship code: SEBI's code requires all AIFs to actively monitor investee companies and vote in important company matters, and to have a clear policy for collaborating with other institutional investors.

Merger arbitrage

• Acquiring company — buys the shares of another company. Target company — is sold or merged into the acquirer.
• The fund goes long the target and short or long the acquirer.
• Why long the target? The acquirer usually pays a premium over the target's unaffected share price, because the target's board will only approve a price significantly higher than the current price. The fund captures the spread between the current price and the acquisition price.
• Why short the acquirer? Two reasons: (1) uncertainty in deal completion — board, regulatory and shareholder approvals may fail or be delayed; (2) the premium — if it is over-valued, the acquirer's price may fall; if under-valued, it may rise.
• Success depends on estimating the fair value of the premium, which decides the conversion ratio.

Pre-IPO strategy

• Pre-IPO shares are issued to employees or institutional investors, including Category III AIFs, before the shares are offered to the public in an IPO.
• They come at a discount to the IPO issue price, because of the large amount invested and the risk taken.
• Pre-IPO placement is allotment of pre-IPO shares to institutional investors just before the IPO date.
• Under the SEBI (ICDR) Regulations, 2018, institutional investors including AIFs subscribing to pre-IPO shares or a QIP are subject to a lock-in period from the date of listing. (The workbook does not state the length of the lock-in in this chapter.)