Concentration risk
Also written Concentration limits · Investment concentration · Single investee exposure
The risk that a few positions are large enough, against the fund's capital, that one loss damages the whole portfolio — capped by SEBI at 25% of investable funds for Category I and II AIFs and 10% for Category III.
In plain language
Managers of AIFs follow a general policy of diversifying their investments. The workbook then adds the sentence that matters: the fund may at certain times hold only a few relatively large positions in relation to its capital, which means a loss in any one of them could have a material adverse impact on the fund.
That is concentration risk, and unlike most risks in the chapter it is not left to disclosure alone. SEBI puts a hard number on the largest single bet a fund may take.
How it works
The general investment conditions.
| Fund | Maximum in one investee company |
|---|---|
| Category I and Category II AIF | 25% of investable funds |
| Large value fund for accredited investors, Category I or II | 50% of investable funds |
| Category III AIF | 10% of investable funds |
| Large value fund for accredited investors, Category III | 20% of investable funds |
The limit bites directly or through investment in the units of other AIFs, so a fund cannot rebuild a concentrated position by routing it through a second fund. For investments in listed equity, a Category III AIF may compute the 10% against either investable funds or the net asset value of the scheme.
Investable funds is the base, and it is defined: the corpus of the scheme net of expenditure for administration and management of the fund, estimated for the tenure of the fund. It is therefore smaller than corpus, which makes the cap slightly tighter than it first looks.
Disclosure runs on two clocks. Concentration risk is one of the material risks an AIF must identify and report to investors, alongside foreign exchange, leverage, realisation, strategy, reputation and extra-financial risks. Under the Investor Charter, disclosure of material risks is made by Category I and II AIFs within 180 days from the year end, and by Category III AIFs within 60 days from the end of the quarter, or earlier if the fund documents say so.
Beyond the regulation, industry best practice asks the manager to fix, in the investment strategy itself, the maximum amount of each investment, the concentration restrictions, and the list of excluded sectors — and an investor conducting due diligence is expected to know the permissible concentration limits before committing.
A worked example
Chenab India Fund II, a Category II AIF, has a corpus of Rs 520 crore. Estimated administration and management expenditure over the tenure is Rs 20 crore, so investable funds are Rs 500 crore.
Single investee cap 25% x Rs 500 crore = Rs 125 crore
Largest holding, a logistics platform = Rs 120 crore (24% - compliant)
The logistics platform halves in value.
Loss Rs 60 crore
As a share of investable funds 12%
NAV falls from Rs 500 crore to Rs 440 crore
One name, inside the limit, costs the fund an eighth of its capital. Fourteen other holdings have to return 13.6% between them just to bring the fund back to where it started.
Now the same Rs 500 crore run three other ways:
| Fund | Cap | Largest single loss on a 50% fall |
|---|---|---|
| Category II | 25% — Rs 125 crore | Rs 62.5 crore, 12.5% of the fund |
| Category II large value fund | 50% — Rs 250 crore | Rs 125 crore, 25% of the fund |
| Category III | 10% — Rs 50 crore | Rs 25 crore, 5% of the fund |
| Category III large value fund | 20% — Rs 100 crore | Rs 50 crore, 10% of the fund |
The accredited-investor concession doubles the permitted concentration in every case. That is the regulator's judgement about who can be left to look after themselves, and it is exactly the kind of row an exam turns into a question.
Why NISM asks about it
Chapter 9 section 9.5 carries concentration risk with the 25% and 10% caps, Chapter 17 section 17.9 gives the general investment conditions including the large value fund concessions and the definition of investable funds, Chapter 6 section 6.8 lists concentration risk among the material risks an AIF must report, and the Investor Charter in Chapter 13 sets the reporting clocks. A numeric question on 25 versus 10 is close to certain.
Common exam traps
- 25% for Categories I and II, 10% for Category III. The smaller number belongs to the listed-markets category, which is counter-intuitive until you remember Category III trades.
- Large value funds for accredited investors get double — 50% and 20% respectively.
- The base is investable funds, corpus net of estimated administration and management expenditure — not corpus, and not NAV, except that Category III may use NAV for listed equity.
- Exposure through units of other AIFs counts. The cap cannot be sidestepped by investing through a second fund.
- Diversification is a policy, not a promise. The workbook explicitly allows that a fund may hold a few relatively large positions.
- Two reporting clocks: 180 days from year end for Category I and II, 60 days from quarter end for Category III.
Check yourself
1.How often must AIFs report to their investors on financial information of investee companies and material risks?
- a)All categories quarterly, within 60 days of quarter end
- b)Category I and II at least annually within 180 days from the year end; Category III quarterly within 60 days of the end of the quarter
- c)All categories annually within 90 days of the balance sheet date
- d)Only on request from investors
Show the answer
Answer: (b) Category I and II at least annually within 180 days from the year end; Category III quarterly within 60 days of the end of the quarter
AIFs (except Category III AIFs) shall provide at least on an annual basis, within 180 days from the year end, reports to investors... However, Category III AIFs shall provide quarterly report to its investors on the below mentioned information within 60 days of end of the quarter. The content is prescribed: financial information of investee companies and material risks and how they are managed, covering concentration risk at fund level; foreign exchange risk at fund level; leverage risk at fund and investee company levels; realisation risk... at fund and investee company levels; strategy risk... at investee company level; reputation risk at investee company level; extra financial risks, including environmental, social and corporate governance risks, at fund and investee company level. Note which risks are fund-level only, which investee-level only, and which both.
Where this is taught
Free preparation for NISM Series XIX-DRelated terms
- Net Asset ValueThe net assets of a mutual fund scheme divided by the number of units outstanding — what one unit of the scheme is worth on a given day, after every liability except the unitholders' own.
- Accredited InvestorAn investor certified by an accreditation agency as meeting SEBI's income or net-worth tests, and therefore allowed into products on relaxed terms — including below the Rs 1 crore AIF floor.
- DiversificationSpreading an exposure across holdings that do not move together, so that total risk falls by more than total return does — minimising risk per unit of return.
- Private placement memorandumThe offer document of a Category III AIF, filed with SEBI through a merchant banker at least 30 days before a scheme launches — and the document SEBI comments on but never approves.
- Leverage riskThe risk that borrowing or derivative positions magnify a fund's losses — which is why SEBI caps Category III leverage at two times NAV and permits Category I and II almost none.
- Investor Due DiligenceThe investigation an investor runs on an AIF and its manager before committing capital — the process of investigation and evaluation into the details of a potential investment.
- Fund of fundsAn AIF that invests in the units of other AIFs rather than directly in investee companies — buying diversification across managers and strategies, and paying two layers of fees for it.
- Downside riskThe probability of a loss on account of falling asset prices in changing market conditions — the half of volatility investors actually mind, measured by maximum drawdown and value at risk.