Alternative Investment Funds (AIFs) in India – Evolution | Types | Categories

Alternative Investment Funds (AIFs) refer to privately pooled investment vehicles that collect funds from sophisticated individual or institutional investors to invest in a variety of non-traditional assets. Unlike conventional investment funds, AIFs target investments outside of standard asset classes like stocks, bonds, and cash, opting instead for private equity, venture capital, hedge funds, real estate, commodities, and even art or rare collectibles. In India, AIFs are regulated by the Securities and Exchange Board of India (SEBI) under the SEBI (Alternative Investment Funds) Regulations, 2012.

Table of Contents

1. Evolution and Growth of AIFs in India and Factors Enabling Preference for Indian AIF MarketEvolution and Growth of AIFs in India
2. Types of AIFs
3. Categories of Alternative Investment Funds (AIFs)Comparison of AIF Categories
4. Comparison of Alternative Investment Funds CategoriesSuitability and Enablers for AIF Products in India

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1. Evolution and Growth of AIFs in India and Factors Enabling Preference for Indian AIF Market

1.1 Evolution of Venture Capital and Private Equity

The evolution of alternative investments in India can be traced to the Venture Capital Guidelines notified on 25th November, 1988 by the Government of India which initially provided a restricted scope for venture capital (VC) financing.

The scope for VC was broad-banded by SEBI in 1996 by notifying a new set of regulations for the VC industry called the SEBI (Venture Capital Fund) Regulations, 1996 which brought the entire spectrum of private capital investment in unlisted companies into the ambit of institutional investment. Subsequently, tax breaks were given to VCFs at fund level and the SEBI regulations were also revised following the recommendations of the K.B. Chandrasekhar Committee in 2000. In the growth phase that followed from 2003 with the emergence of a strong domestic capital market and the impressive growth of corporate India, many Venture Capital Fund and Private Equity Funds emerged mainly with off-shore capital. Domestic institutions such as ICICI, UTI etc. evolved into full-fledged private equity players.

From a business perspective, from 2001 onwards, Indian industry was on a consolidation drive in various sectors. This corporate growth initiative coupled with an investor friendly regime and good economic conditions led to a spurt in private equity activity in India. The first characteristic private equity transaction in India is arguably the USD 292 million investment made by Warburg Pincus in Bharti Televentures Ltd. which also resulted in a successful exit strategy for the fund when Bharti was taken public with its IPO in 2002.

In the initial stages, though private equity was largely confined to the information technology sector, by the end of 2007, the sectoral bias was largely removed and private capital had got extended to several other sectors. In addition, the Indian market also saw the emergence of buyout transactions spearheaded by funds such as Blackstone, KKR, Actis etc. which acquired controlling interest in both listed as well as closely held companies. The buyout of Flextronics Ltd. by KKR in 2006 was a landmark deal.

In the aftermath of the Global Financial Crisis 2008, the industry was subdued till 2012 until growth started to pick up significantly from 2012 mostly due to the introduction of the SEBI (Alternative Investment Funds) Regulations. But the period between 2011 and 2019 can be termed as the consolidation and transformation phase during which some of the older funds exited and newer funds consolidated their presence. This phase also marked the transformation of a VC and PE industry into an AIF industry.

1.2 Evolution of Hedge Funds

The term “hedge funds”, first came into use in 1949, when Alfred Winslow Jones’s company, A.W. Jones & Co. launched the first hedge fund. “Hedge Funds” were described as any investment fund that used incentive fees, short selling, and leverage to maximize returns for the investors. Over time, hedge funds began to diversify their investment portfolios to include other financial instruments such as fixed income securities, convertible securities, currencies, exchange traded futures contracts, commodity futures and commodity options.

Indian capital markets witnessed significant growth in the 1990s. With the notification of rules and regulations governing Portfolio Managers and SEBI (Mutual Funds) Regulations, the asset management business took shape in the private sector in India.

Foreign Investors were investing significant funds through Hedge funds and Funds-of-Funds, set-up in offshore jurisdictions. Such funds invested directly in Indian Securities Market, or through Offshore Derivative Instruments (ODIs), issued by Foreign Institutional Investors (FIIs) against underlying Indian securities.

Eurekahedge India Long Short Equities Hedge Fund Index is an equally weighted index of 15 constituent funds. The index was designed to provide a broad measure of the performance of underlying hedge fund managers who invest exclusively in India. The index is base weighted at 100, as on December 1999. As seen from Figure 1, the India-focused hedge funds have shown consistent returns, even after a decrease in the index value during the Global Financial Crisis of 2008.

Figure 1: Historical Performance of Eurekahedge India, since Inception

However, no hedge funds were domiciled in India. Offshore hedge funds were not able to offer their products to Indian investors within India as there was no regulatory regime for hedge funds to be set up or marketed in India.

Considering the lack of a separate regulation for hedge funds and other restrictions under FEMA, hedge funds had limited options for marketing their products to Indian investors. SEBI provided a limited window upto 2012 for hedge funds to register under the SEBI (Foreign Institutional Investors) Regulations as an FII with additional safeguards. Under the SEBI (Alternative Investment Funds) Regulations, 2012. Hedge Funds were classified under “Category III AIF” which follows diverse and complex investment strategies, akin to investment strategies followed by Hedge Funds, globally.

1.3 Trends Post 2012

The significant trends post 2012 can be summarised as follows:

• The industry evolved from a predominantly venture capital and private equity industry into a full-fledged alternative investment industry spanning several alternative asset management funds and UHNIs/family offices. For e.g. Real estate sector and infrastructure sector are two examples in point. Further, one can also consider foreign or domestic hedge funds that are registered under AIF Regulations.
• Global events such as Brexit and US-China trade war notwithstanding, private equity inflows and activity reached record levels in Asia Pacific region with India registering highest growth in 2017¹ and 2018².
• The significant emergence of domestic capital to support the AIF industry has been evident during this phase. The AIF industry caught the fancy of the ultra-rich billionaires of India. Several new fund houses and investment managers set up or launched new AIFs to cater to the very wealthy Indian investor community.
• Government reforms were introduced to provide tax incentives to start-ups. This has given the much needed boost to the Private Equity and Venture Capital markets and ensured continuous inflow of capital from international and domestic investors such as Sovereign Wealth Fund, Pension Funds, Foundations, Insurance Companies, Banks, Charitable Organizations, Family Offices and High Net Worth Individuals.
• The domestic AIF market grew by identifying new alternative investment opportunities such as pre-IPO financings, special situations such as stressed asset auctions under the Insolvency and Bankruptcy Code 2016, debt resolution refinancing with banks, M&A financings and co-investments, real estate debt financings, mezzanine funding, infrastructure debt and equity funds and so on.
• The emergence of AIF schemes with focus on listed market space is a new phenomenon that emerged in this time period. These funds are akin to hedge funds that take long-short positions on the equity, debt and derivative segments of the stock market. Some of them also focus on special situations such as merger arbitrage, buybacks, de-listings, open offers under the Takeover Code, rights offers and hedging. Several real estate debt funds as well as venture debt funds also emerged with focus on specific niches in the AIF investment world.
• Rationalisation of Total Expense Ratio (TER) charged by equity-oriented Mutual Fund schemes, as per amendments made to SEBI (Mutual Funds) Regulations, have encouraged mutual fund managers to exit and launch their own vehicles as AIFs in India and make investments, with greater flexibility. As per the structure of AIFs, Managers of AIFs are flexible to charge Performance-based Fees, on the ‘Additional Return’ earned by the fund above the ‘Reference Hurdle Rate. This fee is paid in addition to the Management Fees charged at a fixed rate by the Manager, on a yearly basis.
• All AIFs registered with SEBI are monitored as per the Operational Guidelines and Risk Management Framework, including the prudential norms and applicable leverage limits specified from time to time.
• The domestic Category III AIF market grew by identifying new alternative investment opportunities, such as taking exposures in exchange-traded Commodity Futures and Commodity Options contracts.
• The emergence of e-commerce and digital technology start-ups with cutting edge solutions to myriad service delivery and frontier areas such as fintech, digital payments, artificial intelligence, Internet of Things, Machine Learning, Data Analytics, Cloud Computing etc. has provided a new world of opportunities for AIFs and has also been instrumental in bringing in enormous capital from off-shore funds and sovereign wealth funds as well.

2. Types of AIFs

The SEBI (Alternative Investment Funds) Regulations 2012 (AIF Regulations) that currently regulate such activity define the term ‘Alternative Investment Fund’ (AIF) as one which is primarily a privately pooled investment vehicle. However, since there are several types of investment funds in the market, the definition prescribes that only a ‘privately pooled’ structure with funds pooled from India or abroad for a defined investment policy is to be considered as an AIF. The words ‘privately pooled’ denote that the fund is pooled from select investors and not from the general public at large. These private investors are sourced from categories such as institutions and HNIs who can understand the nuances of higher risk taking and complex investment arrangements. Nonetheless, the following categories are explicitly excluded from this definition:

• Any fund which is a mutual fund or a collective investment scheme as per SEBI regulations.
• Family trusts, ESOP or other such employee benefit trusts, holding companies, SPVs set up for securitisation or other such purposes.
• Funds set up under RBI regulations such as securitisation companies or under the purview of any other regulator.

It may be noted that 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.

Alternative Investment Funds (AIFs) can be of different types based on their investment strategy and types of assets under management. Under the SEBI (AIF) Regulations, 2012, a Sponsor or trustee (if AIF is in trust form) can register the following types of funds as AIFs:

2.1 Venture Capital Fund (VCF)

Venture Capital Fund (VCF) means

“an AIF which invests primarily in unlisted securities of start-ups, emerging or early-stage venture capital undertakings mainly involved in new products, new services, technology or intellectual property right based activities or a new business model and shall include an angel fund”.

“Start-up” means a private limited company or a limited liability partnership which fulfils the criteria for start-up as specified by the Department of Promotion of Industry and Internal Trade (DPIIT), Ministry of Commerce and Industry, Government of India, vide notification no. G.S.R. 127(E) dated February 19, 2019 or such other policy of the Central Government issued in this regard from time to time³. “Venture capital undertaking” means a domestic company which is not listed on a recognised stock exchange at the time of making investment.

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 by such company or start-up. It is mostly applicable to asset light businesses that are intensive in technology, intellectual property or digital media applications.

2.2 Angel Fund

Angel Fund means

“a sub-category of Venture Capital Fund under Category I AIF that raises funds from angel investors and invests in accordance with the SEBI (AIF) Regulations”.

Angel Investor means any person who proposes to invest in an angel fund and satisfies one of the following conditions, namely, –

• an individual investor who has net tangible assets of at least INR 2 crore excluding value of his principal residence, and who

1. 1. has early stage investment experience, (i.e. prior experience in investing in start-up/emerging/early-stage ventures), or
   2. or has experience as a serial entrepreneur (i.e. a person who has promoted/co-promoted more than one start-up venture), or
   3. is a senior management professional with at least 10 years of experience,

• a body corporate with a net worth of at least INR 10 crore
• a registered AIF under SEBI (AIF) Regulations or a venture capital fund registered under the erstwhile SEBI (Venture Capital Funds) Regulations 1996.

2.3 Private Equity Fund

Private Equity Fund means

“an AIF which invests primarily in equity or equity linked instruments or partnership interests of investee companies according to the stated objective of the fund⁴”.

It may be understood that private equity fund is primarily an equity-based investor but unlike venture capital funds which are focussed on early stage investments, private equity funds are mostly involved in later stage financing in business entities that have established a business model and need to be scaled up for further growth.

2.4 Debt Fund

Debt Fund means

“an AIF which invests primarily in debt securities of listed or unlisted investee companies or in securitised debt instruments according to the stated objectives of the Fund⁵”

Many types of debt, that are private, are considered to be alternative investments because of their illiquidity and often because they are not commonly held by traditional investors. Even listed companies issue debt securities such as non-convertible debentures (NCDs) and bonds through private placement that are not available in the traditional investment route.

Some of the venture financing funds also term themselves as ‘venture debt funds’ since they finance advanced stage of venture capital through mezzanine financing, i.e. debt financing with an equity upside, like warrants attached to the debt. Pure venture debt funds are also prevalent that provide debt finance at a higher than market rate for high growth start-ups which are already venture equity funded.

Some private debt funds also finance sub-ordinate debt, in the form of ‘leveraged loans’ which is used in funding companies with high amount of senior debt on their balance sheet.

2.5 Infrastructure Fund

Infrastructure Fund means

“an AIF which invests primarily in unlisted securities or partnership interest or listed debt or securitised debt instruments of investee companies or special purpose vehicles engaged in or formed for the purpose of operating, developing or holding infrastructure projects”.

Infrastructure debt or equity financing through AIFs is of recent phenomenon in India. Sovereign Wealth Funds, Multi-lateral Funds and Thematic AIFs are the key investors in this space, due to its high illiquidity, long gestation risk in project implementation and long amortisation of the debt to infrastructure projects.

2.6 SME Fund

Small and Medium Enterprise (SME) Fund means

“an AIF which invests primarily in unlisted securities of investee companies which are SMEs or securities of those SMEs which are listed or proposed to be listed on a SME exchange or SME segment of an exchange”.

In this context, SME means a Small and Medium Enterprise and shall have the same meaning as assigned to it under the Micro, Small and Medium Enterprises Development Act 2006, as amended from time to time. Both BSE and NSE runs a separate segment for SME companies to list and trade. The eligibility criteria and compliances for the said exchange are more relaxed than the main board listing criteria.

2.7 Hedge Fund

Hedge Fund means

“an AIF which employs diverse or complex trading strategies and invests and trades in securities having diverse risks or complex products including listed and unlisted derivatives”.

2.8 Social Impact Fund⁶

Social Impact Fund means

“an AIF which invests primarily in securities or units or partnership interest of social ventures or securities of social enterprises and which satisfies the social performance norms laid down by the fund”.

‘Social Ventures’ are formed with the purpose of promoting social welfare, solving social problems, or providing social benefits. These may include:

• Public Charitable Trusts registered with the Charity Commissioner
• Societies registered for charitable purposes or for promotion of science, literature, or fine arts
• Section 8 company, registered as per the provisions of the Companies Act, 2013
• Micro-finance Institutions

2.9 Special Situations Fund⁷

Special Situations Fund (SSF) has been included as a sub-category in Category I AIFs which are distressed debt funds now specifically defined by SEBI. SSFs can acquire debt/equity by participating in debt resolutions under the IBC 2016. They can also finance companies in default to banks and NBFCs for a period of not less than 90 days, acquire stressed loans and security receipts issued by asset reconstruction companies.

2.10 Corporate Debt Market Development Fund⁸

Corporate Debt Market Development Fund is a close-ended AIF formed as a trust and with a 15-year tenure. Units of a Corporate Debt Market Development Fund are issued to Asset Management Companies. The purpose of such fund is to purchase corporate debt securities from debt-oriented mutual fund schemes during periods of market dislocation as may be decided by SEBI. Such debt-oriented mutual fund schemes must ensure that:

• Corporate Debt securities shall be listed and have an investment grade rating.
• Residual maturity of such securities shall not exceed five years on the date of purchase.
• Such securities have no material possibility of default or adverse credit news or views.

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.

3. Categories of Alternative Investment Funds (AIFs)

All the types of funds that have been described above are divided into three categories under the SEBI (AIF) Regulations for the purposes of registration and other operational requirements. These categories are mentioned below.

Category I AIF – is an AIF that invests in start-up or early stage ventures or social ventures or SMEs or infrastructure or other sectors or areas which the government or regulators consider as socially or economically desirable and shall include venture capital funds, SME Funds, social venture funds, special situation funds, infrastructure funds and such other AIFs as may be specified under the Regulations from time to time. 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 AIF – is an AIF that does not fall in Categories I and III and which does not undertake leverage or borrowing other than to meet day-to-day operational requirements or as permitted in the Regulations. For this purpose, AIFs such as private equity funds or debt funds for which no specific incentives or concessions are given by the government or any other Regulator are included under this Category.

Category III AIF – is an AIF that employs diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. AIFs such as hedge funds or funds which trade with a view to make short term returns or such other funds which are open ended and for which no specific incentives or concessions are given by the government or any other Regulator are included under this Category.

Specified AIF – is a fourth category of AIF inserted by SEBI⁹. This category includes Corporate Debt Market Development Fund as discussed above. Additional categories may be added under Regulation 19 by SEBI from time to time.

4. Comparison of Alternative Investment Funds Categories

It may be observed from the above definitions that under the SEBI (AIF) Regulations, AIFs that are economically important or socially impactful may enjoy greater benefits, under Category I AIFs. Angel Funds, Venture Capital Funds, SME Funds, Infrastructure Funds, Special Situations Funds and Social Impact Funds, that are considered important for employment generation, qualify under Category I AIFs. Other AIFs that invest in unlisted securities, such as Debt Funds, Private Equity Funds and Pre-IPO Funds fall under Category II AIFs. Those AIFs that deploy complex trading strategies in secondary listed markets, derivatives and or may also use leverage at fund level such as Hedge Funds qualify as Category III AIFs.

Being early stage investors, Venture Capital Funds are allowed to invest primarily in unlisted securities i.e. equity, debt, preference capital or other convertible securities, of start-ups, emerging venture capital undertaking or early-stage companies. Therefore, the definition uses the word ‘securities’ to provide latitude to structure the investments appropriately. However, according to the definition of Private Equity Funds, these AIFs are required to invest primarily in equity or equity linked instruments or partnership interests of investee companies. This is because being later-stage investors, Private Equity Funds are in a better position to take equity risks in investee companies. Similarly, funds structured purely as Private Debt funds also qualify under Category II AIFs. Table 1 compares and contrasts between the categories of AIFs.

Table 1: AIF Comparison

1. PWC Report – Reflections – Indian Private Equity in 2017
2. India Private Equity Report 2019 – Bain & Company
3. Inserted by the SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2021 w.e.f. May 5, 2021
4. Equity linked instruments include instruments convertible into equity shares or share warrants, preference shares, debentures compulsorily or optionally convertible into equity.
5. Inserted by the SEBI (Alternative Investment Funds) (Fourth Amendment) Regulations, 2018 w.e.f. August 13, 2021.
6. Inserted by SEBI (AIF) (Third Amendment) Regulations, 2022 w.e.f. July 25, 2022.
7. SEBI (AIF) Amendment Regulations 2022 w.e.f. January 24, 2022.
8. SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2023 w.e.f. June 15, 2023.
9. SEBI (Alternative Investment Funds) (Second Amendment) Regulation, 2023 w.e.f. June 15, 2023.