How To Choose The Right Alternative Investment Fund

Alternative Investment Funds (AIFs) are private pooled investment vehicles that collect funds from sophisticated investors, whether Indian or foreign, for specific investment strategies. They are regulated by the Securities and Exchange Board of India (SEBI) and differ from mutual funds and collective investment schemes as described in the SEBI (Alternative Investment Fund) Regulations, 2012.

AIFs are meant for sophisticated investors as they are floated through private placement and not through public offers. They cannot issue public offers to invest and their schemes can be offered only to a defined number of investors: 1,000 in the case of general AIFs and 49 in the case of angel funds.

Some types of entities like family trusts for relatives, employee welfare trusts, and holding companies are exempt from mandatory registration under the AIF framework of SEBI.

SEBI categorizes AIFs into three categories based on their investment objectives and strategies:

1. Category I AIFs

These funds invest in sectors considered to be socially or economically beneficial to the government or regulators. Examples include venture capital funds, SME funds, social venture funds, and infrastructure funds. This category is ideal for investors seeking to support start-ups, infrastructure development, or social impact projects.

2. Category II AIFs

These funds include private equity, real estate, and distressed asset funds. They are not highly leveraged and target investors seeking stable growth with moderate risk.

3. Category III AIFs

These funds employ complicated and highly leveraged strategies that involve derivatives and leveraging. Hedge funds and PIPE (Private Investment in Public Equity) funds fall in this category. Investors who are looking for extreme returns and can afford to take high risks prefer to invest in this option.

Legal Structures of AIFs

An AIF under the SEBI (Alternative Investment Funds) Regulations, 2012 can be established or incorporated in the form of a trust or a company or a limited liability partnership or a body corporate. Most of the AIFs registered with SEBI are in trust form. 

Why AIFs Are Regulated by SEBI

SEBI regulation ensures AIFs work in an orderly and transparent manner, exposing the risk factor to the investor to a minimal extent. SEBI strict registration and operation guidelines protect the investor from fraudulent activities and ensure that AIFs achieve the stated objective.

How SEBI Guarantees Transparency and Investor Protection

SEBI rules ensure that the AIF is operated transparently and protects investor interests. Major provisions include the following:

1. AIF registration with SEBI is necessary before it can legally operate.

2. The units must be privately placed, and public solicitation is prohibited.

3. The objectives, strategies, and risks related to the fund must be communicated to the investors.

4. Periodical disclosure with performance reports maintains transparency.

Selecting the Best AIF

1. Know Your Investment Needs

Decide if you're searching for income, capital growth, or a combination of the two. Your objectives need to align with the strategy of the fund. Category I AIFs are ideal for those searching for social or economic impact while Category III funds are ideal for aggressive investors targeting high returns.

2. Measure Risk and Liquidity

Different AIFs have different risks and liquidity levels. For example, real estate funds may offer stability but with long lock-in periods, while hedge funds may offer liquidity but with high risk. Choose a fund that matches your risk tolerance and liquidity needs.

3. Research Fund Managers

The expertise of the fund manager plays a critical role in AIF performance. Seek managers with a proven track record, sound strategies, and strong market experience. Their alignment with your goals and fee structure is also important.

4. Review Fund Documents

Before investing, read the private placement memorandum and related documents. These give details on the fund's strategy, risks, fees, and operational rules.

5. Understand Tax Implications

AIFs have unique tax structures. Category I and II funds are usually pass-through vehicles, which means that the income is taxed in the hands of investors. Category III funds are taxed at the fund level.

6. Diversify Your Investments

Diversify your portfolio and do not concentrate investments in one AIF. Real estate, private equity, and hedge funds should be in combination to reduce the risk and maximize overall returns.

Alternative Investment Funds provide a means of diversifying a portfolio by sophisticated investors, which may be achieved either through growth-oriented start-ups, stability in real estate, or aggressive returns by hedge funds, and AIFs can turn out to be an effective weapon. However, the complexity and strict regulations under SEBI require taking advice from financial advisors and choosing wisely.