Alternative Investment Fund(AIF): Types, Benefits, & Taxation

An Alternative Investment Fund (AIF) is a privately pooled investment avenue consisting of private equity, venture capital, hedge funds, managed funds, etc. SEBI regulation 2(1)(b) defines AIF as a Limited Liability Partnership (LLP) or a company or a trust. 

  • These funds open a doorway beyond conventional equity and debt instruments. 
  • Generally caters to Indian, NRIs, and foreign high-net-worth individuals with a minimum of 1 crore of investable amount. 
  • AIF typically has a four-year tenure which can be extended by two more years with unit-holders’ approval. 

Here’s everything you need to know about AIF.

3 Categories of Alternative Investment Fund (AIF)</span>

Category I AIF

Investment across early-stage start-ups, venture capital, angel funds, and the infrastructure sector. The government and regulators refer to this category as socially or economically desirable. 

  • Venture Capital Funds invest in start-ups with high growth potential. VCFs offer funding to these companies by buying the equity stake. These funds often target a specified sector which is declared at the launch of VCF. Social VCFs invest in companies that create a positive impact on society. 
  • Angel Funds raise investments from angel investors with at least 2 crore net tangible assets. Angel investors are required to have investment experience, serial entrepreneurship experience, and ten years of experience in a senior management role. AIF Investors are allotted units of the funds. 
  • Infrastructure Funds invest in companies that develop infra projects such as roads, railways, renewable energy, etc. These funds generate capital from private investors. AIF Investors can purchase units of these funds. 

Category II AIF

This category invests across private equity, debt, and funds of funds. It also includes securities that do not fall under category I and III, and do not use borrowing or leverage for other than meeting operational requirements. 

  • Private Equity Funds invest in unlisted private companies. Listed companies raise funds via equity or debt instruments. Similarly, unlisted companies raise capital via private equity funds. These funds may come with four to seven years of lock-in period. 
  • Debt Funds in category II AIF invest in debt instruments offered by listed or unlisted companies. The funds choose the companies with a high growth potential looking to raise funds. 
  • Funds of Funds invest in other AIFs, hence the name. These funds do not have their own portfolio. 

Category III AIF

This AIF category invests across listed or unlisted derivatives such as hedge funds, open-ended funds, or funds trading to make short-term returns. These funds use diverse trading and arbitrage strategies. Category III can be both open or close-ended funds.

  • Hedge Funds gather investments from private investors and invest in both domestic and international markets. Underlying assets in these funds, including listed and unlisted, can have both short and long-term horizons. These funds can be highly volatile and may charge higher fees to optimize returns. 
  • Private Investment in Public Equity (PIPE) invests in publicly traded companies at a discounted price. These funds primarily help small and medium-sized companies to raise capital. 

Category III AIFs are more common among the three. Contact VNN Wealth Advisors for more information. 

Benefits of Investing in Alternative Investment Fund

1. Specialized Diversification in Your Portfolio

Though mutual funds are diverse, they are regulated and restricted to certain asset classes and exposure to those asset classes. 

AIFs allow investors to expand their portfolios beyond mutual funds. These funds bring non-conventional investment instruments such as private equity, angel funds, venture capital, unlisted stocks, and more.

Investors wanting to explore diverse investment strategies can invest in AIF.

2. Potential of Earning Superior Returns

With a large corpus, fund managers have enough flexibility and scope to explore unique investment strategies. They aim to maximise returns using their analysis and expertise.

Therefore, AIFs have the potential to deliver significant returns over the years. 

3. Lower Volatility

The underlying assets in alternative investment funds are less volatile compared to pure equity funds. Some of these instruments are not listed on the stock market, hence, do not fluctuate frequently.

The wide spectrum of instruments manages the volatility quite well.

Taxation on Alternative Investment Fund (AIF)

Taxation on AIF Category I and II: Since these two categories are pass-through vehicles, the fund doesn’t have to pay tax on the gains. Investors, however, have to pay the tax on capital gains. Short-term Capital gains will be taxed at 15% whereas long-term will be taxed at 10%. Returns on debt instruments will be taxed as per the investor’s tax slab. 

Taxation on AIF Category III: This category is taxed at the fund level with the highest income tax slab which is about 42%. Investors will receive the gains after the tax deduction at the fund level, hence, do not have to pay any additional tax.

Final Words

AIFs cater to more sophisticated investors with a minimum of 1 crore of ticket value. Hence, it is not easily accessible to many retail investors. 

Almost every AIF subcategory accepts investments from only 1000 investors. Angel funds have a limit of 49 investors. 

Regulated by SEBI, these funds are worth exploring for portfolio diversification. 

Though we have briefly discussed all categories above, there’s more to learn. Give VNN Wealth a call if you wish to invest in AIFs. Our team will review your portfolio and guide you through the process. Find more personal finance insights at @vnnwealth