What is an Alternative Investment Fund?

Alternative Investment Fund or AIF is a privately pooled investment vehicle that invests in
alternative asset classes such as private equity, venture capital, hedge funds, real estate,
commodities, and derivatives. Generally, HNIs (High net worth individuals) and institutions
invest in the AIFs as the investment amount is substantially higher.

AIFs are regulated by the SEBI (Securities and Exchange Board of India). As per the SEBI
(Alternative Investment Funds) Regulations, 2012, an AIF can be set up as a trust, a company, a
limited liability partnership, or a corporate body. However, many of the AIFs that have been
registered with SEBI are in the form of trusts.

Types of AIFs in India

AIFs can be further divided into three categories, such as:

Category I AIF: This category of AIF invests in start-ups, early-stage ventures, social ventures,
SMEs, or infrastructure or other sectors considered socially or economically beneficial by the
government or regulators fall into this category. It may be further classified into:

 Venture capital funds (Including Angel Funds): This fund specifically invests in start-up or early-stage
ventures that have high growth potential.

 SME Funds: This fund invests in small and medium enterprises with a good track record in profitability
and growth.

 Social Venture Funds: This fund invests in companies that aim to make a positive impact on society or
the environment, such as sustainability, clean energy, etc. It has also generated favorable returns in the
past.

 Infrastructure funds: This fund invests in infrastructure projects such as railways, bridges, airports, etc.

Category II AIF: These are the AIFs that do not fall under categories I and III. They do not use
leverage or debts other than to cover their day-to-day operational expenses. Some of the funds
included in the Category II are as follows:

 Private Equity Funds: It makes equity investments in unlisted companies and helps them to raise
capital. As unlisted companies face problems in raising capital through debt or equity, private equity
funds allow them to raise capital easily.

 Debt Funds: This fund invests in the debt securities of the unlisted companies via debt instruments such
as bonds, debentures, and other fixed-income instruments.
 Fund of Funds: This fund invests in multiple AIFs. It doesn’t directly buy stocks or bonds. Instead, it
invests in a portfolio of other investment funds.

Category III AIF: These AIFs use complex trading strategies in their investment. It may use
leverage or debt for investment in listed or unlisted derivatives. Some of the funds included in
Category III are:

 Private Investment in Public Equity Fund (PIPE): This fund invests in the equity of companies that
are listed on the stock exchange. This often happens when the value of the company’s shares has dropped,
and the company is looking to raise capital. Hence, in this case, AIFs receive the equity at a discounted
price.

 Hedge fund: Hedge fund uses various investment strategies like short selling, arbitrage, futures,
derivatives, and margin trading to generate maximum returns for the investor.

Who can invest in an AIF?

The following are the criteria for investing in AIF:

 Indian Residents, NRIs (Non-Resident of India), and foreign nationals are eligible to invest in these
funds.

 Joint investors can also invest in AIF. They can be spouse, parents, or children of investors.

 The minimum investment amount for investors is Rs1 crore for investors. For directors, employees, and
fund managers, this limit is Rs 25 lakh.

 Most AIFs come with a minimum lock-in period of three years.

 The maximum number of investors in every scheme is capped at 1,000. However, in the case of angel
fund, the cap is 49.

Why invest in AIFs?

AIFs can be an attractive option for some investors seeking diversification and potentially higher
returns outside traditional asset classes like stocks and bonds. Here are some reasons why
investors might consider investing in AIFs:

Potential for Higher Returns: AIFs may offer higher returns than traditional investments due to
their exposure to a broader range of assets and investment strategies. However, this higher return
also comes with higher risk.

Portfolio Diversification: By giving investors access to alternative asset classes, including

hedge funds, real estate, and private equity, AIFs help them diversify their portfolios.
Low Volatility: AIFs are unrelated to the stock market and, hence, are less volatile than other
investments like equity or mutual funds investments.

Alternative Investment Fund (AIF) Taxation

AIF taxation depends on the type of the category of AIFs you have invested in. Let’s understand
how different categories of AIFs are taxed:

Category I and Category II investments have been given a pass-through status. This means any
income (Other than business income) earned by the AIF is tax-exempted.

These gains will be taxable in the hands of investors. It will be taxed as if you have personally
made the investments, even though the AIF is the one actually making the investments.

Category III has not been given a pass-through status. This means that the income earned will be
taxable in the hands of the fund. However, taxation varies depending on the type of the fund
(Company, LLP, trust, etc.). In this category, investors are not required to pay any taxes on the
gains.

If you're looking to diversify your portfolio beyond traditional stocks and bonds, then Alternative
Investment Funds (AIFs) are an excellent avenue. The Securities and Exchange Board of India
(SEBI) has categorized these funds into three categories: Category I, Category II, and Category III.

Among these, Category II stands out as a popular choice among investors looking to leverage
opportunities that are not typically accessible in the conventional market. Unlike Category I AIFs,
which are incentivised for certain social or economic goals, and Category III AIFs, popular for their
short-term and speculative investments, Category II AIFs offer a middle ground. They don't benefit
from specific incentives or concessions but are also not as aggressively speculative as Category III
funds.

What is category II AIF?

According to SEBI, AIFs that do not fall under Category I and Category III and do not undertake
leverage or borrowing except for meeting everyday operational needs, fall under Category II.

Unlike Category I AIFs, these funds do not enjoy any specific government incentives or concessions.
They operate under standard market conditions without any particular benefits. Category II AIFs
have a moderate risk profile and come with a fixed term ranging from a few years to a decade.

Under Category II AIFs, you can invest in a variety of asset classes like:
1. Private equity funds
These funds typically invest in unlisted private companies to earn profit through eventual exits, such
as IPOs, buybacks, or sales to other investors. Private equity funds have the potential for high returns
but come with higher risk and longer investment horizons.

2. Debt funds
Debt funds in Category II AIF focus on investing in debt securities of unlisted companies. These can
range from bonds and debentures to other fixed-income securities. These funds typically offer more
stable returns compared to equity-oriented funds and are suitable for investors with a lower risk
tolerance.
3. Fund of funds
Fund of funds (FoF) invest in various other AIFs, instead of directly investing in stocks, bonds, or
other securities. It doesn't have an investment portfolio but invests in a portfolio of other investment
funds. But remember, unlike FOF under mutual funds, FOF of AIFs does not issue units of the fund
publicly.

Investment restrictions for Category II AIFs

While Category II AIFs offer a range of investment opportunities, they also come with certain
restrictions laid out by SEBI. These restrictions help ensure investor protection. Here are some of the
key investment restrictions for Category II AIFs:

1. Investments in this category must only be in unlisted securities. This aligns with the fund's
objective of seeking alternative investment avenues beyond the traditional stock market.

2. These funds can only borrow money to meet temporary requirements. The borrowing is further
restricted to only 30 days and a maximum of 4 times a year. Additionally, the borrowed amount must
not exceed 10% of its investible funds.

3. These funds are exempt from Insider Trading Regulations if they invest in SMEs listed on the
SME Exchange and hold the securities for at least a year.

4. Category II AIFs can engage in hedging and can even invest in the unsubscribed portion of an IPO
by making an agreement with the merchant banker.

Taxation of Category II AIFs

Category II AIF has a pass-through status. This means that the income earned by the fund is not
taxed at the fund level but is passed on to the investor. The investor is then taxed per their tax bracket
and the nature of the income. The Fund is liable for deduct tax (TDS) at 10% for residents and full
tax for NRIs (except beneficial jurisdiction).

The Fund does not pay any tax at Fund level and the Investors are required to discharge the taxes (net
of the taxes withheld by the Fund) on their respective share of income from the Fund at the
applicable rates. The investor level taxation is as below:
-Long-term capital gains (LTCG): 10% on listed shares/ bonds/ debentures and 20% on unlisted
shares / bonds / debentures.
-Short-term capital gains (STCG): Based on the investor's tax slab; generally taxed at 15% for listed
shares/bonds/debentures
-Dividend income: Taxed according to the investor's tax slab.
-Interest income: Taxed according to the investor's tax slab.
-Business Income: Taxed according to the investor's tax slab
Final words
Category II AIFs offer a unique and diversified avenue for investors looking to venture beyond
traditional investment options. The diverse range of funds under this category offers an excellent
opportunity for effective portfolio diversification and tailored investment strategies.
However, if you're new to investments, it's best to seek professional guidance.