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
2. Trends Post-2008
3. Types of AIFs
4. Comparison of AIF Categories
5. Suitability and Enablers for AIF Products in India

Check out NISM X Taxmann's Alternative Investment Funds (Category I and II) Distributors which covers all important aspects of the Alternative Investment Funds (AIFs) in India, focusing on Category I and Category II AIFs. These include a basic understanding of the alternative asset classes, alternative investment funds in India, the role and functions of various stakeholders in the AIF domain, etc.

1. Evolution and Growth of Alternative Investment Funds (AIFs) in India

The evolution of alternative investments in India can be traced to the modest beginnings in venture capital financing in the 1980s mostly through the initiatives of state level industrial development corporations, financial institutions and a few PSU banks. The reasons for the late emergence of the venture capital industry in India are mostly historical and linked to the state of the capital market and ownership patterns of Indian companies. The Venture Capital Guidelines notified on 25th November, 1988 by the Government of India provided a restricted scope by defining venture capital mainly to include assistance provided to enterprises where the risk element is comparatively high due to a new or untried technology and/or the entrepreneurs being technocrats or first generation entrepreneurs.

The traditional concept of VC being technology risk capital 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 did away with the requirement of looking for ‘untried technologies’. The entire spectrum of private capital investment in unlisted companies was thus brought into the ambit of institutional investment. Though the framework for full-fledged venture capital and private equity investments were put in place in 1996, the tax law was not investor friendly. 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 dotcom era of 1997-2001, several technology VCFs were set up in India modelled after their Silicon Valley counterparts with VC financing. 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. However, the representation of domestic private equity was still small in the overall supply of private capital at that time.

From a business perspective, from 2001 onwards, Indian industry was on a consolidation drive in various sectors. Companies sought to grow not only to stand up to competitive market forces in the domestic market but to attain global scale of operations as well. 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 including large scale manufacturing (such as pharmaceuticals, auto-ancillaries, FMCG), real estate and construction, core sectors (like cement, steel, metals) and infrastructure. The interest of private equity also got extended to service sectors such as banking and financial services, logistics, e-commerce, entertainment, healthcare, wellness and education. Private equity investors showed interest even in project financing, an area dominated by large banks and specialised financial institutions. In the real estate and infrastructure sector, private equity has played a role in financing both the developers as well as specific projects. 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.

2. Trends Post-2008

The global financial crisis of 2008 had its ripple effects in the Indian markets and accordingly, growth in private equity activity was affected in the following few years. Several funds that had invested in the bullish markets prior to 2008 found it difficult to sustain their investment values. Weak capital market added to their exit woes due to which their follow-on fund raising efforts were also quite unsuccessful. In the years following the global financial crisis, private equity sector in India suffered due to a plethora of sectoral and macroeconomic issues including the scare of regressive taxation laws.

The industry was subdued till 2012 until growth started to pick up significantly from 2014 mostly due to the introduction of the SEBI (AIF) 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. The significant trends during this phase of evolution 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.
• Private Equity investments hit an all-time high of USD 77 billion in 2021, across 1,266 deals, including 164 large deals worth USD 58 billion³. Exits worth USD 43.2 billion were made through 280 deals in 2021. India has surpassed UK to become the third-largest ecosystem for start-ups. India now has 90 unicorns, which are companies valued at USD 1 billion or more.
• 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 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 and recommendations were made by the SEBI Alternative Investment Policy Advisory Committee, headed by Shri. Narayan Murthy, in order to improve the tax regime for Category I AIFs and Category II AIFs to accord them a pass-through status. 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.
• 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 AIFs and sovereign wealth funds as well.

3. Types of Alternative Investment Funds (AIFs)

Alternative Investment Funds can be of different types based on their investment strategy and types of assets under management. Under the SEBI (AIF) Regulations 2012, we can list the following types of funds as AIFs –

3.1 Venture Capital Fund (VCF)

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”.

Further to it, SEBI (AIF) Regulations also defines the following:

1. 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.
2. Venture capital undertaking means a domestic company which is not listed on a recognised stock exchange at the time of making investment⁴.

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.

3.2 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, –

1. an individual investor who has net tangible assets of at least INR 2 crore excluding value of his principal residence, and who has early stage investment experience, or has experience as a serial entrepreneur or is a senior management professional with at least ten years of experience⁶,
2. a body corporate with a net worth of at least INR 10 crore or
3. a registered AIF under SEBI (AIF) Regulations, 2012 or a VCF registered under the erstwhile SEBI (Venture Capital Funds) Regulations 1996.

3.3 Private Equity Fund

PE 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 fund⁷”.

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.

3.4 Special Situation Fund

Special Situation Fund means a Category I Alternative Investment Funds that invests in special situation assets in accordance with its investment objectives and may act as a resolution applicant under the Insolvency and Bankruptcy Code, 2016. Special situation assets include:

1. Stressed loans acquired by Asset Reconstruction Companies (ARCs) or entities permitted by RBI, as part of a Resolution Plan approved through RBI (Prudential Framework for Resolution of Stressed Assets) Directions or a resolution plan as per Insolvency and Bankruptcy Code, 2016.
2. Security Receipts issued by an Asset Reconstruction Company registered with the Reserve Bank of India.
3. Securities of investee companies whose stressed loans are available for acquisition in terms of RBI’s Master Direction or as part of a resolution plan approved under the Insolvency and Bankruptcy Code, 2016.
4. Securities of investee companies against whose borrowings, security receipts have been issued by an ARC or whose borrowings are subject to corporate insolvency resolution process under Insolvency and Bankruptcy Code, 2016.
5. Securities of investee companies who have disclosed defaults relating to interest and principal payments on loans from banks, financial institutions, non-banking financial companies and debt securities, in terms of SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 and such payment default is continuing for at least ninety calendar days after the occurrence of such default.

3.5 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 Fund⁸”

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 (debt financing with some equity upside like warrants attached to them.). Some private debt funds also finance sub-ordinate debt which can go in funding companies that are already having high senior debt (loans that are secured on the assets and have first claim on cash flow) on their balance sheet, such debt financing is called ‘leveraged loan’. Distressed debt financing through private debt funds is also catching on in India in the form of refinancing settlements with banks and insolvency resolution schemes under the IBC proceedings. Distressed financing is mostly about providing capital for companies to turn with heavy debt burden to turn around or to help in their acquisition by new owners through auctions that are conducted under the Insolvency and Bankruptcy Code, 2016. Such processes are known as ‘insolvency resolution’. Private debt funds are often classified as a form of private equity funds rather than being treated as another alternative asset class.

3.6 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. It is mostly the sovereign wealth funds, multi-lateral funds and sector focused AIFs that operate in this space due to its high illiquidity, long gestation risk in project implementation, long amortisation of the debt and lower equity returns from such SPVs.

3.7 SME Fund

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.

3.8 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”.

3.9 Social Venture Fund

Social Venture Fund means

“an AIF which invests primarily in securities or units of social ventures and which satisfies social performance norms laid down by the fund and whose investors may agree to receive restricted or muted returns”.

Social venture is a trust or society or company or venture capital undertaking or limited liability partnership formed with the purpose of promoting social welfare or solving social problems or providing social benefits.

3.10 Categories of Alternative Investment Funds

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.

4. Comparison of Alternative Investment Funds Categories

It may be observed from the above definitions that under the SEBI (AIF) Regulations, funds that are economically important or socially impactful and may even enjoy special privileges are bracketed under Category I. Therefore, angel funds, venture capital funds, SME funds, special situation funds, infrastructure funds and social sector funds that are considered important qualify under Category I. Other categories of funds that invest in unlisted space such as debt funds, private equity funds, pre-IPO funds fall under Category II AIFs. Those funds that deploy complex trading strategies in on-market investing (secondary listed market), or in derivatives and may also use leverage at fund level such as hedge funds qualify as Category III AIFs.

Being early stage investors, VCFs are allowed to invest primarily in unlisted securities (equity or debt or preference capital or other convertible structures) of such start-ups, emerging or early-stage companies. Therefore, the definition uses the word ‘securities’ to provide latitude to structure the investments appropriately. However, according to the definition, Private Equity Funds are required to invest primarily in equity or equity linked instruments or partnership interests of investee companies. This is because being later stage investors, PE 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

The scope of this book is on the discussion pertaining to Category I and Category II funds only. Hence the discussions that follow will be restricted to these two categories only.

5. Suitability and Enablers for AIF Products in India

India has seen tremendous economic growth in the twenty-eight years of post-liberalisation economic era, more particularly in the specific growth phases that followed. The economic prosperity of the entrepreneurial class and corporate executives created several high-net worth investors and family offices. Several NRIs also favour investing in Indian market and alternative investment products are an ideal asset class for being positioned for such investors. After SEBI allowed non-resident non-institutional investors to tap the Indian market as FPIs, it provided additional class of investors to invest in AIFs with India investment focus. India’s economic prosperity has been underpinned by the increasing tribe of billion-dollar ultra-high net worth investors (UHNI). As of May 2021, India has 140 billionaires which put the country third in the world, after the United States of America and China⁹. The new generation of digital economy entrepreneurship coupled with high valuations of start-up companies is producing wealthy and super-rich class in India much faster than the era of globalisation did in the 1990s and the first decade of the 21st century. According to the Knight Frank Research Report 2019, the number of India’s UHNIs is set to rise to 2697 by 2023. According to The Global Wealth Report 2021 by Credit Suisse, the total wealth in India was estimated at USD 12.8 trillion in 2020 with an eight-fold increase between 2000 and 2020.

1. PWC Report – Reflections – Indian Private Equity in 2017
2. India Private Equity Report 2019 – Bain & Company
3. IVCA-EY Report – January 2022
4. Vide SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2021 w.e.f. May 5, 2021.
5. Vide SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2021 w.e.f. May 5, 2021.
6. Early stage investment experience means prior experience in investing in start-up or emerging or early-stage ventures and a serial entrepreneur means a person who has promoted or co-promoted more than one start-up venture.
7. Equity linked instruments include instruments convertible into equity shares or share warrants, preference shares, debentures compulsorily or optionally convertible into equity.
8. Vide SEBI (Alternative Investment Funds) (Fourth Amendment) Regulations, 2018 w.e.f. August 13, 2021.
9. “Forbes’ 35th Annual World’s Billionaires List: Facts And Figures 2021”.

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