Opinion: India Could Use More Alternative Investment Funds (AIFs)

India's become a hot bed for investments, from abroad and domestic sources. Many investors see India as a gold mine, but may not have the expertise of the markets, time and resources to invest in lucrative opportunities. A solution to this is more onshore Alternative Investment Funds (AIFs).

AIF's are a collective investment fund which invests in non-traditional, tangible & non-tangible assets. AIFs can range from Private Equity funds to Hedge Funds. There are currently only 600 AIFs in India, where as in the US, the number is more than 15 fold bigger. The population's perception of AIFs, the Government's hesitations and the desire to invest abroad for domestic investors have been barriers to the penetration of AIFs, despite their benefits.

What are AIFs?

AIFs can be broadly defined as a collective investments into various assets. The most popular AIFs people are aware of are Private Equity, Venture Capital and Hedge Funds. AIF's typically raise money from a pool of different types of sophisticated investors then invest their money for a specific purpose. Globally, $7 trillion has been allocated to AIFs, which is close to 18% of the total market capitalization of all equities globally.

An AIF's revenue is usually generated from a management fees and percentage on return on capital, though new revenue models are coming up in this space. AIFs are grouped by three different categories, which is shown below.

As mentioned, AIFs do not only invest in traditional assets, such as equities and fixed income. Rather, they may invest in private companies, startups, distressed assets, currencies, real estate and social enterprises. As a result of this, AIFs demand a higher level of sophistication in their investments. Not only does an investor in an AIF have to be sophisticated, they also have a required minimum investment amount of INR 1 crore ($140,000) and a minimum of a three-year lock-in. Since AIF's invest in non-traditional assets, it takes longer for investors to see returns, and usually, more money. In addition, AIFs charge a higher fees than traditional funds because the AIFs usually have a more active involvement in their investments, compared to other funds such as mutual funds.

Perhaps the best reason to invest in an AIF is portfolio diversification. As a traditional investor, one's money may be only tied up in the stock market, which faces lots of volatility. By investing in an AIF, one's money is secure in the hands of professionals to invest in a range of different assets, most of which earn lucrative returns for investors. By diversifying one's portfolio, it is a great way to earn a passive income from several different assets.

The drawbacks to AIFs are that they can be risky and can tie up an investors money for a relatively longer period. AIFs invest in assets such as startups, which are very risky (we have all heard that 95% of startups fail) and may see an investor's money lost. In addition, AIFs do not provide as much liquidity as investing in traditional means, like the stock market. As a result of minimum lock-in periods and the difficulty of transfer of ownership of certain assets (e.g. real estate), investors cannot get their cash out quick. It is a long game, typically 3-10 years.

The Opportunity in India

Currently, as of December 2020, almost $26 billion has been invested into AIFs in India. This amount only represents 1% of the total market capitalization of the capital markets in India. Compared to the global scale, the penetration is much lower.

The penetration in India, so far, has been low because of several reasons. Firstly, perception of AIFs. Much of the Indian population still believes in keeping their hard-earned money secure, away from risk and usually rely on returns from fixed deposits. In addition, those who do invest in non-cash assets, usually invest in very traditional ones such as Gold or purchasing property themselves. The concept of letting another entity handle one's money, specially in more risky avenues, is one which much of the Indian population still needs to digest. Furthermore, those who have invested in AIFs, are more interested in investing abroad in markets such as Singapore- which offer more professional services as it stands. Lastly, the Government's hesitation to create an attractive environment for AIFs has also held back the industry's growth.

However, as India becomes more globalized, more educated and as disposable income carries on rising, AIFs have a large opportunity to manage investor's money. The opportunity lies across all the different categories of AIFs.

In India, the Category 1 is the leading AIF, with almost 20% of funds going into this category. Category 1 AIFs usually invest in startups and new ventures, through Venture Capital Funds or Angel Funds. India is becoming a strong source of innovation in the startup-world, with more and more unicorns being added to the list each year. Many startups receive ample funding, total funding reaching $11 billion, mostly from foreign investors. However, many remain unfunded or underfunded and there is a lack of domestic investors playing this game. There are more than 50,000 startups in India, and their growth is increasing YoY. Likewise, disposable income in India has been on the rise, yet, the two rivers aren't coming together. There are plenty of innovative projects which require funding and expertise, and plenty of investors with extra cash, but without enough AIFs the two shall never meet.

In addition to Category 1 AIF's, Category 2 AIFs, particularly Distressed Asset Funds (DAFs) are a very interesting opportunity in India. Non-Performing Assets (NPAs) have haunted India's banking sector for years now, with public sector banks holding almost a $100 billion of NPAs alone. These assets tend to be debt ridden and filled with controversy, but no one is there to clean up the mess. DAFs usually turnaround these depressed companies and build them up out of bankruptcy. Once the company is self-sufficient, there are numerous ways in which the DAF can create value, IPO's and M&A being the main ones.

India has a big uphill battle with its infrastructure. Though the company is poised for an explosion of growth, without significant investments into infrastructure, India will not realize its true potential. The Government, in their 2021 Budget, has pledged to invest almost $2 trillion into infrastructure. However, it will be interesting to see how much of the pledged amount is actually invested. This is where infrastructure or real estate AIFs could have a strong potential. Collectively investing in infrastructure or real estate projects in emerging regions of India could earn high, long-term gains for investors. Some AIFs are already aware of this opportunity, for example Kotak has planned to raise a $400 million fund for investments into real estate.

In the Category 3 AIFs, Hedge Funds are still a very new concept in India. India has special zones have been dedicated to attract more onshore AIFs to pull away from markets such as Singapore and Mauritius. The Gujarat International Finance Tec-City (Gift City), is a special domestic zone which is enabling financial services companies to offer attractive options for investors (mainly significant tax benefits). Though such a special domestic zone exists, the rest of the Hedge Funds in India have hard a hard time growing. The Government raised taxes on returns higher than $700,000 to 43% from 38%. The reasoning behind this policy is unclear, but it is believed it is because money earned from corruption and illegal channels is usually invested in Hedge Funds. The Government should consider becoming more lenient on Hedge Funds because there is lack of investments in productive assets. Currently, much of extra-cash is invested into Gold by investors, which is a very traditional, and non-productive asset. We also know that traditional investments such as Gold can be volatile, given the recent $162 price decrease in one day. The risk appetite should be created and fed, which needs to be enabled by the Government.

Conclusion

In conclusion, AIFs and wealth management as a whole is a sector which needs further development in India. The market is poised for explosive growth and AIFs can help guide investors to the right, lucrative investments to make it happen. It gives investors a great chance to diversify their portfolios, and may give them a shot at gaining higher returns than investing in traditional assets.

There is an opportunity across all three categories of AIFs, with more of each needed in the market to grasp at this opportunity. As the overall Indian market develops to become more educated in specialized sectors, and a higher emergence of professionals happening, many can look to starting their on AIFs. Furthermore, the advantage of AIFs is they do not have to educate the whole market on their model as they usually target high-net worth individuals and sophisticated investors, whom are already aware of the benefits.

I believe, the capital and where the capital should be invested is already there, its just about creating more middlemen to facilitate it.

Hope you enjoy the read. Please let me know if you have any thoughts, questions or feedback. Thank you!

Written By,

Abhishek Khetan

[email protected]

BU 2020 Graduate