Fundraising Strategies for Alternative Investment Funds (AIFs)

Posted On - 10 October, 2024 • By - Pooja Chatterjee

Introduction

Alternative Investment Funds (AIFs) are privately pooled investment vehicles established or incorporated in India that collect funds from sophisticated investors—whether Indian or foreign—intending to invest in accordance with a defined investment policy for the benefit of their investors. Alternative Investment Funds (AIFs) have become an essential vehicle for sophisticated investments in India, catering to high-net-worth individuals (HNIs) and institutional investors. These funds fall outside the purview of traditional asset classes such as stocks, bonds, and cash, offering diversified portfolios that include private equity, venture capital, hedge funds, and real estate investments. Regulated under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012, Alternative Investment Funds are categorized into three categories

Category I AIFs – This category Such Alternative Investment Funds (AIFs) invest in start-up or early-stage ventures or sectors considered socially or economically more desirable. Therefore, they are subjected to greater regulation but enjoy greater benefits as well. The sub-categories of category I AIFs are venture capital funds, small and medium sized enterprise (‘SME’) funds, infrastructure funds, social venture funds and angel funds.

Category II AIFs – In this category, various types of funds such as real estate funds, private equity funds, funds investing only in debt securities and funds for distressed assets are typically registered.

Category III AIFs – Category III AIFs are interested in fetching short term returns, and therefore may make riskier investments (for instance, hedge funds). Such Alternative Investment Funds (AIFs) employ diverse or complex trading strategies, such as investments in listed and unlisted derivatives, and may employ leverage.

The regulatory environment for Alternative Investment Funds in India is primarily governed by:

1. SEBI (Alternative Investment Funds) Regulations, 2012: These regulations define the structure, compliance requirements, and operational limitations of AIFs.

2. Foreign Exchange Management Act (FEMA), 1999: Governs investments into AIFs from foreign investors, with rules set by the Reserve Bank of India (RBI).

3. Income Tax Act, 1961: Provides tax incentives and tax-neutral structures for AIFs, influencing investor decisions.

4. Reserve Bank of India (RBI): Apart from SEBI, RBI also has jurisdiction over certain aspects of AIF operations, particularly those relating to foreign investment and corporate governance.

  •  Minimum Investment Requirement: The Alternative Investment Funds Regulations do not permit an AIF to accept an investment of less than INR 10 million crore (“Minimum Investment Amount”) from any investor unless such investor is an employee or a director of the AIF or an employee or director of the manager of the AIF in which case the AIF can accept investments of a minimum value of INR 2.5 lakh million.
  • Fund Structure: AIFs can only raise funds through private placement and not public offerings from Indian as well as Foreign investors.
  • Investor Protection: SEBI regulations ensure that AIFs maintain transparency and accountability through regular audits and investor disclosures.

Fundraising Strategies for AIFs in India

  • Tapping High-Net-Worth Individuals (HNIs) and Family Offices- A common fundraising strategy for AIFs is to target HNIs and family offices. Given the substantial minimum investment limit imposed by SEBI, HNIs are a primary source of capital. Fund managers must ensure full compliance with SEBI regulations to avoid legal disputes.
  •  Corporate Investors and Institutions- Corporates, especially large conglomerates, and institutional investors such as banks, pension funds, and insurance companies, often contribute a significant portion of the AIF’s corpus. Corporate investors are attracted to AIFs due to their potential to generate high returns and access to alternative investment classes. Entering into strategic partnerships with corporate entities can also enhance credibility. These partnerships should be legally documented in joint venture agreements, ensuring that the fund manager’s fiduciary duties and the investor’s interests are safeguarded.
  • Overseas Fundraising- Foreign investors, particularly those from jurisdictions with favourable tax treaties, are another target. AIFs can attract foreign investors by offering a robust investment strategy coupled with the prospect of high returns in a growing market like India. However, such investments must adhere to the Foreign Exchange Management Act (FEMA) regulations and the Foreign Portfolio Investment (FPI) regulations, to ensure that they do not violate sector-specific caps on foreign investments. Taxation on income and capital gains arising from these investments should be structured carefully under the Double Taxation Avoidance Agreements (DTAA) to ensure that the net returns remain attractive for foreign investors.
  • Co-Investment Opportunities- Co-investment opportunities allow investors to invest alongside the AIF in specific transactions. This strategy appeals to investors seeking greater control over their investments and the opportunity to directly participate in high potential deals. Co-investment structures must comply with SEBI’s guidelines and should be clearly outlined in the fund’s PPM. Fund managers must ensure that such arrangements do not dilute the interests of other investors in the AIF.
  • Venture Debt Funds- In a relatively nascent market like India, venture debt funds have emerged as a popular fundraising strategy for start-ups and early-stage companies. By focusing on venture debt, an AIF can target investors looking for lower-risk investments compared to equity financing. These funds operate under Category II AIF regulations, and their legal documentation must ensure compliance with the borrowing norms under Indian law.
  • Infrastructure Funds- With India’s push towards infrastructure development, many AIFs are setting up infrastructure-focused funds, particularly under Category I AIF regulations. These funds can attract long-term investors, such as pension funds and sovereign wealth funds, looking to invest in projects with stable cash flows. Infrastructure funds can benefit from tax incentives, such as exemptions under Section 54EE of the Income Tax Act, which provide relief on long-term capital gains when invested in infrastructure.
  • Use of Technology in Fundraising- AIFs are increasingly leveraging technology to streamline the fundraising process. Digital platforms can enhance investor communication, compliance, and reporting. Use of blockchain technology for secure transaction documentation and AI-driven analytics for better decision-making is becoming popular. Fund managers must ensure compliance with SEBI’s norms on technology usage, particularly concerning data privacy and investor security, as outlined in the SEBI (Investment Advisors) Regulations, 2013. ·
  • Strategic Partnerships with Banks and NBFCs – SEBI permits Alternative Investment Funds (AIFs) to enter into partnerships with banks and Non-Banking Financial Companies (NBFCs) to fund infrastructure projects, offering a stable return to investors. AIFs partner with banks and NBFCs to co-fund large-scale infrastructure or real estate projects. This allows AIFs to diversify their funding sources while banks benefit from exposure to new asset classes.
  • Side Pockets and Special Situations- SEBI allows AIFs, especially in Category III, to create “side pockets” in cases where certain assets are illiquid or distressed, ensuring that such assets do not affect the liquidity of the entire fund. Category III AIFs use this mechanism to attract investors willing to invest in stressed assets, presenting higher returns in exchange for greater risk. These niche strategies often appeal to foreign distressed-asset investors and special-situation funds.
  • Small & Medium Sized Funds- Funds are a type of Alternative Investment Fund (AIF) that provide equity financing to small and medium-sized businesses. SME funds are a Category I AIF, which are regulated by SEBI and are intended to have a positive impact on the economy

Challenges in Fundraising

While Alternative Investment Funds offer numerous advantages, they also face legal and operational challenges in raising funds, such as:

  • Regulatory Complexity: SEBI regulations require strict compliance, and the legal landscape for foreign investment can be complex due to overlapping laws like FEMA.
  • Market Volatility: Raising funds during times of economic uncertainty can be difficult, especially for Category III Alternative Investment Funds (AIFs) that engage in high-risk trading strategies.
  • Investor Awareness: A lack of understanding about the risk and rewards of AIFs can make it difficult to attract investors, especially those unfamiliar with alternative investments.
  • Taxation and Structuring: Inconsistent tax treatments for different categories of AIFs, combined with capital gains and DTAA issues, complicate the fundraising process.
  • Competition from Other Products: Alternative Investment Funds face stiff competition from mutual funds, PMS, and REITs, which often offer better liquidity and lower risk.
  •  High Minimum Investment Threshold: The SEBI-mandated minimum of INR 1 crore per investor limits participation to ultra-high-net-worth individuals, reducing the potential investor pool.

Conclusion

Fundraising for Alternative Investment Funds in India is a dynamic and complex process, involving strategic planning and strict adherence to the regulatory framework. AIFs must innovate their fundraising strategies while ensuring compliance with SEBI regulations, FEMA guidelines, and tax structures to remain competitive and attract domestic and foreign capital. The future of Alternative Investment Funds (AIF) fundraising in India appears promising, given the growing interest in alternative investments and the regulatory ecosystem supporting innovation in this space. However, fund managers must always remain vigilant about their fiduciary duties, investor protection norms, and legal obligations to avoid pitfalls and ensure sustainable growth.

Contributed by – Aribba Siddique

King Stubb & Kasiva,
Advocates & Attorneys

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