[HNIs] How to say NO to an AIF investment?

The HNI and UHNI (including NRI) investor has a ‘new’ pitch – the AIF or an Alternative Investment Fund.

Given the recent spurt of assets in AIFs (7 lakh crores+ as of June 2022), several mutual fund houses have even started to launch their own AIFs. Sadly, they are just lame copies of their MF portfolios to target the HNI investor’s fancy.

An AIF needs a minimum investment of Rs. 1 crore clearly making it a tool for ego massage by Private Wealth offices. The manufacturers of the products are more than happy to oblige.

Well, let’s not get carried away and understand what we are getting into.

[Now, if you just want to know the questions to ask, skip to the end.]

What does the AIF have to offer?

The AIF structure was envisaged for specific investment strategies specially in the unlisted space or hedge funds. They get to access a much wider opportunity set than the listed company space available to mutual funds and/or PMS.

There are 3 categories of AIFs, each with a distinct role to play and a method to capture value.

a) Category 1 AIF – Startup investments – seed / angel funds, infrastructure funds. At least 2/3rds is invested in unlisted equity shares or equity linked investments. In case of SME funds or social venture funds, 75% or more is invested in unlisted securities.

b) Category 2 AIF – AIFs which are not Category 1 or 3 funds and do not undertake borrowing or leverage except for day to day operational requirements are treated as Category 2 AIFs. These include debt funds, private equity funds, distressed asset funds, real estate funds. Again, larger portion of investments should be in unlisted space.

c) Category 3 AIF – Hedge funds, long short strategies – active use of derivatives as well as complex, structured products with leverage; This category has no particular restrictions and can freely invest in listed companies as well.

As you can notice, Category 1 & 2 AIFs can have a lot of illiquidity. Also, Category 2 & 3 AIFs are pitched the most by banks to investors.

An AIF can be a good route to add more diversification to your portfolio, provided you ask all the right questions.

Know that, much like mutual funds, an AIF is also a pooled investment, where you are allotted units against your investment.

In contrast, with a PMS, you hold the investment directly in your name. The PMS entity is mostly a manager of your funds in your demat account.

Then there is the matter of costs and taxes.

Beware of costs

AIF costs consist of fixed fee and/or variable, that is, profit share / carry.

The fixed fees include, placement fee / setup fee, operations fee, taxes, etc.

My view is that such strategies should have only profit share and no fixed fees.

In terms of taxes, the income of the AIF is passed through to the investor and the investor is liable to pay the relevant taxes on the same.

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Let’s take a quick look at some of the current and new AIFs

True Beacon is a Category 3 AIF run by Nikhil Kamath (also co-founder of Zerodha) and uses long/short strategies based on its assessment of market. Invests in large cap stocks and uses derivatives for hedging. Fees is 10% profit share.

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ABSL India Equity Services Fund is a service focused multicap AIF .

It is not clear if the AIF will use any of the approaches that an AIF can or just rely on investing in regular listed businesses.

If that is the case, then it looks no different than a thematic services oriented mutual fund such as Sundaram Services Fund or Mirae Great Consumer Fund with an existing track record.

Layers of fees, fixed + profit share.

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TrueNorth Fund VII is a Category 2 AIF with a concentrated portfolio strategy, closed ended (5 years), with a minimum commitment of Rs. 2 crores and a fixed + variable fees with a hurdle rate.

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Yet another one is the latest HDFC Select AIF FOF – 1, which aims to invest in 10 or more other AIFs in the Private Equity, VC space.

The tenure for this fund is 11 + 2 years – huge to put off many investors but for a fund like this.

The only claim this AIF can make is that it selects other managers who then invest in startups to pre-IPO companies through their respective VC/PE funds.

To make that possible, it has several layer of costs – setup, management fee, operating fee, profit share over and above what other fund mangers will charge. Good luck!

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The questions to ask the AIF

Now, you think you have found an AIF that you seem to have liked. Before you invest though, here are a few questions / information you can ask to evaluate.

1. What’s the AIF trying to do? How is the strategy unique, differentiated and distinct from anything already out there?

2. Some AIFs can focus on concentration of the portfolio as well, say for holding just 10 to 15 stocks, which may not be possible in an MF structure. But that should come out explicitly in the offering.

3. What is the minimum investment amount? Is there a commitment period or a lock in? What happens if you need to exit midway, for any reason?

4. How will the fund invest – directly in companies or via another fund (FOF)?

5. Who are the people running the show? Background and track record? Can you meet the fund manager?

6. How will it communicate with investors? Frequency and the type of reports.

7. Given the unique nature of the strategy (hopefully), at what point will they say that the strategy is not working and return the money to the investors?

8. What are the costs of investment management?
   

9. Is the fee charged on the entire commitment right from the beginning or only on the capital drawn?

10. In case of fixed + profit share, is the fixed cost adjusted for the profit share calculation?

11. Is the hurdle rate with catch up, that is, if the fund failed to meet the hurdle in one year, will the hurdle rate go up next year?

12. Does the fund follow a high water mark principle, meaning, will it charge fees after if it crosses the previous value at which fees was charged.

13. Any other charges not explicitly stated in the offer document?

14. What will be the taxation? Who pays the taxes?

15. Is the performance guaranteed? If not, what is a reasonable expectation range to have, net of costs and fees? Careful there.

16. Can you get a few references of other client/investors (including clients who have withdrawn the investment)?

I guess that post this interrogation, you will find it easy to say NO to most pitches coming your way.

That’s the idea.

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You may need a large dose of patience for AIF strategies to work out.

If you evaluate carefully, you might think that you are better off with a simpler, more tax efficient and lower cost structure such as Mutual Funds.

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