Is the rise of AIFs the barometer of rising revenue inequality in India?

An AIF is a privately pooled funding automobile with a minimal funding quantity requirement of ₹1 crore (it’s ₹25 lakh for a enterprise capital fund) that gives entry to unconventional asset lessons reminiscent of personal fairness, pre-IPO funds, hedge funds or easy funds claiming to have larger alpha-generating capabilities. These funds come below the purview of the Securities and Exchange Board of India’s (Sebi) AIF laws.

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Overview of AIF business

Around 56% of the 881 AIFs, as of March 2022, had been registered with Sebi within the final 4 years, as per Crisil. “Awareness concerning the AIF funding product has elevated manifold in the previous couple of years. One large driver for that was the Franklin Templeton’s debt fund disaster (when the AMC shut down a number of debt funds in 2020 on account of sudden redemption strain), which resulted in credit score changing into a part of the AIF territory. The second large contributor has been the low-interest charge regime throughout the globe, which resulted in funds channelling to alternates looking for larger yield,” said Vineet Sukumar, founder and managing director at Vivriti Group.

The phenomenal growth in the AIF industry, which is accessible only to high-net-worth individuals (HNIs) and ultra-high-net-worth individuals (UHNIs) with a minimum ticket size of ₹1 crore in most cases, brings into question if it is an indicator of growing income inequality in the country.

To put this in perspective, the retail investors’ favourite, the mutual fund industry, grew by about 16% CAGR in the said period.

Of course, the low base of the AIF industry makes the growth figures look optically elevated. The assets under management (AUM) of mutual funds and the AIF industry stood at ₹38.4 trillion and ₹6.4 trillion, respectively, as of FY 22 (see table).

Category II AIF space attracted significant interest with a lion’s share of capital allocated to this segment that includes private equity funds, real estate funds and debt funds. This category is said to offer the maximum level of customization and innovation in the alternates space that HNIs and UHNIs have been looking for.

For the uninitiated, an AIF comes in three different categories. Category I funds invest in startups or early-stage ventures. Category III funds such as hedge funds employ diverse or complex trading strategies for investment in listed or unlisted securities/derivatives. These funds are permitted to take leverage (borrowing) subject to specific conditions. Category II is a residual category that doesn’t fit Category I or III.

The growing credit requirement from the mid and small-cap companies and the drying up of financing from NBFCs (Non-banking financing companies) also leads to the faster growth of private credit funds within Category II funds. “AIFs lending to the unmet credit needs of mid and small-size companies and making money available for long-term is helping the structural rise of the AUM in the private credit space of AIFs,” stated Vikas M Sachdeva, managing director of Sundaram Alternates.

Delivered outcomes?

Investors’ willingness to take larger dangers with startups and unlisted fairness house, resulted in these funds forming a good portion of property below administration of AIFs.

As per the Crisil AIF Benchmarks analysis, enterprise capital funds (Category I) outperformed the general public market index—S&P BSE 500 TRI—most occasions with a mean outperformance by 20 share factors in a 3 to five-year interval as of FY21. The efficiency of unlisted fairness funds (Cat II), is combined, with close to zero to nominal outperformance – for the chance it takes – in comparison with the market. The long-only fairness AIFs in Category III couldn’t show their outperformance throughout the identical interval, which brings into query the upper payment and decrease tax effectivity these classes of funds include.

Note that AIF benchmarking in India remains to be in its nascent stage and because of the numerous nature of funding themes that every AIF adopts, there’s a chance of mixing not-like-to-like funds whereas taking a class common.

Also, a lot of the AIFs, as per Crisil, are but to finish their life cycle and distribute a big portion of their portfolio. The attractiveness of the AIF house may be assessed solely within the coming few years when many AIFs can be transferring in the direction of the tip of their life cycle.

Jiju Vidyadharan and Piyush Gupta from Crisil, who authored the brand new report on funding business, stated, “The capability of fund managers to make well timed exits from their portfolio firms at beneficial valuations can be a key issue that can determine the expertise that an AIF investor can have.”

Income inequality?

Saurabh Mukherjea, founder, of Marcellus Investment Managers believes that the growth in the stock market/AIF space is in part a manifestation of the polarization of the Indian economy around a couple of efficient companies in every sector.

“As corporate profitability polarizes every year with 7-8 lakh small businesses shutting down, the formalization of the economy and consolidation in the market share in the hands of a few companies in every sector accelerates. This results in both income and wealth inequality in our country,” added Mukherjea.

He, nonetheless, believes that India is following a reasonably classical financial cycle. “Economic improvement internationally, together with different Asian economies, usually all the best way as much as $10,000 per capita revenue tends to be related to rising inequality. India is on its journey to the $10,000 mark and thus, we live by way of revenue inequality,” he added.

Nikhil Kamath, co-founder of Zerodha and True Beacon that has both PMS and AIF funds under its umbrella, says, “Any suggestion that India’s booming AIF sector has been precipitated by growing income inequality would be a mischaracterization of India’s socio-economic and financial landscape. As an emerging economy with a nascent financial sector, growth in Indian AIFs reveals augmented appetite and capacity among middle-class citizens to become participants in their country’s economy due to regulatory relaxation. Aside from a growing middle-class investor base, AIF sector growth also reveals a demand from its wealthiest citizens—most of whom were already involved in financial markets—to take advantage of these more sophisticated investment strategies now available to them. Although wealth inequality is a real and growing problem in India, AIF sector growth should be regarded not as being indicative of the problem, but as part of the solution.”

Other specialists, too, assume that the rising AIF business is probably not a sign of revenue inequality. They consider it’s a reflection of the center class upgrading to the higher center class on account of financial progress however not at the price of the low-income group.

“Let alone revenue inequality, lots of the third and fourth technology members of household enterprise are buyers within the enterprise capital house of AIF. That’s an entrepreneurial wealth that’s creating additional employment within the financial system leading to financial progress,” said Munish Randev, founder & CEO, Cervin Family Office & Advisors.

The road ahead

The AIF space is expected to grow at a healthy pace in the coming years as well with various initiatives from the industry and the regulator such as digital onboarding, AIF benchmarking and the introduction of an accredited investor framework.

Based on the 2022 survey of the Indian Association of Alternative Investment Funds (IAAIF), investors are willing to increase their allocation to alternates in the coming years by about 5-10 percentage points in the overall portfolio.

The industry players wish for certain amends in the current ecosystem to see further traction in the AIF space. The accredited investor framework comes with a host of benefits that include flexibility to participate in AIF with an investment amount lesser than the mandated minimum amount of ₹1 crore. “This concept is well thought-out, but the current framework is very onerous. This can genuinely deepen the market if it is executed well,” added Sukumar.

Apoorva Vora, founder & CEO, Finolutions LLP within the IAAIF Survey 2022 identified that AIFs have turn out to be a really generic time period. “You might have an AIF with the target of being at-par or barely higher than a liquid fund versus an aggressive AIF coping with distressed property. Unfortunately, each are categorised as AIFs. To the tip investor, this can be difficult to decipher. First and foremost, business leaders ought to begin speaking concerning the classification of AIFs based mostly on threat and asset class. It will assist in bringing extra investor confidence and assist wealth managers as effectively.”

Besides, the survey additionally highlights that 100% of the respondents wished for rationalisation of taxation of class III AIF. Currently, Category I and Category II AIF have tax pass-through standing for Indian income-tax functions. That means, buyers are taxed on revenue arising from investments made by the AIF as if the investments had been made instantly by them. For Category III AIFs, tax is mostly paid on the fund stage relying on the authorized construction of the AIF.

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