CAT III Alternative Investment Fund: What are the risk factors & who can invest in them?

The SEBI AIF regulations 2012 defines CAT III AIFs as funds which employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted instruments. The CAT AIF industry is growing rapidly — the number of SEBI registered AIFs went from 173 in March 2022 to 207 in March 2023. The total commitment raised from investors stands at Rs 80,900 crore as on March 2023.

The AIF may either be a long only or a long-short fund. The AIF could be Open or Close ended. Open ended funds usually have no restrictions, an investor may add or withdraw funds at any given point in time, some funds may have a lock-in period. Close ended funds on the other hand have a restriction of not being able to withdraw funds for at least 3 years.

Where does a CAT III AIF invest?

Category III AIFs mostly invest in public equities only, which is similar to what a mutual fund or PMS does. Some funds may invest in unlisted equities as well. However, it is expected that most CAT III AIFs invest in public listed stocks only. When it comes to investing in public equities, the SEBI regulation states that a fund can invest only up to 10% of the investible fund in any one company.

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How can an investor invest in a CAT III AIF and who all can invest?

The minimum investment as per SEBI regulations to invest in an AIF is Rs 1 crore. Someone wishing to invest in a fund may approach the fund house and ask for details about their fund such as past returns, investment strategy, etc. The investor is also required to execute an agreement with the fund before investing. Anyone whether Indian, foreign national, NRI can invest in an AIF. This includes retail investors, HNIs, corporates, family offices and institutions as well.

Fees and charges involved while investing in an AIF

The fee structure differs from one fund to another. Usually, the fund charges a management fee & performance fees or just one of them on the capital of the investor.

Taxation structure in a CAT III AIF

Investors receive tax-free income from investments in category III AIFs. Category III AIFs must pay tax at the fund level since they lack pass through status. As a result, investors who get redemption money are not required to pay taxes.

What are the ways to track fund performance?

Investors investing in a CAT III AIF are issued units in lieu of their investment and based on the NAV of the fund, one can track the performance. An investor may receive a weekly, fortnightly or monthly report from the fund manager showcasing the performance of the fund.

In addition to this, the fund also shares a detailed report on a quarterly basis about.

A. financial information of investee companies.

B. material risks and how they are managed which may include:

(i) concentration risk at fund level;
(ii) foreign exchange risk at fund level;
(iii) leverage risk at fund and investee company levels;
(iv) realization risk (i.e. change in exit environment) at fund and investee company levels;
(v) strategy risk (i.e. change in or divergence from business strategy) at investee company level;
(vi) reputation risk at investee company level;
(vii) extra-financial risks, including environmental, social and corporate governance risks, at fund and investee company level.

Risks involved

The risks involved are similar to what one gets in any market linked product such as a PMS or mutual fund. The performance is dependent on the fund holding, rising value of such holding will result in high returns and vice-versa. Although CAT III AIFs which invest in public equities only are exempt from liquidity risk which arise in other categories AIFs which are involved in investing in long gestation areas such as real estate and private equity where exit opportunity is difficult.

(By Aman Soni, Head of Operations at Prudent Equity. Views are personal)

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