A similar thing happened at 360 ONE Private Equity Fund (formerly known as IIFL Private Equity Fund). When the real estate AIF closed in March, investors realized they did not benefit much. The asset management company (AMC) told Mint that its fund generated a 6% annual return for its investors.
ICICI AMC told Mint that it is looking to liquidate its remaining investment in the fund by next March, in line with AIF regulations. Market regulator Sebi allows one additional year post the expiration of the term to liquidate assets and make distributions to investors. Mint could not independently ascertain the annual return generated by ICICI Prudential fund’s real estate AIF. On an absolute basis though, it returned 117% of the investment amount over the duration of the fund.
Both these incidents highlight the inherent risky nature of AIFs. The liquidity risk in AIFs is so grave that even some venture capital funds have been unable to sell their investments due to the ongoing startup funding winter, according to financial market experts.
To be sure, AIFs are high-risk investments with a minimum ticket size of ₹1 crore. These instruments are meant for ultra high net-worth individuals with a very high risk appetite. There are three categories of AIFs. Category 1 AIFs, which include venture capital funds, invest in start-ups or early-stage ventures or small and medium enterprises (SMEs). Category 2 AIFs include those funds that don’t take leverage or borrowings other than to meet daily requirements. They also include funds that don’t come under either category 1 or category 3. This comprises real estate funds, private equity (PE) funds, and funds for distressed assets, etc.
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Category 3 AIFs are those that employ complex trading strategies and employ leverage through investment in listed or unlisted securities. This includes hedge funds and private investment in public equity (PIPE) funds.
The big fat commissions
Munish Randev, founder and chief executive officer of Cervin Family, said that distributors pushed these real estate AIFs heavily as they were getting fat commissions. Many high net-worth individuals (HNIs), he said, are unaware of the inherent risks of investing in these funds. “If even 3-4 of the projects fail, there is a risk of return of capital let alone generating returns,” said Randev.
Large commissions in AIFs are not limited to real estate funds. Sebi, in a recent consultation paper, pointed out that the quantum of AIF commissions goes as high as 4-5% of the committed amount in some cases. In sharp contrast to the trail commissions for other products, such high upfront commissions increase the chances of misselling of AIF schemes. In fact, the growth in AIFs in the past few years could partly be attributed to distributors pushing these products to earn hefty commissions.
In category 2 AIFs, which includes the above real estate funds along with private equity funds, the cumulative fundraising amount went up more than 218% from ₹83,554 crore in FY19 to ₹2,66,296 crore in FY23.
In a recent order, Sebi said that upfront fees, which means charging commissions beforehand, will be capped at one-third of the total commissions for category 1 and category 2 AIFs. Earlier, any amount could be taken upfront by AMCs from investors. Experts said this gives an incentive to distributors and wealth managers to sell these AIFs. Upfront commission is not permitted under Category 3 AIFs.
Portfolio Management Services (PMSes) is another product meant for HNIs with greater risk appetite. The minimum ticket size for a PMS investment is ₹50 lakh.
Unlike mutual funds, where the total expense ratio is capped at 2.25%, no such caps exist for PMSes and AIFs. This means that higher management fees can be charged on these products and distributors get more commission to sell these products. Additionally, equity mutual funds enjoy long-term capital gains benefits for units held for more than one year. Such benefit does not exist in the case of PMS as the underlying securities are held in the personal demat account of the investor. This means they are taxed every time a buy or sell execution is carried out. Category 3 AIF gains are taxed at the highest slab rate. For category 1 and category 2, the taxes are paid by investors at their individual tax slab rate.
Abhishek Kumar, a registered investment adviser and founder of SahajMoney, said AIFs and PMSses rely on contracts signed between a client and the company whereas mutual funds are highly regulated. He added that many clients don’t know the risk associated with such products and are also not familiar with the details of the contract term.
He added that in PMSes and AIF, since there is no cap on total expenses, the fund manager could charge higher fees than what mutual funds would normally charge and in some cases, these structures also include a performance bonus. Add to this the high distribution cost, and it would mean that the fund manager has to try to get a much superior alpha to beat its benchmark. This may lead to concentrated bets on a few securities that can turn risky.
Srikanth Bhagavat, managing director and principal advisor of Hexagon Wealth, said many investors get into AIFs without adequately understanding the risks due to their high returns. Distributors, too, are eager to sell those products due to their high commissions.
AIFs and PMS have also filled in for credit risk mutual funds that lost sheen after the Franklin Templeton (FT) crisis in 2020. From managing ₹61,837 crore of assets under management (AUM) earlier, credit risk MFs now manage ₹24,687 crore of AUM, which translates into a decline of about 60%. Such funds invest in the credit of not the best-rated companies to get higher yield. These risky investments migrated towards AIFs and PMSes.
“When people started exiting from credit risk mutual funds, lots of AIFs and PMS were getting set up and it was them that started filling in the gaps,” said Kumar.
Experts point out that since the differences in commission structures create an incentive for distributors to push one product over another, the solution is to simply have the same commissions across all investment products including AIFs, PMSses, and mutual funds. This, they said, would remove the incentive to push high-risk investments to unsuspecting clients.