scorecardresearchDebt AIFs: Does the return commensurate with the risks?

Debt AIFs: Does the return commensurate with the risks?

Updated: 29 Sep 2022, 11:08 AM IST
  • Debt AIFs fall under CAT II AIF where minimum 51% of investments should be into unlisted securities and rest can be listed.
Debt AIFs returns range from a minimum of 9-10% to as high as 18-20%.

Debt AIFs returns range from a minimum of 9-10% to as high as 18-20%.

There was a time when credit risk funds within debt mutual funds (MFs) used to be widely invested to get the additional return kicker over traditional debt assets.

Definitely, it came with its own set of risks but no one was aware of its risks until the Franklin fiasco happened and there were a series of media trials and investors’ suits filed in different courts of India against the so-claimed malpractices of fund managers.

However, two to three years later, more than 100% of outstanding investments were returned.

Investors are awake now and want to understand it more before putting any money in any credit investments. 

One more reason given for this fiasco was the open-ended nature of this category, which led to a spiral of redemptions and the fund managers could not manage the liquidity with a surge in redemption requests amid the IL&FS fiasco in the market which had already dampened the credit mood in the market.

Later on, the manufacturers and investors moved ahead and debt AIFs (alternative investment funds) took the center stage. Though SEBI regulations for CAT II AIF came in 2012, it didn’t pick much till this event and post which most credit investments happened through this route only as MFs took backstage in credit exposures.

What are debt AIFs?

Debt AIFs fall under CAT II AIF where a minimum of 51% of investments should be into unlisted securities and the rest can be listed.

There is no such minimum rating requirement to be invested into and the AIF is close-ended in nature which means that it can be exited only after it completes its maturity or early as per the fund manager's convenience.

However, SEBI allows its secondary trading on the exchange but it’s for name shake or if anyone wants to sell the existing units to other identified investors.

Since it falls into the AIF category, the minimum investment required for this kind of product is 1 crore; it can either be upfront or in the form of drawdowns as and when the fund manager calls for contributions.

Kind of debt AIFs

Credit investments as such are very wide in nature – they can either be ‘A’ rated or below or equivalent to investment grade i.e. ‘BBB’ or they can be special situation investments which warrant restructuring of companies or bridge financing or growth capital, etc.

Recently, venture debt, alternatively known as growth capital also picked up very fast and many players like Trifecta Capital, Alteria Capital, BlackSoil, etc. are prominent players in it.

Venture debt is a form of debt financing, typically a non-convertible, senior secured loan, offered to venture-backed new-age startups. It serves as an alternative to complement equity financing.

Generally, the IRR ranges from 15-20% depending upon what kind of risk stage the fund is entering. It is also considered an alternative to equity dilution.

So, debt AIFs returns range from a minimum of 9-10% to as high as 18-20% depending on the level of structuring or credit risks the fund is entering into.

These days, some fund houses also provide loss protection up to 5% or 10% which means for any default in principal or coupon up to the said no, the fund manager will bear the losses and there won’t be any impact on returns for investors even if there are any defaults.

Tax efficiency

Unlike debt MF where there are no taxation at the fund manager level and the debt indexation kicks in after three years, credit AIFs are taxed marginally or it depends upon how the fund manager structures the end investments.

For example, few make the investments bullet-ended so that the taxation is indexed at the end of tenure if transacted on an exchange or some mix it with a mix of some upfront coupon to facilitate interim liquidity along with bullet payout at the end of tenure.

Since debt AIF belongs to CAT II where 51% of investments need to be unlisted, fund managers make it tax efficient by investing in the form of MLDs whether listed or unlisted as they are taxed at 10% or 20% respectively.

Also, in CAT II AIF, the taxation is passed through a structure which means that the investors are liable for paying the tax. The fund manager will simply provide a statement whether the gains are in the form of coupons or long-term capital gains or return of capital.

Has it found acceptance amongst investors?

Definitely yes! After mutual funds left the credit space actively and banks/NBFCs not lending to these stressed companies aggressively, there was a huge gap opened up for filling and that’s where the credit AIFs have been filling the gap. And it’s a win-win situation for all stakeholders –investors, fund managers and investee companies.

AUM pick up

Though there is no specific AUM bifurcation in CAT II AIF as there are other categories which also belong to CAT II, the overall commitments raised and funds raised shot up to 5.62 lakh crore and 2.4 lakh crore respectively as on June 2022 from 2.08 lakh crore and 0.89 lakh crore respectively as on June 2019 which is almost more than double.

So, this category really picked up the space vacated by banks and debt MFs. Additionally, new categories like Venture Debt also evolved which were not present earlier.

What’s the downside?

No doubt this is not for all kinds of investors. Investors need to know the risk aligned with this kind of investment. If you are getting a 10-20% kind of wide range of returns relative to safe bets like FDs or G-Secs where you get 6.5-7%, it comes with its own set of risks.

Nevertheless, if the risks are managed properly, it can be a good kicker to your debt portfolio. Additionally, there is no liquidity available for this kind of fund though the units are listed on an exchange, liquidity is not available.

So, the investors need to be aware of the investment horizon while entering into this kind of fund. Generally, debt AIFs come with an investment horizon of four-six years end-to-end with an average maturity of two-three years.

Also, unlike debt MFs where all income is considered the same, the taxation depends upon what kind of returns the fund manager generates – if it is in the form of coupons or interest, it is fully taxable or if it is in form of capital gains, it is taxed accordingly if it is listed or unlisted.

In a nutshell, debt AIFs have gained lots of prominence in the last few years amongst sophisticated investors and also drew foreign institutional investors into this space. This is one of the best platforms to create an additional kicker to your debt portfolio with manageable risks.

(The author of this article is Head - Investment Products & Advisory, Anand Rathi Shares & Stock Brokers)

Disclaimer: The views and recommendations given in this article are those of the analyst. These do not represent the views of MintGenie.

What are short duration debt funds? 
First Published: 29 Sep 2022, 11:08 AM IST