How to Become a Limited Partner in AIFs

Over the past few years, many wealthy Indian investors have sought to diversify their portfolios beyond stocks, fixed income, mutual funds, and even portfolio management services. One option gaining popularity is Alternative Investment Funds (AIFs)—a term that encompasses various investment vehicles like private equity, venture capital, angel funds, and hedge funds. These AIFs make debt, equity, and hybrid investments in unlisted startups, listed equities, social ventures, infrastructure projects, and real estate.

The Securities and Exchange Board of India (SEBI) introduced AIF regulations in 2012 to create a regulatory framework, ensure transparency, protect investors, and help the industry grow efficiently. Since then, AIFs have become a popular investment choice not only for institutional investors but also for high-net-worth individuals (HNIs). The investors who commit capital to such AIFs are known as Limited Partners (LPs) in industry parlance.

The growing popularity of AIFs is evident from SEBI data. The capital markets regulator’s annual report for 2023-24 shows that 1,283 AIFs were registered with SEBI as of March 31, 2024, up from 1,088 at the end of March 2023. Remarkably, nearly half of these were registered in the last three years alone—195 in FY24, 235 in FY23, and 157 in FY22. SEBI data also indicates that the amount committed by investors to these AIFs surged around 36% to ₹11.35 trillion as of March 31, 2024, from ₹8.33 trillion a year earlier.

So, how can HNIs invest in such AIFs? In other words, how can one become a Limited Partner, or LP, in an AIF? And what factors should LPs consider before committing capital to an AIF? Here’s a quick primer.

What is an AIF?

An AIF is essentially a privately pooled investment vehicle that collects capital from investors, who may be located in India or overseas. These investors could be institutions or individuals. AIFs, in turn, invest in various asset classes, companies, and sectors according to their investment strategies.
AIFs set up in India and investing in the country are regulated by SEBI under the SEBI (Alternative Investment Funds) Regulations, 2012. However, not all AIFs that invest in India are registered with SEBI—some may be investing via entities based in countries like the US, the UK, Singapore, and Mauritius.
AIFs are managed and run by General Partners (GPs). GPs are responsible for raising money from LPs, deploying this capital, selling investments when necessary, and returning the capital to LPs after deducting their fees.

Types of AIFs

SEBI’s AIF regulations classify these funds into three categories—Category I, II, and III—based broadly on their investment mandates:
Category I AIFs: Include angel investment funds and venture capital funds that invest in socially or economically desirable sectors, as well as startups, SMEs, infrastructure, and social ventures.
Category II AIFs: Comprise private equity funds and debt funds.
Category III AIFs: Include hedge funds that invest in both listed and unlisted companies, follow complex trading strategies, and may use leverage.

What is a Limited Partner (LP) and How to Become One?

An LP is an institution or individual who provides capital to an AIF but has limited liability in the fund. The LP’s liability is typically limited to the amount of money they invest. Unlike GPs, who manage the fund, LPs are not involved in the day-to-day management of the AIF.

Investors looking to join an AIF as an LP must meet certain eligibility criteria and consider a few key aspects:

Eligibility Criteria: HNIs and other investors must meet high minimum investment requirements to become an LP in an AIF. According to SEBI regulations, an investor must commit at least ₹1 crore in an AIF. For context, this is double the ₹50 lakh required to invest in a portfolio management service (PMS) scheme.
Getting Information About AIFs: Unlike mutual funds and stocks, there is no single platform to obtain information about AIFs. HNIs typically need to reach out to wealth managers or private bankers to access such information. Often, AIFs partner with wealth management firms when raising funds.
Selecting the Right AIF: With numerous options available, HNIs should consider the fund’s investment strategy, past performance, reputation of the fund managers, and the risk-return profile. The fee structure is often standard across the industry, but it’s crucial to check it as part of due diligence before committing capital.
Terms and Conditions: LPs should thoroughly review the terms and conditions of the AIF before signing the check. The LP agreement should clearly outline capital commitments, drawdown schedules, profit-sharing, fees, and exit options. Seeking legal advice is recommended to fully understand the implications of the agreement.
Maintaining Liquidity: LPs typically don’t need to provide the entire committed capital upfront. Instead, fund managers draw down the money as they find investment opportunities. This process can take months or even years, so HNIs must ensure they have sufficient liquidity to meet these demands.
Compliance Norms: LPs must comply with SEBI rules, including Know Your Customer (KYC) norms. While fund managers usually handle the documentation process, investors should be aware of the regulatory requirements to avoid any legal issues later.

Key Factors to Consider Before Becoming an LP

Investment Duration: AIF investments often span several years. HNIs must have a long-term investment horizon and be prepared to keep their capital invested until the fund reaches maturity.
Risk Profile: Potential investors should assess their risk tolerance before committing to an AIF. Investments in startups, real estate, and unlisted companies can be riskier than traditional options.
Monitoring Performance: Investors should regularly monitor the AIF’s activities. Many AIF managers provide LPs with updates on the fund, its investments, and the performance of portfolio companies on a quarterly or annual basis.
Exit Plan: It’s crucial to understand the options for exiting the AIF. AIFs generally offer less flexibility than mutual funds and PMS schemes in this regard, but some may provide early exit options.

Pros of Becoming a Limited Partner

Portfolio Diversification: AIFs allow HNIs to diversify their portfolios by investing in unlisted securities, startups, and real estate projects, which are often not accessible through traditional investment vehicles.
High-Growth Opportunities: AIFs often invest in high-growth sectors such as artificial intelligence, robotics, and other innovative industries, offering the potential for significant returns.
Professional Management: Like mutual funds and PMS schemes, AIFs are managed by experienced fund managers who have the expertise and resources to identify lucrative investment opportunities.

Cons of Becoming a Limited Partner

Illiquidity: Unlike mutual funds and stocks, where investors can typically withdraw their money at any time, AIFs have lock-in periods that may last from a few years to as long as 8-10 years. This means LPs cannot easily access their capital until the fund matures.
High Risk: Investments in startups, real estate, and unlisted companies can be riskier than other options, potentially leading to higher losses.
Management Fees and Profit Share: AIFs charge a management fee based on committed capital and a performance fee based on profits generated, which can reduce returns for LPs.
Regulatory and Market Risks: Like any investment, AIFs are subject to market and regulatory risks. Changes in government policies, economic conditions, or regulations can impact the fund’s performance.

Conclusion

Investing in an AIF as a Limited Partner presents a unique opportunity to diversify one’s investment portfolio and gain exposure to high-growth sectors. However, it also comes with its share of risks. Before committing, investors must carefully evaluate the AIF’s investment strategy, structure, and associated risks. Becoming an LP in an AIF can be a lucrative addition to an HNI’s overall investment strategy, helping them achieve their financial goals over time with the right approach.

Investors interested in becoming a Limited Partner in AIFs should consult their financial advisers, wealth managers, and legal experts to navigate the process and ensure that their investment aligns with their risk tolerance and financial objectives.