What are CAT III Alternative Investment Funds and what are the advantages for investors?

As per the SEBI AIF regulations of 2012, Category III AIF (Alternative Investment Funds) are investment funds that employ diversified trading and investment techniques, including the use of leverage, for both listed and unlisted financial instruments. These AIFs can be either long-only or long-short strategies and may operate as either open-ended or closed-ended funds. 

Open-ended funds typically allow investors to add or withdraw funds at any time, although some may have specific lock-in periods. 

Category III AIFs primarily focus on investing in publicly traded equities, similar to the approach taken by mutual funds or Portfolio Management Services (PMS). While some of these funds may also venture into unlisted equities, the primary focus is on publicly traded securities. SEBI regulations stipulate that such funds can allocate a maximum of 10 per cent of their investable capital to any single company

What are the advantages for investors in Category III AIFs? 

1. Taxation: In Category III AIFs, taxation occurs at the fund level, meaning that the redemption proceeds received by the investor are tax-exempt. According to Aman Soni, Head of operations at Prudent Equity, the funds themselves are responsible for paying taxes based on their specific structure and investment strategy. 

“For example, a long-short fund engaged in leveraged transactions may incur higher taxes compared to a long-only fund, which is taxed at the applicable slab rates. This eliminates the need for investors to calculate taxes on their investments at the end of the financial year, providing added convenience,” he said.

2. Diversified Portfolio of Companies: Unlike a PMS where each individual investor has their own demat account and stocks are credited individually, Category III AIF investors receive units of the fund at a specific Net Asset Value (NAV), which represents a diversified portfolio of companies. This means that from day one, an investor's money can begin generating returns if the portfolio of companies appreciates in value. This structure is similar to what mutual fund investors experience. 

3. Freedom for the Fund Manager: Category III AIFs currently enjoy relatively more flexibility from a SEBI perspective compared to mutual funds or PMS. For instance, mutual funds are typically restricted from holding cash above a certain percentage of their Assets Under Management (AUM) and must continually seek investment opportunities. 

“This sometimes forces fund managers to buy securities in an overheated market. In contrast, AIF fund managers have the freedom to implement their own strategies. They can choose to hold cash and patiently wait for the right time to deploy capital, potentially resulting in better returns for investors. This is evident from the trend where we observe top Asset Management Company (AMC) fund managers departing from their existing organizations to establish their own ventures as AIF fund managers,” Soni summed up.