View: What do HNWIs look for, while investing in AIFs

Driven by a vibrant savings culture, the Indian populous is enthusiastic about investment vehicles that yield higher results with the involvement of moderate risks. The fluctuating market scenario owing to the ever-changing global fiscal dynamics has instilled the need to diversify existing investment portfolios in the minds of the Indian audience. Factoring in the seven percent inflation in the economy, most veteran HNWI investors have been able to map the plausible trajectory of the ‘real returns’ on their investments. Yields on equity funds, bank deposit rates and volatility of stocks are all subject to market risks, presumably leaving Indian depositors with negative real returns on their domestic deposits.

Alternate Investment Funds (AIFs) are privately pooled regulated investment vehicles that collectively finance various undertakings such as venture capital, real estate, private equity, hedge funds and etc. A serious investor must evaluate the pros and cons for available funds both domestically and internationally when deciding to park their capital for a particular duration.

A novelty factor of AIFs is that they offer steady annualised yields on the investment and are not burdened by the impact of sudden market fluctuations. Often referred to as ‘racehorse investments’, AIFs have increasingly become popular amongst investors with a high-risk appetite such as the HNWI section owing to their potential of outperforming traditional investment routes.

While a mix of both conventional and AIFs as investment vehicles are imperative to maintain a diversified portfolio, a lack of understanding before investing in the latter can prove to be detrimental in the long run.

Many real estate AIFs are sponsored by real estate developers and savvy investors look for this right away. If a Fund is sponsored or affiliated to one or more real estate developers, there is a clear conflict of interest unless the fund is a special purpose company between the developer and the investor. Retail investors are unlikely to spot this conflict. Investors need to be cautious about this aspect because it results in a lack of transparency and due diligence, and while the investments may be diversified, the sponsor as a whole poses the risk.

2. Fees and distribution ladder — HNWIs will always look at the management fee component and the distribution ladder. The most common private equity model is 2-20, i.e. 2 percent management fees and 20 percent share of profit above hurdle (minimum rate of return). However, in recent times, HNWIs have started questioning the 2 percent management fees because it creates a possibility of stagnation at high AUM levels. For example, a fund that has reached an AUM of a Bn$ will yield 20 Mn$ in management fee irrespective of the outcome of the activities of the Fund. In some cases, this may be counterintuitive.

For specialty funds, management fees is slowly getting obsolete and Investment Managers are more amenable to more aggressive profit-sharing ratios. It is worth remembering that management fees is fixed, and either eat into the investors’ returns or in the capital itself. And then comes the distribution ladder, which essentially clarifies, who gets paid first — the investor or the investment manager. Increasingly, HNWIs are looking for Funds where Investment managers don’t get paid upfront.

3. Real return on investment — Well-informed professional investors understand the difference between ‘real’ and ‘nominal’ return on investment and aim at gaining an in-depth understanding of the former before investing in any AIF. This essentially means that they drill down on the concrete real-time value of the cash returns after factoring in currency depreciation and inflation for the desired investment period as opposed to the percentage returns offered by financial institutions on paper.

For instance, if today you invest Rs 5,000 with your bank, you would get Rs 5,300 after one year, considering the 6 percent rate of interest (which is the nominal return). However, if you walk into a mall today and can purchase two shirts for this amount, but next year owing to the inflation you are required to put in Rs 1,000 from your pocket additionally to purchase the same shirts — your ‘real return’ becomes zero percent or negative as the ‘value’ of the money has depreciated in a real-world condition.

Every fund runs accounting in their own manner and can habitually confuse investors with the overuse of jargon that cannot be assessed at the given time. Therefore, it is essential to understand the nuances of their repayment strategy with a keen understanding of the minutest details. For Indian HNWI’s European AIFs are increasingly becoming an attractive option as it allows them to navigate challenges with domestic policies, low-interest rates and high inflation. The appreciation of $ against the ₹ and € against the dollar is an added benefit -laying the foundation for a steady earning of 8 to 10 percent annually over the fund’s lifespan.

4. Fund specifications — A fund is an amalgamation of several assets, which means due diligence of how its strategy meets your overall investment goal is an absolute necessity. As AIF investments fall in the non-listed space and capital is usually directed towards real estate and small businesses; data on asset allocation and liquidity can aid in determining the disbursement of resources to this asset class. Understanding the time horizon and intended objective of the fund has proven to be a fundamental conversation starter with advisors and aids in a comprehensive decision-making process.

While the information on a fund’s performance from the past is usually a good sounding board, information on that front is fairly limited when it comes to AIFs. Indian AIFs and foreign AIFs have a significant difference in approach and outcome which should be duly measured before a decision to commit to one is made. The current economic volatility points to the fact that overseas funds may be a more lucrative option for steady returns in the long run and are thus becoming popular amongst the HNI community.

5. Involved risks — Investing in AIFs carry risks, hence it is not ideal for “retail investors”. Most jurisdictions have their own definition of sophisticated investors, by way of a minimum threshold of investment. And AIFs are usually intended at these investors. They are known by many names such as sophisticated/well-informed/professional, etc. However, there is still an unresolved argument if AIFs are more risky than other equity investments, or debt investments. They are probably not, unless in certain categories like early-stage investing.

6. Add-on benefits — High Net Worth investors are always on the lookout for additional benefits from their investments. Many such fund investments overseas can be a route to a secondary residency of a foreign country. Permanent residency of rewarding nations such as the United States or countries of the European Union via the investment route comes with a plethora of benefits such as access to world-class educational institutions, superior healthcare and retirement provisions, a better quality of life, increased mobility for business expansion and much more. These aspects also factor into the decision-making mix when HNWI’s are looking at killing two birds with one stone.