Learn about the Nuances of Valuation of an Alternative Investment Fund

If you are an investor and want to invest in an Alternative Investment Fund (AIF) then you should read this piece of information as we will help you in navigating through the complexities involved in the valuation of AIF. So, let’s move on to it.

What is an Alternative Investment Fund?

An alternative investment fund(“AIF”) is a type of investment option in India that is established or incorporated in the form of a limited liability partnership a company or trust or a corporate body. AIF is a fund of funds that invests in classes of assets, other than cash, stocks and bonds.

The mechanism of AIF is that it invests in the pool of investor funds and invests these amounts under the different categories of investment options which are specified by the Securities and Exchange Board of India.

Generally, AIF invests in private equity, venture capital hedge funds and managed funds, etc. AIF does not invest in conventional investment funds such as debt securities and stocks. High-net-worth individuals and institutions invest in the AIF.

AIFs are either established or incorporated in the form of a company, trust or body corporates which are:

• A private pool of investment funds gathered from Indian and foreign investors is used to invest in the funds for the benefit of the investors.

• not including funds covered under the SEBI (Collective Investment Scheme) Regulations, 1999, SEBI (Mutual Funds) Regulations, 1996 or any other regulations provided by the SEBI which regulates the fund management activities.

However, the below-mentioned are not considered as an AIF and these are as follows:

• ESOP employee stock ownership plan) or trust set-up under the SEBI (Share-based Employee Benefits Regulations, 2014) as permitted under the Companies Act, 2013.
• holding companies defined under section 46(2) of the Companies Act, 2013
• family trust that are set up for the benefit of the relatives under the Companies Act, 2013.
• employee welfare trust or the gratuity trust as set up under the Companies Act, 2013 for the Welfare of the Companies Act 2013.
• other special purpose vehicles that are not established by the fund managers
• funds which are managed by the securitisation company or a reconstruction company that are registered with the Reserve Bank of India under Section 3 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.
• any other pool of funds that are directly regulated by any other regulators in India.

What is the role of SEBI in regulating the valuation of the AIF?

Back in the year 2023 SEBI has introduced a standardized approach towards the valuation of the AIF portfolios and with their approach they aim towards adhering to specific methodologies. With this approach they also aim towards minimising the discrepancies in different funds, reducing the chances of manipulation and bringing the overall transparency.

What is the importance of valuation in AIF?

Accurate valuation in the AIF is a key that directly affects the confidence of the investors and the overall success of the fund. Valuation helps the investors to make informed decisions after taking into consideration the real-time situation of the funds of the company and for the fund managers it allows for setting accurate net asset values (nav).

What is the role of valuation in investor decision-making?

The category of the AIF investor is usually the high-net-worth individuals or the institutional investors and these investors are required to make precise and timely decisions regarding their investments.

In the case where the valuation results are not accurate, it leads to an incorrect decision thereby resulting in financial losses. Therefore, it is imperative that the standardised approaches should be used to accurately assess the risk, award and enable the investor to make well-informed decisions,

Valuation of AIF in regulatory compliance and benchmarking

Valuation of the AIF plays an important role in regulatory compliance and performance benchmarking. Because the AIF performance bench marking totally depends on the standardized valuation reports these reports help the benchmarking agencies to compare the fund’s performance against any industry standards and also at the same time provide an insight to the investors into the performance of the funds. 

Disclosures and transparency

SEBI has discussed the relevancy of regular reporting and the transparency with regard to the valuation methods. Therefore, the valuation managers are required to maintain full transparency as to which method was used and why it was used.

What are the categories of the Alternative Investment Fund?

The applicant may seek registration under AIF in any one of the below-mentioned categories.

Category I AIF

Category I AIF are those types of AIF that invest in the early stages of the ventures, start-ups, social ventures, Small and medium enterprises infrastructure or the sector/areas that are considered by either the regulators or the government.

Category I AIF can include:

• Venture capital fund (VCF): new enterprises that require large around of finances during the initial days may approach the venture capital fund as these funds help in overcoming any financial crunches. VCF invests in those startups that has a high growth potential.

• Angel Funds: it is the type of fund that is being brought in by the angel investors at the very early stages of the organisation to bring in the requisite capital. The minimum amount of investment for this start-up is Rs 25 lakhs.

• Infrastructure Funds: as the name suggests these types of funds invests in the infrastructure companies.

• Social Venture Funds: as its name suggests it is a type of investment fund that invests in the organizations that are socially driven.

Category Il AIF 

These are those types of funds that do not fall into Category I or Category Il of the AIF and these funds do not undertake borrowing or the leverage to meet the day-to-day operational requirements these funds are also permitted under the SEBI (alternative investment funds) regulations, 2012.

Category Il AIF includes:

Private Equity Funds: Private Equity Funds are those funds that invest in unlisted private companies and these funds comes along with a lock-in period of 4 to 7 years. These funds are invested because it is difficult to raise funds through the equity or the debt instruments by the unlisted companies.

Debt funds: This fund invests in the debt securities of the unlisted companies. These are issued by the companies that have opted for good governance models and high growth potential.

Funds of funds: As the name suggests these funds invest in other AIF

Category lll of AIF 

These funds are the funds that employ a complex diverse trading strategy and employs leverage including investments in unlisted and listed derivatives.

Category III of AIF includes:

• Hedge Funds: Hedge Funds pool money from renowned investors or institutions. These funds invest in both international and domestic debt and equity markets.

• Private investment in Public Equity Fund: These funds are the funds that invest in the shares of publicly traded companies. The investors acquire the shares at a discounted price.

Who may invest in an AIF?

Any investor who is willing to expand their portfolio may invest in an AIF if the investor follows the below-mentioned criteria:

• Residents, NRIs or even foreign nationals who invest in AIF
• The minimum amount of investment for the nominal investors is Rs. 1 crore while for the director, employees and fund managers is Rs. 25 lakhs
• The lock-in period for AIF is three years
• The total number of investors in any scheme is up to 1,000 but the number of angel investors may go up to 49.

What are the benefits of investing in AIF?

AIF comes with a lot of benefits for the investor and the organization and these are as follows:

• High growth potential: AIF yields a high growth of returns and the massive involvement of the amount gives the funds manager the liberty to prepare flexible strategies to yield higher returns

• Lower volatility: in the case of AIF the volatility is lower because of their non-involvement of the stock markets. Therefore, these funds are preferred more over equity funds.

• Diversification: these types of funds allow the much-needed diversification to an investment portfolio.

Valuation of the AIF

The valuation of the AIF is done in accordance with Regulation 23 of the Securities and Exchange Board of India Regulations, 2012. These rules were outdated and to bring in uniformity and to avoid variances in the rules an amendment was brought in the year 2023 to curb the above difficulties.

What are the norms for the valuation of securities?

SEBI has specified the manner of valuation of securities whose valuation rules have already been prescribed under the Eight Schedule of SEBI (Mutual Funds) Regulations 1996.

Valuation Guidelines under SEBI (Mutual Funds) Regulations, 1996.

Convertible securities

In the case of convertible debentures the non-convertible portion is valued on the same basis as applicable to the debt instrument and for the convertible portion the valuation is done in the same manner as equity instruments are valued

Rights shares 

The rights shares are valued as the number of shares offered that are divided by the number of the original shares held and then multiplied by the difference between the ex-rights price and the rights offer price.

Traded and Non-Traded Securities

Traded securities other than debt securities and money market securities are valued at the last quoted closing price on the stock exchange on the other hand, the non-traded securities are valued in good faith by the Asset Management Company and these appropriate valuation methods are based on the principles approved by the Board of the Asset Management Company.

Valuation of the other securities

The valuation of the other securities that are not covered under the ambit of the ‘securities’ whose valuation norms are prescribed under the Eighth schedule of SEBI (Mutual Funds) Regulations, 1996 is carried out in accordance with the guidelines prescribed by any AIF industry association and these guidelines have been prescribed after taking into the recommendation of the alternative investment policy advisory committee of SEBI.

What are the approved valuation methods?

Market approach: the market approach is one of the used methods for valuing publicly traded securities. As per the guidelines of the SEBI, AIF is required to value the publicly traded securities by using the last quoted closing price. For the non-traded securities SEBI advises using the market multiples such as the revenue or the earnings multiples-or benchmarking.

Income approach

For non-traded assets private equity investments or real estate the income approach is widely used.in this method, the present value of the future expected cash flows is used. This approach is used for assets that generate revenues over time and this is why this approach or the discounted cash flow analysis, is used for valuing the AIF portfolios with long-term investments.

Cost-approach 

The cost approach is also known as the replacement or production cost this approach is used while valuing tangible assets. In this method, the estimated cost of replacing or reproducing an asset is determined.

What are the reporting and disclosure requirements for different AIF categories?

As we have already discussed SEBI makes it an obligation for the fund managers to provide detailed disclosures on the valuation methods to the investors and this also includes

• Providing regular updates in their private placement memorandum (ppm) where managers are required to disclose the exact methods and their assumptions.

• To provide any significant deviations from the standard valuation methods such as large fluctuation in the value of the assets which is required to be reported to the investors.

What is the responsibility of the managers with regard to the valuation of AIF?

True and Accurate Valuation: Under Regulation 23(5) of the AIF regulations it is the responsibility of the manager and the key managerial personnel of the manager to ensure that independent values carry out the valuation of the schemes of the AIF. Further under Regulation 23(6),  a manager is responsible for the true and fair valuation of the investment schemes of the AIF. 

Deviation: The manager can deviate from the already established policies and the procedures established at each level of the asset valuation, if there is a deviation of more than 20% between two valuations or if there is a deviation of more than 33 % through the manager is duty-bound to inform the investor about the change in policies and its reasons thereof

Discourse in the private placements memorandum (PPM): The managers are required to provide detailed information related to the used valuation methods in the private placement memorandum (PPM). The ppm is shared with the investors at the time of the launch of the funds. ppm includes a clear explanation of the used valuation methods for asset fund type in the portfolio of the funds. Also, any deviations from the standardized valuation methods are required to be documented and justified.

Reporting to SEBI and benchmarking agencies: the managers are required to submit the valuation report to SEBI and the industry benchmarking agencies. With the help of these performance benchmarks marks it helps the investors evaluate the performance of the AIF then they guide them to make informed divisions.

What are the eligibility criteria for an Independent Valuer?

The independent values are required to be:

• Not be an associate of manager or the sponsor or the trustee of the AIF
• Have at least three years of experience in the valuation of unlisted securities.
• Fulfill anyone of the below:

• The independent value should be registered with the Insolvency & Bankruptcy Board of India (IBBI) and should also possess membership of the Institute of the Chartered Accountants of India or registered with the Secretaries of India or Institute of Cost Accountants or CFA institute.
• The independent values is either a holding company or subsidiary of A credit rating agency registered with SEBI.
• Any other criteria as specified by the SEBI.

What are the challenges in the valuation of the AIF?

Complexity in the unlisted assets: unlisted securities do have not any readily available market prices and valuation of the AIF and this is why it makes it difficult to determine the fair value as there will be no regular trading available to be relied upon.

The valuation of the assets is mostly upon. The discounted cash flow (DCF) models, also require accurate projections of future earnings or cash flows.

• Lack of standardization amongst the classes of assets: AIF consists of different varieties of assets that require different valuation methods and applying different valuation methodologies on different types of assets is a complex and cumbersome task even though the SEBI has provided standardized norms to it.

• Likelihood of the manipulation in valuation: Flexibility in the use of different methodologies for the valuation of assets has resulted in manipulation also as the illiquid assets do not possess A daily market price which is one of the reasons fund managers either stating or understating the price of these asset values for the Propose of attracting more investors or to avoid any reporting losses.

• External factors and the market volatility: the value of the assets is highly sensitive to the changes due to the change in the interest rates, inflation, and other market conditions. Due to these external factors and market conditions, it becomes highly difficult to derive an accurate valuation.

• Challenge in reporting and compliance: SEBI has made it an obligation to report about the AIF to the investors and to SEBI. The need for accurate and timely reporting plays a significant role and a burden on the fund managers to deal with the large portfolio of funds and this also requires close coordination between the fund managers, investment companies and the independent values.

SEBI’s new rules impact the AIF

Enhancement in the transparency and confidence of the investors: with the introduction of SEBI guidelines there has been an enhancement in the transparency in the AIF industry.

Before the advent of these guidelines the valuation process used by the AIF industry was varied and at the same time was inconsistent which leads to grave manipulation or the misrepresentation of the value of the assets.

With this level of transparency, turned into higher investor confidence because it develops trust in the performance of the funds and makes informed decisions.

• Consistency in the industry: With SEBI standardized valuation framework much needed consistency in the AIF industry. This consistency is very important at the time of comparing fund performance as investors may compare multiple AIFs on a level playing field.

• Accountability of the fund managers: SEBI places the fund managers at a high level of accountability. Fund managers hold a responsibility to ensure true fair and the valuation of the assets.at the same time, the fund managers are also required to justify any deductions and the rationale behind this to the SEBI and the investors.

• Improvement in the benchmarking and performance measurement: with the advert of SEBI standardization norm the fund managers are now using the same principles of valuation and it becomes easier for fun investors to compare the performance of one fund against others working in the industry.

• Difficulties for the smaller funds: Small AIFs face difficulties in engaging the independent valuer, conducting regular valuations, and thereby meeting stringent requirements reporting, and can also create an extra financial and administrative burden.

Conclusion

AIF is a fund option that is divided into three categories respectively and these funds invest in the classes of ass its other than cash, bonds and stocks. The valuation of AIF is performed by independent values in accordance with the prescribed rules where the independent values may deviate from the prescribed rules in case of either 20% or 33% deviation.

Frequently Asked Questions on Valuation of Alternative Investment Fund

Q1. Who can do the valuation of an AIF?

Ans1. An independent valuer can do the valuation of an AIF.

Q 2. What is the net worth requirement for an Alf?

Ans2. The net-worth requirement for an AIF is having net tangible assets of at least INR 2 cr excluding the value of the principal residence of the investor.

Q3. Who controls an AIF?

Ans3. The Securities and Exchange Board of India controls an AIF.

Q4. What is Category 3 AIF?

Ans4. Category 3 of the AIF invests in the Securities of the listed and the unlisted Companies.

Q5. How is NAV calculated in AIF?

Ans5. NAV stands for net asset value as it is the value of an investment fund determined by subtracting its liabilities from the assets.

Q6. What is the minimum value of AIF?

Ans6. The minimum value of an AIF is Rs. 1 crore.

Q7. What is the maximum investor in AIF?

Ans7. The maximum investor in an AIF shall not be more than 1000 investors.

Q8. How does AIF make money?

Ans8. AIF generates returns from capital appreciation, interest, dividends and fees.

Q9. Is AIF tax-free?

Ans9. Yes, AIFs are taxable as per the slab of the investor. 

Q10. Who can not invest in AIF?

Ans10. The regulated entities cannot make investments in AIF.