India, in the post-Covid scenario, is looking for a strong investment-led thrust in the forthcoming Union Budget for FY2022-23 to aid the economic recovery.

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The pandemic has left an unprecedented adverse impact on the credit market. With a significant amount of economic output getting lost post-lockdown, cash flows in the corporate sector started drying up.

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The sudden rise in potential risk of bankruptcy, particularly after the Franklin Templeton crisis in early 2020, created a huge risk aversion among large NBFCs and banks that were already drifting towards the retail space and mutual funds moving away from the lower-rated space.

Zee Business spoke to Vineet Sukumar, Founder and CEO, Vivriti Asset Management to understand what AIFs are expecting from Budget 2022:

The growth in the Alternative Investment Fund (AIF) industry has been phenomenal. Over the last 5 years, it has grown more than 8 times with assets under management (AUM) crossing the psychological Rs 5 lakh crores-mark last September.

The growth has mainly been driven by growing appetite of high-net-worth individuals (HNIs) that find alternate assets more palatable, and the shift away from traditional investment avenues such as fixed deposits to generate additional alpha.

AIFs have been able to fit well in their criteria as they offer a more structured vehicle of getting into higher yielding debt or arbitrage strategies.

At the deployment end, AIFs have been able to meet the financing needs of small and medium-sized enterprises (SMEs), which contributes roughly 30% to India’s GDP and 45% to industrial output, amid the tightening of the credit market.

As the growth in India is contingent on growth in SMEs, the regulatory landscape should clearly work in favour of SMEs to scale well.

Given these perspectives, certain changes in the regulatory framework regarding AIFs are expected as below.

If implemented, these changes could have a far-reaching impact on the ability of AIFs to build investor confidence, raise long term and stable institutional capital, and rapidly scale up their assistance to SMEs that lack access to capital markets.

Framework #1:

As per guidelines of Pension Fund Regulatory and Development Authority (PFRDA), National Pension System (NPS) schemes are allowed to invest in Category 1 & Category 2 AIFs if they are listed/soon to be listed.

Further, securities in the fund should have minimum AA equivalent rating from at least 2 credit rating agencies registered with SEBI.

As per guidelines of the Insurance Regulatory and Development Authority (IRDA), there is a cap on AIF investments for Life insurance (LI) companies, which is 3% of the respective fund, as well as on General insurance (GI) companies, which is 5% of investment assets.

Lastly, the Employees' Provident Fund Organisation (EPFO) has allowed provident funds to invest up to 5% of its investible surplus in AIFs.

ASK: Insurance companies have been investing in AIFs for the past 7 years, with excellent outcomes. Learning from this, the IRDAI norms for insurance companies, the PFRDA norms for NPS and the EPFO norms should be aligned, for investment in AIFs by insurance companies.Rating requirements should be removed completely (and left to the discretion of respective organisations), while the investment caps should be increased to 10% of assets.

Framework #2:

As per RBI norms, when banks invest in fixed income Category II AIFs, they need to set aside capital, determined by the risk weight, against the exposure.

Currently, investments by banks in all Category II AIFs attract a 150% risk weight for the first 3 years and 250% after 3 years. There is no differentiation for fixed income versus equity and other strategies.

ASK: Investments in fixed income Category I and Category II AIFs do not carry a mark to market (MTM) risk, as the funds mostly undertake long-only investments not trading strategies.

Hence, RBI should align the the risk weight of banks’ investments in AIFs with corporate bonds, which is determined by domestic Credit Rating Agencies. To elaborate, for closed-ended funds, the risk weight should be linked to either

i) Rating of the debt AIF unit that the bank is holding (in line with the risk weight for investing in rated corporate bonds) OR

ii) Median/average rating of the portfolio that the AIF is holding (if debt, and if rated, in line with risk weight for investing in rated corporate bonds)

Otherwise, if unrated, the risk weight could be 100%, similar to other unrated debt investments.

For open-ended funds, RBI could add a market risk element with an additional 25% risk weight.

Framework #3:

The Cat I and II AIFs enjoy a pass-through status, which means that the income or loss (other than that from business income) generated by the fund will be taxed in the hands of the investors on a pro-rata basis in the same form and manner assuming if the investor had directly made the underlying investments.

However, Cat III AIFs have no such pass-through status. Given this, the basic principles of Trust taxation come into picture and the taxation in case of Cat III AIFs is unclear / open to interpretation.

ASK: For Cat III AIFs, the pass-through status should be explicitly accorded in line with Cat I and Cat II AIFs.

Further, pass through status for all AIF categories should be accorded for business income and investment income alike, given that the AIF is being managed purely for the benefit of contributors.

This would completely remove ambiguity and sharply improve market confidence in AIFs.

(Disclaimer: The views/suggestions/advices expressed here in this article is solely by investment experts. Zee Business suggests its readers to consult with their investment advisers before making any financial decision.)