CAT-III AIF commitments are expected to grow to ₹2.5-lakh crore by 2028, with major firms planning to cumulatively raise at least ₹60,000 crore in the next two years, according to a report by Indian Venture and Alternate Capital Association (IVCA), India’s apex industry body for alternative assets, launched in partnership with Eleveight, a new-age strategy consulting firm.

As of December 2023, there are 257 registered CAT-III AIFs, which have together garnered commitments of ₹1,28,058 crore. In FY24, 53 CAT-III AIFs were launched, a significant uptick from the 37 launched in FY23.

Room for growth

There is considerable room for CAT-III AIFs to grow in the Indian market, said the report. In India, long, short and other hedge fund strategies account for a mere 3 per cent of total AIF assets, while globally, hedge funds contribute more than 30 per cent to alternative assets.

Within the CAT-III space, two strategies primarily dominate offerings: long-only and long-short. Long-only AIFs account for 61 per cent of the CAT-III share. Of these, 40 per cent of long-only funds are market cap-agnostic, indicating that flexibility in allocation and the capacity to invest across market caps are priorities for generating alpha. Conversely, long-short strategies account for ~38 per cent of CAT-III AIFs, indicating investor demand for absolute return and hedge fund strategies.

Absolute returns strategy

Most long-short funds in India were started with an absolute returns strategy. These are expected to become more popular due to loss of tax arbitrage in debt mutual funds, according to the report. The potential for deploying unconventional strategies such as derivatives, arbitrage and leverage for generating positive returns has also attracted investor capital to funds adopting absolute returns strategies. While equity long-short funds are still nascent in India, they offer huge potential, as investors have become aware of the merits of downside protection.

Although CAT-III AIFs have gained popularity, complex tax requirements remain a hurdle. The lack of pass-through taxation in CAT III AIFs is a well-known industry issue. Moreover, the industry believes that taxation has led to constraints on the product range available. To fully realise the potential of CAT-III AIFs and improve the investment environment, clearer tax laws and tax equity are required.

Gift City has become a popular destination for AIFs. Since April 2023, the number of funds has doubled, reaching 124 by March 2024. This expansion is fuelled by a supportive regulatory framework, tax incentives and compliance with offshore regulations.

Vikaas Sachdeva, Managing Director, Sundaram Alternatives and Co-Chair, CAT III Council, IVCA said, “While the AIF industry has grown by leaps and bounds, the CAT-III segment has seen a meteoric rise of late (52 per cent CAGR over the last 3 years), albeit on a lower base. This space will continue to grow, which augurs well for the industry participants, especially investors who want to diversify their investments, preserve their capital and generate alpha.”

Bhautik Ambani, Chief Executive Officer, AlphaGrep Investment Management and Co-Chair, CAT III Council, IVCA, said, “CAT-III AIFs are poised for exponential growth. Factors driving this include rising wealth, diverse product offerings and a supportive regulatory environment. Mutual funds are increasingly integrating AIFs for strategic advantages while challenges like complex tax regulations persist. Gift City’s emergence as a hub and wealth managers’ pivotal role in educating investors underscore the industry’s evolution, emphasising innovation and opportunities in the alternative investment landscape.”