Alternative Investment Funds: Understanding Alpha and Cash Returns

Alternative Investment Funds (AIFs) have become a significant part of the investment landscape for India's wealthy, evolving into a Rs.16 lakh crore opportunity with a 30.7% compounded annual growth rate between FY21 and the first half of FY26. The minimum investment for an AIF in India is Rs.1 crore per investor. These funds typically involve capital lock-in for years as fund managers build and exit positions, with actual cash distributions occurring only upon successful sales through IPOs, mergers, or secondary transactions.

High net worth individuals (HNIs) are drawn to AIFs for their potential to deliver alpha, which is the excess return over a benchmark index after risk adjustment. A Crisil-Oister benchmarking report indicated that unlisted equity AIFs have generated an average alpha of approximately 8.7% relative to the Sensex Total Return Index (TRI). However, a critical question for investors is how much of this reported alpha translates into actual cash returns.

While audited by agencies like CRISIL, a significant portion of AIF returns remains unrealized, driven by markups and interim valuations rather than actual cash exits. Rohit Bhayana, Co-Founder of Oister Global, states that while approximately 80% of AIFs are now making some distributions, the larger part of reported alpha is still based on paper gains. Shobhit Mathur, Co-Founder of Ionic Wealth, estimates that 60-80% of gains in early- and mid-life funds are marked to market, with late-stage and private credit funds showing higher realization rates.

Understanding AIF performance metrics is crucial. The Internal Rate of Return (IRR) accounts for the timing of cash flows, making it more sophisticated than a simple percentage gain. A high IRR with low distributions can be a red flag. Other key metrics include Multiple on Invested Capital (MOIC), which shows how many times the invested capital has grown in value (realized or not), and Distribution to Paid-In Capital (DPI), which measures the actual cash returned to investors. Crisil data shows that out of 170 analyzed schemes, 142 have made distributions, with top-quartile funds showing a DPI of up to 5.03 times. On average, schemes have taken about 6.5 years to return 75% of contributed capital.

IRR becomes a more reliable indicator after the fund's sixth or seventh year, when a substantial part of the portfolio has been deployed and exited. Before this, early-stage paper gains can inflate IRR unsustainably. Bhayana likens understanding AIF performance to touching different parts of an elephant; only by considering IRR, MOIC, and DPI together can a comprehensive picture be formed. In top-quartile VC and PE funds, DPI has already crossed 2 times, indicating substantial cash returns.

The timeline for distributions varies by fund stage. For startup and angel investing (Category I AIFs), expect meaningful cash flows from year four onwards, with distributions continuing until year ten. Mid-stage funds typically distribute from year three to seven, while late-stage and pre-IPO funds can have shorter windows of one to four years. Late-stage funds attract interest due to their visible liquidity cycle, targeting companies planning IPOs within 6-18 months to capture valuation arbitrage.

However, structural risks exist, such as fund extensions and delayed exits that can stretch holding periods beyond the stated tenure. Fund managers may extend holding periods for portfolio winners to improve overall fund performance. Private credit AIFs offer predictable returns (12-14% for performing, 16-18% for special situations) with regular quarterly distributions, behaving like fixed-income instruments. Secondary funds also perform well by entering late-stage, offering cleaner return profiles. Early-stage venture capital, conversely, has high dispersion, significant write-off risk, and longer liquidity timelines.

Category III AIFs, including hedge funds and listed equity strategies, invest in listed securities, offering continuous mark-to-market valuations and often monthly liquidity. Multi-adviser Category III structures, combining several boutique managers, are emerging as an option for HNIs seeking alpha without long lock-ins.

Fund manager selection is paramount due to the wide performance gap between top and bottom quartiles. Investors should prioritize a fund manager's exit track record over just their investment history. A robust due diligence process, mirroring institutional practices, involves evaluating quartile performance, distribution of investee company performance, franchise strength, replication of success, and governance. For Category II funds, analyzing past exits by timeline, multiples, and route is recommended. For Category III listed-equity AIFs, manager discipline on profit-booking and rebalancing is key.

The tax treatment of AIFs differs by category. Category I and II AIFs generally operate under a pass-through structure, meaning gains are taxed as capital gains in the hands of investors. However, income accrued, even if not distributed, can create a tax liability. Category III AIFs do not benefit from pass-through status; income is taxed at the fund level, and investors are taxed only on distributions received. Certain Category III AIFs in International Financial Services Centres may qualify for exemptions for non-resident investors.

In conclusion, while the alpha generated by AIFs over public markets is real and wealth creation has been genuine for funds that have completed their cycles, much of the industry's reported performance is still in paper valuations. True wealth creation will be validated as exits materialize. Investors should focus on DPI alongside IRR, understand realistic distribution timelines, scrutinize fund managers' exit records, ensure locked-in capital is part of a larger, liquid portfolio, and avoid committing based solely on compelling presentations.