CHAPTER 7 (PART 1): CATEGORY III AIF INVESTMENT STRATEGIES AND DUE DILIGENCE PROCESS

1. Overview of Category III AIF Investment Strategies

Category III Alternative Investment Funds (AIFs) represent a sophisticated segment of the Indian alternative investment landscape. These funds are structured to employ diverse and complex trading strategies, with the flexibility to trade in listed and unlisted securities, derivative contracts, and currencies, often utilizing leverage.

1.1 Core Investment Philosophy

Unlike traditional mutual funds that primarily buy and hold securities, Category III AIFs are characterized by their dynamic and multi-asset approach.

• Asset Allocation: They have been primarily investing in equities and derivative contracts, with equities or equity indices as the underlying asset.
• Absolute Return Mandate: The primary objective of these funds is to deliver positive absolute returns (generating "alpha") for investors over the medium to long term, regardless of overall market direction.
• Investment Horizon: A Category III AIF is a pooled investment vehicle that collects investment capital from investors to deploy over a long-term horizon. They generally do not invest for the purpose of intra-day trading.
• Speculative Allocations: While the long-term focus remains paramount, speculative investments in equities may be executed if the investment manager can predict short-term profit generation for the fund.

1.2 The Regulatory and Disclosure Framework

Before an investment manager can execute trades, a clear operational framework must be established and communicated:

• The Investment Strategy Document: The targeted sector for investment, the basis for selection of investments, the targeted time horizon, and the risk-return profile of selected investments are clearly outlined by the investment manager in the Investment Strategy section of the Private Placement Memorandum (PPM).
• Investor Consent: By making capital commitments to the fund, the investor indirectly provides consent to the investment manager on the stated investment strategy. Any major deviation or change in this strategy requires formal investor approvals as mandated by SEBI.

2. Equity-Market Investment Strategies

Equity-market investment strategies followed by Category III AIFs represent a diverse and complex matrix formulated by the investment manager. These strategies state the nature of positions to be taken in equities or derivative contracts, using equities or equity indices as the underlying asset.

The strategy may involve taking:

1. Only Long positions in equities.
2. Short positions in equities.
3. A combination of both types of positions.

The primary types of equity-market strategies include Long-only, Long-Short, Market-Neutral, and Directional/Short-bias. This Part 1 notes will cover the Long-only and Long-Short strategies in comprehensive detail.

3. Long-Only Equity Strategy

3.1 Definition and Core Philosophy

The Long-only Equity Strategy focuses on delivering absolute returns for investors over the medium to long-term, with a strong emphasis on capital preservation.

In a Long-only Strategy:

• Buy Orientation: The Category III AIF manager takes a long position, or a "buy" position, in the selected stocks.
• No Shorting at Inception: The manager would generally not take a short position, or a "sell" position, in the selected stocks at the time of initial investments.
• Fundamental Selection: Stock selection is conducted using a highly disciplined top-down or bottom-up fundamental approach. The ultimate goal is to invest in companies possessing predictable, scalable, and high-quality business models.
• Analytical Parameters: To identify suitable companies, the investment manager conducts rigorous fundamental research, analysing critical historical data of the target companies, including:
  • Dividend payouts
  • Return on Capital Employed (ROCE)
  • Other critical financial and balance sheet parameters

3.2 Hedging Mechanics in a Long-only Strategy

Despite a strict fundamental focus, equity markets are inherently volatile. To protect the fund against systemic downfall, a prudent investment manager will implement hedging positions to minimize the market risk due to a decrease in the value of a stock.

• Execution of Hedge: Hedging positions are taken by establishing opposite positions—specifically, a Sell position—in a Futures or Options contract of the stock or index under consideration.
• Derivative Instruments Used:
  • Short Futures: Taking a short position in a Futures contract of the stock or index.
  • Buying Puts: Buying a "Put" option, where the underlying asset has similar characteristics as the reference asset in the portfolio.
• Inherent Volatility: Even with robust hedging positions, a Long-only Strategy remains highly volatile and risky during severe economic downturns.

4. Example 1: Long-Only Strategy in Action (Fund FGH)

To understand the practical application of a Long-only strategy, we examine Fund FGH, a Category III AIF that invests in large-cap and mid-cap stocks.

4.1 Portfolio Holdings (As on April 01, 2023)

Table 7.1: Fund FGH Long Positions

Table 7.2: Fund FGH Hedging Positions

4.2 Portfolio Analysis and Rollover Mechanics

1. Unhedged Exposure: The total active long exposure in physical equities is Rs. 50 crore, spread across four large-cap and two mid-cap stocks.
2. The Hedging Rationale: Given the volatile nature of the stock market, the investment manager establishes a hedging position against potential future downfalls.
3. Index Hedging: Using broad-based indices like NIFTY50 or S&P BSE SENSEX can partially hedge the inherent market risk of the fund.
4. Efficiency of Options vs. Futures: For hedging purposes, Options can prove to be more efficient than Futures. This is because buying Put options limits the downside (the premium paid) while leaving the upside potential of the equity portfolio intact.
5. Rollover Mechanics: The Put option in Example 1 has an expiry of December 31, 2023, which is nine months from the purchase date. To maintain protection over the long-term holding period of the equities, these option contracts must be rolled forward to a future expiry date.
6. Dynamic Adjustment: The hedging positions, type of contracts, and indices used must be adjusted and changed on a regular basis to accurately replicate and offset the changing risk characteristics of the active investment portfolio.

5. Long-Short Equity Strategy

5.1 Definition and Core Philosophy

The Long-Short Equity Strategy focuses on delivering absolute returns by simultaneously identifying overpriced and under-priced stocks relative to the investment manager's fair valuation.

• Fair Valuation Process: The investment manager determines the fair valuation of target stocks by conducting detailed fundamental analysis and factoring in:
  • Macroeconomic indicators
  • Industry-specific factors
  • Implemented and proposed government reforms
• Absolute Flexibility: Unlike Long-only managers, a Long-short manager has the structural freedom to take:
  • A Long ("Buy") position in stocks deemed to be under-priced.
  • A Short ("Sell") position in stocks deemed to be over-priced.
• Active Shorting at Inception: Short positions can be established at the time of initial stock investments, providing immediate hedging capabilities.
• Instrument of Execution: Short positions are typically executed by trading through Options and Futures contracts on the underlying equity assets.

5.2 Mechanics of "130/30" and "120/20" Funds

Long-short funds are frequently referred to as 130/30 or 120/20 funds. This notation represents a specific leverage and exposure structure:

• 130/30 Structure Explained:
  • Long Exposure: The investment manager invests 130 percent of the total investable funds in long equity positions.
  • Short Exposure: The manager simultaneously short-sells individual securities equal to 30 percent of the total investable funds.
  • The Funding Mechanism: The 30% cash proceeds generated from short-selling securities are used to purchase the additional 30% of long positions, requiring no additional capital from investors.
  • Net Market Exposure Formula: Net Exposure = Long Positions (%) - Short Positions (%) Net Exposure = 130% - 30% = 100% This ensures that the net exposure to the market remains exactly equal to 100 percent of the total investable funds.

5.3 Risk and Leverage Limits (SEBI Mandate)

While the long-short structure creates a natural hedge against broad market risk (especially if long and short positions are established in stocks with similar characteristics or within the same industry sector), it also introduces unique risks:

• Downside Risks: The strategy can be highly volatile and risky during severe economic downturns.
• Leverage Risk: Excessive leverage and short positions can drastically increase the volatility and risk of the fund.
• SEBI Statutory Exposure Limit: To prevent systemic risk, SEBI strictly restricts the leverage taken by Long-Short Category III AIFs.
  • The Rule: The total gross exposure of the fund in both long positions and short positions (net of any permitted offsetting positions) shall not exceed 2 times (200%) the Assets under Management (AUM) of the fund.

6. Example 2: Long-Short Strategy in Action (Fund TCR)

We examine Fund TCR, a Category III AIF employing a Long-short equity strategy investing in large-cap and mid-cap stocks, alongside derivative contracts.

6.1 Portfolio Holdings (As on April 01, 2023)

Table 7.3: Fund TCR Active Positions

6.2 Portfolio Analysis and Strategic Evaluation

1. Large-Cap Segment:
   • Total Large-cap Longs (Company B + D) = Rs. 25,00,00,000
   • Total Large-cap Shorts (Company C) = Rs. 7,50,00,000
   • Net Large-cap Exposure = 25,00,00,000 - 7,50,00,000 = Rs. 17,50,00,000
2. Index Hedging: The risk is further hedged by holding Put options in NIFTY50 with a total premium value of Rs. 1,12,50,000.
3. Mid-Cap Segment:
   • Total Mid-cap Longs (Company E) = Rs. 5,00,00,000
   • Total Mid-cap Shorts (Company F) = Rs. 9,30,00,000
   • Net Mid-cap Exposure = 5,00,00,000 - 9,30,00,000 = Rs. (4,30,00,000) (Net Short)
4. Critique of the Hedge Efficiency:
   • Imperfection in Offsetting: While the manager has a buy position in Company E (Rs. 5 Cr) and a sell position in Company F (Rs. 9.3 Cr) within the mid-cap sector, these exposures do not perfectly offset the market risk.
   • Company-Specific Risk: Because the long and short positions are in different companies with potentially different betas, operational risks, and volatilities, the hedge is imperfect.
   • Sector Volatility: This net unhedged and mismatched exposure in the mid-cap segment can significantly increase the total risk, tracking error, and overall volatility of Fund TCR.

7. Key Terms and Exam-Relevant Terminology

• Absolute Return: The return that an asset or fund achieves over a period, focusing on positive gains independent of any market benchmark index.
• Alpha: The excess return generated by an active fund manager over and above the return generated by the chosen benchmark index.
• Long Position: A market position where an investor buys a security with the expectation that its price will rise in the future.
• Short Position: A market position where an investor sells borrowed securities, or enters a derivative contract, expecting the price of the underlying asset to fall.
• 130/30 Fund: A type of long-short fund that maintains 130% gross long exposure and 30% gross short exposure, resulting in 100% net market exposure.
• Rollover: The process of closing out an expiring derivative contract (such as a Put option) and opening a similar contract with a further expiration date to maintain a continuous hedge.
• ROCE (Return on Capital Employed): A financial ratio that measures a company's profitability and the efficiency with which its capital is employed, heavily analysed by Long-only managers.

8. Part 1 Key Takeaways

1. Medium-to-Long Horizon: Category III AIFs are long-term pooled investment vehicles and generally do not engage in high-frequency, intra-day trading.
2. Long-Only Philosophy: Long-only equity strategies focus on capital preservation, requiring deep fundamental research (ROCE, dividends) to buy scalpable models, using index put options for downside protection.
3. Long-Short Flexibility: Long-short strategies enable shorting from inception using derivatives to create natural hedges. They can amplify returns using synthetic leverage (like the 130/30 structure).
4. SEBI Leverage Cap: To prevent excessive systemic risk, SEBI caps the gross leverage of Long-Short Category III AIFs at 2 times (200%) of the fund's total AUM.
5. Basis of the Hedge: Broad index options (like Put options) are frequently preferred over futures for portfolio hedging due to asymmetric payoff profiles. However, mismatched individual stock long-short pairs in volatile sectors (such as mid-caps) can escalate portfolio tracking risk and volatility.