By Siddarth PAI
The 2030s will be the decade that alternatives go mainstream. Globally, the alternatives industry consists of any asset class that doesn’t fall in the traditional three, being stocks, bonds or cash. The role of alternatives is to create diversification in an investment portfolio and to act as a hedge against the movements of the traditional asset classes—a role which the industry dominated during Covid-19. The increased volatility of listed equities in 2020-21, historic low-interest rates that caused negative yields amongst $28 trillion of the $42 trillion outstanding bonds in 2020, and inflationary pressures as the Central Banks begin to taper their stimulus programs has engendered uncertainty worldwide. This is further compounded by the Russia-Ukraine conflict, a mid-term election in the US, and other global cues. Alternatives are the most effective way to eke out alpha (outsized returns) in such an environment.
India, in true Indian fashion, leapfrogged several asset classes to embrace alternatives in 2012, when SEBI ushered in the alternatives framework in India. In India, the traditional three asset classes have been FDs, gold, and mutual funds. The pandemic, which saw over 2.6 million Demat accounts open monthly, also saw India’s tally of unicorns (billion-dollar private companies) double and saw a record-breaking Rs 5.5 trillion of investments by private equity and venture capital in India. This is only the beginning.
The alternatives industry in India is dominated by venture capital funds, private equity funds, hedge funds, venture debt funds and, now, special situation funds. The asset classes they straddle range from start-ups to pre-IPO companies, derivative-led hedge fund strategies, debt financing across stages and various forms of cover and hybrids of the above. The flexibility in investment strategies afforded to fund managers allows for great variety amongst the 864 AIFs registered with Sebi. The alternatives space is predicated on two important principles: Innovation always outstrips policy and regulations, and capital is cowardly.
Alternatives have funded many business models which have exposed the shortcoming of regulations worldwide. Ride-hailing was sought to be banned in cities worldwide until passenger protests caused governments to reconsider the same and seek to regulate them under separate categories. In India, e-pharmacy companies faced huge pushback before the pandemic, where they were welcomed as essential services and helped distribute medicines across the populace. The tension between the gig economy’s stance of “independent contractors” vs “employees” will reshape labour relations worldwide. But in time, governments acknowledge the power of disruption and seek ways to work with the industry to ensure that the role of government is not impinged by such changes.
The role of innovation outstripping regulations feeds into the second principle—that capital is cowardly. The risk in investing is split into two kinds: systematic risk (that affects all markets) vs unsystematic or specific risk (that affects only one segment). Investors accept systematic risk, as it usually can’t be avoided, but specific risk causes investors to sit on the sidelines until matters improve. Specific risk is an idiosyncratic risk, isolated to a particular state, sector or even company—it is solved as a function of time or a change in regulation. India has often borne the brunt of such specific risk in the form of the ‘India premium”, an increase in returns demanded by investors investing in India due to the specific risks associated with investing in India. To the credit of the government and Indian regulators, this India premium is now being used to describe the alpha the country generates as opposed to the higher returns for taking India-specific risk. The past few years in India have seen various regulatory changes to simplify investing in India—from broad basing FDI into most sectors automatically, creating single-window clearance regimes, clarifying principles of taxation and removing the retrospective tax that crept into the tax code in 2012 to creating performance-linked incentives for various sunrise sectors.
The government has taken this one step forward in Budget FY23 by announcing the creation of an expert committee to conduct “a holistic examination of regulatory and other frictions” that affects the private equity and venture capital industry. This step signals the intent of the government to support the alternatives industry and is a sign that the industry is viewed as a partner in nation-building and economic development. The Indian government is also viewing the PE/VC model as a means of allocating capital to important sectors through market-determined means, by instituting funds of funds for sectors such as agriculture, deep-tech, etc.
Alternative investment solve the supply-side of mainstream investing by creating companies of scale that can attract mainstream and retail investors. For a country that aims to grow to a $5 trillion GDP by 2025, the alternatives and the innovation economy are expected to contribute $1 trillion to this goal. That is the power that alternatives possess and the potential they will reach this decade.
The author is Founding partner, CFO, ESG officer, 3one4 Capital, and co-chair, Regulatory Affairs Committee, IVCA