Decoding AIFs In India: An Introduction To Category I And II AIFs

Posted On - 18 June, 2024 • By - King Stubb & Kasiva


An Alternative Investment Fund (AIF) in India refers to a privately pooled investment vehicle that gathers funds from sophisticated investors—both Indian and foreign—for investment in accordance with a defined investment policy for the benefit of its investors. These funds are not available to the general public and cater to a niche group of investors such as institutions and high-net-worth individuals (HNIs) who are capable of understanding and handling higher risks and complex investment strategies.

About AIFs:

Alternative Investment Funds (AIFs) are a distinct category of investment vehicles that pool capital from sophisticated private investors. These funds deploy the collected capital in line with their specified investment policies, targeting non-traditional asset classes that lie outside the scope of conventional investments such as equities or fixed income. Unlike mutual funds, AIFs in India operate under a unique regulatory framework defined by Regulation 2 (1) (b) of the Securities and Exchange Board of India (SEBI) Regulation Act, 2012. They can be structured as companies, Limited Liability Partnerships (LLPs), corporate bodies, or trusts.

SEBI classifies AIFs into three broad categories: Category I, Category II, and Category III. Each category encompasses various investment strategies, including private equity, venture capital, hedge funds, and angel funds, among others. These categories define the nature and scope of the investments AIFs can pursue, allowing for a diverse range of sophisticated investment opportunities.

Investing in AIFs typically requires higher minimum investments and fees compared to traditional investment options. The asset classes within AIF portfolios are often rare and illiquid, making valuation challenging. Furthermore, AIFs are not publicly traded and have limited investor accessibility, contributing to their illiquid nature. Despite these complexities, AIFs benefit from lower transaction costs due to their reduced turnover rates. However, they face restrictions on advertising and public information disclosure, limiting their visibility to potential investors.

Key Characteristics and Exclusions:

1. Privately Pooled: AIFs collect funds from a select group of investors, differentiating them from mutual funds and collective investment schemes, which pool money from the general public.

2. Regulatory Exclusion: The Securities and Exchange Board of India (SEBI) regulates AIFs under the SEBI (Alternative Investment Funds) Regulations, 2012. These regulations ensure that AIFs operate within a structured and transparent framework, protecting investor interests and maintaining market integrity. AIFs are distinct from mutual funds governed by the SEBI (Mutual Funds) Regulations, 1996, and collective investment schemes regulated under the SEBI (Collective Investment Schemes) Regulations, 1999. Additionally, AIFs do not include:

  • Family trusts set up for the benefit of relatives as defined by the Companies Act, 1956.
  • Employee welfare trusts or gratuity trusts set up for employee benefits.
  • Holding companies as defined by the Companies Act, 1956.
  • Special Purpose Vehicles (SPVs) for securitization or other specific purposes.
  • Funds regulated by other regulatory bodies such as the Reserve Bank of India (RBI), Insurance Regulatory and Development Authority of India (IRDAI), Pension Fund Regulatory and Development Authority (PFRDA), or the International Financial Services Centres Authority (IFSCA).

Types of AIFs:

AIFs can be categorized into three broad categories under SEBI regulations:

Category I AIFs: These funds typically invest in start-up or early-stage ventures, social ventures, SMEs, infrastructure, or other sectors or areas which the government or regulators consider as socially or economically desirable.

  • Venture Capital Funds: Invest in early-stage companies with high growth potential.
  • Angel Funds: A sub-category of venture capital funds that raise capital from angel investors to invest in start-ups.
  • SME Funds: Target investments in small and medium-sized enterprises.
  • Social Venture Funds: Invest in companies with a strong social impact
  • Infrastructure Funds: Focus on infrastructure projects like roads, ports, airports, etc.

      Category II AIFs: These include private equity funds, debt funds, and funds that do not fall under Category I or III and do not undertake leverage or borrowing other than to meet day-to-day operational requirements. Types of Category II AIFs include:

      • Private Equity Funds (PE Funds): Invest in privately held companies and are involved in buyouts, growth capital, and venture capital.
      • Real Estate Funds: Invest in real estate projects.
      • Funds for Distressed Assets: Invest in non-performing or troubled assets with the intention of restructuring and reviving them.

        Category III AIFs: These funds employ diverse or complex trading strategies and may leverage investment opportunities such as hedge funds. Types of Category III AIFs include:

        • Hedge Funds: Employ various strategies to generate high returns for investors, often involving leverage and derivatives.
        • PIPE Funds: Invest in private investment in public equity, purchasing stocks of publicly traded companies at a discount.

        Benefits of AIFs:

        Investing in Alternative Investment Funds (AIFs) offers numerous advantages, making them an attractive option for sophisticated investors seeking to diversify their portfolios and achieve higher returns. One of the primary benefits of AIFs is their potential for high growth. The substantial corpus amount that AIFs typically manage provides fund managers with the flexibility to explore innovative strategies and high-potential investment opportunities, maximizing the returns for investors. This potential for superior returns is often higher than that of traditional investments due to the fund managers’ ability to access and capitalize on niche markets and unique asset classes.

        Additionally, AIFs offer significant diversification benefits. Unlike traditional investment vehicles that may focus predominantly on equities or fixed income, AIFs invest across a wide range of asset classes, including private equity, venture capital, hedge funds, real estate, and more. This diversification reduces the overall risk of the investment portfolio, as the performance of AIFs is not solely dependent on the stock market. Consequently, during periods of high market volatility, AIFs provide a stabilizing effect, protecting the investments and reducing the impact of market fluctuations.

        Furthermore, AIFs are typically less volatile than pure equity investments, thanks to their diversified nature and inclusion of alternative assets that do not correlate directly with the stock market. This stability makes AIFs an excellent choice for investors seeking to balance their portfolios and mitigate risk. Another compelling reason to invest in AIFs is the opportunity for better returns. Alternative investments, by their nature, often have higher growth potential and can yield significant returns compared to more conventional investment options. Finally, AIFs can serve as a valuable source of passive income.

        The structured nature of AIFs, which includes periodic distributions from investments such as real estate or private equity, allows investors to enjoy a steady stream of income without the need for active management. This makes AIFs an attractive option for investors looking to generate passive income while benefiting from professional fund management and diversified exposure to various asset classes.


        In summary, an AIF is a specialized investment vehicle designed for sophisticated investors who can navigate higher-risk and more complex investment landscapes, with regulatory oversight provided by SEBI to ensure compliance and protect investor interests. The classification of AIFs into Categories I, II, and III provides a structured approach to cater to various investor needs and investment strategies, from early-stage venture investments to complex, high-leverage trading activities.

        King Stubb & Kasiva,
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