Comprehensive Insights into Category I, II, and III Alternative Investment Funds (AIFs) in India

Posted On - 19 June, 2024 • By - King Stubb & Kasiva

The AIFs field in India has had important changes to its rules, made for managing different investment methods and securing the safety of investors.[1] This comprehensive research article thoroughly investigates the regulatory structure and investment tactics controlling Category I, II and III AIFs within India.[2]


A wide range of investment paths, from venture capital and private equity to real estate and hedge funds characterizes India’s alternative investment scenario. Alternative Investment Funds (AIFs) are key players in this environment as they direct funds towards fresh ideas and unique investment chances. The Securities and Exchange Board of India (SEBI) regulates AIFs, that function within a strong regulatory structure overseeing their creation process as well as operations along with investment tactics and

Regulatory Framework for AIFs:

The regulatory structure for AIFs in India is managed under the SEBI (Alternative Investment Funds) Regulations, 2012.[3] This categorizes AIFs into three primary groups depending on their investment goals, methods, and risk levels:

  1. Category I AIFs: These AIFs are specifically concentrated in startups, small-scale ventures, social initiatives, and other areas that have either a social or economic objective. They aid greatly to stimulate innovation, business ventures, and inclusive progress by giving monetary support to promising businesses with considerable growth possibilities. Within the first category, AIFs are divided into sub-categories like Venture Capital Funds (VCFs), Social Venture Funds and Infrastructure Funds. These have their own investment themes and goals.
  • Category II AIFs: In this kind of AIF, the investment strategy is wider and aims at different types of assets and investment methods like real estate, private equity, stressed debt or mezzanine financing.  These funds are made for knowledgeable investors who want to invest in alternative assets that offer good returns with manageable risks. AIFs in Category II consist of Private Equity Funds, Debt Funds, Real Estate Funds and Fund of Funds. They are designed for various investment interests and willingness to take risk.
  • Category III AIFs: This type is made for those who want to invest in complicated investment plans, trade derivatives and find opportunities for arbitrage. These funds use advanced trading methods, number-based models, and risk control tactics to create profits during unstable market situations. Category III AIFs[4] are famous for being flexible, nimble, and skilled at exploiting market timperfections in different kinds of assets.

Investment Strategies of Category I AIFs:

  • Venture Capital Investments: Category I AIFs, specifically those centred on startups and early-stage ventures, frequently utilize a substantial part of their money in venture capital investments. The goal behind these investments is to offer important financial support for creative new businesses that have great potential for growth – they are typically found within technology, healthcare, fintech as well as consumer goods areas.
  • Social Impact Investing: AIFs of Category I also take part in a notable investment method called social impact investing. Here, funds are assigned to projects and businesses that bring about beneficial social or environmental results along with monetary gains. These investments might focus on fields such as education, health care, rural advancement, and sustainable energy production. They match with the goals of sustainable growth and general welfare for society (Securities and Exchange Board of India).
  • Development of Infrastructure: AIFs in Category I can be focused on investments related to infrastructure. They may direct money into crucial infrastructure plans like transportation, energy, water supply, and telecommunications. Such investments are significant for filling up the gaps in infrastructure, helping economic development, and improving connections and availability between different areas.
  • Start-up Funding: Category I AIFs often concentrate on giving initial-stage finance to potential startups and entrepreneurs, aiding them in handling the difficult early stages of business growth. These types of investments usually consist of seed money, angel funds, as well as series A funding rounds with the goal being to encourage innovation along with entrepreneurship while also generating jobs.

Procedures and Compliance Mechanisms for Category I AIFs:

  1. Registration and Regulatory Approval: Category I AIFs need to register with SEBI to start their operations.[5] The procedure for registration includes placing on record comprehensive documents like the investment plan of the fund, its organizational setup, profiles of important staff members, and compliance policies. The application is checked by SEBI according to regulatory factors. These include criteria for promoters and managers, risk management systems’ sufficiency, and how well they link with investor benefits.
  • Disclosure Requirements: Category I AIFs require strict adherence to disclosure requirements for clearness and safeguarding of investors. These needs involve making ready and spreading placement memoranda, offering documents, periodic reports and financial statements. Also, AIFs must reveal facts about their investment collection, methods for managing risks, fee systems, and any possible conflicts of interest.[6]
  • Investment Limits and Risk Control: SEBI puts specific investment limits and risk control policies on Category I AIFs so as to protect the investors and keep the market’s honesty. These limits can be about how much they can invest in certain asset classes, danger from concentrating investments, leverage or borrowing levels, as well as counterparty exposures. AIFs should establish strong frameworks for managing risk, internal control systems, and compliance processes. This is necessary to keep track of and decrease investment risks.
  • Monitoring Compliance and Making Reports: AIFs of Category I must maintain continuous monitoring of compliance and make reports to guarantee that they follow regulatory standards and the finest methods. This involves regular reporting, both to SEBI as well as the investors on aspects such as investment actions, performance measures, spreading out of holdings in portfolios, and fulfilling all regulations. It is necessary for AIFs to choose competent auditors who will carry out yearly audits and give their audit reports to SEBI and investors.

Investment Strategies of Category II AIFs:

  • Diversified Investment Approach: Usually, Category II AIFs use a broad investment strategy that aims at different kinds of investment chances in many sectors and assets classes. These funds can put money into existing businesses, struggling assets, real estate plans, private equity deals, and special situation possibilities to make the most of market weaknesses or new developments because they have the ability to adapt and knowledge.
  • Real Estate Investments: Category II AIFs often use the strategy of real estate investments, which involves commercial, residential, and industrial properties as well as those related to hospitality. This kind of investment can be about buying directly, development projects or even partnerships and organized financial plans with an aim to create rental income along with raising capital value and providing a variety of advantages for the investors.
  • Special Situation Opportunities: Category II AIFs are frequently interested in special situation opportunities like restructuring, turnarounds, distressed debt, and event-driven investments. These changes come up due to corporate restructurings as well as mergers and acquisitions among other things such as shifts in regulations or market disruptions, all of which have the potential to bring about appealing returns on investment when combined with active management of assets and increase in value strategies.
  • Private Equity Transactions: Category II AIFs concentrate on private equity transactions, which encompass investments into companies not publicly traded yet and at different phases of development and maturity. These transactions might involve growth capital, buyouts, recapitalizations as well as secondary market deals with the goal to generate value via operational enhancements, strategic activities while ultimately exiting through Initial Public Offerings or trade sales.

Procedures and Compliance Mechanisms for Category II AIFs:

  1. Registration and Regulatory Approval: Like Category I AIFs, Category II AIFs also need to get registration from SEBI before starting their work. This process of getting registered includes a careful examination by SEBI to check whether they meet all rules set up by law, match with investor benefits, and have fitting investment methods. Fit and proper criteria are applied to AIF managers and important team members, confirming honesty, capability, and financial stability.
  • Disclosure Requirements: Category II AIFs are subject to the extensive disclosure requirements set by SEBI which cover the preparation and distribution of placement memoranda, offering documents, periodic reports as well as financial statements. These disclosures supply investors with crucial details about the fund’s investment approach, risks involved, fees structures and performance indicators and governance setup.
  • Investment Restrictions and Risk Management: For controlling investment risks and protecting investor interests, SEBI applies particular investment restrictions and risk management procedures on Category II AIFs. These limitations can be about the usage of leverage, risks from too much focus in one area, potential for illiquid assets exposure, or following prudential norms.
  • Operational Conditions: SEBI sets out various operational conditions that Category II AIFs must comply with. These include rules regarding the appointment of custodians or debenture trustees, ensuring compliance with anti-money laundering regulations, adhering to valuation norms as well as dealing with conflict-of-interest situations.
  • Reporting Requirements: Category II AIFs are required to submit regular reports to SEBI[7] containing details about their activities within a specified timeframe. This is important for regulatory purposes and helps monitor compliance with these funds.
  • Periodic Reporting to Investors: Category II AIFs are obligated to provide periodic reports to their investors detailing the fund’s performance, financial status, and any other significant changes or matters affecting them. 
  • Valuation Guidelines: To ensure fair valuation of assets held by Category II AIFs, SEBI has put in place specific guidelines that they must follow when valuing such assets.
  • Investor Grievances: If an investor has a complaint against a Category II AIF that is not resolved at the fund level within thirty days of lodging it then this can be brought directly before SEBI for further action if necessary.
  1. Treatment towards Investor Fund Requests: If an investor submits his request for redemption of units within five business days prior to the close-ended scheme maturity date, then he will receive repayment after the period comes into effect on maturity day provided there are no unusual circumstances affecting liquidity (SEBI). AIFs must put into action strong frameworks of risk management, internal controls, and procedures for compliance to oversee the investment risks thoroughly.
  • Checking and Reporting Compliance: Category II AIFs must go through continuous monitoring of their compliance and reporting, so as to make certain they stick to the set rules of the law and good methods. This involves consistent reporting towards SEBI as well as investors about investments made, portfolios’ performances along with risks measurements, following regulations correctly and finally governance practices. There is also the rule that AIFs must choose suitable auditors to perform yearly audits and give audit reports to SEBI and investors.

Investment Strategies of Category III AIFs[8]:

  • Trading of Derivatives: Category III AIFs may have a special focus on the trading of derivatives. They can use complex methods like options, futures, swaps and other derivative tools to benefit from market imperfections, variation in prices and opportunities for arbitrage. These funds might take part in strategies for trading that involve direction, volatility or hedging with the goal of creating alpha and improving portfolio returns.
  • Complex and Structured Products: Category III AIFs can put their money into complex and structured products like structured notes, credit-linked notes, collateralized debt obligations as well as asset-backed securities. These kinds of items give exposure to specialized market segments along with credit risks and return profiles which help in diversifying the portfolio of AIFs while also maximizing risk-adjusted returns.
  • Arbitrage and Market Neutral Strategies: These kinds of strategies, which are often used in Category III AIFs, concentrate on profit from differences in prices and values. They do this by exploiting imbalances or mispricing that exist between various markets, asset types, instruments such as stocks bonds, etc. The actions involve buying and selling of securities at the same time to gain risk-free earnings regardless if it’s a bull or bear market with high or low volatility levels.
  • Driven by Events and Opportunities for Investments: Category III AIFs can follow event-driven and opportunistic investments. They take advantage of corporate events, changes in regulations, disruptions in the market and big-picture economic trends to make better returns possible. These types of investments might involve mergers and acquisitions, restructurings, special circumstances situations as well as troubled debt with chances for turnaround among others – using the fund’s flexibility & nimbleness to seize on changing market situations plus up-and-coming investment concepts.

Procedures and Compliance Mechanisms for Category III AIFs:

  1. Sign up and Regulatory Permission: For a Category III AIF, it’s necessary to get registered with SEBI before starting activities. This involves following strict rules and standards of regulation. SEBI examines the fund’s investment plan, its way of handling risk, how it is organized and run along with its governance practices – all these things are checked by them for making sure everything matches investor interests, market integrity as well as regulatory goals.
  • Capital Requirement: The minimum capital needed for setting up a Category III AIF is twenty crore Indian Rupees or more than that by the regulator.
  • Risk Disclosure: The sponsor or manager must provide detailed information about the fund’s strategy, potential risks involved in its investments, and other related aspects to investors before they make any commitment.
  • Valuation Policy: Category III AIFs should follow a valuation policy that is fair and transparent while valuing their assets periodically or when needed based on guidelines from SEBI.
  • Reporting Obligations: Fund managers have an obligation to send regular reports about their funds’ performance, liquidity positions as well as other important matters to investors within required time periods specified by regulations set forth (SEBI).
  • Limitation of Leverage Usage: Use of leverage in Category III funds cannot exceed two times net asset value (NAV) in all instances.
  • Conflicts Rules & Frameworks for Resolution: Category III Alternative Investment Funds must adhere strictly to conflict resolution rules framed by the Securities Exchange Board India (SEBI). The board has laid out specific frameworks that govern the conduct of related party transactions between such entities so there can be no biased dealings amongst themselves without appropriate checks being put into place first off which includes maintaining records approve them later on during periodic review meetings among others areas like this requiring close monitoring too etcetera[9]
  • Recapitalization Period Limit: If any investee company’s shares are not listed on stock exchanges after five five-year period since investment time then this will be treated as category 3 AIF’s default risk event triggering mandatory recapitalization action taken against said firm according to provisions outlined under Chapter IV Clause 11 of Regulation.
  1. Custodian Requirement: All categories of Alternative Investment Funds must appoint custodians who hold assets purchased using money pooled together from various sources including investors themselves; these parties act independently safeguarding said properties until further instructions are issued either by board member administrators who oversee the entire process involved here like transferring ownership deeds over etcetera through joint signatories designated person tasked specifically handle such duties ongoing basis etcetera per an ongoing agreement signed beforehand among involved parties.
  • Capital Contribution Lock-In Period: Members who commit their capital into an alternative investment fund need to keep it locked in for at least three years from when they begin investing; nothing can touch these monies during this time period except if there some certain circumstances stated under regulations made by Securities Exchange Board India (SEBI).
  • Disclosure Requirements: Category III AIFs must follow SEBI’s detailed disclosure rules, which involve creating and sharing placement memoranda, offering documents along with periodic reports and financial statements. These disclosures offer crucial information to investors about the way the fund manages its investments, risks involved in investment decisions, performance data, fee details as well as governance methods used – all contributing towards making informed choices and promoting transparency.
  • Investment Limits and Risk Control: SEBI requires Category III AIFs to follow some specific investment limits and risk management rules, helping reduce risks in these funds and protect investor benefits. The limitations could involve controlling leverage, managing exposure towards derivatives, dealing with concentration risk as well as following prudential norms. AIFs should put in place strong risk management systems, internal controls and compliance checks to observe, gauge and handle investment risks properly.
  • Monitoring and Reporting Compliance: Category III AIFs are under continuous monitoring for compliance, needing to meet regulatory rules, top methods, and business norms. They must often report on investment actions, portfolio results along with risk measures as well as meeting rules set by SEBI (Securities Exchange Board of India), plus governance practices to both SEBI and their investors. The AIFs must also assign competent auditors for yearly audits, and these reports need to be submitted to SEBI as well as the investors. This adds more clarity and responsibility.

Moving Forward:

In the changing scene of India’s alternative investments, AIFs are becoming more important for gathering capital, encouraging new ideas, and promoting economic progress. The rules set by SEBI make a strong base from which AIFs can work honestly, openly, and with responsibility. This creates safety for investors and stability in the market.

Leveraging the upcoming chances and dealing with the changing market movements, AIFs need to keep their investment strategies, risk handling methods, and compliance setups flexible, adjustive, and future-oriented. By encouraging originality, adopting good methods, and promoting a culture of constant enhancement, AIFs can open fresh paths for expansion. They also have the ability to provide long-lasting value to those who invest money in them while participating in India’s larger economic growth plan.

To sum up, the rules and methods for investing in Category I, II, and III AIFs in India show a coming together of regulatory supervision, industry norms, and what investors hope to see. The funds’ commitment to the rules set by regulators, their focus on principles of responsible investing as well as good governance practices are all crucial elements that help them fulfil their goal of providing better risk-adjusted returns while also encouraging financial involvement along with new ideas for sustainability within India’s constantly changing investment scene.

[1] Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012, India Gaz. Extra ord., Pt. II, Sec. 3(II) (May 21, 2012), as amended.

[2] Regulation 2(1)(b), Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[3] Regulation 3(4)(a) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012

[4] SEBI (Alternative Investment Funds) Regulations 2012, FAQs (

[5] Regulation 3(4)(b) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012

[6] SEBI, Circular No. SEBI/HO/AFD/PoD1/P/CIR/2023/130 (Chapter 15-17) (

[7] Regulation 3(4)(c) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012

[8] SEBI Order dated February 17, 2020 bearing reference Order/SR/PP/2019-20/6814-6818/172-176

[9] Securities Contracts (Regulation) Act, 1956, No. 42, Acts of Parliament, 1956 (India), as amended.

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