Alternative Investment Funds (AIFs) have become a vital component of India’s financial ecosystem, offering investors access to professionally managed, diversified investment vehicles outside traditional markets. Governed by the Securities and Exchange Board of India (SEBI) under the SEBI (Alternative Investment Funds) Regulations, 2012, AIFs pool capital from domestic and foreign investors and deploy it in accordance with a clearly defined investment strategy. Typically established as trusts, limited liability partnerships (LLPs), or companies, these funds operate under a strong legal and governance framework, ensuring transparency and investor protection.

To create a well-balanced regulatory environment, SEBI classifies AIFs into three categories Category I, II, and III each defined by its investment objective, leverage limit, and risk exposure. This classification helps regulate the fund’s activities, ensuring accountability while offering flexibility in portfolio management. Understanding these distinctions enables fund managers and investors to align their risk appetite, investment horizon, and strategic goals within SEBI’s robust compliance framework.

In this article, CA Manish Mishra talks about Differences Among AIF Categories I, II & III: What Fits You Best.

Legal Framework Governing AIFs

The legal framework for Alternative Investment Funds (AIFs) in India is primarily established under the SEBI (Alternative Investment Funds) Regulations, 2012. These regulations govern how AIFs are formed, registered, and managed. They are supplemented by the SEBI Master Circular for AIFs (May 7, 2024) and further amendments introduced in 2025, which collectively ensure transparency, investor protection, and accountability.

• Form A (First Schedule): This is the application form that an entity must submit to SEBI to register as an AIF. It contains details about the fund structure, management, investment strategy, and key personnel.

• Form B: Once SEBI approves the application, it issues this certificate of registration, allowing the fund to operate as a recognized AIF.

• Second Schedule: It lists the fees payable for registration and for filing any new investment schemes thereafter.

In 2025, SEBI brought in several key amendments to modernize and strengthen the regulatory environment:

• Co-Investment Schemes Framework (Regulation 17A): Introduced rules for investors to co-invest alongside AIFs under transparent governance.

• Revised Angel Fund and Private Placement Memorandum (PPM) Norms (September 2025): Enhanced disclosure standards for angel funds and mandated detailed risk and valuation disclosures in PPMs.

• Specialized Investment Funds (February 2025): Introduced a new category of AIFs focusing on niche sectors like sustainable finance and innovation-driven enterprises.

Together, these reforms have expanded investor participation, improved fund governance, and ensured that AIF operations align with SEBI’s emphasis on transparency, investor confidence, and market integrity.

Category I AIFs: Supporting Early-Stage and Developmental Investments

Legal Definition

Under Regulation 3(4)(a) of the SEBI (Alternative Investment Funds) Regulations, 2012, Category I AIFs are those funds that invest in sectors considered socially or economically beneficial to India. These include startups, early-stage ventures, small and medium enterprises (SMEs), social ventures, and infrastructure projects. SEBI provides favorable regulatory treatment to these funds as they promote innovation, job creation, and social impact.

Investment Strategy

The core objective of Category I AIFs is to stimulate entrepreneurship and innovation in priority sectors. They primarily invest in unlisted entities and developmental projects that require patient capital. Within this category, there are sub-types:

• Venture Capital Funds (VCFs): Focus on startups and emerging businesses.

• Angel Funds: Pool investments from angel investors for early-stage companies.

• Social Venture Funds: Invest in businesses creating measurable social impact.

• Infrastructure Funds: Finance projects like roads, energy, and logistics.

• SME Funds: Support small and medium enterprises with growth capital.

Legal and Financial Features

• Minimum Corpus: ₹20 crore for general Category I AIFs; ₹10 crore for Angel Funds.

• Leverage: Permitted only for routine operational purposes, ensuring conservative risk management.

• Tenure: Close-ended with a minimum duration of three years, ensuring long-term commitment.

• Investment Limit: Cannot invest more than 25% of its investable corpus in a single company to avoid concentration risk.

• Sponsor Commitment: The sponsor must contribute at least 2.5% of the corpus or ₹5 crore, whichever is lower, to ensure alignment of interest.

Tax Treatment and Ideal Investors

Category I AIFs enjoy a pass-through status under the Income Tax Act, 1961. This means that income (other than business income) is taxed directly in the hands of investors, avoiding double taxation at the fund level.

They are best suited for investors seeking to participate in high-growth and innovation-driven sectors, including technology, clean energy, healthcare, and social enterprises. These funds not only promise potentially higher returns but also align with government initiatives such as Startup India and Make in India.

Category II AIFs: Private Equity and Debt-Oriented Structures

Legal Definition

As per Regulation 3(4)(b) of the SEBI (Alternative Investment Funds) Regulations, 2012, Category II AIFs comprise all funds that are neither Category I nor Category III and do not use leverage, except for day-to-day operational needs. These funds represent a broad category designed to provide long-term capital to unlisted, growth-stage, and mature businesses through structured investment approaches such as private equity and private debt.

Investment Strategy

Category II AIFs primarily target unlisted companies, growth-stage enterprises, and real estate or debt-linked opportunities. They focus on value creation over the medium to long term by providing both capital and strategic support. Most Private Equity (PE) Funds, Debt Funds, and Real Estate Funds fall under this category. Their approach is typically conservative, focusing on risk-adjusted returns rather than speculative trading.

Notably, Category II AIFs form the largest segment of India’s AIF ecosystem by corpus, driven by participation from domestic institutions, family offices, and high-net-worth individuals seeking stable and predictable returns.

Legal and Regulatory Features

• Minimum Corpus: ₹20 crore (for each scheme).

• Leverage: Prohibited, except for short-term funding needs to manage liquidity.

• Tenure: Must be close-ended, with a minimum tenure of three years.

• Investment Limit: Cannot invest more than 25% of the fund’s investable corpus in a single investee company to ensure portfolio diversification.

• Sponsor Commitment: The sponsor must contribute at least 2.5% of the corpus or ₹5 crore, whichever is lower, ensuring alignment of interest between fund managers and investors.

• Reporting Norms: These AIFs are required to submit quarterly reports to SEBI and their investors, covering portfolio composition, valuation, and risk exposure.

Tax Treatment and Investor Suitability

Category II AIFs enjoy pass-through tax benefits similar to Category I AIFs under the Income Tax Act, 1961. This means that the income (except business income) is taxed directly in the hands of investors, avoiding double taxation.

These funds are ideal for long-term institutional investors, HNIs, and family offices looking to diversify their portfolios through exposure to private equity, debt instruments, or real estate assets. The focus on stable, structured, and long-term investments makes them particularly suitable for those aiming for consistent returns with moderate risk.

Category III AIFs: Hedge and Multi-Strategy Funds

Legal Definition

Under Regulation 3(4)(c) of the SEBI (Alternative Investment Funds) Regulations, 2012, Category III AIFs are investment funds that employ diverse, complex, and high-risk trading strategies with the objective of generating short-term or absolute returns. Unlike Category I and II AIFs, which focus on long-term capital formation, Category III funds actively trade in various instruments and make use of leverage, derivatives, and short-selling to maximize gains. These funds are comparable to hedge funds in global markets.

Investment Strategy

Category III AIFs adopt multi-strategy investment approaches, often combining equity, debt, derivatives, and structured products. They may invest in listed or unlisted securities, hybrid instruments, futures and options, and other financial derivatives to exploit market inefficiencies.
Their investment objective is not limited to long-term growth but rather focuses on absolute returns, irrespective of market direction whether bullish or bearish.

Common strategies include

• Long-short strategies (buying undervalued and shorting overvalued stocks)

• Arbitrage trading (profiting from price differences across markets)

• Event-driven strategies (targeting opportunities around mergers, buybacks, or restructurings)

Legal and Regulatory Features

• Leverage: Allowed with investor consent and within SEBI-prescribed limits, making these funds more flexible but also riskier.

• Tenure: Can be open-ended (allowing investors to enter and exit anytime) or close-ended, depending on the fund’s structure and investment model.

• Investment Limit: Investment in a single investee company is capped at 10% of the fund’s NAV, which can extend up to 20% for large-value accredited investors.

• Sponsor Commitment: The fund sponsor must contribute at least 5% of the corpus or ₹10 crore, whichever is lower, ensuring alignment of interest.

• Valuation & Custody: Category III AIFs must appoint independent custodians and valuers to ensure transparency and fairness. The Net Asset Value (NAV) must be disclosed quarterly to investors.

Taxation

Unlike Category I and II AIFs, Category III AIFs are taxed at the fund level, meaning there is no pass-through benefit. The income earned by the fund (capital gains, interest, or business income) is taxed in the hands of the fund itself before distributions to investors. This higher tax burden reflects the speculative and short-term nature of these funds.

Ideal Investors

Category III AIFs are best suited for high-net-worth individuals (HNIs), family offices, and institutional investors who have a high-risk appetite and seek superior, market-neutral, or absolute returns. These investors are typically sophisticated and capable of understanding complex investment instruments and associated risks.

Key Legal and Structural Differences Among AIF Categories

Recent Regulatory Updates (2024–2025)

Over the last two years, SEBI has significantly modernized the Alternative Investment Fund (AIF) framework to strengthen investor protection, enhance fund governance, and align Indian AIFs with global best practices. The reforms introduced between 2024 and 2025 address critical aspects such as co-investments, angel fund flexibility, and the introduction of a new investment vehicle the Specialized Investment Fund (SIF).

Co-Investment Schemes (Regulation 17A)

Introduced in September 2025, this amendment allows Category I and II AIFs to set up Co-Investment Vehicles (CIVs) that invest alongside the main fund in the same portfolio companies.

• Each co-investment scheme must file a Shelf Placement Memorandum with SEBI, accompanied by a ₹1 lakh filing fee per scheme.

• This mechanism ensures greater investor participation by enabling direct exposure to specific investments while maintaining regulatory oversight.

• The framework enhances transparency, ensures alignment between fund managers and co-investors, and provides flexibility for institutional investors seeking deal-level participation.

In essence, Regulation 17A formalizes co-investments that were previously done through informal arrangements, thereby improving accountability and documentation.

Angel Fund Reforms (2025)

In a bid to encourage more early-stage capital formation, SEBI’s 2025 reforms for Angel Funds have made key changes to ease operations and widen access.

• The investment limit per startup has been raised from ₹5 crore to ₹10 crore, allowing angel investors to back promising startups with larger cheques.

• SEBI has also extended the compliance timeline for Private Placement Memorandum (PPM) audits till April 2026, giving fund managers more time to adapt to the revised disclosure and reporting norms.

These changes reflect SEBI’s ongoing commitment to nurturing India’s startup ecosystem by simplifying funding structures and supporting innovation-led entrepreneurship.

Specialized Investment Funds (SIFs)

A major structural innovation, Specialized Investment Funds (SIFs) were introduced in February 2025 to cater to sophisticated and high-net-worth investors seeking advanced investment strategies.

• The minimum investment threshold for investors is set at ₹10 lakh.

• SIFs can operate under long-short or complex trading strategies, similar to global hedge funds, offering a more flexible regulatory framework.

• They are designed to attract international capital and enhance India’s competitiveness in the global alternative investment market.

This new category bridges the gap between traditional AIFs and hedge funds, allowing for experimentation with diversified strategies while maintaining investor safeguards.

Choosing the Right Category: What Fits You Best

Selecting the right Alternative Investment Fund (AIF) category is a crucial decision that depends on an investor’s financial goals, risk appetite, investment horizon, and liquidity preferences. Each category I, II, and III is designed for a distinct investor profile and investment objective, offering varying levels of risk, regulation, and return potential.

Category I AIFs – For Developmental and Impact-Focused Investors

Category I funds are ideal for investors who want to contribute to economic and social development while pursuing long-term capital appreciation. These funds invest in startups, SMEs, social ventures, and infrastructure projectsareas that promote innovation and nation-building.

• Best for: Impact-driven investors, government institutions, and development finance participants.

• Risk & Returns: Moderate to high, but aligned with government-priority sectors that often receive favorable policy support.

• Horizon: Long-term, typically 5–10 years, as these funds back early-stage ventures requiring patient capital.

Category II AIFs – For Stability and Structured Growth

Category II funds suit investors looking for steady and predictable returns through private equity or debt-oriented structures. These funds invest in mature, growth-stage companies or real estate, focusing on value creation rather than speculation.

• Best for: Institutional investors, family offices, and HNIs seeking diversification beyond public markets.

• Risk & Returns: Moderate, as these funds avoid leverage and invest in proven businesses with measurable growth potential.

• Horizon: Medium to long-term, often 4–7 years, depending on the investment strategy.

Category III AIFs – For Sophisticated and High-Risk Investors

Category III funds are designed for experienced and risk-tolerant investors who understand complex trading strategies and market volatility. These funds use leverage, derivatives, and short-selling to maximize short-term or absolute returns, similar to global hedge funds.

• Best for: HNIs, ultra-HNIs, and institutional investors seeking high-risk, high-return exposure.

• Risk & Returns: High; returns can be substantial but unpredictable due to leveraged and dynamic strategies.

• Horizon: Flexible can be short-term or long-term depending on whether the fund is open-ended or close-ended.

Considerations for Fund Sponsors and Managers

Before launching an AIF, fund sponsors should assess:

• Operational capacity: availability of professional fund management expertise.

• Investor profile: whether their target investors are conservative, moderate, or aggressive.

• Regulatory obligations: as Category III funds face the highest compliance and reporting burden.

• Long-term strategy: whether the fund seeks capital preservation, income generation, or aggressive growth.

Conclusion

Frequently Asked Questions (FAQs)

Q1. What is the main difference between Category I, II, and III AIFs?

Ans. The primary difference lies in their investment strategy and risk profile. Category I AIFs invest in socially or economically desirable sectors like startups, SMEs, and infrastructure. Category II AIFs include private equity and debt funds focusing on stable, long-term growth. Category III AIFs are hedge-style funds that employ leverage and complex strategies to generate short-term or absolute returns.

Q2. Can Category I and II AIFs use leverage like Category III funds?

Ans. No. Category I and II AIFs cannot employ leverage except for short-term borrowing to meet day-to-day operational requirements. Category III AIFs, however, are permitted to use leverage through derivatives or borrowings, subject to SEBI-defined limits and investor consent.

Q3. What is the minimum investment and corpus requirement for AIFs?

Ans. As per SEBI Regulations, the minimum investment per investor in any AIF is ₹1 crore (₹25 lakh for employees or directors of the AIF). The minimum corpus for each scheme is ₹20 crore, while for Angel Funds under Category I, it is ₹10 crore.

Q4. Which AIF category offers tax pass-through benefits?

Ans. Category I and II AIFs enjoy pass-through status under the Income-tax Act, 1961, meaning income is taxed directly in the hands of investors. Category III AIFs do not receive this benefit; income is taxed at the fund level based on its nature (business or capital gains).

Q5. How do investors choose the right AIF category?

Ans. The choice depends on investment goals, risk tolerance, and liquidity preferences. Category I is ideal for developmental and startup-focused investors, Category II suits those seeking long-term stable returns from private equity or debt, and Category III is best for high-net-worth investors looking for short-term gains through leveraged or derivative strategies.