Alternative Investment Funds (AIFs) in India are privately pooled investment vehicles, regulated by the Securities and Exchange Board of India (SEBI). SEBI defines an AIF as a fund established or incorporated in India that collects funds from Indian or foreign investors to invest according to a defined policy for the benefit of its investors. Unlike mutual funds, AIFs target sophisticated high-net-worth investors and focus on high-growth or niche sectors, offering an alternative route to diversify beyond traditional stocks and bonds.

SEBI Regulations and Registration

Under SEBI's AIF guidelines, any entity acting as an AIF must register with SEBI. Regulation 3 of the AIF Regulations makes it mandatory to obtain SEBI registration before pooling capital. For example, Category I AIF registration is required for funds that want to invest in start-ups, infrastructure projects, social ventures, or SMEs. SEBI registration ensures that the fund adheres to regulatory norms on fund management, disclosures, and investor eligibility. AIFs can be structured as private trusts, LLPs, or companies. In practice, many choose a trust under the Indian Trusts Act, 1881 because it offers flexibility and lighter compliance.

AIF Categories: Cat I, II, III

SEBI divides AIFs into three categories based on investment strategy and incentives:

• Category I AIF: Invests in sectors considered socially or economically desirable (such as startups, infrastructure projects, social enterprises, and small/medium enterprises). Category I funds often receive government incentives. Sub-types include Venture Capital Funds, Angel Funds, Infrastructure Funds, Social Venture Funds, and SME Funds. For example, an SME fund in India (Category I AIF) specifically channels capital to small and medium enterprises, providing growth capital where traditional financing may be scarce.
• Category II AIF: Encompasses private equity and debt funds (including real estate or distressed asset funds) that do not avail themselves of special incentives. These funds focus on long-term returns by investing in unlisted companies. Category II AIFs are typically closed-ended with multi-year lock-in periods.
• Category III AIF: Includes hedge funds and any AIFs employing complex strategies (like leverage or derivatives) for short-term gains. Category III AIFs can be open-ended or closed-ended and are aimed at very experienced investors seeking higher risk-return trades.

SEBI's regulations impose clear rules for each category. Notably, if a fund wishes to use leverage or invest primarily via debt/equity routes, it cannot be a Category I AIF – it must register as Category II or III. This preserves Category I's focus on growth and social impact, rather than financial engineering.

Key Investor Requirements and Fund Structure

SEBI prescribes the following key requirements for all AIFs:

• Minimum Corpus and Investment: Each AIF must have a minimum corpus of INR 20 crore (approximately USD 2.7 million), and each investor must commit at least INR 1 crore. These thresholds make AIFs suitable primarily for HNIs and institutional investors.
• Sponsor/Manager Contribution: The sponsor or manager must invest a minimum portion of the corpus (typically 2.5%) to align their interests with investors.
• Investor Limit & Private Placement: An AIF can have at most 1,000 investors (49 for Angel Funds), and fund-raising must be by private placement only. AIFs cannot publicly solicit their offering.
• Lock-in and Tenure: Category I and II AIFs are generally closed-ended with a lock-in of around 3 years (extendable by up to 2 more years with two-thirds investor approval). Category III AIFs may allow more flexible entry/exit arrangements.
• Diversification & Limits: SEBI restricts concentration risk (typically, an AIF cannot invest more than 25% of its corpus in a single portfolio company) and explicitly bars Category I AIFs from leveraging. These rules protect investor capital.

This structured approach ensures fund managers and investors have aligned interests, with clear governance and risk management norms.

Governance and Compliance Norms

Registered AIFs must follow strict governance standards:

• Periodic Reporting: Fund managers must provide regular updates to SEBI and investors, including audited financial statements and portfolio valuations.
• Independent Oversight: Trust-based AIFs appoint independent trustees; company/LLP-based AIFs often include independent directors. These fiduciaries oversee fund operations and protect investor interests.
• No Public Advertising: All marketing is done privately. By law, AIFs may not publicly solicit investments.
• Regulatory Audits: SEBI can audit AIFs for compliance with investment limits and disclosure norms. Non-compliance can result in penalties or de-registration.

These governance standards, enforced by SEBI, safeguard the integrity of AIFs and protect investor interests.

Benefits of Category I AIFs (e.g., SME Funds)

Category I AIFs, especially dedicated SME funds, are growth catalysts. By targeting startups and small businesses, they fill financing gaps that traditional banks may not address. Since Category I funds align with government priorities, they can qualify for incentives like co-investment schemes or concessions. For SMEs, raising capital through an AIF means access to patient, long-term funding and often mentorship, without the rigors of a public listing. Meanwhile, HNIs and institutional investors gain opportunities to support economic development projects (infrastructure, social ventures) while seeking higher returns.

Conclusion and Next Steps

Navigating SEBI's AIF framework is complex. From obtaining Category I AIF registration to ensuring ongoing compliance (filings, audits, caps), each step is critical. Professional guidance can be invaluable.

If you plan to set up an AIF or invest in one, consult Tax Vimarsh for expert assistance. We can guide you through SEBI registration, fund structuring, regulatory compliance, and strategic benefits. Contact Tax Vimarsh today to align your Alternative Investment Fund strategy with India's regulations and growth opportunities.