Alternate Investment Funds (AIFs): An Overview

Over the past decade, India’s investment landscape has undergone a significant transformation, moving beyond conventional instruments like fixed deposits, mutual funds, and listed shares. With increasing financial awareness and rising disposable incomes, a new class of investors particularly high-net-worth individuals and institutional players has begun to explore more nuanced investment avenues. 

One such alternative that has captured considerable attention is Alternative Investment Funds (AIFs). These funds provide access to less mainstream asset classes and investment strategies that traditional vehicles rarely offer. Under the regulatory framework of the Securities and Exchange Board of India (SEBI), AIFs now represent a credible and structured route for investors looking to build diversified, high-potential portfolios

What are alternative investment funds?

Alternative Investment Funds (AIFS) are privately pooled investment vehicles that collect capital from select investors to invest in non-traditional assets like private equity, venture capital, real estate, or hedge strategies. SEBI regulates them under the AIF Regulations, 2012, and they are structured as trusts, companies, or LLPS.

AIFS are primarily meant for high-net-worth individuals and institutional investors, with a minimum investment requirement of ₹1 crore. Unlike mutual funds, they do not invest in conventional instruments and are not open to retail investors. These funds offer portfolio diversification and the potential for higher returns, but come with higher risk and longer lock-in periods.

What are the different types of AIFS in India?

Based on their investment strategy and regulatory classification, AIFSSS in India is divided into three categories: Category I, II, and III. Each category serves a distinct purpose and focuses on different asset classes. The table below outlines the classification along with common examples under each type:

Category I AIF

Category I Alternative Investment Funds aim to channel investments into sectors that support long-term economic growth and social welfare. These typically include early-stage businesses, infrastructure projects, and ventures focused on inclusive development. Because of their developmental role, the government often encourages them through tax benefits, regulatory support, or relaxed investment norms. Investors in Category I AIFS generally take a long-term view and are willing to accept higher risks in exchange for potentially substantial returns.

Venture Capital Funds (VCFS)

Venture Capital Funds primarily invest in startups or young companies with high growth potential but lack access to conventional sources of capital. These funds support entrepreneurs during the early stages of their business lifecycle, helping them scale and innovate. Due to the high-risk nature of such investments, venture capital funds often seek significant returns on their portfolio companies over the long term.

Angel Funds

Angel Funds are a subset of venture capital that provide seed funding to startups at an even earlier stage, often when the idea is still in its formative phase. These funds are backed by angel investors who not only invest capital (minimum ₹25 lakh per investor) but also bring mentorship, industry experience, and strategic guidance. Angel funds are critical in helping startups validate their business model and build a foundation for future growth.

Infrastructure Funds

These funds invest in infrastructure projects such as transportation, energy, water supply, and urban development. Since infrastructure development is capital-intensive and yields long-term returns, such funds are well-suited for optimistic investors interested in India's economic growth and comfortable with extended lock-in periods.

Social Venture Funds

Social Venture Funds invest in enterprises that address social or environmental issues while maintaining commercial viability. These funds tend to back businesses that operate in critical sectors like education, affordable healthcare, sustainable energy, and inclusive finance. The primary goal is to create lasting social value. Still, many of these ventures are also structured to offer stable, if modest, financial returns appealing to investors looking to make a difference without compromising profitability.

Category II AIF

Category II Alternative Investment Funds primarily invest in private businesses, debt instruments, and other structured strategies that do not fall under Category I or III. These funds are not focused on early-stage or socially driven sectors, nor do they employ complex leverage or speculative trading. Instead, they offer a middle ground targeting companies with strong fundamentals that require capital for expansion, restructuring, or long-term growth. While these funds don’t receive special regulatory incentives, they can operate flexibly and are subject to standard SEBI compliance. Leverage is not permitted, except for routine operational needs.

Private Equity Funds

These funds are invested in privately held companies not listed on stock exchanges. Typically, such businesses have solid potential but need capital for scaling up, entering new markets, or restructuring operations. Since these are long-term investments, the funds usually have a lock-in period of 4 to 7 years. Investors in private equity funds expect higher returns than traditional instruments, though the illiquidity and market risks involved require a strong risk appetite.

Debt Funds

Debt funds under Category II typically put money into bonds or debentures issued by unlisted companies. These businesses often have solid growth plans but can’t easily borrow from banks because of weaker credit ratings. That’s where these funds come in; they help bridge the funding gap. In return, investors might earn better returns than they would from fixed deposits or government bonds. More risk is involved, especially if the company fails to meet its obligations. It’s worth noting that SEBI doesn’t allow these funds to issue loans directly; they can only invest through structured debt instruments.

Fund of Funds

Rather than investing directly in businesses or securities, Fund of Funds (FoFs) invest in other AIFS. This approach offers investors diversified exposure across multiple fund strategies while relying on the performance and expertise of underlying fund managers. Though they don’t manage a direct portfolio, FoFs are often used by investors who want broad access to the AIF space without having to bet on a single strategy or sector.

Category III AIF

Category III AIFS are designed for investors seeking high returns through complex and actively managed strategies. These funds can use leverage and invest in instruments like derivatives, structured credit, and arbitrage trades. Due to their high-risk nature, they are suitable only for experienced and well-informed investors.

Hedge Funds

Hedge funds invest across global and domestic markets using dynamic, high-risk strategies such as long-short equity, macro bets, or event-driven plays. These funds aim to generate profits in both rising and falling markets. However, the fee structures can be steep, with many charging 2% of assets under management plus 20% of profits. They require active management and a deep understanding of market dynamics.

Private Investment in Public Equity (PIPE)

PIPE funds invest directly in publicly listed companies, but unlike regular market transactions, these deals happen privately, often at a negotiated discount. This gives companies quick access to capital without the time-consuming public offering process. For investors, the appeal lies in acquiring equity at a price lower than market value, with the potential for solid returns if the company performs well. However, success in PIPE deals depends heavily on selecting the right businesses and having a strong view on their near-term growth and stability.

Derivatives-Based Funds

These funds trade in financial instruments like futures, options, and swaps to capitalise on price movements and market inefficiencies. Strategies may include managing volatility, hedging positions, or exploiting short-term pricing gaps. While they can deliver strong returns in the right conditions, they are also sensitive to sudden market shifts, and if strategies are poorly executed, losses can be substantial.

Top 10 AIFs in India

The following are the top alternative investment funds in India:

What are the benefits of AIF investments?

Solid Returns

What makes AIFS stand out is its ability to go beyond conventional markets. They don’t just invest in publicly listed companies but also explore areas like private equity, venture capital, and niche debt deals. These are segments where the potential for returns is often far greater, especially when the right opportunities are identified early. Unlike typical investment instruments that follow standard benchmarks, AIFS allow fund managers to be more selective and strategic. That flexibility can translate into stronger performance, though not without risk.

Low Volatility

Many investors consider AIFS because they don’t react to every bump in the stock market. Since a large part of their portfolio is often made up of private assets, valuations don’t swing wildly with daily news or short-term investor sentiment. It doesn’t mean they’re completely risk-free, but compared to publicly traded equities, the ride tends to be much smoother. This trait adds value to those seeking a more stable holding in uncertain times. 

Diversification

Diversification isn’t just about owning different stocks. Proper diversification comes when your investments are spread across asset classes that behave differently. AIF can include private credit, real estate, startup funding, or even special situation strategies all of which tend to move independently from traditional markets. This added layer of variety can make a portfolio more resilient, especially during downturns when public markets are under pressure.

Taxes on Alternative Investment Fund investments

SEBI AIF regulations

Category I AIF

Investment Mandate: These funds are required to channel capital into sectors that promote economic and social development, such as start-ups, small and medium enterprises SMES), infrastructure, and social ventures. The sub-categories include Venture Capital Funds, SME Funds, Social Venture Funds, and Infrastructure Funds.

Allocation Requirement: At least 75% of the investable corpus must be deployed in specified target sectors, primarily in unlisted equity or equity-linked instruments aligned with the fund’s category objectives.

Borrowing Restrictions: Leverage is strictly prohibited. However, Category I AIFS may borrow temporarily for operational purposes, subject to limits—no more than 10% of investable funds, for a maximum of 30 days, and only four instances in a financial year.

Category II AIF

Fund Structure and Scope: This category includes private equity funds, debt funds, real estate funds, and distressed asset funds. These AIFS do not fall under Category I or III and cannot employ leverage for investment purposes.

Investment Limits: Funds may invest in a wide range of instruments, including unlisted equity, debt, structured products, and units of other AIFSS (excluding fund-of-fund schemes). Investment in a single investee company is capped at 25% of investable funds, extendable to 50% for large-value funds comprising only accredited investors.

Leverage and Risk Management: Borrowing is restricted to short-term cash flow management under SEBI-defined conditions. While investment leverage is disallowed, these funds can use derivatives solely for hedging purposes.

Category III AIF

Nature and Strategy: These funds engage in complex trading strategies and may invest in listed and unlisted equities, debt instruments, and derivatives. Category III includes hedge funds and PIPE (Private Investment in Public Equity) funds, and may operate as open-ended or closed-ended schemes.

Leverage Allowance: Unlike the other categories, Category III AIFS are permitted to use leverage, provided total exposure does not exceed two times the fund’s net asset value (NAV). All leveraging activity must be disclosed to investors and comply with SEBI’s risk control requirements.

Exposure Restrictions: Investment in a single investee company is limited to 10% of investable funds. This limit may be extended to 20% for large-value funds that exclusively accept investments from accredited investors.

What is PMS? AIF vs PMS?

Portfolio Management Services (PMS) provide customised investment strategies tailored to individual investors, considering their specific risk tolerance, return expectations, and time commitments. This personalised approach includes establishing dedicated bank and Demat accounts for efficient securities management.

In comparison, Alternative Investment Funds (AIFS) typically require a higher minimum investment and often impose lock-in periods, which can restrict liquidity. On the other hand, PMS offers enhanced liquidity, giving investors the freedom to access their funds more readily. While AIFS presents diverse investment opportunities, including unconventional assets, PMS enables investors to monitor and adjust their portfolios in real-time, ensuring alignment with their financial objectives.

Both PMS and AIF come with significant risk-reward dynamics, making it vital for investors to carefully assess their investment goals, liquidity preferences, time frames, and security choices before deciding on the right option. With a better grasp of the distinctions between AIFS and PMS, you can choose a fund scheme that resonates with your financial goals. Remember, thorough research into a fund’s past performance is essential for making well-informed investment choices and wishing you success in your investment journey!’

Conclusion

Alternative Investment Funds (AIFs) offer investors in India a unique opportunity to diversify their portfolios with non-traditional assets like private equity and venture capital. While they present the potential for higher returns, they also come with increased risks and longer lock-in periods. Understanding the different AIF categories can help investors align their choices with their financial goals.