Investment instrument/security specific conditions for AIFs

Written By BareMinLaw

Chapter 4 - Investment instrument/security specific conditions for AIFs

4.1. Investment in units of AIFs

4.1.1.

  • Under Regulation 15(1)(c) and (d) of the AIF Regulations, an AIF is permitted to invest in an investee company up to the specified regulatory limit.

  • The AIF can make such investment:

    1. Directly in the investee company; or

    2. Indirectly through investment in the units of another AIF.

  • So, an AIF can obtain exposure to an investee company through another AIF instead of investing directly.

  • An AIF is also permitted to invest in the units of other AIFs.

  • Such investment in another AIF does not automatically make the investing AIF a "Fund of AIFs".

  • So , merely investing in units of another AIF does not require the AIF to label itself as a Fund of AIFs.

4.1.2

  • AIFs proposing to invest in units of other AIFs must disclose the following information in their Private Placement Memorandum (PPM):

  • (a). Proposed allocation of investment in units of other AIFs

    1. The AIF must disclose the amount/portion of its investments proposed to be allocated to units of other AIFs.

  • (b). Fees and expenses attributable to investment in other AIFs

    1. The AIF must disclose, out of the total fees and expenses charged to its investors, the portion that may be attributed to investments in units of other AIFs.

    2. This provides investors with clarity on the additional costs arising from investing through other AIFs.

  • (c). Process for ensuring compliance with investment conditions

    1. The AIF must disclose the process that its Manager will follow to ensure compliance with the applicable investment conditions under:

      1. Regulation 15.

      2. Regulation 16, 17 or 18, as applicable to the AIF.

  • (d). Investments in AIFs managed/sponsored by the same or related persons

    1. The AIF must disclose whether it proposes to invest in units of other AIFs that are:

      1. Managed by the same Manager.

      2. Sponsored by the same Sponsor.

      3. Managed by an associate of the Manager.

      4. Sponsored by an associate of the Sponsor.

      5. If such investments are proposed, the AIF must provide details including:

        1. Allocation.

        2. Fees.

        3. Expenses.

        4. Other relevant details.

4.1.3

  • An AIF may initially launch its scheme without proposing any investment in units of other AIFs in its PPM.

  • Even if such investment was not mentioned in the PPM at the time of launch, the AIF may subsequently decide to invest in units of other AIFs.

  • The AIF may simultaneously invest in:

    1. Securities of investee companies.

    2. Units of other AIFs.

  • However, before making such investment in units of other AIFs, the AIF must make appropriate disclosures in its PPM.

    1. The AIF must also obtain the consent of at least two-thirds of the unit holders by value of their investment in the AIF.

    2. The requirement for such consent comes from Regulation 9(2) of the AIF Regulations.

    3. The two-thirds requirement is based on the value of investment, not simply the number of unit holders.

Example:

  • If the total investment of all unit holders is ₹30 crore then:

  • Consent must be obtained from unit holders representing at least ₹20 crore (two-thirds) of the investment.

4.1.4

  • A pooling vehicle is an entity that collects money from multiple investors and pools that money for investment.

    1. A pooling vehicle cannot be created solely for the purpose of investing in an AIF.

    2. So, investors cannot simply create another entity, pool their money through it, and use that entity only to invest in an AIF.

  • The only exception is where the pooling vehicle itself is registered with SEBI as an AIF.

    1. Thus, if a pooling vehicle is created specifically to invest in an AIF, it must obtain registration as an AIF with SEBI.

    2. The purpose is to prevent indirect or layered structures from being created merely to invest in an AIF without being subject to the applicable AIF regulatory framework.

4.2. Participation of AIFs in Credit Default Swaps

  • Regulations 16(1)(aa), 17(da) and 18(ab) of the AIF Regulations permit AIFs to participate in Credit Default Swaps (CDS).

  • However, this participation is not unrestricted.

    1. AIFs can participate in CDS only subject to the conditions specified by SEBI.

    2. SEBI may specify or modify these conditions from time to time.

    3. Therefore, the Regulations provide the legal enabling provision, while the detailed conditions for participating in CDS are prescribed separately by SEBI.

  • The relevant provisions apply to different categories of AIFs:

    1. Regulation 16(1)(aa) - Category I AIFs

    2. Regulation 17(da) - Category II AIFs

    3. Regulation 18(ab) - Category III AIFs

Conditions applicable to Category I, II and III AIFs for buying CDS

4.2.1.

  • Category I and Category II AIFs are permitted to buy Credit Default Swaps (CDS).

  • However, they can buy CDS only where there is an underlying investment in debt securities.

  • So , the AIF must already have an investment/exposure to debt securities, against which the CDS is being used.

  • The purpose of buying the CDS must be hedging.

    1. Hedging means using the CDS to protect the AIF against the credit/default risk associated with its underlying debt investment.

    2. Therefore, the CDS cannot be purchased merely to speculate on whether a company will default.

    3. The CDS should have a genuine connection with the AIF's underlying debt investment.

Example:

  • A Category II AIF invests ₹10 crore in corporate bonds of Company X.

    1. The AIF is exposed to the risk that Company X may default on its debt obligations.

    2. The AIF may buy a CDS on Company X's debt to protect itself against that credit risk.

  • If Company X defaults, the CDS provides protection according to its terms.

4.2.2.

  • Category III AIFs are permitted to buy Credit Default Swaps (CDS).

  • Unlike Category I and Category II AIFs, Category III AIFs can buy CDS for two purposes:

    1. (a) Hedging.

    2. (b) Otherwise, meaning the purchase is not restricted only to hedging an existing debt investment.

  • So , a Category III AIF has greater flexibility in using CDS compared with Category I and II AIFs.

  • However, this flexibility is not unlimited.

    1. The CDS transactions must remain within the permissible leverage limits applicable to Category III AIFs.

    2. These leverage limits are specified in Para 7.2 of the AIF Master Circular.

    3. Hedging purpose: The AIF may use CDS to protect an existing investment/exposure against credit or default risk.

  • Otherwise: Category III AIFs may also use CDS for purposes other than directly hedging an existing investment, subject to the applicable regulatory and leverage restrictions.

Example:

  • A Category III AIF has exposure to corporate debt.

    1. It may buy a CDS to hedge the credit risk.

    2. It may also enter into CDS transactions for other permitted purposes, provided it remains within the prescribed leverage limits.

Conditions applicable to Category II and III AIFs for selling CDS

4.2.3.

  • Category III AIFs are permitted to sell Credit Default Swaps (CDS).

  • Selling a CDS means the AIF takes the role of the protection seller.

    1. The AIF agrees to provide protection to the CDS buyer against the default/credit event of the underlying entity.

    2. In return, the AIF generally receives a premium from the CDS buyer.

  • This is different from buying a CDS, where the AIF purchases protection against credit risk.

    1. Category III AIFs can sell CDS, but the permission is subject to a leverage restriction.

    2. The effective leverage undertaken by the AIF must remain within the permissible leverage limits prescribed under Para 7.2 of the AIF Master Circular.

    3. Therefore, the AIF cannot use CDS transactions to take unlimited leveraged exposure.

  • The leverage arising from the CDS position must be considered while ensuring that the AIF remains within its permitted leverage limit.

4.2.4.

  • Category II AIFs and Category III AIFs are permitted to sell Credit Default Swaps (CDS).

    1. However, when selling CDS, they must earmark unencumbered Government bonds or Treasury Bills.

    2. The value of the Government bonds/Treasury Bills earmarked must be equal to the amount of the CDS exposure.

  • Unencumbered means that the securities are not already pledged, charged, or otherwise committed as security for another obligation.

    1. The earmarked Government bonds/Treasury Bills act as a financial backing/security for the CDS exposure.

    2. The securities that have been earmarked for the CDS exposure may also be used to meet the applicable margin requirements for that CDS transaction.

    3. Margin requirements are amounts/securities that may need to be maintained with the relevant counterparty or clearing mechanism to cover the risk arising from the CDS transaction.

  • Importantly, the CDS exposure created in this manner will not be treated as leverage for the AIF.

  • Therefore, where the AIF:

    1. Sells CDS.

    2. Earmarks unencumbered Government bonds/Treasury Bills.

    3. Earmarks them for an amount equal to the CDS exposure.

    4. Complies with the applicable margin requirements.

  • the resulting CDS exposure does not count as leverage.

4.2.5.

  • The total exposure of an AIF to an investee company must remain within the applicable concentration limit prescribed under the AIF Regulations.

    1. While calculating this total exposure, the AIF must include exposure arising through Credit Default Swaps (CDS).

    2. So, the AIF cannot treat its CDS exposure as completely separate from its other exposure to the same investee company for the purpose of concentration limits.

  • The calculation therefore considers:

    1. Direct exposure to the investee company; plus

    2. CDS-related exposure to the same investee company.

  • The combined exposure must remain within the applicable concentration norm

Example:

  • An AIF has direct investment/exposure of ₹8 crore to Company X.

    1. It also has ₹4 crore CDS exposure relating to Company X.

    2. Total exposure for concentration-limit purposes = ₹12 crore.

  • The AIF must ensure that this ₹12 crore exposure does not exceed the applicable concentration limit.

Other conditions applicable for transacting in CDS

4.2.6.

  • AIFs that enter into Credit Default Swap (CDS) transactions must report the details of those transactions to their custodian.

    1. The reporting must be done by the next working day after the CDS transaction.

    2. So, the AIF should not wait until the end of the month or another periodic reporting date.

    3. The AIF must follow the manner or format specified by the custodian for reporting the CDS transaction.

  • The custodian may prescribe the specific details, format, mode and process through which the transaction must be reported.

  • The requirement applies to CDS transactions undertaken by the AIF.

Example:

  • AIF enters into a CDS transaction on Monday.

  • The details must be reported to the custodian by Tuesday, assuming Tuesday is a working day.

4.2.7.

  • The custodian shall establish a mechanism to collect the necessary details from AIFs that enter into CDS transactions.

  • The purpose of collecting these details is to monitor compliance with the conditions prescribed for CDS transactions.

  • The custodian shall monitor compliance with the conditions specified in:

    1. Para 4.2.1

    2. Para 4.2.2

    3. Para 4.2.3

    4. Para 4.2.4

    5. Para 4.2.5

  • The AIF is required to provide the necessary details of its CDS transactions to the custodian.

  • The custodian is responsible for collecting and monitoring these details to ensure that the AIF complies with the prescribed conditions.

4.2.8.

  • This requirement deals with the responsibilities of the Manager/AIF and the Custodian when a Category III AIF breaches its permissible leverage limit due to transactions in Credit Default Swaps (CDS).

  • A leverage limit breach occurs when the Category III AIF's effective leverage exceeds the permissible leverage limit.

  • The specific obligations of the Manager/AIF and the Custodian in such a situation are prescribed under:

    1. Para 7.3.2 of the Master Circular; and

    2. Para 7.3.3 of the Master Circular.

  • These paragraphs specify the respective responsibilities and actions to be taken by the Manager/AIF and the Custodian following such a breach.

  • Therefore, in case of a CDS-related leverage breach, both the Manager/AIF and Custodian have specific compliance obligations as set out in the above-mentioned paragraphs.

4.2.9.

  • For Category II AIFs and Category III AIFs that sell CDS by earmarking securities as specified in Para 4.2.4:

  • The following requirements shall apply when the amount of earmarked securities falls below the CDS exposure:

  • (a). Reporting the breach - The AIF shall report the breach to the custodian on the same day on which the breach occurs.

  • (b). Rectification of the breach

    1. The AIF shall increase the amount of earmarked securities so that it becomes equal to the CDS exposure.

    2. The AIF shall complete the rectification by the end of the next trading day.

    3. The AIF shall also report the details of the rectification to the custodian by the end of the next trading day.

  • (c). Failure to rectify the breach

    1. If the AIF fails to rectify the breach in the prescribed manner and within the prescribed time, the custodian shall report the details of the breach to SEBI.

    2. The custodian shall make such report on the next working day.

4.2.10.

  • Any unhedged position in CDS transactions must be considered when determining the AIF's overall unhedged exposure.

  • The gross unhedged positions across all CDS transactions must not exceed 25% of the investable funds of the scheme without prior intimation to the unit holders.

  • If an AIF proposes to take an unhedged position that would result in the gross unhedged CDS positions exceeding 25% of the scheme's investable funds then:

    1. It may do so only after intimating all unit holders of the scheme.

    2. The 25% limit is calculated with reference to the investable funds of the scheme, not the total corpus of the AIF.

    3. Unhedged position means a CDS position that is not offset or protected by an underlying hedge.

Example:

  • Investable funds of the scheme = ₹100 crore.

  • 25% of investable funds = ₹25 crore.

  • If the proposed CDS transactions would result in gross unhedged positions exceeding ₹25 crore, the AIF must first intimate all unit holders.

4.2.11.

  • All CDS transactions undertaken by AIFs shall be carried out on a platform regulated by SEBI or RBI.

    1. This means CDS transactions cannot be conducted through an unregulated platform.

    2. The platform must be regulated by either SEBI, or RBI.

    3. The requirement is intended to ensure greater transparency in CDS transactions.

  • It also facilitates better disclosure and monitoring of CDS transactions.

  • Therefore, AIFs must use a SEBI-regulated or RBI-regulated platform for all their CDS transactions.

4.2.12.

  • AIFs that enter into CDS transactions must comply with the applicable requirements prescribed by the RBI.

    1. Specifically, they must comply with the RBI Master Direction - Reserve Bank of India (Credit Derivatives) Directions, 2022, dated February 10, 2022.

    2. Therefore, compliance is not limited to the requirements under the AIF Regulations and SEBI's directions.

    3. AIFs must also follow the applicable provisions of RBI's framework governing credit derivatives.

  • AIFs must also comply with any other directions, instructions or regulatory requirements issued by RBI regarding CDS from time to time.

  • So , if RBI subsequently issues or updates requirements relating to CDS, the AIF must comply with those applicable requirements as well.

4.3. Transaction in Corporate Bonds through Request for Quote (RFQ) platform

4.3.1

  • AIFs must undertake at least 10% of their total secondary market trades in Corporate Bonds through the RFQ (Request for Quote) platform.

    1. The 10% requirement is calculated by value, not by the number of trades.

    2. The requirement applies to the AIF's secondary market trades in Corporate Bonds.

    3. The calculation is made on a monthly basis.

  • The AIF must satisfy the 10% requirement by placing or seeking quotes on the RFQ platform.

  • RFQ (Request for Quote) is a platform mechanism through which a participant can:

    1. Place a quote to buy or sell; or

    2. Seek a quote from other market participants.

Example:

  • Total secondary market Corporate Bond trades during a month = ₹100 crore.

  • At least ₹10 crore of those trades must be undertaken by placing/seeking quotes on the RFQ platform.

4.3.2

  • Under Chapter XXII of the Master Circular dated October 15, 2025, quotes on the RFQ platform can be placed in two modes:

  • One-to-One mode

    1. The quote is placed with a specific, identified counterparty.

    2. The transaction is therefore directed towards one particular participant.

  • One-to-Many mode

    1. The quote is made available to all participants on the RFQ platform.

    2. Any eligible participant can respond to the quote.

  • Where an AIF is on both sides of a Corporate Bond transaction, meaning:

    1. One AIF is the buyer and another AIF is the seller, the transaction must be executed through the RFQ platform in one-to-one mode.

    2. So , an AIF-to-AIF Corporate Bond transaction cannot be treated as a one-to-many transaction merely because it ultimately results from a quote available to multiple participants.

    3. However, if an AIF places a quote through the one-to-many mode, and that quote is ultimately matched with another AIF, the transaction will still be counted as a one-to-many transaction.

  • It will not be reclassified as a one-to-one transaction merely because the counterparty that accepted the quote happened to be another AIF.

Example 1:

  • AIF A wants to sell Corporate Bonds to AIF B.

  • AIF A specifically identifies AIF B as the counterparty.

  • The transaction must be executed through RFQ in one-to-one mode.

Example 2:

  • AIF A places a quote through the one-to-many mode.

    1. The quote is available to all participants.

    2. AIF B ultimately accepts the quote.

  • The transaction will be counted as one-to-many, because that was the mode in which the quote was originally placed.

4.4. Clarifications related to investments by AIFs

4.4.1

  • If an AIF proposes to invest in real estate or infrastructure projects, this requirement shall apply.

  • Every investee company receiving such investment must hold or propose to hold at least one project.

  • The project may be held:

    1. Directly by the investee company; or

    2. Indirectly through another entity or structure.

  • So , an investee company cannot merely be a holding or shell entity with no project. It must hold or propose to hold at least one real estate or infrastructure project.

Example:

  • If Company A directly holds a real estate project, the requirement is satisfied.

  • If Company A holds the project through a subsidiary, the requirement is also satisfied.

  • If Company A neither holds nor proposes to hold any project, the requirement is not satisfied.

4.4.2

  • The term “primarily” indicates where the main focus of a Category II AIF’s investment portfolio should lie.

  • A Category II AIF should have its investment portfolio mainly concentrated in:

    1. Unlisted securities.

    2. Listed debt securities, including securitised debt instruments, which are rated ‘A’ or below.

  • The rating must be given by a credit rating agency registered with SEBI.

    1. The investment in such securities should be more than the aggregate of the AIF’s other investments.

    2. Therefore, the portfolio should have a greater allocation to unlisted securities and/or qualifying listed debt securities than to all other types of investments taken together.

Example:

  • Investment in unlisted securities and qualifying listed debt securities = ₹60 crore

    1. Aggregate of other investments = ₹40 crore

    2. Since ₹60 crore is greater than ₹40 crore, the portfolio is primarily focused on the specified investments.

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