Conditions for All categories of AIFs
Regulation 16. Conditions for Category I Alternative Investment Funds.
16(1).
The following investment conditions shall apply to all Category I Alternative Investment Funds:
Permitted Investments by Category I AIFs
These are the types of investments that may be made by a Category I Alternative Investment Fund.
A Category I AIF may invest in:
Investee Companies.
Venture Capital Undertakings (VCUs).
Special Purpose Vehicles (SPVs).
Limited Liability Partnerships (LLPs).
A Category I AIF may also invest in the units of other Category I AIFs, provided that: The other AIF belongs to the same sub-category.
For example:
An Infrastructure Fund may invest in another Infrastructure Fund.
A Venture Capital Fund may invest in another Venture Capital Fund.
A Social Impact Fund may invest in another Social Impact Fund.
A Category I AIF may additionally invest in the units of Category II AIFs, subject to the conditions specified under the regulations.
So, Category I permits both:
Direct investments in operating entities and investment vehicles.
Indirect investments through eligible AIF structures.
Example:
A Venture Capital Fund (Category I AIF) may:
Invest directly in a start-up company.
Invest in a Special Purpose Vehicle established for a project.
Invest in a Limited Liability Partnership carrying on an eligible business.
Invest in the units of another Venture Capital Fund.
Invest in the units of a Category II AIF, if permitted under the applicable regulatory conditions.
(aa). Hedging by Category I AIFs
A Category I Alternative Investment Fund is permitted to engage in hedging activities.
Hedging is undertaken to reduce or manage risks arising from the fund's investments.
The purpose of hedging is generally risk mitigation, and not speculative trading.
Category I AIFs may use various hedging instruments as permitted under the regulatory framework.
16(1)(aa) specifically permits the use of Credit Default Swaps (CDS) for hedging purposes.
A Credit Default Swap is a financial contract used to protect against the risk of default by a borrower or issuer of a debt instrument.
The ability to undertake hedging, including through CDS, is subject to the conditions specified by SEBI from time to time.
Accordingly, a Category I AIF must comply with any eligibility criteria, exposure limits, disclosure requirements, risk management requirements, or other conditions prescribed by SEBI.
Example:
A Credit Default Swap (CDS) is a financial contract that provides protection against the risk that a borrower may fail to repay its debt.
Think of it as insurance on a loan or bond.
One party owns a debt instrument (such as a bond).
That party is worried that the borrower may default.
To protect itself, it pays a periodic fee to another party.
In return, the other party agrees to compensate it if the borrower defaults.
Example:
Step 1 – Original Investment
A Category I AIF purchases bonds of ABC Ltd. worth ₹10 crore.
ABC Ltd. promises to repay the principal and interest over time.
The AIF earns returns so long as ABC Ltd. remains financially healthy.
Step 2 – Concern About Default
After a year, ABC Ltd.'s financial condition weakens.
The AIF fears that ABC Ltd. may fail to repay the bonds.
Step 3 – Entering into a CDS
The AIF enters into a Credit Default Swap with Bank XYZ.
The AIF agrees to pay Bank XYZ an annual premium of ₹10 lakh.
In return, Bank XYZ agrees to compensate the AIF if ABC Ltd. defaults.
Step 4 – Two Possible Outcomes
Scenario A – No Default
ABC Ltd. continues making payments.
The bonds mature successfully.
The AIF loses only the CDS premium paid to Bank XYZ.
The CDS acted as protection that was never needed.
Scenario B – Default
ABC Ltd. becomes insolvent and fails to repay the bonds.
The CDS is triggered.
Bank XYZ compensates the AIF according to the CDS terms.
The AIF's loss on the bonds is therefore reduced or eliminated.
(b). Omitted
(c). Borrowing and Leverage Restrictions for Category I AIFs
General Rule: A Category I Alternative Investment Fund shall not:
Borrow funds directly.
Borrow funds indirectly.
Engage in any form of leverage
The prohibition applies whether the borrowing or leverage is intended:
For making investments or for any other purpose.
Accordingly, a Category I AIF is expected to invest using its own committed capital and not borrowed money.
Exception: Temporary Borrowings Permitted
A Category I AIF may borrow funds only for:
Temporary funding requirements.
Day-to-day operational requirements.
Examples include:
Temporary cash flow mismatches.
Payment of fund expenses before receipt of capital contributions.
Meeting short-term operational obligations.
Conditions for Permitted Borrowings
The borrowing must satisfy all of the following conditions:
(1). Maximum Duration - The borrowing cannot remain outstanding for more than 30 days.
(2). Maximum Frequency - Borrowing can be undertaken on not more than four occasions in a financial year.
(3). Maximum Amount - The borrowing cannot exceed 10% of the investable funds.
(4) SEBI Conditions - The borrowing must comply with any additional conditions specified by SEBI from time to time.
Exception: Creation of Encumbrance on Equity of Infrastructure Investee Companies
There is a limited exception to the general restriction on borrowing and leverage applicable to Category I AIFs.
A Category I Alternative Investment Fund may create an encumbrance on the equity shares it holds in an investee company.
An encumbrance means creating a charge, pledge, lien, security interest, or any similar restriction over the shares.
Conditions for Creating the Encumbrance
The encumbrance can be created only if all of the following conditions are satisfied:
(1). The Investee Company Must Be an Infrastructure Company
The investee company must be engaged in Development , Operation or Management of projects in an infrastructure sector.
(2). The Infrastructure Sector Must Be Recognised
The project must fall within one of the infrastructure sub-sectors listed in the Harmonised Master List of Infrastructure issued by the Central Government.
(3). Purpose Must Be Borrowing by the Investee Company
The encumbrance can be created only to facilitate borrowing by the investee company.
The borrowing must be undertaken by the investee company itself.
The Category I AIF is not borrowing the money.
The shares are merely being offered as security to support the investee company's borrowing.
(4). Compliance with SEBI Conditions
The arrangement must comply with any additional conditions specified by SEBI from time to time.
Example
Infrastructure Fund A (a Category I AIF) owns 30% equity in Highway Project Ltd.
Generally, the AIF cannot engage in leverage or borrowing arrangements.
Highway Project Ltd. requires a ₹500 crore loan from a bank to expand a highway project.
The bank requires security before granting the loan.
Infrastructure Fund A pledges its shares in Highway Project Ltd. as security for the company's loan.
The pledge creates an encumbrance over the shares.
Since:
Highway Project Ltd. is an infrastructure company.
The borrowing is by Highway Project Ltd.
The project falls within the Harmonised Master List of Infrastructure.
the encumbrance is permitted, subject to SEBI's conditions.
16(2).
The following investment conditions shall apply to venture capital funds in addition to conditions laid down in 16(1):
(a). Minimum Investment Requirement for Venture Capital Funds
A Venture Capital Fund must invest at least 75% of its Investable Funds in any of the following:
Unlisted equity shares of a Venture Capital Undertaking (VCU).
Equity-linked instruments of a Venture Capital Undertaking (VCU).
Companies listed on an SME Exchange or SME Segment of a recognised stock exchange.
Companies proposed to be listed on an SME Exchange or SME Segment of a recognised stock exchange.
Time Limit for Compliance with Investment Conditions
The investment requirement (75%) specified in clause (a) must be complied with by the end of the Fund's life cycle.
Accordingly, the Fund is not required to satisfy the prescribed investment threshold immediately upon commencement of operations.
Compliance is assessed based on whether the Fund has achieved the required investment allocation before the expiry of its tenure (life cycle).
(b). Omitted.
(c). Subscription to Unsubscribed Portion of an Issue and Market Making
A Venture Capital Fund may enter into an agreement with a Merchant Banker.
Pursuant to such an agreement, the Fund may:
Subscribe to the unsubscribed portion of an issue; or
Receive securities in the course of market making activities; or
Deliver securities in the course of market making activities.
Such market making activities must be undertaken under Chapter IX of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018.
What does "Subscribing to the Unsubscribed Portion" mean?
When a company issues securities, investors may not subscribe to the entire issue.
As a result, a portion of the issue may remain unsubscribed.
A Venture Capital Fund may agree with a Merchant Banker to purchase this remaining portion.
In effect, the Fund acts as a backstop investor for the issue.
This helps:
Ensure successful completion of the issue.
Provide support to the issuer.
Improve investor confidence in the offering.
Understanding Market Making
Market making is a mechanism designed to improve liquidity in securities.
A market maker continuously provides Buy quotes and Sell quotes.
This enables investors to enter and exit positions more easily.
In the process of market making, a market maker may Receive securities or Deliver securities.
Venture Capital Funds are permitted to participate in such arrangements through agreements with Merchant Bankers.
Exemption from the Investment Conditions under Clause (a) of Sub-regulation (2)
16(2)(a) prescribes specific investment allocation requirements for a Venture Capital Fund.
However, those requirements shall not apply in relation to securities acquired or sold pursuant to:
Subscription to the unsubscribed portion of an issue; or
Market making activities.
Accordingly, the exemption covers securities:
Acquired through such subscription arrangements.
Acquired during market making.
Sold during market making.
Received or delivered as part of market making operations.
Objective of the Exemption
Clause (a) ordinarily requires a substantial portion of the Fund's investable funds to be invested in specified categories of investments.
Securities acquired through:
Subscription to an unsubscribed issue; or
Market making activities.
may not always fall within those prescribed categories.
Without an exemption:
The Fund could inadvertently breach its investment allocation requirements.
Participation in issue support activities could become impractical.
Market making operations could affect regulatory compliance.
(d). Exemption from the SEBI (Prohibition of Insider Trading) Regulations, 2015
Venture Capital Funds are granted an exemption from certain provisions of the SEBI (Prohibition of Insider Trading) Regulations, 2015.
Specifically, such Funds are exempt from:
Regulation 3(1).
Regulation 3(2).
Regulation 4(1).
of the SEBI (Prohibition of Insider Trading) Regulations, 2015.
The exemption is available in respect of investments made in:
Companies listed on an SME Exchange.
Companies listed on the SME Segment of a recognised stock exchange.
Such investments must be made pursuant to due diligence conducted on those companies.
The exemption is available only subject to the conditions specified thereafter.
Reasoning behind Insider Trading Exemption for Due Diligence
Ordinarily, the Insider Trading Regulations restrict:
Communication of unpublished price sensitive information (UPSI).
Procurement of UPSI.
Trading while in possession of UPSI.
During the course of due diligence, an investor may need access to sensitive non-public information about a company.
Without a specific exemption, the receipt and use of such information could potentially trigger restrictions under the Insider Trading Regulations.
This provision recognises that due diligence is an essential part of evaluating an investment opportunity.
Accordingly, Venture Capital Funds are permitted to undertake such due diligence for investments in eligible SME-listed companies without:
Automatically attracting the restrictions contained in the specified provisions of the Insider Trading Regulations.
Conditions for Due-Diligence
The investment must be made in a company that is:
Listed on an SME Exchange.
Listed on the SME Segment of a recognised stock exchange.
The investment must be made pursuant to due diligence of such company.
The exemption is available subject to the following conditions:
(i). Disclosure of Trading Pursuant to Due Diligence
The Fund must disclose any trading in securities undertaken pursuant to such due diligence.
The disclosure must be made within two trading days of such trading.
The disclosure must be made to the stock exchange(s) where the investee company is listed.
(ii). Lock-in Requirement for Investment
Such investment shall be subject to a lock-in period of one year.
During the lock-in period, the investment cannot be transferred, sold, or otherwise exited by the Fund.
(3). Additional Conditions with respect to SME Funds
In addition to the conditions specified under 16(1), SME Funds must comply with the following requirements:
(a). Minimum Investment in Eligible Investments
At least 75% of the Investable Funds shall be invested in any of the following:
Unlisted securities of Venture Capital Undertakings.
Partnership interests in Venture Capital Undertakings.
Unlisted securities of investee companies that qualify as SMEs.
Companies listed on an SME Exchange.
Companies proposed to be listed on an SME Exchange.
Companies listed on the SME Segment of a recognised stock exchange.
Companies proposed to be listed on the SME Segment of a recognised stock exchange.
Units of Category II Alternative Investment Funds that invest primarily in
Such Venture Capital Undertakings.
Such SME investee companies.
Accordingly, a minimum of 75% of the Fund's Investable Funds must be deployed in the above specified categories of investments.
(b). Subscription to Unsubscribed Portion of an Issue and Market Making
Such Funds may enter into an agreement with a Merchant Banker.
Pursuant to such agreement, the Fund may:
Subscribe to the unsubscribed portion of an issue
Receive securities in the process of market making.
Deliver securities in the process of market making.
Such market making activities must be undertaken under Chapter IX of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018.
(c).
Exemption from the SEBI (Prohibition of Insider Trading) Regulations, 2015
SME Funds are granted an exemption from certain provisions of the SEBI (Prohibition of Insider Trading) Regulations, 2015.
Specifically, such Funds are exempt from:
Regulation 3(1).
Regulation 3(2).
Regulation 4(1).
of the SEBI (Prohibition of Insider Trading) Regulations, 2015.
The exemption is available in respect of investments made in:
Companies listed on an SME Exchange.
Companies listed on the SME Segment of a recognised stock exchange.
Such investments must be made pursuant to due diligence conducted on those companies.
The exemption is available only subject to the conditions specified thereafter.
Reasoning behind Insider Trading Exemption for Due Diligence
Ordinarily, the Insider Trading Regulations restrict:
Communication of unpublished price sensitive information (UPSI).
Procurement of UPSI.
Trading while in possession of UPSI.
During the course of due diligence, an investor may need access to sensitive non-public information about a company.
Without a specific exemption, the receipt and use of such information could potentially trigger restrictions under the Insider Trading Regulations.
This provision recognises that due diligence is an essential part of evaluating an investment opportunity.
Accordingly, SME Funds are permitted to undertake such due diligence for investments in eligible SME-listed companies without:
Automatically attracting the restrictions contained in the specified provisions of the Insider Trading Regulations.
Conditions for Due-Diligence
The investment must be made in a company that is:
Listed on an SME Exchange.
Listed on the SME Segment of a recognised stock exchange.
The investment must be made pursuant to due diligence of such company.
The exemption is available subject to the following conditions:
(i). Disclosure of Trading Pursuant to Due Diligence
The Fund must disclose any trading in securities undertaken pursuant to such due diligence.
The disclosure must be made within two trading days of such trading.
The disclosure must be made to the stock exchange(s) where the investee company is listed.
(ii). Lock-in Requirement for Investment
Such investment shall be subject to a lock-in period of one year.
During the lock-in period, the investment cannot be transferred, sold, or otherwise exited by the Fund.
16(4). Additional Conditions on Social Impact Funds
In addition to the conditions specified 16(1), Social Impact Funds must comply with the following requirements:
(a). Minimum Investment in Social Ventures and Social Enterprises
At least 75% of the Investable Funds shall be invested in any of the following:
Unlisted securities of Social Ventures.
Partnership interests in Social Ventures.
Units of Social Ventures.
Securities of Social Enterprises.
Accordingly, a minimum of 75% of the Fund's Investable Funds must be deployed in the above specified categories of investments.
Investment of Remaining Investable Funds by Existing Social Impact Funds
An existing Social Impact Fund may invest its remaining Investable Funds in:
Securities of Not-for-Profit Organisations (NPOs) registered on a Social Stock Exchange.
Securities of Not-for-Profit Organisations (NPOs) listed on a Social Stock Exchange.
Such investment can be made only with the prior consent of the investors.
The consent must be obtained from at least 75% of the investors, determined by the value of their investment.
Accordingly, the approval threshold is based on the value of investments held by investors, and not merely on the number of investors.
(b). Acceptance of Grants
Such Funds may accept grants.
However, the utilization of such grants shall be restricted to the investments specified under clause (a).
Minimum Grant Amount: The amount of grant accepted by the Fund from any person shall not be less than ₹10 lakh.
Exemption for Accredited Investors: The minimum grant amount requirement of ₹10 lakh shall not apply to Accredited Investors.
No Profit or Gain to Grant Providers: No profits or gains shall accrue to the provider of such grants.
(ba). Exception to the Investment Limits under Clauses (a) and (b)
Notwithstanding the provisions of clauses (a) and (b), a special investment flexibility is available to certain Social Impact Funds.
This exception applies to:
A Social Impact Fund.
A scheme of a Social Impact Fund.
that is launched exclusively for a Not-for-Profit Organisation (NPO) registered or listed on a Social Stock Exchange.
Eligible Not-for-Profit Organisations
The NPO must be:
Registered on a Social Stock Exchange.
Listed on a Social Stock Exchange.
Permitted Investment Deployment
Such Social Impact Funds or schemes may deploy 100% of their Investable Funds in the securities of eligible Not-for-Profit Organisations.
Accordingly, the Fund is permitted to invest its entire Investable Funds in:
Securities of NPOs registered on a Social Stock Exchange.
Securities of NPOs listed on a Social Stock Exchange.
(c). Grants to Social Ventures and Social Enterprises
Such Funds may provide grants to Social Ventures or Social Enterprises.
In order to do so , The Fund may provide such grants only if appropriate disclosure is made in the Placement Memorandum.
(d). Omitted.
16(5). Additional Conditions Applicable to Infrastructure Funds
The following conditions shall apply to Infrastructure Funds in addition to conditions laid down in 16(1):
(a). Minimum Investment in Infrastructure-Focused Investments
At least 75% of the Investable Funds shall be invested in any of the following:
Unlisted securities of Venture Capital Undertakings.
Units of Venture Capital Undertakings.
Partnership interests in Venture Capital Undertakings.
Unlisted securities of investee companies engaged in infrastructure projects.
Units of investee companies engaged in infrastructure projects.
Partnership interests in investee companies engaged in infrastructure projects.
Unlisted securities of Special Purpose Vehicles (SPVs).
Units of Special Purpose Vehicles (SPVs).
Partnership interests in Special Purpose Vehicles (SPVs).
The Venture Capital Undertakings, investee companies, or Special Purpose Vehicles must be:
Engaged in operating infrastructure projects.
Engaged in developing infrastructure projects.
Engaged in holding infrastructure projects.
Formed for the purpose of operating infrastructure projects.
Formed for the purpose of developing infrastructure projects.
Formed for the purpose of holding infrastructure projects.
The 75% investment requirement may also be satisfied through investment in: Units of Category II Alternative Investment Funds.
Provided that such Category II AIFs invest primarily in:
Such Venture Capital Undertakings;
Such investee companies; or
Such Special Purpose Vehicles.
Accordingly, a minimum of 75% of the Fund's Investable Funds must be deployed in infrastructure-focused investments falling within the above categories.
(b). Investment in Listed Debt and Securitised Debt Instruments
Notwithstanding 16(5)(a), such Funds may also invest in:
Listed securitised debt instruments.
Listed debt securities of investee companies.
Listed debt securities of Special Purpose Vehicles (SPVs).
The investee companies or Special Purpose Vehicles must be:
Engaged in operating infrastructure projects.
Engaged in developing infrastructure projects.
Engaged in holding infrastructure projects.
Formed for the purpose of operating infrastructure projects.
Formed for the purpose of developing infrastructure projects.
Formed for the purpose of holding infrastructure projects.
Accordingly, despite the restrictions contained in 16(5)(a):
Infrastructure Funds are permitted to invest in listed debt-based instruments issued by infrastructure-focused investee companies and Special Purpose Vehicles.
Regulation 17. Conditions for Category II Alternative Investment Funds
The following investment conditions shall apply to Category II Alternative Investment Funds:
(a). Permitted Investments by Category II Alternative Investment Funds
Category II Alternative Investment Funds shall invest in:
Investee Companies: A company that receives investment from an investor, or any other investing entity.
Units of Category I Alternative Investment Funds.
Units of other Category II Alternative Investment Funds.
Such investments must be made in accordance with the disclosures contained in the Placement Memorandum.
Explanation: Primary Investment Requirement for Category II Alternative Investment Funds
A Category II Alternative Investment Fund shall invest primarily in:
Unlisted securities and/or Listed debt securities, including Securitised debt instruments.
The listed debt securities must be rated 'A' or below by a credit rating agency registered with the Board.
The Fund may make such investments:
Directly; or
Through investment in units of other Alternative Investment Funds.
Such investments shall be made in the manner specified by the Board.
Understanding Listed Debt Securities Rated "A" or Below
Debt securities are financial instruments through which entities borrow money from investors.
Credit ratings indicate the creditworthiness of the issuer and the likelihood of repayment.
Securities rated 'A' or below generally carry a higher degree of credit risk than highly rated instruments such as:
AAA
AA+
AA
AA−
By permitting investment in such instruments, the regulation allows Category II AIFs to provide capital to issuers that may not qualify for the highest credit ratings.
Example: Investment in Unlisted Securities (Most Common)
Suppose ABC Growth Fund, a Category II AIF, has ₹100 crore.
It invests:
₹60 crore in an unlisted start-up manufacturing EV batteries.
₹20 crore in an unlisted healthcare company.
₹10 crore in an unlisted logistics company.
₹10 crore in cash and treasury instruments.
This complies with the regulation because the Fund is investing primarily in unlisted securities.
Example 2: Investment in Lower-Rated Listed Debt
Suppose XYZ Credit Opportunities Fund, a Category II AIF, has ₹100 crore.
It invests:
₹70 crore in listed non-convertible debentures (NCDs) of a company rated A.
₹20 crore in listed securitised debt instruments rated BBB+.
₹10 crore in cash.
This also complies because:
The debt securities are listed.
The securities are rated A or below.
The Fund's primary investment exposure is in the permitted asset class.
Example 3 – Investment Through Another AIF
Suppose Fund A is a Category II AIF.
Instead of directly investing in startups, it invests:
₹80 crore in the units of Fund B.
Fund B in turn invests in unlisted technology startups and unlisted manufacturing companies.
This is permitted because the regulation expressly allows investment Directly; or Through units of other AIFs.
So Fund A gets indirect exposure to unlisted securities through Fund B.
(b). Omitted.
(c). Restrictions on Borrowing and Leverage by Category II AIFs
A Category II Alternative Investment Fund (AIF):
Cannot borrow funds, either directly or indirectly, for making investments or any other purpose.
Cannot engage in leverage for making investments or otherwise.
AIF cannot borrow funds directly - The AIF cannot take a loan in its own name to make investments
Example:
The AIF has ₹100 crore from investors.
It cannot borrow another ₹50 crore from a bank and invest ₹150 crore.
AIF cannot borrow funds indirectly - The AIF cannot use structures or arrangements that effectively achieve the same result as borrowing.
Example:
The AIF arranges for another entity to borrow money on its behalf.
The borrowed money is then routed to the AIF for investment purposes.
AIF cannot engage in leverage - Even though the AIF has not taken the loan itself, it is still indirectly using borrowed funds, which is prohibited.
Leverage means using borrowed money or financial arrangements to increase investment exposure beyond the fund's actual capital.
Example:
Investors contribute ₹100 crore.
Through borrowing or derivative positions, the AIF obtains exposure of ₹200 crore.
The additional ₹100 crore exposure is leverage and is generally not permitted.
Exception: Borrowing is permitted only to meet:
Temporary funding requirements.
Day-to-day operational requirements.
Such borrowing is allowed only if all the following conditions are satisfied:
The borrowing period does not exceed 30 days.
Borrowing is undertaken on not more than four occasions in a financial year.
The amount borrowed does not exceed 10% of the investable funds of the AIF.
The borrowing complies with any additional conditions specified by SEBI from time to time.
Exception for Infrastructure Investee Companies
Although a Category II AIF generally cannot borrow or use leverage:
It is permitted to create an encumbrance over the shares of certain investee companies in limited circumstances.
Encumbrance means creating a charge , or a pledge or a security interest.
This is allowed only if all the following conditions are met:
The investee company must be an infrastructure company
The investee company must be engaged in the:
Development of infrastructure projects.
Operation of infrastructure projects.
Management of infrastructure projects.
The infrastructure activity must be recognised by the Government
The project must fall within one of the infrastructure sub-sectors listed in the Harmonised Master List of Infrastructure issued by the Central Government.
Examples may include:
Roads and highways
Ports
Airports
Power generation and transmission
Railways
Urban infrastructure
The encumbrance can be created only on the AIF's equity investment
The Category II AIF may:
Pledge its shares.
Create a charge/security interest over its shares held in the investee company.
The purpose must be to facilitate borrowing by the investee company
The encumbrance cannot be created for the AIF's own borrowing.
It can be created only to enable the investee company to obtain financing.
Example:
A Category II AIF invests in an airport development company.
The airport company seeks a loan from a bank.
The bank requires additional security.
The AIF may pledge its shares (investee company’s shares) in the airport company as security for that loan.
SEBI's conditions must be complied with
The creation of such encumbrance is subject to: Any conditions Restrictions and Safeguards specified by SEBI from time to time.
(d).
Even though clause (c) generally prohibits Category II AIFs from borrowing or engaging in leverage, there is an exception.
The exception is as follows:
A Category II AIF is allowed to undertake hedging transactions.
These Hedging transactions are subject to guidelines as specified by the Board from time to time;.
Hedging means taking a position to reduce or manage risk, rather than to earn additional returns through speculation.
Why there is an exception?
SEBI recognizes that certain risks may need protection against, such as:
Interest rate risk
Currency risk
Market price risk
Commodity price risk (where relevant)
So , the use of derivatives or similar instruments for risk management is permitted.
Example 1 – Currency Hedge
A Category II AIF invests in a company that earns revenue in US Dollars.
The fund fears that the US Dollar may depreciate against the Indian Rupee.
The fund enters into a currency derivative contract to protect itself against adverse exchange rate movements.
This is hedging, and may be permitted.
A currency derivative contract is a financial contract whose value depends on the exchange rate between two currencies
It is used to protect against losses caused by changes in foreign exchange rates.
Example
Suppose a Category II AIF invests in a company that will receive USD 1 million after 6 months.
Today: 1 USD = ₹85
So: USD 1 million = ₹8.5 crore
The AIF fears that the dollar may weaken.
If after 6 months: 1 USD = ₹7
Then USD 1 million will be worth only ₹7.5 crore
The investment effectively loses ₹1 crore due to currency movements.
Using a Currency Derivative: The AIF enters into a contract with a bank
After 6 months, I can sell USD 1 million at ₹85 per dollar.
This is a currency derivative contract (commonly a forward contract).
Now: Even if the market rate falls to ₹75, the AIF can still exchange at ₹85, protecting itself from the loss.
(da). Credit - Default Swaps
A Category II Alternative Investment Fund (AIF) may:
Buy Credit Default Swaps (CDS).
Sell Credit Default Swaps (CDS)
It must do so in accordance with the conditions and guidelines specified by SEBI from time to time.
Understanding a Credit Default Swap
A Credit Default Swap (CDS) is a financial contract that provides protection against the risk of a borrower failing to repay its debt (default).
A CDS works like insurance against the default of a debt instrument.
Buying a CDS
A Category II AIF holds corporate bonds issued by Company X.
The AIF is concerned that Company X may default on its repayment obligations.
The AIF buys a CDS from another party.
This another party is called the CDS Seller.
If Company X does not default, the AIF pays periodic CDS premiums.
If Company X defaults, the CDS seller compensates the AIF as per the contract.
Selling a CDS
A Category II AIF believes Company X is financially strong.
Another investor wants protection against Company X's default risk.
The AIF sells a CDS to that investor. In this case , the AIF itself becomes the CDS Seller.
The AIF receives periodic premiums.
If Company X defaults, the AIF must compensate the buyer according to the CDS contract.
In this case, the AIF assumes the credit risk in exchange for earning premiums.
(e). Agreements with the Merchant Banker
A Category II Alternative Investment Fund (AIF) may:
Enter into an agreement with a merchant banker.
Under such agreement, the AIF may undertake either of the following activities:
1. Subscribe to the Unsubscribed Portion of an Issue
When securities are offered to investors, the entire issue may not get subscribed.
The Category II AIF may agree in advance to purchase the portion that remains unsubscribed.
This helps ensure successful completion of the issue.
Example:
A company issues shares worth ₹100 crore.
Investors subscribe to only ₹80 crore.
₹20 crore remains unsubscribed.
Pursuant to its agreement with the merchant banker, the Category II AIF subscribes to the remaining ₹20 crore.
2. Receive or Deliver Securities for Market Making
The AIF may participate in market-making arrangements.
It may receive securities from, or deliver securities to, a market maker as required under the applicable regulations.
This facilitates liquidity and orderly trading in the securities.
Example:
An SME company gets listed.
A market maker is appointed to provide liquidity in the shares.
The Category II AIF enters into an arrangement through the merchant banker and provides or receives shares as part of the market-making mechanism prescribed by SEBI.
Understanding Market Making
Market making is a mechanism to ensure that there is always someone willing to buy and sell a security, so that investors can trade easily.
A market maker continuously provides:
A buy quote (price at which it will buy securities).
A sell quote (price at which it will sell securities).
Some securities, especially:
SME shares,
Start-up listings,
Newly listed companies,
may not have enough buyers and sellers.
Without market making:
Investors may not find buyers when they want to sell.
Investors may not find sellers when they want to buy.
Trading may become difficult and prices may fluctuate sharply.
A market maker:
Maintains an inventory of securities.
Buys securities from investors who want to sell.
Sells securities to investors who want to buy.
Provides continuous liquidity in the market.
(f).
The Category II AIF is exempt from:
Regulation 3(1) of the PIT Regulations: Restriction on communicating UPSI (Unpublished Price Sensitive Information).
Regulation 3(2) of the PIT Regulations: Restriction on procuring or obtaining UPSI.
Regulation 4(1) of the PIT Regulations: Restriction on trading while in possession of UPSI.
The exemption is available only where:
The AIF is making an investment in a company listed on an SME Exchange or SME Segment.
The investment is being considered pursuant to a due diligence exercise conducted on that company.
The AIF complies with the following conditions:
The exemption is available subject to the following conditions:
(i). Disclosure of Trading Pursuant to Due Diligence
The Fund must disclose any trading in securities undertaken pursuant to such due diligence.
The disclosure must be made within two trading days of such trading.
The disclosure must be made to the stock exchange(s) where the investee company is listed.
(ii). Lock-in Requirement for Investment
Such investment shall be subject to a lock-in period of one year.
During the lock-in period, the investment cannot be transferred, sold, or otherwise exited by the Fund.
Reasoning behind Insider Trading Exemption for Due Diligence
Ordinarily, the Insider Trading Regulations restrict:
Communication of unpublished price sensitive information (UPSI).
Procurement of UPSI.
Trading while in possession of UPSI.
During the course of due diligence, an investor may need access to sensitive non-public information about a company.
Without a specific exemption, the receipt and use of such information could potentially trigger restrictions under the Insider Trading Regulations.
The objective is to acknowledge that due diligence is an essential part of evaluating an investment opportunity.
Accordingly, Category II funds are permitted to undertake such due diligence for investments in eligible SME-listed companies without:
Automatically attracting the restrictions contained in the specified provisions of the Insider Trading Regulations.
Conditions for Due-Diligence
The investment must be made in a company that is:
Listed on an SME Exchange
Listed on the SME Segment of a recognised stock exchange.
The investment must be made pursuant to due diligence of such company.
Regulation 17A. Conditions for co-investment by Category I and II Alternative Investment Funds
17A(1). Co-Investment by Investors of Category I and Category II AIFs
Investors of Category I AIFs and Category II AIFs may undertake co-investments alongside the AIF.
However, co-investments can be made only through the mechanisms specifically permitted under the regulations.
Accordingly, co-investment must be undertaken through either of the following:
(a). Co-Investment Scheme
A co-investment may be made through a Co-Investment Scheme launched under the AIF Regulations.
The scheme is specifically established to facilitate co-investment opportunities for eligible investors.
(b) Co-Investment Portfolio Manager
A co-investment may be made through a Co-Investment Portfolio Manager.
Such Portfolio Manager must be registered and operate in accordance with the SEBI (Portfolio Managers) Regulations, 2020.
What is a Co-Investment?
A co-investment occurs when investors in an AIF invest directly in a portfolio company alongside the AIF.
Instead of gaining exposure only through their units in the AIF, the investors make a separate direct investment in the same investee company.
Example
A Category II Private Equity Fund invests ₹100 crore in Startup X.
Certain investors of the fund wish to invest additional money directly into Startup X.
Those investors cannot make the co-investment through an informal arrangement.
The co-investment must be structured through:
A Co-Investment Scheme; or
A Co-Investment Portfolio Manager registered under the Portfolio Managers Regulations.
17A(2). Filing of Shelf Placement Memorandum for Co-Investment Schemes
Under circumstances a co-investment opportunity is proposed to be offered to investors of a Category I AIF or Category II AIF through a Co-Investment Scheme:
Before such co-investment opportunity is offered to investors, a Shelf Placement Memorandum must be filed with SEBI.
The filing must be made in the manner specified by SEBI from time to time.
The Shelf Placement Memorandum must be filed through a Merchant Banker.
The filing must be accompanied by the prescribed fee specified in the Second Schedule to the AIF Regulations.
The filing is a pre-condition to offering the co-investment opportunity to investors.
Accordingly, the co-investment opportunity cannot be offered through a Co-Investment Scheme unless:
The Shelf Placement Memorandum has first been filed with SEBI in the prescribed manner.
Shelf Placement Memorandum
A Shelf Placement Memorandum is a disclosure document filed for a Co-Investment Scheme.
It contains the framework and disclosures relating to the proposed co-investment structure.
Instead of filing a separate placement memorandum for each co-investment opportunity, the regulations permit the use of a shelf document in the manner prescribed by SEBI.
Example
A Category II Private Equity Fund identifies an opportunity to invest in ABC Technologies Pvt. Ltd.
The Manager wishes to offer the same investment opportunity directly to certain investors through a Co-Investment Scheme.
Before offering the opportunity:
A Shelf Placement Memorandum must be filed with SEBI.
The filing must be made through a Merchant Banker.
The prescribed fee must be paid.
Only after compliance with these requirements can the co-investment opportunity be offered to the investors.
17A(3). Separate Co-Investment Scheme for Each Co-Investment Opportunity
Every co-investment opportunity must be undertaken through a separate Co-Investment Scheme.
A single Co-Investment Scheme cannot be used for multiple unrelated co-investment transactions.
Accordingly, each co-investment opportunity requires the launch of its own distinct scheme.
The Co-Investment Scheme must be launched in accordance with the Shelf Placement Memorandum previously filed with SEBI.
The terms, structure, and operation of the scheme must remain consistent with the disclosures and framework contained in the Shelf Placement Memorandum.
Example 1: Investment Opportunity 1
A Category II AIF invests in ABC Technologies Pvt. Ltd.
Certain investors wish to participate through a co-investment.
Co-Investment Scheme – 1 is launched for this investment.
Investment Opportunity 2
Later, the AIF invests in XYZ Healthcare Pvt. Ltd.
Investors again wish to co-invest.
The manager cannot use Co-Investment Scheme – 1 for this new investment.
A separate Co-Investment Scheme – 2 must be launched.
Restriction on Angel Funds
An Angel Fund is not permitted to launch a Co-Investment Scheme.
Accordingly, the co-investment scheme provisions available to other eligible Category I or Category II AIFs cannot be utilized by an Angel Fund.
Even if the investors of an Angel Fund are interested in participating in a co-investment opportunity:
The Angel Fund cannot structure such opportunity through a Co-Investment Scheme under these regulations.
Angel Funds
An Angel Fund is a sub-category of a Category I Alternative Investment Fund (AIF) that:
Pools money from angel investors and invests in early-stage start-ups and emerging businesses.
An Angel Investor is a person who provides capital to very early-stage businesses, usually when:
The company is newly established.
The business has little or no operating history.
Traditional funding sources are unavailable.
The business requires seed or early-stage capital.
17A(4). Eligibility to Invest in a Co-Investment Scheme
With respect to Co-Investment Schemes launched for investors of Category I or Category II AIFs:
Only Accredited Investors of the relevant Category I or Category II AIF are eligible to participate in a Co-Investment Scheme.
Accordingly, merely being an investor in the AIF is not sufficient to participate in the co-investment opportunity.
The investor must also qualify as an Accredited Investor under the applicable SEBI framework.
Investors of the AIF who are not Accredited Investors cannot invest through the Co-Investment Scheme.
Co-investment opportunities are restricted to investors who:
Meet the prescribed accreditation criteria and are considered capable of evaluating and bearing the risks associated with direct co-investments.
Example
A Category II Private Equity Fund has the following investors:
Investor A – Accredited Investor
Investor B – Accredited Investor
Investor C – Non-Accredited Investor
The fund identifies a co-investment opportunity in ABC Technologies Pvt. Ltd.
A Co-Investment Scheme is launched for that opportunity.
Investors A and B may participate in the Co-Investment Scheme.
Investor C cannot participate, even though Investor C is an investor in the main AIF.
17A(5). Investment Restriction for Co-Investment Schemes
Each Co-Investment Scheme shall invest in only one Investee Company.
A Co-Investment Scheme cannot be used to invest in multiple portfolio companies.
Accordingly, a separate Co-Investment Scheme must be launched for every distinct investee company.
17A(6). Restriction on Investment in AIF Units
A Co-Investment Scheme shall not invest in the units of any Alternative Investment Fund.
The scheme must invest directly in the designated investee company and cannot obtain exposure through another AIF.
Accordingly, a Co-Investment Scheme cannot operate as a fund-of-funds structure.
17A(7). Manner and Conditions for Co-Investment Schemes
Co-investment through a Co-Investment Scheme must be carried out in the manner specified by SEBI from time to time.
Such co-investments are also subject to any conditions, requirements, restrictions, or procedural guidelines prescribed by SEBI.
Accordingly, Co-Investment Schemes must comply not only with the AIF Regulations but also with any additional framework issued by SEBI through circulars, guidelines, or directions.
17A(8). Co-Investors Cannot Receive More Favourable Terms than the AIF
The following restriction on favourable terms applies to co-investments made by:
The Manager.
The Sponsor.
A Co-investor.
A Co-Investment Scheme.
When the above persons invest alongside an Alternative Investment Fund in the same investee company then:
Their investment terms cannot be more favourable than those available to the AIF.
Accordingly, the AIF must not be placed at a disadvantage vis-à-vis the Manager, Sponsor, Co-investor, or Co-Investment Scheme.
Understanding More Favourable Terms
The following are examples of terms that generally cannot be more favourable than those received by the AIF:
Lower purchase price for the same securities.
Higher liquidation preference.
Better exit rights.
Preferential dividend rights.
Enhanced voting rights.
Superior anti-dilution protection.
Priority rights in distributions.
More favourable conversion rights.
Any other economic or governance benefit not available to the AIF.
Example:
A Category II AIF invests in Startup X at ₹100 per share.
Simultaneously, a Co-Investment Scheme invests in the same company.
The following terms are Permitted:
The Co-Investment Scheme also acquires shares at ₹100 per share on the same terms as the AIF.
The following terms are not Permitted:
The Co-Investment Scheme acquires the same class of shares at ₹80 per share.
The Co-Investment Scheme receives a guaranteed exit return while the AIF does not.
The Co-Investment Scheme receives superior liquidation rights compared to the AIF.
Exit from Co-Investment Must Coincide with Exit of the AIF
With respect to co-investments made by A Co-investor or A Co-Investment Scheme, alongside an Alternative Investment Fund in an investee company:
The timing of exit from the investee company must be identical to the timing of exit of the relevant scheme of the Alternative Investment Fund.
Accordingly, the co-investor or Co-Investment Scheme cannot exit the investment before the AIF exits.
Similarly, the co-investor or Co-Investment Scheme cannot continue to hold the investment after the AIF has exited.
The exit by the co-investor and the exit by the AIF scheme must occur simultaneously.
Example
A Category II AIF and a Co-Investment Scheme both invest in ABC Technologies Pvt. Ltd.
After five years, the AIF decides to sell its shares to a strategic buyer.
The Co-Investment Scheme must also exit its investment at the same time.
The Co-Investment Scheme cannot:
Sell its shares two years earlier.
Retain its shares after the AIF has exited.
17A(9). Winding Up of a Co-Investment Scheme
A Co-Investment Scheme shall be wound up upon exit from the co-investment.
The winding up must take place once the scheme has exited its investment in the investee company.
Since a Co-Investment Scheme is permitted to invest in only one investee company, its purpose comes to an end after the exit from that investment.
Accordingly, the scheme cannot continue to exist after the co-investment has been exited.
The winding up must be carried out in accordance with the provisions of the AIF Regulations.
Example:
A Co-Investment Scheme is launched to invest in ABC Technologies Pvt. Ltd.
After six years, the AIF and the Co-Investment Scheme exit their investment in ABC Technologies.
Following the exit, the Co-Investment Scheme must be wound up.
The scheme cannot retain its structure for making new investments in other companies.
17A(10). Regulatory Exemptions Available to Co-Investment Schemes
There are specific regulatory exemptions to Co-Investment Schemes.
Accordingly, the following provisions of the AIF Regulations do not apply to a Co-Investment Scheme:
Regulation 10(b)
Regulation 10(d)
Regulation 11(2)
Regulation 12(2)
Regulation 12(3)
Regulation 12(4)
Regulation 12(5)
Regulation 13
Regulation 15(1)(a)
Regulation 15(1)(c)
Regulation 15(1)(da)
Regulation 15(1)(g)
Regulation 15(1)(h)
Regulation 16
Regulation 17
As a result, a Co-Investment Scheme is not required to comply with the obligations, restrictions, thresholds, or conditions contained in the above provisions.
This exemption recognises that a Co-Investment Scheme is a special-purpose structure:
Available only to Accredited Investors;
Established for a specific co-investment opportunity; and
Restricted to investment in a single investee company.
So, certain requirements that ordinarily apply to Category I, Category II, or Category III AIFs have been expressly disapplied.
Regulation 18. Conditions for Category III Alternative Investment Funds
The following investment conditions shall apply to Category III Alternative Investment Funds:
(a). Permitted Investments by Category III AIFs
A Category III Alternative Investment Fund may invest in a wide range of investment instruments.
Such investments may be made in:
Securities of Listed Investee Companies
The fund may invest in securities of companies that are listed on a recognised stock exchange.
Examples include:
Equity shares;.
Debentures.
Preference shares.
Other listed securities.
Securities of Unlisted Investee Companies
The fund may also invest in securities of companies that are not listed on a stock exchange.
This enables Category III AIFs to participate in private and pre-listing investment opportunities.
Derivatives
The fund may invest in derivative instruments.
Examples include:
Futures.
Options.
Swaps.
Other derivative contracts permitted under applicable laws.
Derivatives may be used for hedging, trading, arbitrage, or other investment strategies permitted by SEBI.
Units of Other Alternative Investment Funds
The fund may invest in the units of other AIFs.
This allows indirect exposure to investments managed through other Alternative Investment Funds.
Complex or Structured Products
The fund may invest in complex or structured financial products.
These are products whose returns are linked to one or more underlying assets, indices, securities, interest rates, commodities, or other financial variables.
Such products may have customized features and risk-return profiles.
Example:
A Category III AIF may simultaneously:
Purchase shares of a listed company.
Invest in an unlisted start-up.
Trade index futures and options.
Invest in units of another AIF.
Acquire a structured product linked to a basket of securities.
All of these investments are permitted, subject to compliance with SEBI regulations and any applicable investment restrictions.
(aa). Dealing in Goods Received Through Physical Settlement of Commodity Derivatives
A Category III AIF may deal in goods that are received upon the physical settlement of commodity derivatives.
Commodity derivatives are derivative contracts whose underlying asset is a commodity, such as:
Gold.
Silver.
Crude Oil.
Agricultural commodities.
Other commodities traded on recognised exchanges.
In certain commodity derivative contracts, settlement may occur through physical delivery of the underlying commodity instead of cash settlement.
Where a Category III AIF receives the actual commodity upon such physical settlement, it is permitted to deal in those goods.
Accordingly, the AIF may hold, transfer, sell, or otherwise deal with the commodities received through physical settlement.
Example
A Category III AIF purchases a gold futures contract.
Upon expiry of the contract, settlement takes place through physical delivery rather than cash settlement.
The AIF receives the actual gold.
Under this provision, the AIF is permitted to deal with the gold received, including selling or transferring it in accordance with applicable laws and regulations.
(ab). Credit Default Swaps by Category III AIFs
A Category III Alternative Investment Fund may buy Credit Default Swaps (CDS).
A Category III Alternative Investment Fund may also sell Credit Default Swaps.
Any purchase or sale of CDS must comply with the conditions specified by SEBI from time to time.
(b). Omitted.
(c). Borrowing and Leverage by Category III AIFs
Unlike Category I and Category II AIFs, a Category III Alternative Investment Fund is permitted to engage in leverage or borrow funds.
The ability to use leverage or borrowing is not unrestricted.
Such leverage or borrowing is subject to the conditions prescribed by SEBI.
The conditions are as follows:
(a). Investor Consent Required
The Category III AIF must obtain the consent of its investors before engaging in leverage or borrowing.
Accordingly, leverage cannot be employed unless the investors have agreed to it in the manner prescribed under the fund documents and applicable regulations.
(b). SEBI-Prescribed Maximum Limit
The leverage or borrowing must remain within the maximum limit specified by SEBI.
The fund cannot exceed the leverage threshold prescribed by the Board from time to time.
SEBI may revise or prescribe different limits through regulations, circulars, or other directions.
Example 1: Borrowing
A Category III AIF has investor capital of ₹100 crore.
The fund borrows ₹50 crore from a lender.
Total investment exposure becomes ₹150 crore.
The additional ₹50 crore exposure arises because of borrowing.
Example 2 – Leverage Through Derivatives
A Category III AIF has ₹100 crore in capital.
Through derivative contracts, the fund obtains market exposure of ₹300 crore.
Although the fund has invested only ₹100 crore of capital, its effective exposure is ₹300 crore.
This additional exposure constitutes leverage.
Disclosure of Leverage by Category III AIFs
Category III Alternative Investment Funds that employ leverage or borrow funds are required to make periodic disclosures regarding their leverage.
The disclosures must be made to the investors of the fund; and to SEBI.
The frequency, format, and manner of disclosure shall be as specified by SEBI from time to time.
Information Required to be Disclosed
Overall Level of Leverage Employed
The fund must disclose the total leverage being used by it.
This provides investors and SEBI with an overall picture of the fund's leveraged exposure.
Leverage Arising from Borrowing of Cash
The fund must separately disclose the extent of leverage resulting from direct borrowings.
This includes leverage created through loans, credit facilities, or other borrowing arrangements.
Leverage Arising from Derivatives or Complex Products
The fund must separately disclose leverage arising from:
Derivative positions.
Complex or structured products.
This enables investors and SEBI to understand the leverage embedded in sophisticated financial instruments.
Main Source of Leverage
The fund must disclose the primary source from which its leverage is derived.
For example, whether leverage is mainly generated through:
Borrowed funds.
Futures and options.
Swaps.
Structured products.
Other leveraged positions.
(d). Regulatory Oversight of Category III AIFs
Category III Alternative Investment Funds are subject to regulatory oversight by SEBI through the issuance of directions and regulatory requirements.
SEBI may prescribe specific rules, standards, and compliance requirements for Category III AIFs from time to time.
Such directions may cover the following areas:
(a). Operational Standards
The Requirements relating to the functioning and operations of the fund.
The Standards for managing and administering the fund's activities.
(b). Conduct of Business Rules
The Rules governing how the fund, its Manager, and associated persons conduct their business.
The Standards intended to ensure fair, transparent, and ethical conduct.
(c). Prudential Requirements
The Risk management and financial discipline requirements.
The Measures designed to promote the safety and stability of the fund's operations.
(d). Restrictions on Redemption
The conditions or limitations relating to the redemption of units by investors.
The measures intended to manage liquidity and protect investor interests.
(e). Conflict of Interest
The Requirements for identifying, disclosing, managing, and mitigating conflicts of interest.
The Safeguards to ensure that decisions are taken in the best interests of investors.
Regulation 19. Other Alternative Investment Fund
Power of SEBI to Create Frameworks for Other Types of AIFs
The Board may lay down a regulatory framework for AlF that do not fall within the categories specified in the AIF Regulations.
Accordingly, SEBI is not restricted to regulating only:
Category I AIFs.
Category II AIFs.
Category III AIFs..
The provision empowers SEBI to recognize and regulate new or specialised types of Alternative Investment Funds that may emerge over time.
