Alternative Funds – Diversified & Complex Assets
AIFs pool capital into non-traditional assets: private equity, hedge strategies, real assets, etc.
Snapshot
Overview
Types
Metrics
Taxation
Glossary
Snapshot
| Aspect | Description |
|---|---|
| Instrument | Units or Share of pooled investment vehicle |
| Returns | Capital Gains / Dividends / Interest |
| Minimum Investment | ₹1 crore |
| Liquidity | Low – closed-ended with fixed tenure |
| Regulator | SEBI |
| Taxation | Pass-through for Cat I & II; Fund-level tax for Cat III |
Overview
What are Alternative Funds?
Alternative Investment Funds (AIFs) are privately pooled investment vehicles that raise capital from sophisticated investors (HNIs, institutions) for investing in non-traditional or alternative asset classes like startups, private equity, hedge strategies, distressed assets, real estate, etc.
They are regulated by SEBI (AIF) Regulations and are designed to expand the capital formation ecosystem beyond conventional equity and mutual funds.
How AIFs Work?
- An AIF is structured as a trust, company or LLP and registered under SEBI.
- It raises money from investors via private placement.
- The fund manager deploys capital as per the defined investment mandate.
- AIFs typically have lock-in periods and drawdown structures, with periodic or terminal returns.
Market Structure & Regulatory Oversight
Regulator: SEBI (Securities and Exchange Board of India)
- Governed by SEBI (AIF) Regulations
- Mandatory registration, fund-level disclosures, and valuation norms
- Leverage restrictions:
- Cat I & II: No leverage except for day-to-day operations
- Cat III: Permitted leverage (with strict risk controls)Regulates issuance and trading of equity shares.
Key Intermediaries in the AIF Market
- Sponsor: Sets up the fund, contributes minimum capital (2.5% of corpus or ₹5 crore)
- Fund Manager / Investment Manager: Decides the strategy, selects investments, and manages operations
- Trustee: Monitors fund operations and ensures fiduciary oversight
- Custodian: Holds assets in custody (mandatory for Category III and large Category I/II AIFs)
- Valuer: Conducts periodic valuation of portfolio assets
Types
SEBI classifies Alternative Investment Funds (AIFs) into three categories based on their investment strategies, risk profile, and economic impact. These categories differ in their target assets, regulatory limits, and investor suitability.
Category I AIF – Development-Oriented
| Feature | Description |
|---|---|
| Focus | Early-stage, socially beneficial or government-prioritized sectors |
| Invests in | Startups, SMEs, social ventures, infrastructure, clean tech, VC |
| Risk Level | High (early stage / unlisted companies) |
| Liquidity | Closed-ended; typically 5–7 years |
| Positioning | Encouraged due to positive spillovers on the economy |
| Leverage | Not permitted |
| Valuation Requirement | Periodic valuation by independent registered valuer is mandatory |
Category II AIF – Private Capital & Credit
| Feature | Description |
|---|---|
| Focus | Medium to long-term private capital, debt, and real asset exposure |
| Invests in | Private equity (PE), debt funds, real estate, distressed assets |
| Risk Level | Moderate to High |
| Liquidity | Closed-ended; typically 4–8 years |
| Positioning | Neutral stance; not incentivized or restricted |
| Leverage | Not permitted (except for operational requirements) |
| Valuation Requirement | Required for unlisted securities |
Category III AIF – Complex / Hedged Strategies
| Feature | Description |
|---|---|
| Focus | Open-ended or short-term strategies with complex risk-return profiles |
| Invests in | Public market securities, long-short equity, arbitrage, derivatives, algorithmic trades |
| Risk Level | High to Very High |
| Liquidity | Open-ended or closed-ended |
| Positioning | Tightly regulated due to potential systemic risk |
| Leverage | Permitted under SEBI limits and subject to enhanced risk control |
| Valuation Requirement | NAV to be disclosed at least quarterly |
Metrics
Evaluating AIFs requires understanding both quantitative and qualitative metrics. Unlike mutual funds, AIFs often operate in illiquid, unlisted, or complex markets, requiring custom risk-return frameworks and manager-level diligence.
Fundamental Metrics
| Metric | What It Indicates |
|---|---|
| Internal Rate of Return (IRR) | The annualized effective compounded return rate the AIF generates for investors, considering cash inflows and outflows. It is preferred over CAGR in private capital due to irregular cash calls and distributions. |
| Net Asset Value (NAV) | The total fair market value of the portfolio minus liabilities, divided by outstanding units. |
| Gross IRR | Return before deducting management fees, expenses, and performance-linked charges |
| Net IRR | Return received by investor after all costs; industry benchmark for fund comparison |
| Multiple on Invested Capital (MoIC) | Total returns divided by capital committed; used in PE & VC AIFs |
| Asset Concentration | Exposure to top holdings — SEBI mandates diversification norms (e.g., max 25% in one investee) |
| Vintage Analysis | Tracks how returns vary based on fund start year — useful for multi-cycle investing |
| Exit Ratio | Ratio of exited investments to total invested — used to assess liquidity and realization efficiency |
| TVPI (Total Value to Paid-In Capital) | Measures total performance (realized + unrealized gains); often called "Net Multiple" |
| DPI (Distributions to Paid-In Capital) | Indicates how much capital has been returned to investors; assesses realized performance |
| RVPI (Residual Value to Paid-In Capital) | Shows how much value is still tied up in current holdings |
| Cash Drag | Capital unutilized vs committed — important in drawdown-based models |
| Commitment Utilization | Proportion of capital drawn down from total commitment |
| Hurdle Rate | Minimum IRR above which performance fee applies |
| Carry or Performance Fee | Fee on Profits above hurdle rate |
| Catch-Up | Allows full carry post-hurdle once preferred return is met |
Qualitative Factors
| Metric | What It Indicates |
|---|---|
| Fund Vintage | Helps understand track record in specific economic cycles |
| Sponsor Commitment | Confidence indicator; SEBI mandates minimum sponsor stake |
| Co-Investment Track Record | Useful for Investors looking for sidecar or direct deals with AIF managers |
Taxation
The tax treatment of AIFs in India depends on their category and the nature of income they generate. SEBI-regulated AIFs enjoy either pass-through status or are taxed at the fund level, based on whether they are Category I & II (private equity, debt, VC) or Category III (hedge/arbitrage funds).
Category I & II AIFs - Pass Through Taxation
- Capital Gains: Taxed directly in the hands of the investors based on holding period and asset type (equity/debt)
- Interest Income: Taxed at investor’s slab rate (TDS @ 10% applicable)
- Dividend Income: Taxed at slab rate (TDS @ 10% applicable)
Category III AIFs - Fund Level Taxation
- All Income (Capital gains, interest, trading): Taxed in the hands of the AIF itself as per applicable rates. Investors do not pay tax separately on income distributed by fund
Tax Filing Requirements
- Schedule OS (Other Sources) in ITR should capture Interest and Dividend income from AIFs.
- Schedule CG (Capital Gain) in ITR should capture capital gains from AIFs.
- Use AIS for validating reported sale proceeds, interest and dividend income.
Glossary
- AIF (Alternative Investment Fund): A privately pooled investment vehicle that collects funds from sophisticated investors for investing in private equity, venture capital, hedge strategies, and other alternatives.
- Anchor Investor: A large early investor (often HNI or institutional) who commits a significant portion of capital upfront, improving fund credibility.
- Carry / Carried Interest: The share of profits (usually 10–20%) that the fund manager earns once a pre-agreed return (hurdle rate) is achieved.
- Commitment: The total capital pledged by an investor to the fund, to be drawn down over time as needed.
- Custodian: A SEBI-registered entity that holds the fund’s assets in trust. Mandatory for Category III AIFs and Category I/II AIFs with corpus > ₹500 crore.
- GP (General Partner): The fund manager or sponsor who sets up and manages the AIF (used in LLP or partnership structures).
- Hurdle Rate: The minimum IRR that the fund must generate before the manager is entitled to earn carry.
- High-Water Mark: In Category III AIFs, ensures that fund managers can only earn performance fees on gains above the previous peak NAV.
- IRR (Internal Rate of Return): The annualized rate of return on capital invested, accounting for all drawdowns and distributions over the fund’s life.
- MoIC (Multiple on Invested Capital): Measures how many times the invested capital has grown; similar to TVPI in private equity.
- NAV (Net Asset Value): The valuation of the fund’s portfolio net of liabilities. Required to be disclosed periodically as per SEBI norms.
- Pass-Through Status: A tax provision where income is not taxed at the fund level but in the hands of the investor (applies to Category I and II AIFs).
- Private Placement: The method by which AIFs raise capital — from a select group of eligible investors and not via public issue.
- RVPI (Residual Value to Paid-In Capital): The proportion of unrealized value in the fund portfolio relative to total investor contributions.
- Special Situation Funds (SSF): AIFs (usually Category II) focused on stressed or distressed asset investing, often within insolvency or restructuring regimes.
- SPV (Special Purpose Vehicle): An entity set up by the AIF to hold a single or group of investments for regulatory or operational convenience.
- TVPI (Total Value to Paid-In Capital): A key private capital metric combining both realized (distributions) and unrealized (NAV) returns to measure overall fund performance.
- Vintage Year: The year in which the AIF starts its investment cycle; used to benchmark fund performance across market cycles.
