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Practice Note: The Category II AIF

Alternative investment funds (“AIFs”) are regulated by the Securities and Exchange Board of India (“SEBI”) which is the regulator of the Indian securities market. In particular, the SEBI (Alternative Investment Funds) Regulations, 2012, (“AIF Regulations”) govern the formation as well as investment criteria of AIFs.

In effect, any privately pooled vehicle established in India which collects funds from “sophisticated investors” [SEBI’s Frequently Asked Questions on AIF Regulations (“SEBI’s FAQs”)], irrespective of their Indian or foreign status, is deemed to be an AIF. It may be noted that while the term “sophisticated investors” does not appear in the AIF Regulations, it can be linked to the minimum investment amount threshold permitted by the AIF Regulations i.e. being INR 10,000,000 (i.e. approximately USD 142,857 at a working conversion rate of Indian Rupees 70 for every US Dollar). For other investment avenues involving lower investment size, there are a cluster of other applicable SEBI routes involving mandatory registrations such as collective investment schemes, mutual funds etc. Below are key highlights of AIF Regulations:


AIFs are registered and invest following a defined investment policy for the benefit of their investors- based on this AIFs have been categorized into three types. Category I AIFs invest in socially or economically desirable sectors such as startup or early stage ventures, infrastructure funds etc. Category III AIFs have open-ended schemes employing complex trading methodologies and undertaking leverage. Category II AIFs are the default category i.e. AIFs which do not fall in Category I and III and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements. In this note, we have focused on Category II AIFs.

PERMITTED INVESTMENT AVENUES: The AIF Regulations do not prescribe the sectors in which Category II AIFs can invest. The SEBI FAQs indicate that the range of investments is wide as it includes real estate funds, private equity funds, funds for distressed assets, etc. registered as Category II AIFs. There is no regulatory distinction amongst such funds based on sector or instrument of investment. AIF Category II are required to invest “primarily” in unlisted investee companies or in units of other Category I and II AIFs as specified in the placement memorandum.

MINIMUM INVESTMENT SIZE: Each scheme is required to have a corpus of at least INR 200,000,000 (i.e. USD 2,857,143).

TENURE: The tenure is determined at the time of application. A minimum of three years is required and can be extended up to two years subject to approval of two-thirds of the unit holders by value of their investment in the AIF and if such consent is not received then the AIF has to liquidate within one year following the expiration of the fund tenure.


An AIF is required at a minimum to have the following cast of characters:

The “manager”: this can be any entity appointed by the AIF to manage its investments and may be same as the sponsor of the fund. The “sponsor”: this is the entity which sets up the AIF and therefore, includes a promoter in case of a company and designated partner in case of a limited liability partnership. The “fund”: the fund itself is required to be set up as any of a trust or a company or a limited liability partnership or a body corporate. The sponsor/manager is required to have a continuing interest in the AIF (not through a waiver of management fees) of at least 2.5% of the corpus of scheme or INR 50,000,000 (i.e. approximately USD 714,285), whichever is less. Further, Indian exchange control regulations require that the control of the AIF should be only with the sponsors and managers. If the sponsors and managers of the AIF are individuals, then for the more favourable characterisation of “downstream” investment by such AIF as domestic, the AIF sponsors and managers should be resident Indian citizens.


The applicant for registration has to be the fund. An application fee of INR 100,000 (i.e. USD 1,428) is to be paid at the time of application and a registration fee of INR 1,000,000 (i.e. USD 14,285) is required to be paid on receipt of approval for registration by SEBI. At the stage of assessment of its application (Form A), SEBI assesses inter alia if the sponsor and manager are both “fit and proper persons” based on criteria specified in Schedule II of the SEBI (Intermediaries) Regulations, 2008 (“Intermediaries Regulations”). As per Schedule II of the Intermediaries Regulations, for the purpose of determining as to whether an applicant is a “fit and proper person”, SEBI may take into account the criteria of integrity, reputation and character; absence of convictions and restraint orders; competence including financial solvency and net worth; absence of categorization as a wilful defaulter.

The Sponsor or Manager of the AIF needs to appoint a custodian registered with SEBI for safekeeping of securities if the corpus of the AIF is more than five hundred crore Indian rupees. There is no minimum time for SEBI approval- typically it takes a couple of months to obtain a registration if the application is in order.


Co-investment in an investee company by a manager or sponsor is required to be on terms no more favourable than those offered to the AIF.


Category II AIFs are restricted from investing over 25% of the investible funds in one investee entity. “Investible funds” for this purpose mean the corpus of the AIF net of estimated expenditure for administration and management of the fund. The uninvested portion of the investible funds may be invested in liquid mutual funds or bank deposits or other liquid assets of higher quality such as treasury bills, commercial papers, certificates of deposits till deployment of funds as per the investment objective of the scheme. AIF cannot invest in “associates” (a defined term) except with the approval of 75% of investors by value of their investment in the AIF. Category II AIFs cannot invest in units of other fund of funds.


Prior approval of SEBI is required to be taken by the AIF before effecting “change in control” ( a defined term) of the AIF, sponsor or manager.


Review of policies and accounts: All AIFs are required to review the policies and procedures, and their implementation, on a regular basis, or as a result of business developments, to ensure their “continued appropriateness”. The books of accounts of the AIF are required to be audited annually by a qualified auditor.


Every AIF is required to provide to its investors, a description of its valuation procedure and of the methodology for valuing assets. Category II AIFs are required to undertake valuation of their investments, at least once in every six months, by an independent valuer appointed by the AIF. This can be extended to one year upon approval of at least 75% seventy-five percent of the investors by value of their investment in the AIF.


AIF Regulations provides for specific periodic disclosure obligations to the investors including conflict of interest, information on fund investments, fees, various risks, valuation, etc.


SEBI may, suo motu or upon receipt of a complaint, inspect the books of account, records and documents of the AIF to ensure that these are being maintained as per the requirements of the AIF Regulations. SEBI may further examine the affairs of the AIF on any matter having a bearing on the activities of the AIF.


Winding up is driven by the nature of the AIF.

– Any AIF set up as a trust can be wound up: (a) on the expiry of tenure of the AIF or all schemes launched by the AIF; or (b) if it is the opinion of the trustees or the trustee company that the AIF be wound up in the interests of investors in the units; or (c) if 75% of the investors by value of their investment in the AIF pass a resolution at a meeting of unit holders that the AIF be wound up; or (d) if SEBI so directs in the interests of investors. – Any AIF set up as a limited liability partnership shall be wound up in accordance with the provisions of the Limited Liability Partnership Act, 2008: (a) on expiry of tenure of the AIF or all schemes launched by the AIF; or (b) if 75% of the investors by value of their investment in the AIF pass a resolution at a meeting of unit holders that the AIF be wound up; or (c) if SEBI so directs in the interests of investors. – Any AIF set up as a company can be wound up in accordance with the provisions of the Companies Act, 2013. – Any AIF set up as a body corporate can be wound up in accordance with the provisions of the statute under which it is constituted.

Procedure for winding up:

The trustees or trustee company or the Board of Directors or designated partners of the AIF, as the case maybe, are required to intimate SEBI and investors of the circumstances leading to the winding up of the AIF. On and from the date of intimation, no further investments can be made on behalf of the AIF so wound up. Within one year from the date of intimation to SEBI and investors, the assets are required to be liquidated, and the proceeds accruing to investors in the AIF are to be distributed to them after satisfying all liabilities. Subject to the conditions, if any, contained in the placement memorandum or contribution agreement or subscription agreement, as the case may be, in specie distribution of assets of the AIF, can be made by the AIF at any time, including on winding up of the AIF, after obtaining approval of at least 75% of the investors by value of their investment in the AIF. Upon winding up of the AIF, the certificate of registration shall be surrendered to SEBI.


The AIFs are regulated more in areas of registration process and entity selection, and ongoing obligations. Several commercial structures such as hurdle-rates are not regulated.


The Income Tax Act, 1961 provides that a company shall be considered as resident of India for tax purposes if it is an “Indian company” or if it has its “place of effective management” in India. The Draft Guiding Principles for determination of Place of Effective Management (POEM) of a Company by the Central Board of Direct Taxes issued on December 23, 2015 provide that the “place of effective management” is a place where the key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance, made in the relevant financial year. In other words, the jurisdiction of incorporation of an entity will not solely determine its Indian resident status. There are other applicable tax nuances such as applicability of tax on AIF set up as a trust if the investors are unspecified. Tax is out of scope of this note.

* This note is intended for the purpose of general reading and discussion. It does not constitute legal advice or establish an attorney-client relationship between Verist Law or its constituents and any other entity.


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