Alternative Investment Funds (AIFs) have emerged as a popular investment option for both traditional and non-traditional investors. While traditional investors often opt for low-risk, high-return tools like debt mutual funds, non-traditional investors, including High Net-worth Individuals (HNIs), seek to diversify their portfolios and explore alternative avenues. In this regard, Category II AIFs have gained significant attention as they provide an enticing platform for investors to participate in the Indian debt asset class.

What are Category II AIFs?

Category II AIFs, as defined by the Securities and Exchange Board of India (SEBI), do not fall under Category I or III AIFs and do not undertake leverage or borrowing, except for their day-to-day operational requirements. These funds primarily invest in unlisted companies with sound business models by raising funds from High Net-worth Individuals (HNIs) and Foreign Portfolio Investors (FPIs). They encompass a variety of funds, including real estate funds, private equity funds (PE funds), and funds for distressed assets.

Who Should Choose AIF Category II?

  1. High Net-Worth Individuals (HNIs): HNIs often look for investment avenues that offer higher returns and are less correlated with traditional markets. Category II AIFs are an excellent choice for such investors as they can invest in unlisted companies, providing potentially higher returns.
  2. Institutional Investors: Banks, pension funds, and other institutional investors can benefit from the diversified and risk-adjusted returns that Category II AIFs offer. These funds are particularly appealing due to their straightforward compliance requirements.
  3. Foreign Portfolio Investors (FPIs): FPIs who are keen on investing in the Indian debt market can opt for Category II AIFs. These funds provide a more flexible and less onerous regulatory regime compared to direct FPI routes.

Who Should Not Choose AIF Category II?

  1. Retail Investors: Given the high minimum investment requirements and the complexity of the investment strategies, Category II AIFs may not be suitable for retail investors.
  2. Risk-Averse Investors: If you are not comfortable with the risks associated with investing in unlisted companies or alternative asset classes, Category II AIFs might not be the best fit for you.

Types of AIF Category II

  1. Private Equity Funds: Invest in unlisted companies with growth potential.
  2. Debt Funds: Focus on lending to businesses or buying debt securities.
  3. Real Estate Funds: Invest in property development or real estate companies.
  4. Fund of Funds: Invest in other AIFs, except for Funds of Funds.

Can AIF Category II Provide Plain Debt?

Yes, Category II AIFs can engage in plain vanilla debt transactions. They are permitted to invest in various forms of debt securities, including non-convertible debentures and optionally convertible instruments. This flexibility allows these funds to offer a wider pool of capital for debt investments.

Investment Restrictions for Category II AIFs

Category II AIFs have specific investment restrictions that govern their operations. These restrictions include:

  1. Investment Philosophy: Category II AIFs can only invest in unlisted companies or units of other AIFs. The fund's investment philosophy is typically outlined in the placement memorandum, which is similar to the Scheme Information Document (SID) of mutual funds.
  2. Investment Options: They can also invest in units of venture capital funds, infrastructure funds, and hedge funds of AIFs, with the exception of Funds of Funds.
  3. Borrowing Limitations: Category II AIFs are not allowed to borrow funds, except for temporary requirements. If a category II fund borrows funds, it can only do so for a maximum of 30 days and not on more than four occasions in a year. The borrowed amount must not exceed 10% of its investible funds.
  4. Hedging: These funds are permitted to engage in hedging activities.
  5. Investment in IPOs: Category II AIFs can invest in the unsubscribed portion of an Initial Public Offering (IPO) by entering into an agreement with a merchant banker.
  6. Exemption from Insider Trading Regulations: SEBI has exempted Category II AIFs from Insider Trading Regulations if they invest in Small Medium Enterprises (SMEs) listed on the SME exchange. However, these funds must hold such securities for at least one year.

Key Themes under the AIF Regulations

The AIF Regulations encompass several key themes that are relevant to the functioning of Category II AIFs:

  1. Continuing Interest: The AIF Regulations require the sponsor or manager of an AIF to contribute a certain amount of capital to the fund, known as the continuing interest. This capital remains locked in the fund until distributions have been made to all other investors. Category II AIFs are required to maintain a continuing interest of 2.5% of the corpus of the fund or INR 50 million, whichever is lower.
  2. Tenure: Category II AIFs can only be closed-end funds, meaning they have a fixed tenure. The AIF Regulations prescribe a minimum tenure of 3 years for Category II AIFs. The tenure is calculated from the date of the final closing of the scheme, and any extension of the tenure requires the approval of at least two-thirds of the unit-holders.

Taxation of Category II AIFs

Taxation for Category II AIFs is similar to that of debt funds. Short-Term Capital Gains (STCG) are taxed at the marginal rate of taxation, which is 30% for High Net-worth Individuals (HNIs). Long-Term Capital Gains (LTCG) are taxed at 20% with indexation benefits. LTCG is applicable if investors redeem their investments after holding them for a minimum of two years.

Commissions for Category II AIFs

Category II AIFs typically offer upfront commissions to distributors, ranging from 2% to 3% depending on the type of AIF. However, the structure and quantum of commissions may vary from fund to fund.

Unlocking the Potential of Category II AIFs in Plain Vanilla Debt Investments

Foreign investors have shown a keen interest in investing in Indian debt as an asset class. While Foreign Portfolio Investment (FPI) route has been the popular choice for these investors, alternative investment routes like Category II AIFs have the potential to become attractive platforms for pooling money in plain vanilla debt investments.

Regulatory Regime and Compliance

Category II AIFs are regulated by SEBI under the AIF Regulations. The registration process for Category II AIFs is straightforward, and the compliance requirements are less onerous compared to those for FPIs. Category II AIFs are required to have a minimum corpus of INR 20 crores, providing a wider pool of capital for debt investments.

Investment Instruments and Flexibility

Category II AIFs are permitted to invest in various forms of debt securities, including non-convertible debentures, listed and unlisted optionally convertible instruments, and security receipts issued by asset reconstruction companies. This flexibility allows Category II AIFs to engage in plain vanilla debt transactions as well as structured debt transactions that combine debt and equity components.

Credit Concentration and Maturity Norms

Unlike FPIs, Category II AIFs are not subject to restrictions on credit concentration and minimum residual maturity requirements. FPIs are limited to investing a maximum of 50% of their portfolio in a single debt issuance of a portfolio company, and they cannot invest in corporate bonds with a residual maturity of less than one year. Category II AIFs, on the other hand, are only restricted from investing more than 25% of their investible funds in a single portfolio entity.

Security Creation and Enforcement

Category II AIFs have the advantage of holding security on their own, whereas FPIs are required to create security in favor of a security trustee in India. However, both AIFs and FPIs lack protection under The Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI Act), and security enforcement requires court intervention. Nonetheless, Category II AIFs have the ability to appropriate the security towards outstanding debt, while FPIs must enforce security through a security trustee, with the proceeds remitted to them.


Category II AIFs offer a promising avenue for investors looking to diversify their portfolios and explore alternative investment options in the Indian debt asset class. With their relaxed regulatory environment, flexibility in investment instruments, and potential to provide liquidity to Indian businesses, Category II AIFs have the potential to become game-changers in the realm of debt investments in India. However, it is essential for investors to carefully consider the investment conditions, taxation implications, and compliance requirements before venturing into Category II AIFs for plain vanilla debt investments.

Read More on Alternative Investment Funds: 

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Classification of AIF Units As Securities & its effects

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