Highlights

Source: SEBI Quarterly Report

What Are Category II AIFs?

Types of Funds Under Category II AIFs

• Private Equity Funds: Invest in unlisted companies, focusing on growth and expansion across various sectors.
• Debt Funds: Target structured credit and debt instruments, providing financing solutions to companies while adhering to leverage restrictions. These funds cannot engage in leverage except for temporary funding requirements.
• Real Estate Funds: Provide sophisticated equity and debt financing solutions for premium commercial and residential projects. These funds address the traditional challenges of direct real estate investment – such as high capital requirements, liquidity constraints, and complex management – by offering professionally managed, diversified exposure to real estate opportunities. They bridge critical funding gaps while providing investors streamlined access to India’s dynamic real estate market.
• Distressed Asset Funds: Focus on acquiring and revitalising stressed assets or companies with recovery potential.
• Fund of Funds (FoF): Allocate capital across other AIFs, providing diversified exposure across different strategies.

The Investment Approach: How Do They Work?

1. Capital Pooling:
   • These funds raise capital through private placement from sophisticated investors
   • Requires a minimum investment of ₹1 crore per investor (₹25 lakh for employees/directors)
   • Must achieve a minimum corpus of ₹20 crore to begin operations
2. Investment Phase:
   • Primary focus on investing in unlisted companies
   • May invest directly or through other Alternative Investment Funds
   • Can pursue various strategies including private equity, debt, and real estate investments
   • Investment decisions based on fund strategy outlined in the placement memorandum
3. Value Addition:
   • Fund managers actively monitor and manage investments
   • Focus on medium to long-term value creation
   • Exit strategies aligned with fund tenure and market conditions

Regulatory Framework and Key Requirements

Essential Requirements

• Minimum Corpus: Each Category II AIF must have a minimum corpus of ₹20 crore.
• Manager/Sponsor Commitment: The fund’s manager or sponsor must contribute at least 2.5% of the total corpus or ₹5 crore, whichever is lower.
• Investment Cap: Investments in a single company cannot exceed 25% of the total corpus, ensuring diversification.
• Minimum Investor Contribution: Typically, a minimum of ₹1 crore per investor, with exceptions for employees, directors, or fund managers, where it can be as low as ₹25 lakh.
• Close-ended Structure: These funds must be close-ended with a minimum tenure of 3 years

Operational Guidelines

• Valuation and Reporting: SEBI mandates regular valuations of the fund’s investments by independent and transparent quarterly and annual reporting. This helps maintain investor confidence and compliance with regulations.
• Disclosure Obligations: Detailed Private Placement Memorandums (PPMs) must outline investment strategies, risks, expected returns, and governance measures.
• Leverage Restrictions: Category II AIFs cannot use leverage for investments. They can only use leverage temporarily for operational needs, such as short-term borrowing to manage liquidity.
• No Speculative Trading: These funds are prohibited from engaging in speculative trading strategies, aligning them with a focus on sustainable, long-term investments.

Pros and Cons of Investing in Category II AIFs

Advantages

• Access to Private Markets: Investors gain exposure to assets traditionally limited to institutional investors.
• Professional Management: Experienced fund managers oversee the investment process, ensuring strategic allocation.
• Portfolio Diversification: AIFs offer diversification across asset classes, reducing overall portfolio risk​​.

Challenges

• High Minimum Investment: A minimum investment of ₹1 crore can be restrictive for some investors.
• Long Lock-in Periods: Close-ended structures often require lock-in periods of 4-7 years, limiting liquidity.
• Complex Fee Structures: Fees may include management fees, performance-based fees, and exit loads, which can vary across schemes​​.

Conducting Due Diligence Before Investing

1. Fund Manager Assessment: Evaluate the manager’s track record, team experience, and risk management frameworks.
2. Investment Strategy Review: Understand the sector focus, exit strategies, and projected returns.
3. Fee Structures and Terms: Review distribution waterfalls, investor rights, and exit provisions in detail.
4. Legal and Regulatory Compliance: Ensure that fund documentation adheres to SEBI guidelines and other applicable laws​​.