Alternative Investment Fund: Category II vs Category III

Ankita Tiwari

13 Apr, 2023

Alternative Investment Fund (AIF) is a privately pooled investment vehicle incorporated or established in India in the form of a company, LLP, trust or a body corporate. AIF collects funds from investors who are majorly foreigners and invests those funds in accordance with the defined investment policy. AIFs are special or unconventional funds that are not covered under the SEBI (Mutual Funds) Regulations, 1996^[1] or SEBI (Collective Investment Scheme) Regulation, 1999 or any other regulation of SEBI which relate to funding management activities. AIFs are only regulated under the SEBI (Alternative Investment Fund) Regulation, 2012.
The SEBI (Alternative Investment Fund) Regulation, 2012 prescribes three categories of AIFs namely Category I, Category II and Category III. AIF Category I are funds that invest in start-ups, early-stage ventures, SMEs, social ventures, infrastructure or any other sector which the government considers socially or economically desirable. AIF Category II are funds that invest in private equity funds or debt funds for which no incentives or concessions are provided by the Government of India or any other regulator. AIF Category III are funds that invest in hedge funds, funds that trade to make short-term returns or funds which are open-ended for which government provides no incentives or concessions. Category III funds, employ diverse trading strategies to make investments. In this blog, we will restrict our discussion to AIF Category II vs Category III. 

Types of AIFs Category II vs Category III

Investment Limit under AIF Category II vs Category III

AIF Category II investment funds limit is set to not more than 25% of the investable funds in an Investee company either directly or through investments in other AIFs. An exception to this limit under Category II are large value funds for accredited investors who may invest up to 50% of the total investable funds in an investee company directly or through units in other AIF.

Whereas AIF Category III is allowed to invest only up to 10% of the investable funds in an Investee Company either directly or through investment in units of other AIFs and large value of funds for accredited investors of AIF. Category III may invest up to 20% of the total available investable funds in an Investee company directly or through other AIF. However, for calculating the investment limit for investment in listed equity of an Investee Company, AIF Category III may take 10% of either the investable funds or the net asset value of the scheme and for large accredited investors the AIF Category III may calculate the investment limit of 20% of either investable funds or the net asset value of the scheme subject to the conditions specified by the SEBI from time to time.

Investment Conditions under AIF Category II vs Category III

Category II

1. AIF Category II invests in Investee companies or units of AIF Category I or other Category II disclosed in the placement memorandum. Category II invests directly in unlisted companies or through investment in units of other AIF.
2. AIF Category II is not allowed to borrow funds directly or indirectly or indulge in any leverage except for meeting temporary funding requirements for a maximum of 30 (thirty) days for not more than four occurrences in a year and in greater than 10% of the investable funds.
3. AIF Category II may engage in hedging however, it should be as per the guidelines specified by SEBI from time to time.
4. AIF Category II may also buy or sell default swaps in terms of conditions as may be specified by SEBI.
5. AIF Category II may enter into an agreement with the merchant banker to subscribe to an unsubscribed portion of the issue or to receive or deliver securities that are in the process of market-making.
6. AIF Category II are exempt from Regulation 3 & 4  of insider trading regulations for investing in companies listed on the SME exchange or SM segment of an exchange pursuant to the due diligence of such companies and subject to the conditions that the fund shall disclose any trading in securities pursuant to due diligence within 2(two) trading days and the investment shall be locked in for a period of 1 (one) year from the date of investment.

Category III

1. AIF Category III invests in securities of listed as well as unlisted investee companies, derivatives, units of other AIFs, and complex or structured products.
2. It deals in goods received in delivery against physical settlement of commodity derivatives.
3. It may buy or sell credit default swaps in terms of the conditions specified by SEBI.
4. It may also engage in leverage or borrowing but is subject to consent from the investors in the fund up to the maximum limit specified by SEBI. However, if it engages in leverage and borrowings then it has been to mandate to disclose information regarding the overall level of leverage employed, the level of leverage arising from borrowings of cash, etc.
5. These investments are regulated by issuing directions regarding areas like operational standards, conduct of business rules, prudential requirements, restrictions or redemption and conflict of interest as prescribed by SEBI.

Valuation under AIF Category II vs Category III

AIF Category II shall conduct a valuation of their investments through an independent valuer appointed by AIF once every 6 (six) months. The period of 6 (six) months may be enhanced to 1(one) year with the approval of a minimum of 75% of the investors by the value of their investment in AIF. Whereas AIF Category III shall ensure calculation of net asset value (NAV) is independent of the fund management function of the AIF and that the NAV is disclosed to the investors at intervals shorter than a quarter for close-ended funds and at intervals not longer than a month for open-ended funds.

Tenure of AIF Category II vs Category III

AIF Category II is a close-ended fund that has a minimum tenure of 3 (three) years that may be extended for a further period of 2 (two) years subject to the approval of 2/3rd of the unit holders by value of their investment in AIF. Whereas AIF Category II may either be open-ended or close-ended. Only the closed-ended funds under Category III may be extended for a period of 3 (three) years.

Reporting Requirements

AIF Category II has to report on an annual basis to investors providing all the information as prescribed under Regulation 22 of the SEBI (AIF) Regulations, 2012 within 180 days from the end of the year. Whereas under AIF Category III quarterly reports to investors have to be provided within 60 days from the end of the quarter.

Continuing Interest

Under AIF Category II, the manager or the Sponsor shall have a continuing interest in the AIF of more than 2.5% of the corpus or Rs. 5 crore whichever is lower. The continuing interest should be in the form of investment in AIF and the interest shall not be through the waiver of management fees. Whereas in AIF Category III, the continuing interest shall be more than 5% of the corpus or Rs. 10 crores whichever is lower. 

Taxation of AIF Category II vs Category III

Under AIF Category II, the tax is to be borne by the investor whereas for AIF Category III, the fund has to bear the tax liability. Category III has not been accorded the pass-through status as Category I & Category II.

Conclusion

Even though Category II and Category III are both categories of AIF. They are very different from each other. It becomes important to understand the difference for investment purposes. Understanding of each category is necessary to understand the overall restrictions and compliance requirements. A proper understanding of the categories of AIF helps the investor in decision-making regarding the category of AIF to opt for.

Also Read:
Categories of Alternative Investment Funds
Rules for Category III AIFs and Co-Investment by Investors of Alternative Investment Funds