Rules for Category III AIFs and Co-Investment by Investors of Alternative Investment Funds

Rules for Category III AIFs and Co-Investment by Investors of Alternative Investment Funds

The Securities and Exchange Board of India (SEBI), India’s market regulator, has revised the regulatory system governing Alternative Investment Funds (AIFs) to allow for co-investment via the portfolio management approach. It has modified the Alternative Investment Funds Regulations, 2012, in a notification released on November 9. Further, the regulations for category III AIFs have also been streamlined.

What is an Alternative Investment Fund and what are Category I, Category II and Category III AIFs?

Any fund formed or established in India that is a privately consolidated investment vehicle that accumulates funds from sophisticated investors, either Indian or foreign, for investing in accordance with a defined investment policy for the advantage of its investors is referred to as an Alternative Investment Fund (AIF).

Category I, Category II, and Category III AIFs

AIFs are privately pooled investment funds that invest in private equity, venture capital, hedge funds, managed funds, and so on. AIF refers to an investment that is distinct from traditional investments such as debt instruments, equities, and so on. It is an investment opportunity for high rollers in India, comprising both domestic and foreign investors. AIF is typically invested in by institutions and high-net-worth people since it requires a large initial commitment.

Further, Category I AIFs are AIFs that invest in start-up or early-stage ventures, social ventures, SMEs, infrastructure, or other sectors or areas deemed socially or economically desirable by the government or regulators, including venture capital funds, SME funds, social venture funds, infrastructure funds, and such other Alternative Investment Funds as may be specified.

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Category II AIFs are AIFs that do not fall under Category I or III and do not engage in leverage or borrowing for purposes other than meeting day-to-day operating requirements, as approved by the SEBI (Alternative Investment Funds) Regulations, 2012[1]. As Category II AIFs, many types of funds such as real estate funds, private equity funds (PE funds), distressed asset funds, and so on are registered.

In addition, Category III AIFs are AIFs that use a variety of trading methods and may use leverage, such as investing in listed or unlisted derivatives. Several types of funds such as hedge funds, PIPE Funds (Private investment in public equity), etc. are registered as Category III AIFs.

Clarifications by SEBI on co-investment

Co-investment is defined as an investment done by a manager, sponsor, or investor of Category I and Category II AIFs in investee firms in which such category of AIFs makes an investment.

Fund managers who want to facilitate Co-investments for contributors, sponsors, or themselves in their Category I or Category II AIFs must register with SEBI as a “Co-investment Portfolio Manager”, which is a new category of portfolio managers under the SEBI (Portfolio Managers) Regulations, 2020 (“SEBI PM Regulations”), which will take effect on December 9, 2021.

The SEBI clarified that co-investment by investors of alternative investment funds shall only be made through a co-investment portfolio manager. It also stated that the terms & conditions of co-investment in an investee firm by a manager or sponsor or co-investor, shall not, in any case, be more favourable than the terms & conditions of investment of the AIF.

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It went on to say that the terms of exiting a co-investment in an investee firm, including the date of withdrawal, will be the same as the terms applicable to the exit of the Alternative Investment Fund. These guidelines will only apply to co-investments made on or after December 9.

The manager will not give investment advice to anybody other than the customers of the co-investment portfolio manager for securities of investee firms in whom the AIF it manages invests.

The SEBI further stated that the appointment of a custodian would be necessary if the total of the AIF’s corpus plus the value of the co-investment handled by the AIF’s manager as co-investment portfolio manager exceeds rupees 500 crores.

Clarifications for Category III AIFs

The regulator has also given Category III AIFs the opportunity to compute concentration standards based on the fund’s net asset value.

The investment limit in listed equities must be computed based on the fund’s NAV on the business day preceding the date on which the category III AIF makes an investment, according to SEBI. The AIF’s NAV will be the total of all securities’ values, adjusted for mark-to-market gains and losses.

Cash and cash equivalents would be included, but any monies borrowed by the AIF would be excluded. When the market value of a category III AIF’s investment in the listed stock of an investee business exceeds the permissible investment limit, SEBI states that the breach must be corrected within 30 days of the date of the violation.

According to SEBI, Category III AIFs shall invest no more than 10% of their net asset value in the listed stock of an investee firm. They shall not invest more than 10% of their investable funds in instruments other than the listed stock of an investee firm, either directly or through investment in units of other AIFs.

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It is also specified that substantial value funds for accredited investors of Category III AIFs can invest up to 20% of their net asset value in an investee company’s listed shares. They can invest up to 20% of their investable funds in instruments other than listed equity of an investee firm, either directly or indirectly through investment in units of other AIF.

The regulator has revised AIF standards to reflect these changes. This happened after the SEBI board of directors adopted a proposal in this respect in late September.


The Markets regulator of India (SEBI) has amended the governing regulations in relation to alternative investment funds (AIFs), to facilitate co-investment through the portfolio management route. The SEBI stated in a statement that co-investment made by investors of alternative investment funds (AIF) should be through a co-investment portfolio manager.

Read our article:Alternative Investment Funds (Second Amendments) Regulations, 2021

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