Table of Contents

1. Overview

2. Understanding AIFs

3. Regulatory Framework

4. Taxability of AIFs

5. Key Documents

6. How to get registered with SEBI?

7. Final Thoughts

8. FAQs

9. Contact Us
Overview

Alternative Investment Funds, often abbreviated as AIFs, have become a buzzword among
sophisticated investors, especially High Net Worth Individuals (HNIs).

As of September 2023, India has 1,200+ registered AIFs. This domain has witnessed
remarkable growth, underscored by the 30% surge in commitments which escalated from
INR 6.41 trillion in the fiscal year 2021-22 to a staggering INR 8.33 trillion in 2022-23. This
growth translated to a substantial jump of INR 1.92 trillion within a year!

The total assets under management (AUM) of AIFs have grown at a CAGR (Compound Annual
Growth Rate) of 28% over the last five years1.

In light of the burgeoning AIF industry, its regulatory authority, the Securities and Exchange
Board of India (SEBI), hasn't remained a silent observer. SEBI has proactively been fortifying
protocols to guarantee investor safety, heighten transparency, and ensure fair practices within
the AIF guidelines.

So, the question arises, what exactly are AIFs? And how do they function within the Indian
regulatory landscape?

1
https://aifpms.com/blog/growth-of-aif-pms-investments-in-india/

2
Understanding AIFs

An AIF is a privately pooled investment vehicle that gathers funds from investors, Indian or
foreign, for investment as per a defined investment policy to benefit its investors.

With their promise of high returns across diverse asset classes, AIFs are attractive for those
aiming to diversify and enhance their portfolios.

Some key terms used in AIFs:

Carry
Carry or carried interest is akin to performance fees which is paid to the investment manager
as a share of the AIF’s profits which the investment manager is entitled to if they exceed a
specific threshold return. Carry is typically in the range of 15-20% of the profits earned by the
AIF in excess of the specified threshold.

Hurdle / Preferred rate of return

Minimum percentage of returns that an investor earns before the Investment Manager can
catch-up and charge carry to the investor.

Catch-up
Catch-up allows the investment manager to earn the hurdle rate of return on its investment in
the AIF but only after the investors have received their investment along with the hurdle rate of
return on such investment.

Distribution waterfall
Provides for an order of specified priority in which the distributions are made by AIF which
includes the capital contributions, fees, hurdle, catch up (if any), carry, etc.

3
Closing
Closing is the date fixed by the Investment Manager as a cut-off date to obtain capital
commitment from investors.

4
Regulatory Framework

In India, AIFs operate under the purview of the SEBI.

Since their establishment in the late 1980s, Venture Capital Funds (VCFs) have been a
significant focus for the government to bolster the growth of specific sectors and early-stage
companies. However, the desired outcomes in supporting emerging sectors and startups were
not realized, largely due to regulatory uncertainties. Recognizing this challenge, in 2012, the
Securities and Exchange Board of India unveiled the SEBI (AIF) Regulations. This was done to
categorize AIFs as a unique asset class, similar to Private Equities (PEs) and VCFs.

Any entity wishing to function as an AIF must seek registration with SEBI. While there are
various legal structures under which an AIF can be established - such as a trust, a company,
an LLP, or a body corporate - trusts are the most commonly chosen form in India.

A typical AIF structure looks like the following:

Figure 1: Typical AIF structure

5
The entities are:

● Settlor - Person who settles the trust with a nominal initial settlement
● Trustee - Person in charge of the overall administration and management of the Trust. In
practice, this responsibility is then outsourced to the investment manager.
● Contributor - Investor to the Trust (AIF) and makes a capital commitment to the AIF
● Sponsor - Face of the AIF i.e. Person who sets up the AIF
● Investment Manager - Brain of the AIF i.e. Person who is appointed to manage the
investments

It's noteworthy that the roles of the Sponsor and Investment Manager can be unified, with one
entity performing both functions.

Under the SEBI AIF Regulations, AIFs are classified into 3 distinct categories. Each category
serves a unique purpose and is characterized by specific investment conditions and varying
degrees of regulatory oversight. Below is an overview of the categories, highlighting their
primary purpose and key conditions:

Parameters Category I AIF Category II AIF Category III AIF

Definitions Funds with strategies to Funds that cannot be Funds which

invest in start-up or early categorized as Category employ diverse or
stage ventures or social I AIFs or Category III complex trading
ventures or SMEs or AIFs. These funds do strategies and
infrastructure or other not undertake leverage may employ
sectors or areas which the or borrowing other than leverage including
government or regulators to meet day-to-day through
consider as socially or operational investment in
economically desirable. requirements and as

6
 permitted in the AIF listed or unlisted
Includes: Regulations. derivatives.
● Venture Capital Funds
(angel funds are a Examples - Private Examples -
subcategory of VCFs) Equity or Debt Funds Hedge funds or
● SME funds funds which trade
● Social Impact Funds with a view to
● Infrastructure Funds make short-term
● Special Situation Funds returns

Minimum INR 1 crore INR 1 crore INR 1 crore

ticket size

Minimum INR 20 crore INR 20 crore INR 20 crore

fund size

Open or close Close-ended Close-ended Can be open or

ended fund close-ended

Tenure Minimum tenure of 3 years Minimum tenure of 3 NA

years

Continuing Lower of: Lower of: Lower of:

interest of ● 2.5 % of corpus ● 2.5 % of corpus; ● 5 % of
Sponsor / ● INR 5 crores ● INR 5 crores corpus;
Manager ● INR 10 crore
(a.k.a skin in
the game)

Investment Permissible subject to SEBI approval

outside India

7
 Concentration Can't invest more than 25% Can't invest more than Can't invest more
norms in 1 investee company 25% in 1 investee than 10% in 1
company investee company

Borrowing Cant borrow funds except Cant borrow funds Can engage in
for : except for : leverage &
(a) temporary funds not (a) temporary funds not borrowing as per
more than 30 days more than 30 days prescribed rules
(b) less than 4 occasions in (b) less than 4
a year occasions in a year
(c) less than 10% of (c) less than 10% of
investable funds investable funds

Overall Low Medium High

restrictions /
compliances

SEBI INR 500,000 INR 1,000,000 INR 1,500,000

registration
fees

Per scheme INR 100,000 INR 100,000 INR 100,000

filing fees

Table 1: Categories of AIFs

Apart from the categories mentioned above, any of the three categories of AIFs can be
classified as a large-value fund (LVFs), provided that each investor is an “accredited investor”
as per the AIF Regulations and invests a minimum of INR 70 crores in the AIF. LVFs have
certain investment and compliance related exemptions.

Angel Funds also hold a distinct categorization under the AIF Regulations. These funds are a
subcategory of Category I AIFs - VCFs, primarily designed to acknowledge and support the

8
unique role of angel investors in the startup ecosystem. The key characteristics of Angel funds
are summarized below:

Parameters Category I AIF

Minimum ticket size INR 25 lakhs

Minimum fund size INR 5 crore

Investments Should be not less than INR 25 lakhs and not more than
INR 10 crores, with a minimum lock-in period of 3 years.

Open or close ended fund Close-ended

Continuing interest of Sponsor Lower of:

/ Manager ● 2.5 % of corpus
(a.k.a skin in the game) ● INR 50 lakhs

Investors Angel investors who meet the specified criteria

SEBI application fee INR 200,000

Per scheme filing fee NIL

Table 2: Angel Funds

9
Taxability of AIFs

Category I and II AIFs:

Category I and II AIFs are granted pass-through status from an income-tax perspective,
whereby any income earned by these AIFs (other than profits or gains from business) is not
taxed at the AIF level, but directly taxed as income at the hands of the investors as if these
investors had directly received this income from the investments.

Unabsorbed losses (other than business losses) of the AIF may be allocated to the investors for
them to set off against their respective individual incomes, subject to such investors having
held the units in the AIF for at least 12 months.

Further, the distributions from Category I and II AIFs are subject to a withholding tax of 10% in
the case of resident investors, and at the rates in force in the case of non-resident investors
(after giving due consideration to any benefit available to them under the applicable tax treaty).

Business income of Category I and II AIFs is chargeable to tax at the maximum marginal rate
(MMR) i.e. 30% plus applicable surcharge and education cess at the AIF level as per the legal
status of the AIF and once this tax is paid, no further tax on the same is payable by the
investors.

Category III AIFs

Category III AIFs have not been granted statutory pass-through status. Typically, they are set
up as “determinate and irrevocable trusts.” This means the trusts have identifiable
beneficiaries, and their respective beneficial interests can be determined at any given time. In
such trusts, the trustee can discharge the tax obligation for the income of the trust on behalf of
its beneficiaries (i.e., the investors) in a representative capacity. This is similar to the tax liability
an investor would face if they had received the income directly. However, there's an exception:
trusts with any business income must pay tax at the MMR. As per income-tax law, tax

10
authorities can recover tax either from the trustee or directly from the beneficiaries. Given this
flexibility, a trustee might opt to pay the entire tax amount at the AIF level. Moreover, the law
permits the trustee (acting as a representative assessee) to recover from investors any taxes it
has paid on their behalf.

We have not covered tax implications for investment managers and sponsor entities above.

11
Key Documents

Private Placement Memorandum (PPM):

The PPM provides comprehensive details about the AIF. Contents include information about
the manager, key investment team, targeted investors, proposed fees and expenses, scheme
tenure, redemption conditions or limits, investment strategy, risk factors and management,
conflict of interest procedures, disciplinary history, service terms and conditions by the
manager, affiliations with intermediaries, winding up procedures, and any other relevant details
helping investors make informed decisions about investing in an AIF scheme.

SEBI has introduced mandatory templates for PPMs (for and) which provides for two parts:
Part A – section for minimum disclosures
Part B – supplementary section to allow full flexibility to the AIF in order to provide any
additional information, which it may deem fit.

There are two templates - one for Category I and II AIFs and the other for Category III AIFs.
Angel Funds, LVFs and AIFs in which each investor commits to a minimum capital contribution
of INR 70 crores are exempted from following the aforementioned template.

Indenture of Trust / Trust Deed:

This document is an agreement between the settlor and the trustee. It involves the settlor
transferring an initial settlement (can be nominal) to the trustee to create the fund's assets. The
Indenture details the roles and responsibilities of the trustee.

Investment Management Agreement:

This agreement is entered between the trustee and the investment manager. Here, the trustee
designates the investment manager and transfers most of its management powers regarding
the fund to them. However, certain powers retained by the trustee are outlined in the Indenture
of Trust.

12
Contribution Agreement:
This agreement is between the contributor (investor), the trustee, and the investment manager.
It mentions the terms of an investor’s participation in the fund, covering areas like beneficial
interest computation, distribution mechanism, expense list to be borne by the fund, and the
investment committee's powers. SEBI mandates that the Contribution Agreement's terms
should align with the PPM and shouldn't exceed its provisions.

13
How to get registered with SEBI?

This is the registration process if the Fund is set up as a Trust.

To register an AIF with SEBI, the fund needs to make an application to SEBI on its online portal.

The trust deed i.e. incorporation document of the fund where it is set up as a trust, needs to be
registered with the local authorities. Further, the PAN needs to be obtained before making the
application to SEBI.

The application to SEBI has the following key documents to be submitted:

● Application form in Form A
● Private Placement Memorandum (PPM)
● Trust Deed
● Declarations and KYC documents of the entities involved i.e. investment manager,
sponsor, trustee (if the AIF is structured as a trust), and the AIF itself

Further, before submitting the application to SEBI, the AIF must engage a merchant banker
who performs due diligence on the PPM and subsequently provides a certification that needs
to be filed with SEBI. However, there's an exemption for LVFs and Angel Funds for this
requirement.

Once the application is submitted, SEBI will evaluate the application. Generally, the entire
setup and registration process, including SEBI's assessment, spans around four to six months.

14
Broadly, the process flow looks as follows:

Figure 2: AIF process flow

15
Final Thoughts

With their ability to diversify investment portfolios and provide potential high returns, AIFs
undeniably present an attractive avenue for investment in today's dynamic market scenario.
The regulatory framework, set by SEBI, ensures transparency, credibility, and alignment with
global best practices, further instilling confidence among stakeholders.

However, AIFs can be tricky to understand because of the different types, how they are taxed,
and the many documents involved. It's like trying to put together a puzzle with lots of pieces.

For both potential AIF managers and investors, understanding this intricate ecosystem is
crucial. It is recommended to talk to experts who know the details. They can guide you through
the process, help you understand the rules, and make sure you're making the best decisions.
As the world of AIFs keeps changing, staying informed and getting the right advice will be key
to success.

16
FAQs:

1. What is an Alternative Investment Fund (AIF)?

Answer: An AIF is a privately pooled investment vehicle that collects funds from investors,
either Indian or foreign, to invest as per a defined investment policy, with the aim of benefiting
its investors. It offers diversified asset classes and promises potentially high returns, making it
an attractive choice for High Net Worth Individuals (HNIs) and other discerning investors.

2. How are AIFs regulated in India?

Answer: AIFs in India operate under the regulatory framework of the Securities and Exchange
Board of India (SEBI). SEBI introduced the SEBI (Alternative Investment Funds) Regulations in
2012 to categorize AIFs as a distinct asset class. All entities desiring to function as an AIF must
register with SEBI.

3. What are the different categories of AIFs?

Answer: SEBI classifies AIFs into three categories:

● Category I AIF: Focus on sectors or areas which are socially or economically desirable.
Includes Venture Capital Funds, SME funds, and more.
● Category II AIF: Funds that do not fall under Category I or III and don’t undertake
excessive leverage.
● Category III AIF: Funds employing diverse or complex trading strategies, often using
leverage. Examples include hedge funds.

17
4. How is the taxability of AIFs determined?

Answer:
● Category I and II AIFs: Granted pass-through status, meaning income (other than
business profits) is taxed directly in the hands of investors.
● Category III AIFs: Not granted a statutory pass-through. Typically, tax liability for trusts
can be met by the trustee or the beneficiaries directly.

5. What are Angel Funds and how do they fit into the AIF landscape?

Answer: Angel Funds are a subcategory of Category I AIFs – specifically Venture Capital
Funds. They are designed to support the crucial role of angel investors in the startup
ecosystem. Angel funds have distinct features like a minimum ticket size of INR 25 lakhs and a
minimum fund size of INR 5 crores.

6. How does one register an AIF with SEBI if set up as Trust?

Answer: To register with SEBI, the fund must make an online application. Prior to this, the trust
deed must be registered locally, and a PAN should be obtained. Key documents like the PPM,
Trust Deed, and relevant KYC documents must be submitted. The entire setup and registration
process usually takes around four to six months.

7. What is the typical cost for setting up an AIF in India?

Answer: The typical cost for setting up an AIF in India ranges from INR 10 to 15 lakhs. The
SEBI registration fees depend on the Category of AIF. We have prepared an indicative cost
sheet for a Catgeory II AIF here which gives an overview of the costs.

18
Want to Know More?

Get in touch with the AIF Team

Jitesh Agarwal Garima Mitra

jitesh@treelife.in garima@treelife.in

Priya Kapasi Gaurav Shetty

priya.k@treelife.in gaurav.s@treelife.in

About Treelife
Treelife provides support to entrepreneurs and investors with access to a team of professionals,
including chartered accountants, lawyers, and company secretaries, who have deep domain
expertise in the startup industry.
Our mission is to empower the startup ecosystem by providing holistic legal and finance
solutions and save at least 80% time of stakeholders by delegating tasks to experts with
accountability and confidence.

Disclaimer: The above is for information purposes only and does not constitute advice or a legal opinion and are personal
views of the author. The possibility of other views on the subject matter cannot be ruled out. By the use of the said information,
you agree that the Author / Treelife is not responsible or liable in any manner for the authenticity, accuracy, completeness, errors
or any kind of omissions in this piece of information for any action taken thereof.

19