Understanding Category I, II & III AIFs: What’s the Difference?

The Securities and Exchange Board of India (SEBI) classifies privately pooled investment vehicles registered in India as AIF investment funds—formally termed Alternative Investment Funds (AIFs)—and divides them into three mutually exclusive categories. The classification determines eligible investors, leverage limits, taxation, transparency obligations, and, ultimately, the risk-adjusted return profile of the underlying portfolio. The following exposition analyses each category in detail and clarifies what, precisely, is different among them.

Regulatory Genesis

SEBI’s 2012 AIF Regulations created three silos:

1. Category I: strategies with demonstrable positive spill-overs for the Indian economy.
2. Category II: neutral-impact strategies that neither receive incentives nor face prohibitions.
3. Category III: trading-oriented strategies that may employ leverage and complex derivatives.

The differences begin with legislative intent and cascade through every operational parameter.

Category I: Statutory Preferences

A Category I AIF company must deploy a minimum of two-thirds of its corpus in unlisted securities of start-ups, infrastructure ventures, social enterprises, or other sectors that the government deems socially desirable. The vehicle is prohibited from borrowing, must hold each investment for at least three years, and is required to submit quarterly factsheets to investors. Units may be listed on recognised stock exchanges after the lock-in, yet secondary-market liquidity remains constrained.

Tax treatment is favourable. Long-term capital gains realised after the three-year lock-in are taxed at 10 per cent without indexation. Dividend income is exempt at the fund level but taxable in the hands of investors at the applicable marginal rate. Because of the tax holiday and the qualitative mandate, Category I attracts capital from Indian banks, insurance companies, and foreign sovereign wealth funds seeking impact-oriented exposure. The principal difference from the other two categories is the explicit policy preference embedded in both tax and prudential norms.

Category II: The Default Regime

Category II functions as the residual classification for strategies that do not qualify for incentives under Category I and do not engage in frequent trading that would place them in Category III. A Category 2 AIF company may acquire equity, quasi-equity, or debt instruments and is permitted to borrow up to twice the net asset value. The regime grants pass-through taxation: all income, save for business income, is assessed in the hands of investors, thereby avoiding double taxation.

The customary tenure is ten years, extendable by two additional one-year periods with two-thirds investor consent. Inter-fund transfers are permissible provided the transaction is executed at fair-market value determined by an independent appraiser. Because of the balanced risk-return profile, Category II is the preferred vehicle for domestic pension funds, large corporates, and family offices seeking private-market exposure without the volatility associated with leveraged trading. The key difference relative to Category I is the absence of tax concessions; relative to Category III, it is the prohibition on high-frequency trading and leverage beyond the statutory cap.

Category III: The Leveraged Trader

Category III encompasses hedge-fund and absolute-return strategies that employ leverage, short-selling, and derivative instruments. A Category 3 AIF company is subject to fund-level taxation at the maximum marginal rate applicable to individuals; investors therefore receive post-tax distributions. The regime mandates daily mark-to-market disclosure and imposes a leverage ceiling of two times the net asset value. Redemption windows are customarily monthly or quarterly, although gated clauses may suspend withdrawals during periods of exceptional volatility.

The regulatory burden is higher. Managers must submit strategy-level exposure reports to SEBI within seven calendar days and maintain a dedicated compliance officer conversant with derivative accounting. Despite the tax drag, Category III appeals to ultra-high-net-worth investors and corporate treasuries seeking uncorrelated alpha and tactical downside protection. The most salient difference from the other two categories is the combination of fund-level taxation and the freedom to deploy leverage and derivatives for short-term trading gains.

Comparative Matrix

The matrix summarises the quantitative differences that flow from the qualitative regulatory distinctions.

Fee Architecture

Industry practice prescribes a two per cent annual management charge and a twenty per cent performance allocation above a preferred return, customarily eight per cent. Category I managers frequently incorporate hurdle-plus-catch-up mechanisms to compensate for the illiquidity premium. Category III managers may reduce the management charge to one per cent and increase the performance allocation to twenty-five per cent, contingent upon absolute returns.

Investors should scrutinise the waterfall diagram, as differences in claw-back clauses and distribution frequency can alter net returns by 200–300 basis points.

Portfolio Integration

Institutional investors typically allocate fifteen to twenty per cent of their alternative-asset sleeve to Category I for tax-advantaged alpha, twenty-five to thirty per cent to Category II for steady private-market exposure, and ten to fifteen per cent to Category III for absolute-return diversification. The amalgamation mitigates the j-curve effect and constrains portfolio beta to domestic equity indices below 0.6. When executed rigorously, this AIF investment approach allows investors to harvest illiquidity premia while containing systematic risk.

Due-Diligence Protocol

• Verification of track record across a complete economic cycle, ideally 2008–09 and 2020.
• Manager co-investment representing at least two per cent of aggregate commitments.
• Adoption of third-party valuation agents and documented conflict-of-interest policies.
• Identification of prospective exit routes, including initial public offerings, strategic divestments, and secondary sales.
• Enforceability of key-person and change-of-control provisions that trigger automatic suspension of new investments.

Each item underscores a material difference in operational risk among managers, even within the same category.

Regulatory Evolution

In 2023, SEBI introduced enhanced disclosure obligations for Category III, including granular exposure reporting for derivative positions. Category II debt funds are now required to maintain a five per cent liquidity buffer in cash or sovereign instruments. The regulator is consulting on permitting Category I vehicles to invest in green real-estate investment trusts, a modification that could augment the eligible universe by ₹40 000 crore.

The differential treatment illustrates the regulator’s continued reliance on category-specific incentives and constraints.

Risk Considerations

Liquidity risk is pronounced in Category I and II owing to the unlisted nature of underlying assets. Market risk in Category III is amplified by leverage; a 10 per cent adverse move in the Nifty can translate into a 20 per cent NAV decline at the fund level. Tax policy risk persists: the government may withdraw pass-through status for Category II or tighten the definition of business income.

Operational risk encompasses valuation disputes, manager turnover, and cyber-security breaches at the administrator level. The differences in risk taxonomy are neither academic nor trivial; they directly affect capital allocation decisions.

Strategic Outlook

The Indian AIF industry has grown at a compound annual rate of 24 per cent since 2018, with assets under management exceeding ₹7 trillion. Regulatory headwinds are likely to persist, yet the structural shift toward private-market capital formation remains intact. Investors seeking diversification from public-market concentration and fixed-income repression will continue to allocate to AIFs, albeit with greater selectivity and fee pressure. Understanding the differences among categories is therefore a prerequisite for sustained out-performance.

Discriminating Allocation via ALTPORT

The differences among Category I, II, and III AIFs are material, measurable, and regulatory in origin. Optimal allocation is contingent upon an investor’s liquidity horizon, tax tolerance, and risk appetite. Prospective limited partners should prioritise managers who have navigated at least one market downturn and who maintain institutional-grade operational infrastructure.

For investors seeking integrated analytics, post-tax cash-flow modelling, and streamlined subscription processes, ALTPORT provides a comprehensive platform facilitating informed AIF investment decisions.