AIF Category I vs II vs III: Which SEBI Category Fits Your Fund

Most people who want to launch a fund start with the strategy: early-stage startups, private credit, listed long-short equity, real estate. SEBI starts with the category. Under the SEBI (Alternative Investment Funds) Regulations, 2012, every AIF registers as Category I, II or III, and the category decides what the fund may buy, whether it may borrow, how long it must run, how much the sponsor must put in and, most importantly, how its income is taxed.

Getting the category wrong is expensive. A strategy that needs leverage will not work as a Category II fund, and a fund that could have passed its income through to investors as Category II may end up paying tax itself if it registers as Category III. Changing category after registration needs SEBI approval, so decide it properly the first time.

For context: I am Strategic Advisor at Stonebridge Advisors LLP, Sponsor and Investment Manager of Anchor Rock Investment Fund - I, a SEBI-registered Category III Alternative Investment Fund. This note is general guidance, not legal advice: counsel should draft the fund documents, and every figure below should be checked against the current regulations and SEBI circulars.

What counts as an AIF

An Alternative Investment Fund is a privately pooled investment vehicle set up in India that collects money from investors, Indian or foreign, and invests it under a defined investment policy for the benefit of those investors. It can be a trust, a company, an LLP or a body corporate, and it raises money privately through a private placement memorandum (PPM), never through a public offer.

Some pools sit outside the AIF regulations because another framework already covers them, such as mutual funds, collective investment schemes, family trusts for relatives, ESOP trusts and employee welfare trusts. If you plan to pool outside money and none of those exclusions fits, assume you need AIF registration and take advice before accepting a rupee.

Category I: funds the policy framework wants to encourage

Category I covers funds that invest in areas regulators and policymakers treat as socially or economically desirable: venture capital funds, angel funds (which after the 2025 changes sit as their own sub-category within Category I), SME funds, social impact funds, infrastructure funds and special situation funds.

Category I funds are close-ended, cannot borrow except for short-term operational needs, and may not put more than a set share of investable funds into one investee company, 25 per cent under the general rule. Their income passes through to investors for tax, a large part of their appeal to resident investors.

Category II: private equity, private credit and everything in between

Category II is the residual bucket: any AIF that is neither Category I nor Category III and does not borrow beyond what the rules allow for day-to-day operational needs. Private equity funds, debt and private credit funds, real estate funds and funds of funds usually sit here, and they invest primarily in unlisted companies.

Borrowing is limited to temporary funding needs: no more than 30 days at a time, no more than four occasions a year and no more than 10 per cent of investable funds. The same 25 per cent single-company cap applies, and large value funds for accredited investors get more room.

For a first-time manager raising a private equity or credit fund from Indian investors, Category II is usually the default, because it combines flexibility on what you buy with pass-through tax.

Category III: hedge funds and complex trading strategies

Category III funds use diverse or complex trading strategies and may take leverage, including through listed or unlisted derivatives. Long-short equity funds, PIPE funds that buy into listed companies, and arbitrage or quantitative strategies usually fall here. They may be open-ended or close-ended.

Leverage is allowed within a ceiling that SEBI links to net asset value, and the single-company cap is tighter than for Category I and II, historically 10 per cent, with later changes to how it is measured for listed equity. The trade-off is tax: Category III income is taxed at the fund level, not passed through to investors, so the vehicle and trust design matter even more.

Side by side: the differences that matter

Some rules are common to all three categories: a minimum corpus of Rs 20 crore per scheme, a minimum investment of Rs 1 crore per investor (Rs 25 lakh for employees and directors of the fund or its manager) and a cap of 1,000 investors per scheme. Large value funds, where each investor is accredited and commits at least Rs 25 crore after the 2025 amendment, and schemes open only to accredited investors get lighter compliance in some respects.

The differences that usually drive the decision are below; each can change, because SEBI amends the framework often.

• Tenure: Category I and II are close-ended with a minimum tenure of three years, extendable by up to two years with approval of two-thirds of investors by value; Category III may be open-ended or close-ended.
• Sponsor or manager commitment: the lower of 2.5 per cent of corpus or Rs 5 crore for Category I and II, against the lower of 5 per cent or Rs 10 crore for Category III.
• Leverage: operational borrowing only for Category I and II; leverage within a NAV-linked cap for Category III.
• Valuation: at least half-yearly by an independent valuer for Category I and II; NAV disclosed at least quarterly for close-ended and at least monthly for open-ended Category III schemes.
• Tax: pass-through under Section 115UB of the Income-tax Act, 1961 for Category I and II; tax at the fund level for Category III.

How to choose: the questions to answer first

Start with the strategy and test it against the category rules, not the other way round. The Income-tax Act, 2025 replaces the 1961 Act from 1 April 2026, so section references are changing; ask your tax adviser to map each provision you rely on to the new Act.

Once the category is clear, the next decisions are the legal vehicle (trust, LLP or company), the sponsor and manager set-up and the SEBI filing itself. Each of those builds on the category. These questions usually settle it:

• Will the strategy need leverage or derivatives beyond hedging? If yes, it is almost certainly Category III.
• Are the investees startups, SMEs, infrastructure or social-sector businesses? Category I may fit.
• Is the fund buying unlisted equity or lending to companies without leverage? Category II is usually the answer.
• Who are the investors? Resident individuals care most about pass-through tax; foreign investors care about treaty access and the FEMA status of the fund's downstream investments.
• How long can the money be locked in? Close-ended tenure suits private markets; open-ended structures suit liquid strategies.

Frequently asked questions

Which AIF category suits a startup or venture capital fund?

Usually Category I, as a venture capital fund, or as an angel fund if the investors are accredited individuals writing smaller cheques. Category I funds get pass-through tax under Section 115UB. A fund that wants flexibility across growth-stage private equity and structured deals may prefer Category II.

Can a Category II AIF invest in listed shares?

Within limits. Category II funds invest primarily in unlisted companies, but they may hold listed securities within the investment conditions SEBI sets. If trading listed securities with leverage is the core strategy, the fund belongs in Category III.

What is the minimum investment in an AIF?

Rs 1 crore per investor under the general rule, and Rs 25 lakh for employees or directors of the AIF or its manager. Large value funds for accredited investors have a much higher per-investor minimum, Rs 25 crore after the 2025 amendment.

Can an AIF change its category after registration?

Only with SEBI approval, and in practice it means reworking the documents, the investor terms and the tax position. It is far cheaper to settle the category before the PPM is filed.

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