NISM Series XIX-B · Chapter 3: Introduction to Category III AIF Ecosystem

L1 · Foundation

Foundation — What a Category III AIF is and who makes up its ecosystem

What Category III AIFs invest in and the leverage instruments they may use; the Private Placement Memorandum and the meaning of a unit; the six characteristics — investment strategy with its five components, professional managers and fees, liquidity, portfolio diversification, investors and taxation; the ten percent single-investee limit and the twenty percent limit for large value funds for accredited investors; and the four parts of the ecosystem — investors, sponsors, trustees and investment managers, with the sponsor obligations, conflict of interest policy and the qualification requirement for managers.

22 min read · Worth 12% of the paper · Written from pages 44–73 of the official NISM workbook · Updated 18 September 2026

The Category III AIF and its ecosystem

1. What these funds invest in

A Category III AIF is a fund that trades. It can buy shares and bonds, use borrowed money and derivatives, and even bet on prices falling. Because it takes more risk than a mutual fund, it takes money only from wealthy and institutional investors.

⚠️ "Category III AIFs are PERMITTED TO TAKE LEVERAGE POSITIONS THROUGH FUTURES AND OPTIONS (F&O) CONTRACTS, STRUCTURED PRODUCTS, CREDIT DEFAULT SWAPS AND ARBITRAGE STRATEGIES, with the purpose of EARNING SPECULATIVE PROFITS, OR HEDGING THEIR CURRENT EXPOSURES".

⚠️ "Based on the investment strategy — such as LONG-SHORT FUNDS — MANAGERS MAY TAKE SHORT POSITIONS IN EQUITY SECURITIES OR FIXED INCOME SECURITIES TO MAXIMISE GAINS OR FOR THE PURPOSE OF HEDGING".

⚠️ "Common investments using Category III AIF structure are made by PIPE (PRIVATE INVESTMENT IN PUBLIC EQUITY) FUNDS, HEDGE FUNDS AND SIMILAR FUNDS which use diverse and complex investment strategies to make investments in LISTED AND UNLISTED EQUITIES, DERIVATIVES, CURRENCIES, CONVERTIBLE SECURITIES AND FIXED INCOME SECURITIES".

⚠️ PIPE FUNDS: "purchase securities of a PUBLICLY TRADED STOCK, AT A DISCOUNT TO THE CURRENT MARKET PRICE of such security being traded, whether in the PRIMARY MARKET OR SECONDARY MARKET".

2. The PPM and the unit

The PPM is the fund's rule book and offer document. The unit is what the investor owns in return for his money.

⚠️ "Category III AIFs follow A STATED INVESTMENT STRATEGY, MENTIONED IN ITS OFFER DOCUMENT, OR PRIVATE PLACEMENT MEMORANDUM (PPM). The PPM is ISSUED BY THE CATEGORY III AIF INVESTMENT MANAGER OR SPONSOR TO PROSPECTIVE INVESTORS FOR THE PURPOSE OF INVITING SUBSCRIPTIONS TO UNITS OF A NEW SCHEME".

⚠️ "The PPM SETS OUT THE BROAD TERMS AND CONDITIONS subject to which the fund is proposed to be operated, ASSOCIATED RISK FACTORS, POTENTIAL CONFLICTS OF INTERESTS, FEE STRUCTURE, DISTRIBUTION WATERFALL, TAXATION ASPECTS, APPLICABLE REGULATORY NORMS AND NECESSARY DISCLOSURES".

⚠️ "The PPM is OF PARTICULAR RELEVANCE TO DISTRIBUTORS AND IS FUNDAMENTAL TO MARKETING THE RIGHT PRODUCT TO INVESTORS, as well as EXPLAINING THE POTENTIAL RETURN AND RISKS THEREIN".

3. The six characteristics

3.1 Investment strategy

The strategy says what the fund will buy and how it will go about it.

⚠️ "The investment strategy DESCRIBES THE TYPE(S) OF ASSET CLASSES IN WHICH THE CATEGORY III AIF WILL INVEST". Five components are set out:

Component	⚠️ What it covers
⚠️ Market capitalisation of target companies	Whether the fund aims at SMALL-CAP, MID-CAP OR LARGE-CAP companies; those "WILLING TO TAKE HIGHER RISK MAY ALSO CHOOSE TO INVEST IN SME COMPANIES OR MICRO-CAP COMPANIES OR THROUGH SECURITIZED DEBT INSTRUMENTS"; some make OVERSEAS INVESTMENTS in listed investee companies
⚠️ Investment style	VALUE STOCKS — "companies which are GENERALLY UNDER-PRICED AT PRESENT MARKET PRICES AND HAVE A REASONABLE FUTURE GROWTH TRAJECTORY" · GROWTH STOCKS — "companies with HIGH GROWTH PROJECTIONS and EXPECTED GROWTH RATES IN SALES/PROFIT TO BE HIGHER THAN THE INDUSTRY AVERAGE" · GARP — "GROWTH AT A REASONABLE PRICE, WHICH COMBINES THE TENETS OF VALUE INVESTING AND GROWTH INVESTING"
⚠️ Asset allocation and stock selection	"The Investment Manager DETERMINES INDUSTRY ALLOCATION AND ASSIGNS MAXIMUM WEIGHT TO BE GIVEN TO EVERY INDUSTRY AND SECTOR... After determining industry weights, STOCK SELECTION CAN BE DONE WITHIN THE TARGETED INDUSTRY ALLOCATION, SUBJECT TO REGULATORY LIMITS"
⚠️ Investment horizon	"Outlines the TARGETED INVESTMENT HORIZON AND HOLDING PERIOD, depending on the structure being AN OPEN-ENDED FUND OR A CLOSED-ENDED FUND. Managers of open-ended funds SHOULD ENSURE THAT THERE IS SUFFICIENT LIQUIDITY TO MEET POTENTIAL REDEMPTION CALLS"
⚠️ Investment approach	"One Manager may TAKE LEVERAGE, SHORT POSITIONS IN EQUITIES OR DERIVATIVES EXPOSURE WITH THE OBJECTIVE OF EARNING PROFITS IN TRADING; while another may take derivatives exposure WITH THE OBJECTIVE OF HEDGING THE INHERENT MARKET RISK"

3.2 The concentration limits

These limits stop a fund putting too much into one company. The normal cap is 10%. Large value funds for accredited investors may go up to 20%.

3.3 Professional managers and fee structure

Investors pay two kinds of fee. One is fixed, charged on the NAV. The other is a share of the profit above a minimum return, called the hurdle rate.

⚠️ "Managers of AIF and their team ARE EXPERTS IN CAPITAL MARKETS AND INVESTMENT, especially in the industry or sector or geography the fund is investing in. MOST MANAGERS COME WITH MINIMUM 5 YEARS OF EXPERIENCE DEALING IN EQUITIES, FIXED INCOME SECURITIES AND DERIVATIVES".

⚠️ HURDLE RATE: "the MINIMUM RATE OF RETURN TO BE ACCRUED TO FUND INVESTORS EVERY YEAR, of the fund operation".

3.4 Liquidity

There is a tug of war here. The manager wants money to stay put so the strategy can work. The investor wants a way out if the manager does badly. Open-ended and closed-ended structures strike this balance in different ways.

⚠️ "In order to execute complex investment strategies, MANAGERS NEED CONSISTENT CAPITAL INFLOWS AND FREEDOM TO USE LEVERAGE. Managers MAY NOT BE ABLE TO PRODUCE THE REQUIRED RETURN ON CAPITAL IF THERE ARE MULTIPLE REDEMPTIONS. UNTIMELY REDEMPTIONS CAN FORCE MANAGERS TO EXIT POSITIONS AT UNDESIRED PRICE LEVELS".

⚠️ "As per the present taxation structure, CATEGORY III AIFs ARE REQUIRED TO PAY INCOME TAX ON INCOME EARNED FROM INVESTMENTS, WHICH CAN BE A SIGNIFICANT CASH OUT-FLOW. Hence, INVESTORS MAY BE REQUIRED TO LOCK-IN THEIR CAPITAL for a particular period".

⚠️ "Category III AIFs structured as CLOSED-ENDED FUNDS OFFER LIMITED REDEMPTION OPTIONS TO THE INVESTORS, AS COMPARED TO OPEN-ENDED FUNDS".

3.5 Portfolio diversification, investors and taxation

The fund gives access to strategies an investor could not easily run alone. The price is more risk. And unlike Category I and II funds, it pays tax itself before income reaches the investor.

⚠️ DIVERSIFICATION: "Investment Managers offer A RANGE OF INVESTMENT OPPORTUNITIES WHICH MAY OTHERWISE NOT BE AVAILABLE TO INVESTORS WHO INVEST DIRECTLY IN SECURITIES MARKET... with A DIVERSIFIED INVESTMENT STRATEGY, USE OF LEVERAGE AND DERIVATIVE EXPOSURES".

⚠️ INVESTORS: "need to FACE THE RISK OF ILLIQUIDITY AND INCREASED MARKET RISKS, on account of DERIVATIVE EXPOSURES AND USE OF LEVERAGE. Depending on MACRO ENVIRONMENT such as MARKET SENTIMENTS, GOVERNMENT REFORMS AND OTHER GLOBAL FACTORS which are NOT IN CONTROL OF THE INVESTMENT MANAGER, THE RETURNS MAY FLUCTUATE".

4. The ecosystem

Several players make a Category III AIF work: the investors, the manager, the sponsor, and service providers such as trustees and custodians.

⚠️ "The AIF industry is nurtured by the PRIVATE CAPITAL ECOSYSTEM that consists primarily of (a) THE INVESTORS, looking out for alternative investment opportunities, (b) THE ALTERNATIVE INVESTMENT MANAGERS, having the expertise to IDENTIFY, INVEST, MANAGE AND HARVEST THE RETURNS, (c) THE SPONSORS, WHO INITIATE AND FLOAT THE CATEGORY III AIFs (MORE OFTEN THE INVESTMENT MANAGERS THEMSELVES), and (d) THE EXTERNAL SERVICE PROVIDERS".

4.1 Investors

Investor	⚠️ Description
⚠️ Foundations and Endowments	A FOUNDATION is "a NOT-FOR-PROFIT ORGANIZATION THAT DONATES FUNDS AND PROVIDES SUPPORT TO OTHER ORGANIZATIONS FOR CHARITABLE PURPOSES." An ENDOWMENT is "an investment fund established by an individual or institution — UNIVERSITY, HOSPITAL, OR FOUNDATION — to be used for PRE-DEFINED PURPOSES, WITH A PRINCIPAL PROTECTION OBJECTIVE." Both have "LONG-TERM HORIZONS AND LARGE CORPUSES"
⚠️ Insurance Companies and Pension Funds	"A SIGNIFICANT CATALYST IN THE GROWTH of Category III AIFs and hedge funds globally"; in India they have "REGULATORY CAPS ON THEIR ASSET EXPOSURES IN ALTERNATIVE INVESTMENTS IN THE UNLISTED SPACE"; they "FORM THE LARGEST POOL OF DOMESTIC CAPITAL IN INDIA"
⚠️ Sovereign Wealth Funds	Started "due to LARGE TRADE SURPLUSES GENERATED BY OIL TRADE AND GLOBAL COMMERCE" by countries such as "MEMBERS OF THE OPEC, CANADA, MAURITIUS, EUROPEAN UNION, JAPAN, SINGAPORE AND MALAYSIA"
⚠️ Family Offices and HNIs	Post-2012, the Indian industry is "LED BY HNI AND FAMILY OFFICE ACCOUNTS UNDER PRIVATE BANKING MANAGERS, FOLLOWED BY INVESTMENT ADVISORS, CORPORATE INVESTORS AND OFFSHORE INVESTORS"
⚠️ Fund of Funds	"A pooled investment vehicle WHICH INVESTS IN OTHER AIFs, with the purpose of ACHIEVING GREATER DIVERSIFICATION ACROSS DIFFERENT INVESTMENT STRATEGIES." Global FoF AUM "STANDS AT 6.35 PERCENT OF THE TOTAL HEDGE FUNDS AUM GLOBALLY"

⚠️ "SEPARATELY MANAGED ACCOUNTS (SMA) ARE A CARVE-OUT FROM THE FUND STRUCTURE".

4.2 Sponsors

The sponsor is the one who sets the fund up and gets it registered. Often the sponsor and the manager are the same.

⚠️ "After seeking registration, THE SPONSOR INVESTS IN THE CAPITAL OF THE COMPANY OR THE PARTNERSHIP. IN CASE THE AIF IS SET UP AS A TRUST, THE SPONSOR WOULD CONTRIBUTE TO THE CAPITAL OF THE INVESTMENT MANAGEMENT COMPANY".

⚠️ Their functions: "SPONSORING THE FUND, DEFINING THE THEME, CONSTITUTING THE FUND IN THE APPROPRIATE STRUCTURE, REGISTRATION WITH SEBI AND FORMATION OF THE INITIAL AND SUBSEQUENT CORPUSES. SPONSOR CAN ALSO BE THE MANAGER OF AIFs".

⚠️ "The sponsor SHOULD SATISFY THE REQUIREMENTS OF 'FIT AND PROPER PERSON' BASED ON THE CRITERIA SPECIFIED IN SCHEDULE II OF THE SEBI (INTERMEDIARIES) REGULATIONS, 2008. Any change in the sponsor or designated partner SHALL BE INFORMED TO SEBI, and WHERE THERE IS A CHANGE IN CONTROL OF THE AIF, PRIOR APPROVAL FROM SEBI IS REQUIRED".

4.3 The six sponsor and manager obligations

Once the fund is running, the sponsor and manager carry six standing duties.

#	⚠️ Obligation
1	⚠️ APPOINTING A CUSTODIAN — "shall COMPULSORILY APPOINT A CUSTODIAN, REGISTERED WITH SEBI, for SAFEKEEPING OF SECURITIES, and shall keep custody of SECURITIES AND GOODS RECEIVED IN DELIVERY AGAINST PHYSICAL SETTLEMENT OF COMMODITY DERIVATIVES"
2	⚠️ REVIEW POLICIES AND PROCEDURES — "along with its implementation, ON A REGULAR BASIS"
3	⚠️ AUDITED FINANCIALS — "Books of accounts SHALL BE AUDITED ANNUALLY BY A QUALIFIED AUDITOR"
4	⚠️ DISPUTE RESOLUTION MECHANISM — "shall LAY DOWN APPROPRIATE PROCEDURES FOR RESOLUTION OF DISPUTES between the investors and the Fund, WHETHER THROUGH ARBITRATION OR ANY SUCH MECHANISM AS MUTUALLY DECIDED"
5	⚠️ MAINTENANCE OF RECORDS — "for a period of 5 YEARS AFTER THE WINDING UP OF THE FUND: ASSETS UNDER THE SCHEME, VALUATION POLICIES AND PRACTICES, INVESTMENT STRATEGIES, DETAILS OF INVESTORS AND THEIR CAPITAL CONTRIBUTION AND INVESTMENT DECISION-MAKING PROCESS"
6	⚠️ INSPECTION — "required to CO-OPERATE WITH SEBI by providing all required information for CONDUCTING INSPECTION OF RECORDS with respect to ACTIVITIES OF FUND, ASSESSMENT OF SYSTEMIC RISK OR PREVENTION OF FRAUD"

⚠️ "The Manager is obliged to ADDRESS INVESTOR COMPLAINTS, PROVIDE ANY INFORMATION SOUGHT BY SEBI, MAINTAIN NECESSARY RECORDS, ENSURE TRANSPARENCY AND TAKE ALL STEPS TO ADDRESS CONFLICT OF INTEREST".

4.4 Conflicts of interest

The sponsor and manager must act in the investors' interest. Where their own interest could clash with that, they must say so.

At FUND-CONSTITUENT level:

⚠️ "Employees of SPONSOR COMPANY, ASSET MANAGEMENT COMPANY, TRUSTEE AND SERVICE PROVIDERS should not have potential conflicts WHEN DISCLOSING MATERIAL INFORMATION TO THEIR CLIENTS".
⚠️ "NO POTENTIAL CONFLICT SHOULD PREVAIL BETWEEN INVESTORS AND THE INVESTMENT MANAGER".
⚠️ "Employees SHALL PUT THE CLIENTS' INTEREST OVER THEIR PERSONAL INTEREST. Employees SHOULD NOT SOLICIT GIFTS, HARD/SOFT COMMISSIONS".
⚠️ "Conflicts within CO-INVESTMENTS by the Investment Manager SHALL BE DISCLOSED to potential and existing investors BEFORE ANY ALLOCATION".
⚠️ "DISCLOSE THE POTENTIAL CONFLICT IF THE TRUSTEE IS A GROUP OR ASSOCIATE ENTITY of the fund, or sponsor/investment manager, OR HAVE ONE OR MORE DIRECTORS IN COMMON".

At EMPLOYEE OR STAFF level:

⚠️ "ECONOMIC INTEREST OF THE EMPLOYEE should NOT BE CONTRARY TO THE BEST INTEREST OF THE FUND".
⚠️ "Employees SHOULD NOT BE BIASED TOWARD THE RESULT OF THE TRANSACTION, as a result of A PERSONAL, FAMILY, FRIENDSHIP OR SUCH OTHER RELATIONSHIP WITH THE COUNTERPARTY".
⚠️ "The staff member SHOULD NOT BE EMPLOYED, OR ACT ON BEHALF OF, ANOTHER ENTITY WHICH SHARES THE SAME ECONOMIC INTEREST OR HAS THE SAME BUSINESS as the employer organization".

⚠️ The policy must describe: "NATURE OF POTENTIAL CONFLICTS which could arise at various levels · METHODOLOGY proposed for EFFECTIVE MITIGATION · DISCLOSURE MECHANISM to inform investors and SEEK THEIR ACKNOWLEDGEMENT towards existence of potential investment risks".

4.5 Trustees

A trustee is needed only when the fund is set up as a trust. The trustee must be honest and independent of the manager.

⚠️ "A TRUSTEE OR TRUSTEE COMPANY IS APPOINTED WHEN THE CATEGORY III AIF IS CONSTITUTED AS A TRUST. Though SEBI (AIF) Regulations DO NOT SPECIFICALLY PROVIDE FOR THE QUALIFICATION REQUIREMENTS FOR TRUSTEES, THEY DO HAVE LAID DOWN THE CODE OF CONDUCT FOR TRUSTEES".

⚠️ "SEBI REVIEWS THE APPOINTMENT OF THE TRUSTEE AT THE TIME OF REGISTRATION, and SUBSEQUENT CHANGES NEED TO BE NOTIFIED AND APPROVED BY SEBI".

4.6 Investment Managers

⚠️ "INVESTMENT MANAGER is the person or entity APPOINTED BY THE SPONSOR to MANAGE ITS INVESTMENTS, AND MAY ALSO BE SAME AS THE SPONSOR".

⚠️ "Investment managers ALSO NEED TO KEEP INVESTORS INFORMED OF THE PROGRESS OF THE FUND, INVESTMENTS MADE, KEY TERMS OF THE FUND, NEW DEVELOPMENTS IN THE INDUSTRY IMPACTING THE FUND, LAUNCH OF FOLLOW ON FUNDS".

⚠️ "The Investment Managers SHOULD SATISFY THE REQUIREMENTS OF 'FIT AND PROPER PERSON' under SCHEDULE II OF THE SEBI (INTERMEDIARIES) REGULATIONS, 2008. Any change SHALL BE INFORMED TO SEBI, and where there is A CHANGE IN CONTROL OF THE INVESTMENT MANAGEMENT COMPANY, PRIOR APPROVAL FROM SEBI IS REQUIRED".

Think of it like this

The builder who buys the first flat in his own project

A developer who buys a flat in his own building, at the same price as everyone else, and cannot sell it until the last owner has taken possession, is making a statement no brochure can make. His money is where his promises are.

⚠️ That is sponsor commitment. "The Sponsor or Manager of a Category III AIF SHALL HAVE A CONTINUING INTEREST OF NOT LESS THAN 5 PERCENT OF THE CORPUS OF THE FUND OR Rs 10 CRORE, WHICHEVER IS LOWER."

⚠️ "SUCH CONTINUING INTEREST CANNOT BE WITHDRAWN FROM THE FUND AND WILL REMAIN LOCKED-IN UNTIL DISTRIBUTIONS TO INVESTORS ARE COMPLETED IN FULL."

Its stated purpose: "to DEMONSTRATE THE ALIGNMENT OF INTERESTS between them and the AIF, SO THAT THE INVESTORS ARE ASSURED OF THEIR BEST INTERESTS BEING TAKEN CARE OF IN THE FUTURE." A fee waiver would cost the sponsor income; a cash investment costs him capital — and that is a different kind of promise.

The wedding caterer paid in instalments

A family booking a caterer does not hand over the whole sum on the day of booking. Money is called as ingredients are bought and staff hired. The caterer knows the total is committed; the family keeps the cash until it is needed.

⚠️ That is the drawdown mechanism. "CAPITAL COMMITMENT refers to the TOTAL FUNDS TO BE CONTRIBUTED BY INVESTORS... DURING THE LIFE OF THE FUND", while "DRAWDOWN is the process by which the manager WILL CALL THE CAPITAL COMMITMENT FROM ITS INVESTORS, AS PER THE FUNDING REQUIREMENTS AND INVESTMENT STRATEGY." These calls are ⚠️ "known as CAPITAL CALLS."

The workbook's illustration: a fund closes with Rs 1,000 crore of commitments; when Rs 650 crore has been drawn, the "INVESTED CAPITAL" is Rs 650 crore against "COMMITTED CAPITAL" of Rs 1,000 crore, and ⚠️ "THE UNDRAWN AMOUNT OF Rs 350 CRORE IS KNOWN AS 'DRY POWDER'."

The arrangement has a cost for the investor, and it is worth stating plainly: "it is DIFFICULT FOR INVESTORS TO FORECAST THE TIMING OF A CAPITAL CALL, in case of a drawdown on an 'AS-NEEDED' BASIS. INVESTORS HAVE TO MAINTAIN SUFFICIENT LIQUIDITY AND CAPITAL IN ORDER TO HONOUR THE CAPITAL CALLS."

The high-jump bar that never comes down

An athlete who clears 2 metres does not get credited again for clearing 1.9 metres next time. The bar stays where his best jump left it.

⚠️ That is the high-water mark. "HIGH-WATER MARK is THE HIGHER OF THE SUBSCRIPTION PRICE OF UNITS ISSUED TO A PARTICULAR CLASS OF INVESTORS, OR THE HIGHEST NET NAV ACHIEVED AT THE END OF ANY PREVIOUS FINANCIAL YEARS. High-Water Mark is important FOR THE PURPOSE OF COMPUTING THE INCREMENTAL RETURNS EARNED BY THE MANAGER."

Without it, a manager who lost 20 per cent one year and gained 20 per cent the next would collect performance fees on the recovery — charging the investor for getting back to where he started.

⚠️ It works alongside the HURDLE RATE, "the threshold return that the investors MUST RECEIVE BEFORE THE MANAGER RECEIVES ADDITIONAL RETURNS." And the workbook is careful about what a hurdle is not: its purpose is "TO BENCHMARK THE EXPECTATIONS OF THE INVESTORS, RATHER THAN TO PROVIDE A GUARANTEED RETURN TO INVESTORS, WHICH IS NEITHER ETHICAL NOR PRACTICALLY POSSIBLE."

And why the hurdle must be demanding: Category III AIFs "SHOULD COMPENSATE INVESTORS FOR TAKING HIGHER RISK OF ILLIQUIDITY AND LONGER TERM OF HOLDING. HENCE, HURDLE RATES HAVE TO BE BETTER THAN COMPARABLE MARKET RETURNS IN TRADITIONAL INVESTMENTS."

Dividing the harvest at the threshing floor

A tenant farming arrangement settles in order: first the seed is returned to whoever supplied it, then the agreed share to the landowner, then the labourer takes his portion, and only what remains is split.

⚠️ A distribution waterfall works the same way, in four steps:

⚠️ "RETURN OF CAPITAL CONTRIBUTION OF INVESTORS"
⚠️ "PAYMENT OF THE PREFERRED RETURN, OR THE HURDLE RETURN, TO THE INVESTORS"
⚠️ "PAYMENT OF A CATCH-UP RATE TO THE INVESTMENT MANAGERS"
⚠️ "After the catch-up rate is paid, ANY EXCESS PROFITS ARE THEN DISTRIBUTED TO THE INVESTORS"

⚠️ CATCH-UP RATE: "the rate at which RESIDUAL PROFITS, AFTER RETURNING INVESTORS' CAPITAL AND HURDLE, WILL BE DISTRIBUTED TO THE MANAGER IN ORDER TO 'CATCH-UP' TO AND RECEIVE THE PRE-DETERMINED SHARE OF THE 'TOTAL PROFITS' (GENERALLY 20%)."

The order is not decorative — it is the entire economics. Investors get their capital back first, then their hurdle, and only then does the manager begin to earn. The manager is paid last, out of what is genuinely surplus.

Three shops selling the same goods on different terms

A wholesaler, a supermarket and a members-only club may all sell rice. The rice is similar; the minimum purchase, the membership rules and whether you can return it differ entirely.

⚠️ So it is with PMS, mutual funds and Category III AIFs, and the differences are the examinable part:

	PMS	Mutual Fund	Category III AIF
⚠️ Pooling	"NOT DONE. SEPARATE DEMAT ACCOUNTS for every investor"	Pooled, public	⚠️ "COMPULSORY, for collective investment. TRADING IS DONE ONLY AT POOLED LEVEL"
⚠️ Minimum	⚠️ Rs 50 LAKH	⚠️ Rs 500 or as specified	⚠️ Rs 1 CRORE, or Rs 25 LAKH for employees
⚠️ Minimum corpus	None — "even one client is good to start"	None	⚠️ Rs 20 CRORE
⚠️ Investor cap	"NO CAP SPECIFIED"	"NO UPPER CAP"	⚠️ "CANNOT EXCEED 1,000"
⚠️ Issue process	—	⚠️ PUBLIC ISSUE	⚠️ PRIVATE PLACEMENT

The one that most often catches candidates: in PMS the investor "OWNS" every security purchased, while in an AIF the investors own "UNITS OF THE FUND REPRESENTING THE UNDERLYING SECURITY." That single difference explains why PMS investors can withdraw at any time — the securities are already in their own name.

The batting order and the pitch

A team's score depends on two quite different things: how well its batsmen play, and what the pitch is doing. A century on a flat track is not the same achievement as fifty on a turning wicket.

⚠️ Alpha and beta separate exactly these two. "ALPHA is the EXCESS RETURN GENERATED BY THE CATEGORY III AIF MANAGER, OVER AND ABOVE THE RETURN GENERATED BY ITS BENCHMARK" — the batsman's skill. "BETA MEASURES SYSTEMATIC RISK, WHICH IS THE CHANGE IN THE RETURNS EARNED BY THE FUND PORTFOLIO ON ACCOUNT OF A CHANGE IN THE RETURNS ON A BROAD-BASED INDEX" — the pitch.

⚠️ "HIGHER THE BETA, THE MORE VOLATILE IS THE FUND PORTFOLIO AS COMPARED TO THE MARKET RETURN." The workbook's own comparison: a fund holding small and mid-caps has high beta against one holding large-caps, and ⚠️ "THIS RISK CANNOT BE DIVERSIFIED, BY INVESTING ACROSS INDUSTRIES, SECTORS AND GEOGRAPHIES."

Which is why alpha is pursued through "ACTIVE MANAGEMENT" — "accurately identifying mispriced securities, TO BUY UNDER-PRICED SECURITIES AND SELL OVER-PRICED SECURITIES" — while beta is managed rather than eliminated.

Key terms in this chapter

2-20 Structure: A fee arrangement where the manager takes 2 per cent management fee and 20 per cent of additional returns. Common globally but not a standard in the evolving Indian Category III AIF market.
Alpha: The excess return generated by the manager over and above the return of the benchmark, pursued through active management by identifying mispriced securities.
Beta: A measure of systematic risk — the change in portfolio returns caused by a change in returns on a broad-based index. It cannot be diversified away across industries, sectors or geographies.
Capital Call: The individual demand a manager makes on investors to pay in part of their committed capital.
Capital Commitment: The total funds an investor promises to contribute to the AIF over the life of the fund. Minimum Rs 1 crore from an ordinary investor, Rs 25 lakh from employees or directors of the AIF or Manager.
Catch-up Rate: The rate at which residual profits, after returning investors' capital and hurdle, go to the manager so that he catches up to his pre-determined share of total profits. Managers prefer a rate of 100 per cent.
Category III AIF: An AIF that employs diverse or complex trading strategies and may employ leverage, including through investment in listed or unlisted derivatives. Hedge funds and PIPE funds are the common examples.
Commodity Trading Advisor (CTA): A manager registered with the National Futures Association in the USA who runs a managed futures strategy in commodity, equity and currency futures, either systematically through algorithms or at his own discretion.
Contribution Agreement: The document recording the terms on which an investor participates in the Category III AIF, including the drawdown schedule, notice period and penalties for failing to honour a call.
Corpus: The total of capital commitments raised from investors for a scheme. A Category III AIF scheme must have a corpus of at least Rs 20 crore.
Distribution Waterfall: The order of payouts — return of investor capital, then the hurdle or preferred return, then the catch-up to the manager, then any excess profits to investors.
Drawdown: The process by which the manager calls committed capital from investors as investment needs arise, following the capital call schedule agreed in the contribution agreement.
Dry Powder: The committed capital that has not yet been drawn down. On Rs 1,000 crore committed with Rs 650 crore drawn, dry powder is Rs 350 crore.
Due Diligence: Processes ensuring enough safeguards are taken and reasonable care exercised in protecting the interests of the investigating party. Conducted at fund level by investors and at investee company level by the fund.
ESG: Environmental, Social and Governance — a generic term for evaluating corporate behaviour, used interchangeably with sustainable, responsible, impact or ethical investment.
Exit Load: The additional fee charged on redemptions made after the lock-in period ends but before the stated fund tenure expires. It ranges from 0 to 5 per cent of NAV and may be variable so that earlier exits pay more.
Final Close: The last date on which the fund accepts contributions, occurring not later than a specified period after first close, with necessary approvals.
First Close: The declaration that a fund will proceed, made once commitments exceed the minimum corpus or the stipulated fund-raise period is complete. It must be declared within 12 months of SEBI communication taking the PPM on record.
Fund of Funds: A hedge fund investing in other hedge funds running different strategies. It diversifies strategy risk but charges substantially higher fees because of the extra layer of management fee.
GARP: Growth at a Reasonable Price — an investment style combining the value approach of buying under-priced securities with the growth approach of seeking above-average industry growth rates.
High-Water Mark: The higher of the subscription price of units issued to a class of investors or the highest net NAV achieved at the end of any previous financial year, used to compute the manager's incremental returns.
Hurdle Rate: Also called preferred return — the threshold return investors must receive before the manager earns additional returns. It benchmarks expectations rather than guaranteeing a return.
Invested Capital: The total amount actually drawn down by the manager from investors for the purpose of making investments.
Large Value Fund for Accredited Investors: An AIF or scheme in which each investor is an accredited investor investing not less than Rs 25 crore. Its single-investee limit rises from 10 to 20 per cent of investable funds.
Lock-in Period: The period during which an investor cannot redeem units. A two-year lock-in is prevalent for Category III AIFs though not mandated by the SEBI (AIF) Regulations.
Managed Futures: The strategy CTAs follow, commonly used to benefit from short-term mispricing among asset classes and derivative contracts.
Management Fee: The fee paid by the fund to the manager, usually 1 to 2 per cent of committed capital during the commitment period and thereafter of invested capital or AUM. Payable even if the fund earns no profit, with GST charged over and above.
Multi-Strategy Fund: A hedge fund deploying multiple investment strategies within the same scheme, giving diversification while controlling the pay-out of management fees.
Performance Fee: Also called incentive fee — the manager's reward for outperforming the hurdle rate and high-water mark, generally up to 20 per cent of additional return and ranging from 0 to 30 per cent.
PIPE: Private Investment in Public Equity — buying securities of a publicly traded company at a discount to the current market price, in either the primary or the secondary market.
Portfolio Management Services (PMS): Customised investment advisory and portfolio management for a client investing a minimum of Rs 50 lakh, where the investor owns each security directly rather than holding units of a pool.
Principles for Responsible Investment (PRI): A United Nations backed global network of investors launched in 2006 that attempts to integrate ESG practices into investment practice as part of fiduciary duty.
Realization Risk: The risk that a Category III AIF fails to liquidate its investments in a timely and profitable manner. One of the seven material risks reportable to investors quarterly.
Redemption Gate: A cap on the maximum amount investors may redeem in each redemption period, subject to applicable expenses, taxes and exit load.
Set-up Cost: A one-time cost directly attributable to formation of the fund and initial sale of units — external legal and accounting fees, statutory compliance costs, directors' fees, intermediary commissions, printing and out-of-pocket expenses.
Specialized Investment Fund (SIF): A product line under the SEBI (Mutual Funds) Regulations bridging the gap between mutual funds and PMS, with a minimum investment of Rs 10 lakh across all strategies of the AMC.
Sponsor Commitment: The continuing interest the sponsor or manager must hold in the fund — not less than 5 per cent of the corpus or Rs 10 crore, whichever is lower — in cash, not by waiving fees, and locked in until distributions to investors are complete.
Stewardship Code: SEBI's code for all categories of AIFs in relation to their investments in listed equity, covering policy and disclosure, conflicts of interest, monitoring investee companies, intervention and collaboration, voting, and periodic reporting.
Unit: The beneficial interest of an investor in the AIF. It may be fully paid-up or partly paid-up, the partly paid-up portion representing committed capital actually drawn and invested.

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Original explanatory writing based on the official NISM workbook for Series XIX-B, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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