NISM Series XIX-E · Chapter 4: Alternative Investment Funds in India and its Suitability

L1 · Foundation

From Offshore Hedge Funds to Three AIF Categories

How hedge funds began, why India had none until 2012, the trends since, what counts as an AIF and what is excluded, and the three categories with every sub-category in Category I and II, and the hedge fund in Category III.

15 min read · Worth 3% of the paper · Written from pages 69–89 of the official NISM workbook · Updated 18 September 2026

From Offshore Hedge Funds to Three AIF Categories

4.1 How hedge funds began

The term "hedge funds" first came into use in 1949, when Alfred Winslow Jones's company, A.W. Jones & Co., launched the first hedge fund.

Hedge funds were described as any investment fund that used INCENTIVE FEES, SHORT SELLING and LEVERAGE to maximise returns. Over time they added fixed income, convertibles, currencies, exchange-traded futures, commodity futures and commodity options.

The Indian story before 2012

Indian capital markets grew significantly in the 1990s. With rules for Portfolio Managers and the SEBI (Mutual Funds) Regulations, private sector asset management took shape.
Foreign investors put significant money into India through hedge funds and funds-of-funds set up OFFSHORE. These invested directly, or through Offshore Derivative Instruments (ODIs) issued by FIIs against Indian securities.
The Eurekahedge India Long Short Equities Hedge Fund Index is an equally weighted index of 15 constituent funds, measuring managers who invest exclusively in India. It is base weighted at 100 as on December 1999. The workbook says India-focused hedge funds showed consistent returns, even after a fall during the Global Financial Crisis of 2008.

The gap: no hedge funds were DOMICILED in India. Offshore hedge funds could not offer products to Indian investors within India, because there was no regulatory regime for hedge funds to be set up or marketed here. FEMA restrictions added to this.

SEBI gave a limited window up to 2012 for hedge funds to register as an FII under the SEBI (FII) Regulations, with extra safeguards.
Under the SEBI (AIF) Regulations, 2012, hedge funds were classified as CATEGORY III AIFs - funds with diverse and complex strategies, like hedge funds globally.

Trends after 2012

Trend	What happened
Broadening	From mainly venture capital and private equity to a full alternative investment industry, including funds for UHNIs and family offices - e.g. real estate and infrastructure
Record PE activity	Despite Brexit and the US-China trade war, PE activity in Asia Pacific hit records, with India registering the highest growth in 2017 and 2018
Domestic capital	Ultra-rich Indian billionaires took to AIFs; new fund houses launched AIFs for very wealthy Indians
Listed-market AIFs	A new phenomenon - funds like hedge funds taking long-short positions in equity, debt and derivatives, some in special situations: merger arbitrage, buybacks, de-listings, Takeover Code open offers, rights offers and hedging. Also real estate debt funds and venture debt funds
Mutual fund managers moving to AIFs	Rationalisation of expense ratios for equity mutual funds encouraged MF managers to launch their own AIFs, with more flexibility. AIF managers can charge performance fees on the "Additional Return" above the "Reference Hurdle Rate", in addition to a yearly fixed management fee
Monitoring	All SEBI-registered AIFs are monitored under Operational Guidelines and a Risk Management Framework, including prudential norms and leverage limits
New Category III opportunities	Exposure to exchange-traded COMMODITY FUTURES and COMMODITY OPTIONS

4.2 What an AIF is

The SEBI (AIF) Regulations 2012 define an AIF as, primarily, a PRIVATELY POOLED investment vehicle, with funds pooled from India or abroad for a defined investment policy.

"Privately pooled" means pooled from SELECT investors, not the general public. These investors come from categories like institutions and HNIs who understand higher risk and complex arrangements.

Explicitly EXCLUDED from the definition:

Mutual funds and collective investment schemes under SEBI regulations
Family trusts, ESOP or employee benefit trusts, holding companies, and SPVs for securitisation or similar purposes
Funds under RBI regulations, such as securitisation companies, or under any other regulator

The pattern: the exclusions are either private funds of a company, business or family, or funds regulated by another regulator - RBI, IRDAI, PFRDA or IFSCA.

Who registers: a sponsor, or the trustee if the AIF is a trust, can register as Category I, II or III.

4.2.1 Category I AIFs

Invests in START-UPS, EARLY-STAGE VENTURES, SOCIAL VENTURES, SMEs, INFRASTRUCTURE or other sectors the government or regulators consider SOCIALLY or ECONOMICALLY DESIRABLE. Funds with special government or regulator incentives also fall here.

Sub-category	The workbook's definition and key facts
Venture Capital Fund	Invests primarily in UNLISTED securities of start-ups, emerging or early-stage venture capital undertakings in new products, services, technology or IP-based activities or a new business model, including a migrated VCF. A "start-up" is a private limited company or LLP meeting DPIIT criteria (notification G.S.R.127(E) dated February 19, 2019). A "venture capital undertaking" is a domestic company NOT LISTED when the investment is made. VC is the first stage of institutional financing, generally after angel funds are raised, mostly for asset-light, technology, IP or digital media businesses
Migrated VCF	Previously registered under the SEBI (VCF) Regulations, 1996 and later registered under the AIF Regulations as a sub-category of VCF in Category I
Angel Fund	Raises funds from ACCREDITED INVESTORS. An angel investor is an accredited investor, or key management personnel of an angel fund or its manager, who invests in an angel fund
Infrastructure Fund	Invests primarily in unlisted securities, partnership interest, or listed debt or securitised debt of companies or SPVs operating, developing or holding infrastructure projects. Key investors: Sovereign Wealth Funds, Multilateral Funds and Thematic AIFs, because of high illiquidity, long gestation risk and long amortisation of debt
SME Fund	Invests primarily in unlisted securities of SMEs, or SMEs listed or proposed to be listed on an SME exchange or segment. SME has the meaning in the MSME Development Act 2006. BSE and NSE both run separate SME segments with more relaxed criteria than the main board
Social Impact Fund	Invests primarily in social ventures or social enterprises and satisfies social performance norms laid down by the fund. Social ventures include public charitable trusts, societies for charitable or scientific or literary or fine arts purposes, Section 8 companies, and micro-finance institutions
Special Situations Fund	Distressed debt funds now specifically defined by SEBI. Can acquire debt or equity in resolutions under the IBC 2016, finance companies in default to banks and NBFCs for NOT LESS THAN 90 DAYS, and acquire stressed loans and security receipts of ARCs
Corporate Debt Market Development Fund (CDMDF)	A close-ended AIF formed as a TRUST with a 15-YEAR tenure from first closing. Units go to AMCs and specified debt-oriented MF schemes. It buys corporate debt from debt MF schemes during market dislocation, as decided by SEBI - a BACKSTOP FACILITY. Conditions: securities listed with investment grade rating, residual maturity not more than FIVE YEARS on purchase, and no material possibility of default or adverse credit news. In normal times it invests in liquid, low-risk debt

Migrated VCF - the dates

Migration to the AIF Regulations was available till July 19, 2025 only.
Migrated VCFs cannot launch NEW schemes.
Existing schemes' tenure can be extended up to 2 YEARS, with approval of TWO-THIRDS of unit holders BY VALUE.
VCF schemes whose liquidation period expired without winding up, and which migrated, get an additional liquidation period till July 19, 2026.
Manager, trustee and key management personnel are responsible for compliance.

4.2.2 Category II AIFs

An AIF that does NOT fall in Category I or III, and does NOT undertake leverage or borrowing other than as permitted. Funds like Private Equity Funds or Debt Funds, with no specific incentives or concessions, are included.

Sub-category	Definition and notes
Private Equity Fund	Invests primarily in EQUITY or equity-linked instruments or partnership interests of investee companies. Equity-linked instruments include instruments convertible into equity, share warrants, preference shares, and compulsorily or optionally convertible debentures. Unlike VC's early stage, PE is mostly LATER-STAGE financing for businesses with an established model that need scaling up
Debt Fund	Invests primarily in debt securities of listed or unlisted companies, or securitised debt. Private debt counts as alternative because of illiquidity and because traditional investors seldom hold it. Includes privately placed NCDs of listed companies, venture debt funds using mezzanine financing (debt with equity upside, like warrants), pure venture debt at above-market rates for already VC-funded start-ups, and leveraged loans - subordinate debt for companies with heavy senior debt

Sub-category

Definition and notes

Private Equity Fund

Invests primarily in EQUITY or equity-linked instruments or partnership interests of investee companies. Equity-linked instruments include instruments convertible into equity, share warrants, preference shares, and compulsorily or optionally convertible debentures. Unlike VC's early stage, PE is mostly LATER-STAGE financing for businesses with an established model that need scaling up

Debt Fund

Invests primarily in debt securities of listed or unlisted companies, or securitised debt. Private debt counts as alternative because of illiquidity and because traditional investors seldom hold it. Includes privately placed NCDs of listed companies, venture debt funds using mezzanine financing (debt with equity upside, like warrants), pure venture debt at above-market rates for already VC-funded start-ups, and leveraged loans - subordinate debt for companies with heavy senior debt

4.2.3 Category III AIFs

An AIF that employs DIVERSE or COMPLEX TRADING STRATEGIES and MAY EMPLOY LEVERAGE, including through investment in LISTED or UNLISTED DERIVATIVES. Hedge funds, funds trading for SHORT-TERM returns, or other OPEN-ENDED funds without specific incentives are included.

Hedge Fund: "an AIF which employs diverse or complex trading strategies and invests and trades in securities having diverse risks or complex products including listed and unlisted derivatives".

Think of it like this

The three categories are three kinds of shops in a market

The municipal corporation gives cheaper rent to a shop run by a self-help group, because it creates jobs - that is Category I, where socially or economically desirable funds get concessions. An ordinary grocery pays normal rent and is not allowed to borrow heavily against its stock - that is Category II, with no incentives and no leverage beyond what is permitted. A commodity trading desk upstairs buys and sells all day, borrows to trade, and takes the most risk - that is Category III, with complex trading strategies, leverage and derivatives.

Privately pooled is the invitation-only kitty party

A kitty party collects money only from invited members who know the rules and the risks; it does not put up a banner asking the whole colony to join. An AIF is the same - privately pooled from select investors such as institutions and HNIs who understand complex, higher-risk arrangements. A mutual fund is the public mela open to everyone, which is exactly why it is excluded from the AIF definition.

The CDMDF is the fire extinguisher in the corridor

Nobody uses the fire extinguisher on a normal day, but it must be full and checked, and when there is a fire everyone is glad it is there. The Corporate Debt Market Development Fund sits in liquid, low-risk debt in normal times and steps in during market dislocation to buy corporate bonds from debt mutual funds - a backstop facility. And like an extinguisher that only works on small fires, it buys only listed, investment-grade bonds with residual maturity up to five years and no material possibility of default.

VC and PE are the nursery and the growing orchard

A nursery owner takes saplings that may not survive, so he keeps his options open - soil, fertiliser, grafting, whatever the plant needs. A buyer of a growing orchard takes a plant that has already shown it can bear fruit, and pays to scale it up. That is why the workbook says a VCF may invest in "securities" of early-stage companies - giving latitude to structure the deal - while a PE fund must invest primarily in equity or equity-linked instruments, because later-stage investors are better placed to take equity risk.

Mezzanine debt is a loan with a lottery ticket attached

A friend lends money to a growing bakery at interest, and asks for the right to buy a small share if the bakery becomes a chain. If the bakery stays small, he gets his interest; if it takes off, the share makes him rich. That is mezzanine financing, which the workbook describes as debt financing with an equity upside, such as warrants attached to the debt - used by venture debt funds for growth-stage companies.

Key terms in this chapter

Alpha: Excess return over the benchmark - either expected compensation for unsystematic risk after adjusting for risk differences, or superior profit from the manager's skill in selection and allocation.
Alternative beta: A term some schools of thought use for the risk-taking behind skill-based alpha, where carefully picked investments beat market returns.
Alternative Investment Fund: Primarily a privately pooled investment vehicle, with funds pooled from India or abroad from select investors (not the general public) for a defined investment policy.
Angel Fund: A sub-category of Category I AIF that raises funds from accredited investors, investing a minimum of INR 10 lakh and a maximum of INR 25 crore in a particular investee company.
Beta: A measure of systematic risk - the change in fund returns for a change in a broad-based index. Higher beta means more volatility; it cannot be diversified across industries, sectors and geographies.
Category I AIF: An AIF investing in start-ups, early-stage ventures, social ventures, SMEs, infrastructure or other socially or economically desirable sectors - including VCFs, SME, Angel, Social Impact, Infrastructure and Special Situations Funds, and the CDMDF.
Category II AIF: An AIF not falling in Category I or III, which does not undertake leverage or borrowing other than as permitted - such as Private Equity Funds and Debt Funds with no specific incentives.
Category III AIF: An AIF that employs diverse or complex trading strategies and may employ leverage, including through listed or unlisted derivatives - such as hedge funds. The riskiest of the three categories.
Corporate Debt Market Development Fund: A close-ended Category I AIF formed as a trust with a 15-year tenure from first closing, whose units are held by AMCs and debt MF schemes, and which buys listed investment-grade corporate debt of up to five years residual maturity during market dislocation as a backstop.
Debt Fund: A Category II AIF investing primarily in debt securities of listed or unlisted companies or securitised debt, including privately placed NCDs, venture debt and leveraged loans.
Hedge Fund (AIF Regulations): An AIF which employs diverse or complex trading strategies and invests and trades in securities having diverse risks or complex products, including listed and unlisted derivatives. Classified as Category III.
Hedge fund (historical): A term first used in 1949 when A.W. Jones & Co. launched the first hedge fund; described as any investment fund using incentive fees, short selling and leverage to maximise returns.
Infrastructure Fund: An AIF investing primarily in unlisted securities, partnership interest, or listed or securitised debt of companies or SPVs operating, developing or holding infrastructure projects.
Leveraged loans: Subordinate debt provided by private debt funds to companies that already have a high amount of senior debt on their balance sheets.
Material risks of an AIF: Risks AIFs should identify and report at set intervals - concentration, foreign exchange, leverage, realization, strategy, reputation and extra-financial risks including ESG.
Mezzanine financing: Debt financing with an equity upside, such as warrants attached to the debt, used by venture debt funds for growth-stage companies.
Migrated Venture Capital Fund: A fund previously registered under the SEBI (VCF) Regulations, 1996 and later registered under the AIF Regulations as a sub-category of VCF in Category I. It cannot launch new schemes.
Offshore Derivative Instruments (ODIs): Instruments issued by Foreign Institutional Investors against underlying Indian securities, through which offshore hedge funds and funds-of-funds invested in India before 2012.
Portfolio Management Services: Customised portfolio management for individual clients with a minimum of INR 50 lakh, where securities are held in each client's own demat account; discretionary or non-discretionary.
Private Equity Fund: A Category II AIF investing primarily in equity or equity-linked instruments or partnership interests, mostly providing later-stage financing to businesses with established models.
Privately pooled: Money raised from select investors such as institutions and HNIs who understand higher risk and complex arrangements, rather than from the general public.
SME Fund: An AIF investing primarily in unlisted securities of SMEs, or of SMEs listed or proposed to be listed on an SME exchange or segment; SME as defined in the MSME Development Act 2006.
Social Impact Fund: An AIF investing primarily in securities, units or partnership interest of social ventures or social enterprises, and satisfying the social performance norms laid down by the fund.
Specialised Investment Fund: A publicly issued product compared with Category III AIFs, with a minimum of Rs 10 lakh across all strategies of the AMC, daily NAV and no investor cap; not registered under the AIF Regulations.
Special Situations Fund: A Category I sub-category of distressed debt funds that can buy debt or equity in IBC resolutions, finance companies in default for not less than 90 days, and acquire stressed loans and ARC security receipts.
Venture Capital Fund: An AIF investing primarily in unlisted securities of start-ups, emerging or early-stage venture capital undertakings in new products, services, technology, IP-based activities or new business models, including a migrated VCF.
Venture capital undertaking: A domestic company which is not listed on a recognised stock exchange at the time the investment is made.

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

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