Category II AIF
Also written Category II Alternative Investment Fund · Cat II AIF
The residual AIF category: anything that is neither Category I nor Category III and takes no fund-level leverage beyond a narrow temporary carve-out — private equity, private debt and fund-of-funds.
In plain language
Category II is defined by what it is not. A fund is Category II if it is not Category I. So it has no special economic or social purpose and no government concession. It is also not Category III. So it uses no complex trading strategies and no borrowing (leverage) at fund level.
What is left is the workhorse of India's alternatives industry. It includes private equity funds that buy into established businesses that need to scale up. It includes private debt funds that lend where banks will not. And it includes fund-of-funds that put money into other AIFs.
It is the quiet category. It has no incentives and no unusual permissions. Yet it holds the largest share of the money.
How it works
Regulation 17 sets the investment universe: a Category II AIF shall invest in investee companies, or in units of Category I or other Category II AIFs, as disclosed in the private placement memorandum. It shall invest primarily in unlisted securities and/or listed debt securities (including securitised debt instruments) rated 'A' or below by a SEBI-registered credit rating agency, directly or through units of other AIFs.
That rating condition was added by amendment in 2025 and is the reason dedicated debt funds and fund-of-funds can now be floated under this category at all — before it, a listed bond was awkward to hold.
The named sub-types are two:
- Private Equity Fund — invests primarily in equity or equity-linked instruments or partnership interests of investee companies. Equity-linked means instruments convertible into equity shares, share warrants, preference shares and compulsorily or optionally convertible debentures. Unlike a venture capital fund, a PE fund is a later-stage investor, backing businesses that already have a proven model and need scaling.
- Debt Fund — invests primarily in debt securities of listed or unlisted investee companies or in securitised debt instruments.
The operating restrictions mirror Category I almost exactly: no fund-level leverage except for temporary funding requirements of not more than 30 days, not more than 4 occasions a year, and not more than 10 per cent of investible funds; the same drawdown-shortfall borrowing with its 30-day cooling-off and its cost charged to the delaying investor; a 25% concentration cap per investee company; close-ended with a minimum tenure of 3 years from first close.
One permission is genuinely wider. A Category II AIF may buy or sell credit default swaps. A Category I AIF may only buy them.
On tax, Category I and Category II are treated identically: both fall inside the definition of an Investment Fund under section 224 of the Income Tax Act, 2025, and so enjoy tax pass-through on income other than business income.
The formula
Concentration cap per investee company
= 25% × Investible funds of the scheme
Temporary borrowing cap
= 10% × Investible funds, ≤ 30 days, ≤ 4 occasions a year,
with a 30-day cooling-off between two borrowings
A worked example
A private credit house launches a Category II AIF with a corpus of Rs 600 crore. After set-up costs and the first year's fees, investible funds are Rs 560 crore.
| Test | Calculation | Result |
|---|---|---|
| Concentration cap | 25% × 560 | Rs 140 crore into any single investee company |
| Temporary borrowing | 10% × 560 | Rs 56 crore, ≤ 30 days, ≤ 4 times a year |
The manager builds a book of six positions. Two of them are listed non-convertible debentures:
- Rs 90 crore of a listed NCD rated 'A−' — unlisted-or-rated-'A'-or-below, so it sits squarely inside the primary-investment bucket.
- Rs 70 crore of a listed NCD rated 'AA+' — permissible to hold, but it does not count toward the "primarily" test, because the test only recognises listed debt rated 'A' or below.
So of Rs 560 crore deployed, the manager can point to the Rs 90 crore plus its four unlisted positions as satisfying Regulation 17; the Rs 70 crore AA+ line sits outside that count. If AA+ paper grew to a third of the book, the fund would no longer be investing "primarily" as the regulation requires — a compliance problem created entirely by buying better credit.
On a Rs 140 crore position in one company, the fund is at exactly the cap. A follow-on round in the same company — even a Rs 5 crore bridge — breaches it.
Why NISM asks about it
Chapter 3 (Alternative Investment Funds in India and its Suitability), section 3.2.2, defines the category and its two named sub-types, and section 3.3 contrasts all three categories in Table 3.1. Chapter 14 (Regulatory Framework), section 14.9.3, carries the specific investment conditions. Chapter 13 (Taxation) treats Category I and II together as Investment Funds with pass-through status.
The questions that come from here are: the rating threshold ('A' or below), the buy-and-sell CDS permission that separates Category II from Category I, the 25% concentration cap, and the distinction between a venture capital fund's "securities" latitude and a private equity fund's "equity or equity-linked" requirement.
Common exam traps
- 'A' or below, not 'A' or above. The rating condition admits the weaker credits. It is counter-intuitive and it is examined.
- The concentration cap for Category II is 25% of investible funds, the same as Category I. It is Category III that is capped at 10%.
- Category II takes no fund-level leverage — but it can lend into a leveraged deal. A leveraged loan or an LBO facility is borrowing by the portfolio company, not by the fund.
- A private equity fund must invest primarily in equity or equity-linked instruments; a venture capital fund may use "securities" generally, which is wider. The workbook explains why: later-stage investors are better placed to take equity risk.
- Buy or sell CDS is Category II. Buy only is Category I. Getting these the wrong way round is a single-mark loss.
- Fund-of-funds is a permitted Category II structure, not a fourth category.
- Pass-through applies to income other than business income. Business income is taxed at the fund and is then exempt to the investor.
Where this is taught
- Series XIX-B · Chapter 2: Growth of Alternative Investment Funds in India and Suitability of Category III AIFsintroduced here
- Series XIX-A · Chapter 2: Alternative Investment Funds in Indiaintroduced here
- Series XIX-C · Chapter 6: Alternative Investment Funds in India and its Suitabilityintroduced here
- Series X-A · Chapter 13: Overview of Alternative Investment Funds (AIFs)introduced here
- Series XXI-A · Chapter 6: Collective Investment Vehiclesintroduced here
- Series XIX-E · Chapter 4: Alternative Investment Funds in India and its Suitabilityintroduced here
- Series XIX-D · Chapter 3: Alternative Investment Funds in India and its Suitabilityintroduced here
- Series XIX-D · Chapter 14: Regulatory Framework
Related terms
- Category III AIFThe AIF category for funds running diverse or complex trading strategies with leverage — hedge funds and their kin — and the only category denied tax pass-through status.
- Credit ratingAn opinion on how likely a borrower is to service an instrument on time, reduced to a symbol by a SEBI-registered rating agency — and reviewed continuously, not fixed for the life of the bond.
- Alternative Investment FundA privately pooled investment vehicle registered with SEBI that raises money from select Indian or foreign investors under a defined investment policy — never from the public at large.
- Fund of fundsAn AIF that invests in the units of other AIFs rather than directly in investee companies — buying diversification across managers and strategies, and paying two layers of fees for it.
- Category I AIFThe AIF category for funds the government or a regulator treats as socially or economically desirable — venture capital, angel, SME, social impact, infrastructure, special situation and CDMDF funds.
- Private Equity FundAn AIF investing primarily in equity or equity-linked instruments or partnership interests of investee companies — a Category II fund, and the later-stage counterpart to a venture capital fund.
- Debt FundA Category II AIF that invests primarily in debt securities of listed or unlisted investee companies, or in securitised debt instruments, as per its stated objectives.
- Leveraged LoansSub-ordinate debt lent to a company that already carries a large amount of senior debt on its balance sheet, priced for the extra risk of ranking behind the existing lenders.
- Securitised Debt InstrumentA tradable security created by pooling loans or other receivables in a special purpose vehicle and repackaging the cash flows into instruments that pay a pre-determined periodic income.
- Pass-through statusTax treatment under which a fund's income is not taxed in the fund but directly in its investors' hands — and which the Income Tax Act does not give a Category III AIF.
- Investment FundUnder Section 115UB, a Category I or Category II AIF (or an IFSCA-regulated fund) established in India — the only AIFs given tax pass-through. Category III AIFs are outside the definition.
- Aggregate Escrow Demat AccountA separate demat account an AIF opens solely to hold demat units for investors who have not yet given their demat details; units move out to the investor within 5 working days once details arrive.
- Alternate Minimum TaxA floor tax on non-corporate assessees — 18.5% of adjusted total income, 15% for a co-operative society — payable when it exceeds their normal tax, with the excess carried forward as credit for 15 years.
- Management BuyoutA leveraged buyout in which the company's own management team borrows to buy a majority stake from existing shareholders and takes control of the business it already runs.
- Investment Manager approvalThe requirement that an off-market transfer or pledge of AIF units in dematerialised form succeeds only after the fund's Investment Manager has approved it, where the AIF's own documents require that approval.
- Right of First RefusalA shareholder right to match the best outside quote a selling shareholder has obtained — the holder sees the price first and may buy at it, or refuse and let the sale proceed.
- Non-binding Letter of IntentThe document a private equity fund gives a target after initial due diligence, proposing an investment amount, a valuation and a stake — none of which it is yet obliged to honour.
- Distressed debt financingLending to a company that is stretched for cash but still a going concern — refinancing to clear dues and cut leverage, at a higher cost than a performing borrower would pay.
- Secondaries marketThe sale of an existing investor's fund units or partnership interest to co-investors or outside buyers, usually at a negotiated discount to net asset value.
- GAAR testThe two-part test for an impermissible avoidance arrangement: the main purpose must be to obtain a tax benefit, and the arrangement must carry at least one of four tainted elements.
- Later-stage capitalCapital from Series C onwards to scale a business — new markets, geographies, product segments or acquisitions — typically from private equity funds and institutional investors, as angels and VCs exit.
- Growth investingA common private equity strategy of taking a minority stake to help a company grow further — typically at the intersection of VC and PE, where the company is still growing but may already be profitable.
- Thematic investingInvesting behind a significant opportunity or structural trend — such as electric vehicles — across its value chain, without starting from research on individual stocks, and spreading risk across uncorrelated themes.
- Residual put optionA put option that promoters agree to only as a fallback: the AIF cannot exercise it unless the company fails to list within an agreed time or the AIF cannot use the other exit routes.
- Sticky loan in venture debtWhat venture debt becomes when the borrower's fortunes turn: the lending AIF is left holding founder shares in a distressed company as collateral, and because they are untraded the loan cannot be readily recovered.
- Dual class investmentsInvestments whose underlying assets are illiquid but whose instrument can be liquid — listed on an exchange or redeemable through the mutual fund route with restrictions — such as REIT and InvIT units.
- Tax treaty shoppingArrangements aimed at obtaining the reliefs of a double taxation avoidance agreement for the indirect benefit of residents of some other country — which India's treaties must not create opportunities for.
- Warehousing of dealsBuilding a pipeline of investment deals before a fund achieves its first close — a normal part of fund-raising, and not to be confused with warehousing of investments, which parks securities for later transfer.
- Accredited Investors only (AI-only) FundAn AIF or scheme in which every investor apart from the manager, sponsor and their employees or directors is an accredited investor — a class SEBI lets launch on intimation, with lighter investor-protection rules.
- Mezzanine RoundThe last private round before listing: pre-IPO money that pays for listing formalities, often with anchor investors allotted shares at a discount to the IPO price and ESOP holders selling out.
- Equity KickerAn equity sweetener attached to a loan — warrants, preference shares or a right to convert part of the debt at an agreed valuation — usually up to 10% of the loan amount in Indian venture debt.
- Closed-ended AIFAn AIF scheme offered for a limited period, funded by commitments drawn down through capital calls, with no redemption before the fund winds up — compulsory for Categories I and II.
- Temporary borrowingThe only fund-level borrowing Category I and II AIFs may do: for temporary funding needs, for no more than 30 days, on no more than 4 occasions a year, and up to 10% of investable funds.
- Pre-IPO StrategyAn AIF mandate to subscribe to a company's shares before its IPO at a discount to the issue price, accepting the ICDR lock-in that runs from the date of listing.