Category II AIF

Category II is defined by subtraction. A fund is Category II if it is not Category I — so no special economic or social purpose, no government concession — and not Category III, so no complex trading strategies and no fund-level leverage.

What is left is the workhorse of the Indian alternatives industry: private equity funds buying into established businesses that need scaling up, private debt funds lending where banks will not, and fund-of-funds allocating into other AIFs.

It is the quiet category. No incentives, no exotic permissions, and the largest share of the money.

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.

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 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.

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.

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.

• '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.