Debt Fund
A 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.
In plain language
Not every AIF is about shares. The SEBI (AIF) Regulations define a Debt Fund as an AIF of a certain kind. It invests mainly in debt securities of listed or unlisted investee companies. It may also invest in securitized debt instruments. It does so in line with the fund's stated objectives.
Why is lending an alternative investment? The workbook gives two reasons. Many types of private debt are illiquid, which means hard to sell. And they are not commonly held by traditional investors. Even listed companies issue NCDs and bonds through private placement. That route is out of reach for an ordinary investor.
Debt Funds sit in Category II, along with Private Equity Funds and pre-IPO funds. This category is for AIFs that get no specific government incentives or concessions. They also do not use leverage (borrowing) beyond day-to-day operating needs.
How it works
The shapes private debt takes (2.2.5)
| Type | How it works |
|---|---|
| Privately placed NCDs and bonds | Issued even by listed companies, not available through the traditional route |
| Venture debt funds | Finance growth-stage venture capital undertakings through mezzanine financing — debt with an equity upside, such as warrants attached |
| Securitised debt instruments | Pool money to buy assets such as cars, trucks and electric vehicles, lease them to corporate clients, and pass the rental income to investors |
| Distressed debt | Refinancing settlements with banks and insolvency resolution under the IBC, 2016 — capital to turn around heavily indebted companies or fund their acquisition through IBC auctions |
Category II rules that bind it. Category II AIFs do not fall in Category I or III and do not undertake leverage or borrowing other than to meet day-to-day operational requirements or as permitted. Table 2.1 describes them as generally less risky than Category III, seeking returns from value creation in later-stage opportunities without fund-level leverage or complex trading.
Debt versus PE funds. Chapter 1 notes that SEBI's AIF Regulations differentiate private equity funds from pure debt funds, and Chapter 2 confirms that funds structured purely as private debt funds qualify under Category II.
Growth. After 2008, alternative debt funds grew substantially, reviving markets for high-yield debt and structured products.
A worked example
Illustrative figures. Krishna Private Credit Fund, a Category II AIF with a Rs 100 crore corpus, deploys:
| Investment | Rs crore | Illustrative yield |
|---|---|---|
| Privately placed NCDs of a listed NBFC | 40 | 10% |
| Unlisted debentures of a logistics company | 30 | 12% |
| Venture debt to a growth-stage SaaS company, with warrants | 20 | 14% + warrants |
| Securitised debt instruments backed by leased EVs | 10 | 11% |
Annual interest income:
NCDs 40 × 10% = Rs 4.0 crore
Debentures 30 × 12% = Rs 3.6 crore
Venture debt 20 × 14% = Rs 2.8 crore
SDIs 10 × 11% = Rs 1.1 crore
Total = Rs 11.5 crore → 11.5% on Rs 100 crore
All Rs 100 crore is in debt securities or securitised instruments, so the fund invests primarily in debt as its definition requires. The warrants are the venture-debt "equity upside": if the SaaS company is later valued far higher, the fund earns more than its 14% coupon.
What Krishna cannot do is borrow Rs 50 crore to buy more NCDs — a Category II AIF may borrow only for day-to-day operational requirements.
Why NISM asks about it
Chapter 2 (Growth of AIFs in India and Suitability of Category III AIFs) defines the Debt Fund at 2.2.5, places it in Category II at 2.2.12 and 2.3, and its first sample question asks for the name of AIFs that primarily invest in debt securities — Debt Funds. Chapter 1 explains why private debt is alternative, and Chapter 5 lists Debt Funds among Category II examples.
Common exam traps
- Debt Funds are Category II, not Category I. Infrastructure Funds and Special Situation Funds (which also buy debt) are Category I.
- Listed or unlisted investee companies — the definition covers both.
- Private debt is alternative because of illiquidity and because traditional investors do not commonly hold it, not because debt is inherently risky.
- Venture debt uses mezzanine financing — debt plus an equity kicker such as warrants.
- No leverage beyond day-to-day operational requirements for Category II AIFs.
Check yourself
1.Alternative Investment Funds which primarily invest in debt securities of listed or unlisted investee companies are known as:
- a)Venture Capital Funds
- b)Debt Funds
- c)Angel Funds
- d)Infrastructure Funds
Show the answer
Answer: (b) Debt Funds
(This is a sample question from the NISM workbook.)
"DEBT FUND means an AIF WHICH INVESTS PRIMARILY IN DEBT SECURITIES OF LISTED OR UNLISTED INVESTEE COMPANIES OR IN SECURITIZED DEBT INSTRUMENTS as per the stated objectives of the Fund."
Option (d) is the near-miss worth understanding. An Infrastructure Fund may indeed hold "LISTED DEBT OR SECURITISED DEBT INSTRUMENTS" — but only of "INVESTEE COMPANIES OR SPECIAL PURPOSE VEHICLES ENGAGED IN OR FORMED FOR THE PURPOSE OF OPERATING, DEVELOPING OR HOLDING INFRASTRUCTURE PROJECTS." The sector restriction is what separates it from a general Debt Fund.
Why private debt counts as alternative at all: "Many types of debt that are private are considered to be alternative investments BECAUSE OF THEIR ILLIQUIDITY AND OFTEN BECAUSE THEY ARE NOT COMMONLY HELD BY TRADITIONAL INVESTORS. EVEN LISTED COMPANIES ISSUE DEBT SECURITIES SUCH AS NCDs AND BONDS THROUGH PRIVATE PLACEMENT THAT ARE NOT AVAILABLE IN THE TRADITIONAL INVESTMENT ROUTE."
The three sub-varieties to know: ⚠️ VENTURE DEBT (mezzanine financing with an equity upside such as attached warrants) · SECURITIZED DEBT INSTRUMENTS (financing cars, trucks and electric vehicles leased to corporates) · DISTRESSED DEBT (refinancing settlements with banks and insolvency resolution under the IBC).
2.Which of the following funds falls under Category I AIF?
- a)Private Equity Fund
- b)Hedge Fund
- c)Angel Fund
- d)Pre-IPO Fund
Show the answer
Answer: (c) Angel Fund
Category I "shall include VENTURE CAPITAL FUNDS, SME FUNDS, SOCIAL IMPACT FUNDS, ANGEL FUNDS, INFRASTRUCTURE FUNDS, SPECIAL SITUATION FUNDS, CORPORATE DEBT MARKET DEVELOPMENT FUNDS and such other AIFs as may be specified." And an Angel Fund is expressly "A SUB-CATEGORY OF CATEGORY I AIF."
Where the distractors sit:
- ⚠️ PRIVATE EQUITY FUNDS and PRE-IPO FUNDS are CATEGORY II — "OTHER AIFs THAT INVEST IN UNLISTED SECURITIES, SUCH AS DEBT FUNDS, PRIVATE EQUITY FUNDS AND PRE-IPO FUNDS, FALL UNDER CATEGORY II AIFs"
- ⚠️ HEDGE FUNDS are CATEGORY III — "those AIFs that DEPLOY COMPLEX TRADING STRATEGIES IN SECONDARY LISTED MARKETS, DERIVATIVES AND/OR MAY ALSO USE LEVERAGE AT FUND LEVEL, SUCH AS HEDGE FUNDS, QUALIFY AS CATEGORY III AIFs"
So the question to ask is not "what does the fund invest in?" but "does the government have a reason to encourage it?" Category I is the shelf for funds the state wants more of — start-ups, SMEs, infrastructure, social ventures — and it comes with "SPECIAL INCENTIVES."
3.A REIT holds commercial buildings, yet its units are often classified as traditional or dual rather than alternative. Why?
- a)Because REITs are regulated by RBI rather than SEBI
- b)Because the essential test is the liquidity of the instrument, and REIT units are liquid by virtue of being listed even though the underlying assets are illiquid
- c)Because buildings are not considered an asset class
- d)Because REITs may only be held by retail investors
Show the answer
Answer: (b) Because the essential test is the liquidity of the instrument, and REIT units are liquid by virtue of being listed even though the underlying assets are illiquid
And the definition of the dual category makes the reasoning explicit: ⚠️ "THE DUAL CLASS COULD INCLUDE STRUCTURES THAT HAVE UNDERLYING ILLIQUID ASSETS BUT THE INSTRUMENTS PER SE MAY BE LIQUID, AS THEY ARE EITHER LISTED ON THE STOCK EXCHANGE OR ARE REDEEMABLE THROUGH THE MUTUAL FUND ROUTE WITH SOME RESTRICTIONS."
The test is applied to the instrument you hold, not to the asset sitting behind it. A building could hardly be less liquid; a REIT unit can be sold before lunch. What the REIT structure achieves is exactly the transformation the dual category names — illiquid asset, liquid claim.
What a REIT actually is: "SECURITIES THAT ENTITLE THE HOLDERS TO UNDERLYING CASH FLOW GENERATED FROM RENT YIELDING PROPERTIES", offering "THE ADVANTAGE OF INVESTING IN THE SECTOR WITHOUT PHYSICALLY HOLDING REAL ESTATE ASSETS."
The same logic covers InvITs: they too are "LISTED AND TRADABLE ON THE CAPITAL MARKET, MAKING THEM AKIN TO TRADITIONAL ASSETS."
Contrast the genuinely alternative version of the same exposure, which sits in the alternative column: "DIRECT INVESTMENTS IN REAL ESTATE AND INFRASTRUCTURE DEVELOPER PROJECT SPVs", entailing "CONSIDERABLE MARKET RISK... or ILLIQUIDITY RISK DUE TO LONG GESTATION PERIOD." Same sector, entirely different liquidity — and therefore a different classification.
The other dual-category members follow the same pattern: closed ended debt funds with real estate exposures, exchange traded security receipts of securitisation companies, SPVs and ARCs, and mutual funds running alternative or contrarian strategies.
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-E · Chapter 4: Alternative Investment Funds in India and its Suitabilityintroduced here
Related terms
- Alternative InvestmentA financial asset outside the conventional categories of stocks, bonds and cash — defined by what it is not, and marked above all by illiquidity.
- Category II AIFThe 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.
- 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.
- Venture Capital FundA Category I AIF that invests primarily in unlisted securities of start-ups, emerging or early-stage venture capital undertakings, and includes migrated venture capital funds.
- Mezzanine CapitalCapital provided in a hybrid structure carrying features of both debt and equity — typically subordinated debt with an equity upside attached, such as warrants.
- Venture DebtSpecialised lending to start-ups that have already raised institutional venture equity — unsecured, priced above commercial rates, repaid in two to three years, usually with an equity kicker attached.
- SME FundA Category I AIF that invests primarily in unlisted securities of Small and Medium Enterprises, or in securities of SMEs that are listed or proposed to be listed on an SME exchange or SME segment.
- 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.
- 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.
- Specified Alternative Investment FundThe fourth registration category SEBI inserted in 2023 for AIFs that fit none of Categories I, II and III, and for which SEBI may specify separate regulations.
- Insolvency ResolutionThe IBC 2016 process of helping a heavily indebted company turn around or be acquired through auction — an investment opportunity for private debt and distressed-asset funds.