NISM Series XIX-D · Chapter 7: Fund Performance and Benchmarking of AIFs

L1 · Foundation

Risks in Alternative Investment Funds

Plain-English tour of every risk an AIF investor carries - the six investor-level risks, the three governance and fund-level risks, and the ten named risk types from performance risk down to ESG risk.

26 min read · Worth 10% of the paper · Written from pages 133–178 of the official NISM workbook · Updated 18 September 2026

Risks in Alternative Investment Funds

Start with one honest sentence

An AIF is not a fixed deposit. It is not even a mutual fund. When you put Rs 1 crore into an AIF you are handing money to a manager who will lock it for eight to ten years, invest it in companies or assets you cannot see on a screen, charge you a fee whether or not the investments work, and return the money only when he is able to sell. SEBI has said this in the plainest possible language in the mandatory risk disclosure every AIF must give: an AIF is not an assured return product.

Chapter 7 of the workbook is in two halves. The first half - which is this lesson - lists what can go wrong. The second half - the next lesson - shows how you measure whether it went right. A distributor who can only do the second half without the first half is the person who causes mis-selling.

7.1 The two buckets of risk

The workbook splits risks into two buckets, and the split is not cosmetic. It tells you who can do something about the risk.

Bucket	Meaning	Who can act
Investor level risks	Risks that arise because of the position the investor is in - he cannot see inside, cannot exit, cannot vote	The investor, at the time of committing
Governance and fund level risks	Risks that arise inside the fund - how the manager behaves, how the fund is run, what the economy does	The manager, the trustee, the regulator

7.1.1 Investor level risks - six of them

1. Adverse selection. This is the oldest problem in private markets. The investor does not know as much about the deal as the manager does. The manager has met the promoter, read the data room, sat in the board meeting. The investor has read a 90-page Private Placement Memorandum. Because of this gap in information, the investor may end up selecting a fund - or the fund may end up selecting a deal - that the better-informed party was happy to let go. In the second-hand car market this is called the lemon problem. In AIF it shows up as a fund that raised money easily because the manager told a good story.

2. Illiquidity and uncertainty. A close-ended AIF has a fixed life. You cannot redeem. You cannot walk up to a counter and get an NAV-based exit the way you do in an open-ended mutual fund. The only exits are (a) the fund sells its investments and distributes, (b) you find a buyer for your unit in a secondary transfer, which needs the manager's consent and is often at a discount, or (c) the fund is wound up. Add to this that even the manager does not know when an exit will come. An unlisted company can take four years or nine years to reach an IPO. So the investor carries both illiquidity and uncertainty about the timing of liquidity.

3. Fund monitoring. How does an investor know what the fund is doing between two reports? Mostly he does not. The workbook notes that this gap is partly addressed for larger investors: large-ticket investors and accredited investors are often given representation on the Investment Management Committee or an advisory committee, which gives them a seat where investment decisions are discussed. A retail-sized Rs 1 crore investor gets no such seat. That is an asymmetry the investor should price in before committing.

4. Cash management risk. AIF money is drawn in tranches through capital calls, not upfront. That is good for the investor's returns - money sits with him longer - but it creates a problem. He must keep the uncalled amount liquid and ready. If the call comes on 15 days' notice and his money is stuck in a property deal, he defaults. A default on a capital call is the single most expensive mistake an AIF investor can make; the contribution agreement usually allows forfeiture of a part of what he has already paid in. On the other side, the manager runs the mirror-image risk through the over-commitment strategy - accepting commitments beyond the target corpus assuming some investors will default or some deals will not close. If everybody pays and every deal closes, the manager is short of money.

5. Underlying investment risks. The AIF is a wrapper. What is inside the wrapper is the real risk - an unlisted start-up, a distressed loan, a real estate project, a stressed asset. The AIF structure does not reduce the business risk of the portfolio company by even one rupee. It only pools it.

6. Debt financing related risks. Category III AIFs may borrow for investment purposes; Category I and II may borrow only for temporary funding needs and operational requirements, for a maximum of thirty days, not more than four times a year, and not exceeding ten per cent of investable funds. Wherever leverage exists, the risk is magnified in both directions. A fund that is 2x levered and whose assets fall 20 per cent has lost 40 per cent of the investor's money.

7.1.2 Governance and fund level risks - three of them

1. Fiduciary duty risk. The manager owes a fiduciary duty - he must act in the interest of the investor, not his own. Where does this get tested? In conflicts of interest: allocating a good deal between two of his own funds, doing a related party transaction, taking a co-investment for himself alongside the fund on better terms. SEBI's answer is disclosure in the PPM, the approval of the Investment Committee, and reporting to investors. The risk never fully disappears; it only becomes visible.

2. Fund management related risks. This is key-man risk, style drift, and process risk rolled together. The fund raised money because Mr A had a ten-year track record in healthcare investing. If Mr A leaves in year three, the investor has a fund that is not the fund he subscribed to. That is why LP agreements carry key-man clauses that suspend the investment period if named persons leave.

3. Macro-level and general risks. Interest rates, inflation, GDP growth, currency, elections, war, pandemic. No manager controls these. An infrastructure fund committed in 2019 that had to build through 2020 and 2021 lost two years of its investment period to something no clause could have prevented.

7.2 The ten named types of risk

The workbook then lists ten types. Learn the names in order - questions come directly from this list.

1. Performance risk

This is the umbrella and it has nine sub-items worth knowing:

Potential loss of investment. The most basic one. Unlike debt, equity in an unlisted company can go to zero.
Investment strategy risk. The strategy itself may be wrong for the cycle. A pre-IPO strategy in a year with no IPO window has nowhere to go.
Unsuccessful first close. This is an exam favourite. A scheme must achieve its first close within twelve months from the date of intimation of the Private Placement Memorandum to SEBI. If it cannot, the scheme must file a fresh PPM and pay the fee again. For an investor who has already committed, the delay itself is a loss.
Dependence on the investment manager. Returns are a function of one team's judgement.
Incentive fee risk. Carried interest can push the manager toward risk the investor did not want. If the manager is below hurdle in year seven, his rational move is to swing for the fences - his downside is already zero, his upside is 20 per cent.
Liquidity and realisation risk. The investment may be good and still not saleable at the moment the fund must wind up.
Concentration risk. SEBI limits this directly: a Category I or Category II AIF may invest not more than twenty-five per cent of its investable funds in one investee company (for Category III the limit is ten per cent). But twenty-five per cent is still a large single bet - four bad deals can hurt a whole fund.
Distribution or repatriation of income risk. Getting the money out - especially for a foreign investor who needs RBI and tax clearance to repatriate.
Co-investment risk. Where an investor takes a direct stake alongside the fund, he takes the deal risk without the diversification of the pool.
Geo-political risk. Borders, sanctions, export controls.

2. Funding risk

Two-sided, as explained above. The fund may not be able to draw the capital it committed to a portfolio company because investors default; or the fund may over-commit and be short.

3. Macroeconomic risk

Growth, inflation, rates, liquidity cycle. The vintage year of a fund - the year it first draws capital - is a huge determinant of return precisely because of this. A 2008 vintage and a 2010 vintage buying the same assets have completely different outcomes.

4. Foreign exchange risk

Relevant when the fund has offshore investors, invests abroad, or has an IFSC structure. A fund that returns 15 per cent in rupees returns much less to a dollar investor if the rupee has depreciated 4 per cent a year.

5. Operational risk

Failure of people, process or systems - wrong capital call, wrong NAV, custodian error, failure of a third-party administrator.

6. Cyber security risk

This has become a named risk with specific compliance. Three facts to remember:

Data of Indian AIF operations must be stored within Indian geographical boundaries.
CERT-In (Indian Computer Emergency Response Team), which functions under the Ministry of Electronics and Information Technology (MeitY), is the nodal agency.
Cyber incidents must be reported within six hours of noticing or being brought to notice.

7. Country-specific risks

For funds investing overseas: local law, expropriation, capital controls, enforcement of contracts.

8. Legal and regulatory risks

Three sub-parts: (a) the risk that a required regulatory approval does not come or comes late, (b) the risk that tax rates change mid-life, and (c) plain compliance risk - a filing missed, a registration suspended.

9. Reputational risk

If the manager, the sponsor or a portfolio company is in the news for the wrong reason, the fund's ability to raise the next fund and to exit at a good price is damaged.

10. ESG risk

Environmental, social and governance failures now carry real money consequences - a factory shut by a pollution board order, a labour dispute, a governance scandal. Note the compliance point: the Stewardship Code is mandatory for AIFs in respect of their investment in listed equities, requiring them to have a policy on monitoring, engagement and voting.

Annexure 7.1 - the risk factor template

The chapter ends with a template of risk factors that a PPM should carry, compiled largely from SEBI's disclosure requirements in Section X of Annexure 1 to Circular No. SEBI/HO/IMD/DF6/CIR/P/2020/24 dated February 5, 2020. The seven headings are:

Head	Covers
A. General risk factors	Political, social, economic risk in India; global financial conditions; bankruptcy of portfolio vehicles; segregation of assets between schemes not being recognised in third-party suits; illiquidity of the investment; change in accounting practices
B. Risks related to portfolio investments	Nature of the investment and inability to deploy the full capital; exit risk and distribution in kind; inability to raise significant capital; investing with third parties; lack of insurance; environmental liabilities; counter-party default; change in control of parties; liability from the managerial role the fund plays in a portfolio company
C. Risk related to fund structure	Performance risk; ability of the manager to identify and structure investments and divestments; concentration; reliance on forward-looking statements; reliance on trustee, manager and committees; reliance on third-party service providers; default on capital calls; restrictions on withdrawal and transfer, in-kind distribution, and the fact that an AIF is not an assured return product; indemnity and tax obligations of investors
D. Regulatory risk factors	SEBI registration, cancellation or suspension; uncertainty of the legal framework and lack of jurisprudence; Companies Act, takeover code, enforcement, loss of registration
E. Tax related factors	GAAR and Permanent Establishment rules; change in tax laws and renegotiation of treaties; change in administrative interpretation
F. Sector specific risk factors	Risks of the particular sector or strategy the fund focuses on
G. Currency related risks	Currency fluctuation from offshore investment into the AIF; risks of the fund investing abroad

The annexure itself says it is not an exhaustive list - the scheme PPM will carry a longer one.

What a distributor must actually do with this

Do not read the risk factors out like a railway announcement. Pick the four that matter for this fund and this investor:

Can he wait ten years? If his daughter's wedding is in year five, illiquidity risk is his biggest risk, not market risk.
Can he meet every drawdown? Ask him where the uncalled money will sit.
Is the fund concentrated? Ten deals at ten per cent is a different animal from four deals at twenty-five per cent.
Who is the key man and what happens if he leaves? Read the key-man clause aloud.

Everything else in the PPM is real, but these four decide whether the investor is suited to the product at all.

Think of it like this

Adverse selection is the second-hand car bazaar

You walk into a used-car market in Karol Bagh. The seller has driven the car for four years; you have seen it for four minutes. Whatever price you offer, he will happily sell the bad car and refuse for the good one. AIF works the same way: the manager knows the deal, you know the PPM. The gap is not dishonesty, it is information. The only defence is to check the manager's past deals, not his current story.

Illiquidity is a fixed-deposit with no premature-closure option

Every Indian knows you can break an FD by paying one per cent penalty. Now imagine an FD where the bank says, "there is no premature closure at any penalty, and we will tell you the maturity date later." That is a close-ended AIF. This is why the SID of an AIF cannot promise anything and why a 55-year-old planning retirement at 58 should almost never be in an eight-year fund.

Capital call risk is the society redevelopment demand note

Your housing society announces redevelopment. You commit Rs 20 lakh. The builder will call it in four instalments, dates unknown, 15 days notice each. If you park that money in a plot of land in Karjat, you will miss a call and lose your flat allotment. AIF capital calls work exactly like this, which is why the uncalled portion belongs in a liquid fund or a sweep account, not in another illiquid asset.

Over-commitment is airline overbooking

An airline sells 190 seats on a 180-seat plane because it knows about ten passengers will not show up. Usually it works. On a day when everyone shows up, the airline must pay compensation. A manager who accepts Rs 1,200 crore of commitments for a Rs 1,000 crore fund is doing the same arithmetic - and faces the same embarrassment if every investor pays on time and every deal closes.

Key-man risk is the tiffin service whose cook resigns

You subscribed to a tiffin service because of one cook whose dal you loved. The brand, the dabba and the delivery boy remain; the cook has left. Would you continue the subscription? The key-man clause in an AIF is the contract term that lets you pause payment until they find an equally good cook - it suspends the investment period so no new money is drawn while the seat is empty.

Concentration risk is the four-shop landlord

A man owns a market complex and rents it to four shops, each paying 25 per cent of his income. One shop closes and his income drops a quarter overnight. SEBI allows a Category I or II AIF to put 25 per cent of investable funds in a single investee company; that is legal, but it means four bad calls can define the fund. Ten investments at ten per cent each is a structurally calmer portfolio.

Incentive fee risk is the batsman in the last over

A batsman needs 30 off 6 balls. He will not block - he cannot afford to. Every ball will be a swing. A manager sitting below the hurdle in year seven is that batsman: his carry is already zero, so more risk costs him nothing and might earn him everything. The investor, who owns the downside, did not sign up for that innings. Read the clawback and the hurdle terms with this picture in mind.

Cyber security reporting is the six-hour FIR

If your car is stolen, nobody expects the FIR in six hours - but for a cyber incident in an AIF, the rule is exactly that: report to CERT-In, the agency under MeitY, within six hours of noticing or being informed, and keep the Indian data on Indian soil. Six hours, CERT-In, MeitY, India-resident data - four facts, one sentence, and they show up in exams.

Key terms in this chapter

Absolute-return benchmark: For funds pursuing leveraged, concentrated, long/short or market-neutral strategies, the benchmark is a fixed rate pre-determined by the manager at launch - such as 10 per cent a year - not a market index.
Adverse selection: The risk that arises because the manager knows far more about a deal than the investor does, so the investor may end up with what the better-informed party was happy to let go.
Alpha: The excess return of the fund over the return expected for its risk: Alpha = R - E(R), where E(R) = Rf + Beta x (Rm - Rf) under CAPM, measured over the same period as the fund return.
AUM for benchmarking: For benchmarking and reporting purposes, AUM means the value of total capital drawn down under the scheme - not commitments and not market value.
Benchmark: The comparable fund or index having similar risk-return characteristics as the AIF being monitored; the benchmark return is measured over the same reporting period as the fund return.
Benchmarking Agency: An agency notified by an association of AIFs that represents at least thirty-three per cent of the number of AIFs, which collects cash flow and valuation data and publishes industry performance benchmarks.
Benchmarking reporting trigger: Any AIF that has completed a minimum of one year from the date of its First Close must report performance, cash-flow and scheme-wise valuation data to a Benchmarking Agency.
Benchmark Report versus Performance Report: The standard SEBI-mandated benchmarking output is called a Benchmark Report; a customised report generated on an AIF's request, with the express consent of the AIFs whose data is used, is called a Performance Report.
CAPM limitation shown in Example 7.5: Expected return rose in the worst-case scenario (11.08% against 10.35%) simply because beta rose, even though unfavourable market conditions should logically lower the expected return.
Cash management risk: The investor must keep uncalled commitment money liquid so that every capital call can be met; failing a call can cost him part of what he has already paid in.
Catch-up effect on manager economics: A 25 per cent catch-up lifted the manager's share of the Alpha Fund's Rs 5,468 crore excess return from Rs 1,094 crore (20 per cent) to Rs 2,187.2 crore (40 per cent). The higher the catch-up, the better for the manager.
CERT-In: The Indian Computer Emergency Response Team, functioning under the Ministry of Electronics and Information Technology (MeitY), which is the nodal agency for reporting cyber incidents.
Concentration risk (AIF limit): A Category I or Category II AIF may invest not more than twenty-five per cent of its investable funds in one investee company; for Category III the limit is ten per cent.
Cyber security risk (AIF compliance): Data of Indian AIF operations must be stored within Indian geographical boundaries, and cyber incidents must be reported to CERT-In - the agency under MeitY - within six hours of being noticed or notified.
Direct Alpha: The IRR of the market-adjusted cash flows used in KS-PME, expressing outperformance directly as a percentage rate rather than as a ratio.
DPI (Distributions to Paid-in Capital): Total distributions divided by total capital contributions - the realisation multiple, telling the investor how much money he actually got back. Most meaningful later in the fund's life.
DTAA jurisdictions for AIF structuring: Offshore jurisdictions such as Mauritius, Singapore and the Netherlands whose tax treaties with India give benefits on income accrued and received in India; within India, an IFSC set-up carries its own tax advantages.
Effective rate formula: r = (1 + k/m)^m - 1, converting a nominal annual rate k compounded m times a year into the true annual rate.
EIRR (Economic Internal Rate of Return): The same IRR maths applied to economic and social costs and benefits rather than purely financial cash flows; used in infrastructure and impact appraisal.
ESG risk and the Stewardship Code: Environmental, social and governance failures that carry financial consequences; the Stewardship Code is mandatory for AIFs in respect of their investment in listed equities.
Fiduciary duty risk: The risk that the manager acts in his own interest rather than the investor's - typically in deal allocation between his own funds, related party transactions or co-investments on better terms.
FIRR (Financial Internal Rate of Return): The discount rate at which the net present value of all the fund's cash flows is zero - a return measure based on the time value of money, not on accounting profit or gross margin.
Funding risk: The two-sided risk that the fund cannot draw the capital it promised a portfolio company because investors default, or that it has over-committed and is short of money.
Gross IRR: IRR computed at fund level using capital calls and gross asset value, before management fees, set-up cost, expenses, incentive fees and taxes.
GST impact on AIF returns: Services from fund administrators, registrars, custodians, auditors, brokers and advisors, and the management and trusteeship fees, all attract GST at 18 per cent, substantially raising cost and reducing investor returns.
High-water mark: The highest NAV previously reached, above which the manager must take the fund before any fresh incentive fee is payable.
Illiquidity and uncertainty risk: A close-ended AIF has no redemption window, and even the manager cannot say when an exit will come - so the investor carries both the lock-in and the uncertainty about its length.
Incentive fee risk: The risk that carried interest pushes the manager to take more risk than the investor wanted, because a manager below the hurdle has no carry to lose and everything to gain.
Investment Management Committee representation: A seat given to large-ticket and accredited investors on the committee where investment decisions are discussed, partly addressing the fund monitoring risk.
Investor-level FIRR: The IRR an investor actually earns after the distribution waterfall, catch-up and carry have been applied - lower than the fund's Net FIRR, which is itself lower than the Gross FIRR.
J Curve: The shape of an AIF's return over its life - negative in the early vintage years because fees are charged before any exits, then rising through the maturity and harvest years.
Key-man clause: A contract term that suspends the investment period if named individuals leave the manager, so no fresh capital is drawn while the key seat is empty.
KS-PME (Kaplan-Schoar Public Market Equivalent): A market-adjusted TVPI: capital calls and distributions are compounded forward at index returns to the valuation date, then (FV distributions + NAV) is divided by FV capital calls. Above 1 means the AIF beat the market.
MOIC (Multiple on Invested Capital): Total realised and unrealised returns divided by total invested capital. When all capital calls have been met, invested capital equals paid-in capital and MOIC equals TVPI - and therefore equals DPI + RVPI.
MOIC-to-RVPI red flag: A consistently large ratio of MOIC to RVPI should prompt investors and managers to revisit the valuations of the underlying assets.
Net IRR: IRR computed at investor level after deducting set-up cost, expenses, management fees with GST, incentive fees and taxes. Always lower than Gross IRR.
Over-commitment strategy: The manager accepts commitments beyond the target corpus, expecting some investors to default or some deals not to close - the mirror image of the investor's cash management risk.
Performance risk: The umbrella risk covering potential loss of investment, strategy risk, unsuccessful first close, dependence on the manager, incentive fee risk, liquidity and realisation risk, concentration, distribution or repatriation risk, co-investment risk and geo-political risk.
PIC Multiple: Paid-in Capital divided by Capital Commitments - a measure of how deployed the fund is, not of performance. A high PIC means most committed capital has been drawn.
Pre-tax NAV reporting: Performance reporting and benchmarking to Benchmarking Agencies is carried out on the pre-tax Net Asset Value of the scheme, half-yearly on 30 September and 31 March data.
Reference hurdle (compounded): The minimum return threshold, compounded year on year, that the fund must beat before incentive fee is payable.
ROI / Holding Period Return: Gain divided by cost, expressed as a percentage, ignoring the timing of cash flows completely - the plain-arithmetic cousin of IRR.
RVPI (Residual Value to Paid-in Capital): Assets under management divided by total capital contributions - the unrealised multiple, more representative of future returns early in a fund's life, but only an estimate dependent on valuation methodology.
Seven-month valuation timeline: Managers must build a deadline for audited investee accounts into the subscription or investment agreement so that valuation based on audited data as on 31 March reaches the benchmarking agencies within seven months.
Since-inception IRR: IRR measured from the fund's first cash flow to the reporting date; if the fund has been fully liquidated it is also the life-time IRR of the fund.
Tax neutrality of Category I and II AIFs: Gains from investment activity are not taxed at the fund; they are taxed directly in the hands of the investor. Only income classified as business income is taxed at fund level.
TVPI (Total Value to Paid-in Capital): Cumulative distributions plus residual value, divided by PIC - equivalently DPI + RVPI. Commonly called the Net Multiple; it keeps fluctuating until the fund is fully realised.
Unsuccessful first close: A scheme that fails to achieve its first close within twelve months of the date of intimation of the PPM to SEBI must file a fresh PPM and pay the fee again.
Valid benchmark criteria (GIPS): Eight characteristics of a valid benchmark: specified in advance, relevant, measurable, unambiguous, representative of current investment options, accountable, investable, and complete.
Vintage year: The year in which the fund makes its first capital call or first investment; a major determinant of eventual return because it fixes entry valuations and the likely exit window.
Yield to Maturity (YTM): The single discount rate at which the present value of all remaining coupons plus redemption value equals the bond's current market price - effectively an IRR for a bond.

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

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