What are Alternative Investment Funds (AIFs)? Meaning, Types and Taxation
What are Alternative Investment Funds (AIFs)? Meaning, Types, Benefits, Risks and Taxation
What are Alternative Investment Funds (AIFs)?
Alternative Investment Funds (AIFs) are privately pooled investment vehicles that allow investors to invest beyond traditional options like shares, bonds and mutual funds.
These funds collect money from sophisticated investors and deploy it into alternative assets such as:
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Startups
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Private equity
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Infrastructure
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Real estate
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Hedge fund strategies
In India, AIFs are regulated by the Securities and Exchange Board of India (SEBI) under the SEBI (Alternative Investment Funds) Regulations, 2012.
AIFs are generally suitable for High Net-worth Individuals (HNIs) who have higher risk appetite and long-term investment capacity.
Alternative Investment Fund (AIF): Definition
An Alternative Investment Fund is a privately pooled investment vehicle that gathers funds from Indian or foreign investors and invests them according to a defined investment policy.
AIFs can be structured as:
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Trust
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Company
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Limited Liability Partnership (LLP)
Most AIFs in India are set up as trusts, as this structure provides operational and tax flexibility.
Types of AIFs in India
SEBI classifies AIFs into three categories based on their investment strategy and economic impact.
Category I AIF – Startups and Social Impact Investments
These funds invest in sectors that promote economic development and social benefits. They often receive regulatory encouragement.
Includes:
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Venture Capital Funds (VCFs) – Invest in early-stage startups
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SME Funds – Support small and medium enterprises
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Social Venture Funds – Focus on businesses creating social/environmental impact
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Infrastructure Funds – Invest in roads, ports, power, railways, etc.
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Angel Funds – Pool money from angel investors for early-stage companies
Category II AIF – Private Equity and Debt Investments
These funds invest primarily in private equity and debt instruments. They do not use leverage except for operational purposes.
Includes:
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Private Equity Funds – Invest in unlisted growth companies
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Debt Funds – Invest in debt securities of companies
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Real Estate Funds – Invest in property projects
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Fund of Funds – Invest in other AIFs
Category II forms the largest portion of the AIF industry.
Category III AIF – High Risk and High Return Strategies
These funds use advanced strategies and are allowed to use leverage.
Includes:
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Hedge Funds – Long-short, arbitrage and derivative strategies
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PIPE Funds – Private Investment in Public Equity (buying stakes in listed companies)
These are suitable for investors comfortable with higher volatility.
Who Can Invest in AIFs?
Eligible Investors
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Resident Indians
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NRIs (subject to RBI/FEMA norms)
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Foreign investors (permitted routes)
Minimum Investment
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₹1 crore – Regular investors
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₹25 lakh – Angel Funds
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₹25 lakh – Employees/directors of AIF manager
Lock-in Period
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Category I & II – Usually close-ended (3–7 years)
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Category III – May be open-ended but often has exit conditions
Investor Limit
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Maximum 1,000 investors per scheme
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Angel Funds limited to 49 investors
Benefits of AIFs vs Mutual Funds
1. Greater Flexibility
AIFs can take higher single-stock exposure (up to 25%) compared to mutual funds (generally around 10%).
2. Access to Unlisted Opportunities
AIFs provide access to:
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Startups
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Pre-IPO companies
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Private equity deals
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Infrastructure and distressed assets
These are generally not available in mutual funds.
3. Co-Investment Opportunities
Investors may get an option to invest directly alongside the fund in certain deals.
4. Leverage (Category III)
Category III AIFs can use borrowing (up to 2x NAV), allowing strategies not permitted in mutual funds.
Disadvantages of AIFs
1. High Entry Requirement
Minimum investment of ₹1 crore restricts participation.
2. Illiquidity
Most AIFs are close-ended and cannot be redeemed before maturity.
3. Higher Fees
Typically include:
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Management Fee (1.5%–2.5%)
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Performance Fee (~20% of profits)
4. Tax Complexity
Tax treatment differs by category and income type.
5. Manager Selection Risk
Performance variation between top and average managers can be significant.
Taxation of AIFs in India (FY 2025–26)
Tax treatment depends on the category.
Category I & II AIFs – Pass-Through Status
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Income (except business income) taxed in investor’s hands
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Business income taxed at fund level
Category III AIFs – No Pass-Through
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Tax paid at fund level
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Investors receive post-tax returns
| Aspect | Category I & II AIF | Category III AIF |
|---|---|---|
| Pass-through Status | Yes (except business income) | No (fund pays tax directly) |
| Capital Gains | Taxed in investor’s hands | Taxed at fund level |
| Interest Income | As per investor slab | Up to ~42.7% at fund level |
| Dividend Income | As per investor slab | Taxed at fund level |
| Business Income | Taxed at fund level | Taxed at fund level |
| Investor Tax Liability | Investor pays tax directly | Receives post-tax returns |
Conclusion
Alternative Investment Funds provide exposure to unique and sophisticated investment opportunities beyond traditional mutual funds and equities. They are suitable for investors with substantial capital, long investment horizon and higher risk tolerance.
Understanding the fund category, lock-in structure, taxation and risks is essential before investing.
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